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Integrity
Performance Service
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Many of the same liquidity problems that seized up bank lending in the United States have also infected banks in other industrialized nations as well. Along with the loss of economic magnetism from a booming U.S. economy, Euro countries are belatedly showing signs of a significant slow down. Without the flexibility and natural recuperative powers of the United States the economies of the Euro area will take longer and be slower to recover. Over the course of the last half of 2007 and this year, the Federal Reserve has become increasingly aggressive in its actions both on interest rates and providing liquidity to lending institutions. Since September 2007 the cumulative reduction in the Federal Funds Rate, the rate banks charge one another for overnight loans, has been 3.25%, one of the most rapid and steepest declines on record. Other actions by the Federal Reserve became progressively more targeted, beginning in August 2007 with the first of several reductions in the so-called "penalty rate" at the discount window, to its latest effort in March when the Federal Reserve introduced its Primary Dealer Credit Facility. The Federal Reserve has taken far reaching and creative steps to instill confidence in a thoroughly demoralized financial infrastructure. For the first time the new facility allowed all primary dealers access to the discount window on the same terms as commercial banks, assuming all criteria regarding collateral are met. Extending Federal Reserve credit directly to primary dealers is a very significant step, virtually guaranteeing that investment banks will not be allowed to fail due to an unavailability of credit. Overall, the U.S. policy response including the tax rebate has been significant and has not been felt yet. It is broadly recognized that this year will be one of sub par growth.There is no reason to expect that the economic news will suddenly show a dramatic near-term reversal.We disagree with the more apocryphal outcomes arising from some quarters. Beneath the dramatic headlines the raw material for a new equilibrium is beginning to emerge which will result in a more confident attitude toward our economic circumstances. Actions by the Federal Reserve have dramatically increased the liquidity pool of financial institutions.We are witnessing a normalization of credit spreads and risk appetites in the bond market, a necessary precursor to a smooth functioning short term credit environment. While there may still be a reluctance in some quarters to make loans, the new equilibrium emerging in the credit markets will eventually restore confidence and provide a sound platform for meeting future credit needs. Transparency is replacing subterfuge in the credit markets. The weakest proposed bond offerings have already been withdrawn. Some financial institutions are still faced with the need to raise additional capital, dividends in certain cases will be reduced or eliminated, and some hedge funds will collapse. Write downs and charge offs are rapidly coming to an end. The likelihood of confidence shattering additional bankruptcies of financial institutions is fading. We are not so naive to assume that the deep problems initiated by the subprime crisis and revelations of unsavory lending practices will easily disappear. Upsetting news and exaggerated commentaries are still in vogue and the healing process will be slow. Headlines do not create history however. The worst of the credit crisis is behind. With its passing the Federal Reserve can turn its attention to the maintenance of price stability. In large part the dramatic decline of the dollar has resulted in soaring commodity prices, a relentless rise in the price of oil, higher import prices for manufactured goods and a general increase in inflation expectations. Monetary history is replete with examples that there can be no non-inflationary growth or prosperity when a currency is allowed to be debased. The Federal Reserve is well aware of the potential collateral damage inflicted by its aggressive policies.With the latest small reduction in the Federal Funds Rate the central bank is indicating that its interest rate retreat is coming to an end. If so, in time the dollar should stabilize and oil prices decline. A "buy now because prices will be higher tomorrow" attitude will not take hold with consumers. Over the next several years economic progress will be slow as the process of healing and recovery will take time. Real estate prices will remain pressured, but demographics and interest rates favor housing. The rate of price declines will gradually recede especially for residential homes. As inflation succumbs to a slower economic advance the dollar will stabilize and improve. Most importantly a healthy skepticism and a realistic estimation of risk is replacing greed and secrecy as drivers of financial institution behavior. Interest rates will trend up modestly as activity improves but will remain calm. Absent radical changes in trade and tax policy the new equilibrium, low interest rates and less threatening financial backdrop point to a healthy stock market environment.The future is bright for the patient, disciplined investor. Alfred A. Lagan, Chairman May 5, 2008
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