CFM Client Presentation October 15, 2008 Assessment of Economic and Market Down Turn, Outlook and...

CFM Client PresentationOctober 15, 2008

Assessment of Economic and Market Down Turn, Outlook and

Investment Strategy

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Assessment of Downturn

In the beginning. . . Years 2000 to 2003

Stock market bubble 9-11 Earnings scandal – Enron & others All led to Fed keeping interest rates too

low for too long Consumer, corporate and government

debt grew

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Housing Bubble Long period of abnormally low interest rates Politicians push for non-qualified loans via

Fannie Mae and Freddie Mac (Democrats – we will blame Republicans later)

Wall Street learns how to securitize (sell) subprime mortgage pools Maturity tranches (slice of pool) Credit quality tranches Theory – approach spreads the risk

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Continued Bond rating agencies (Moody, S&P, Finch)

give pools high rating Even though they don’t understand

complexity of pools Paid big fees to approve Congress appoints rating agencies Many issues the same as Enron

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Continued Pools sliced and diced and sold throughout

US and Europe Large up-front fees for investment bankers Mortgage brokers made large commissions

on non-qualified borrowers

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By The Way

CFM has never invested in subprime mortgage pools

PIMCO Mortgage Backed Securities Fund High quality, qualified mortgages issued

by Fannie & Freddie Backed by US Gov’t and collateral in houses Fannie & Freddie’s problems are with their

stock and subprime mortgages they own

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Resulted in unhealthy leverage (debt levels) throughout financial structure Commercial banks bought subprime pools

and were levered 10 to 1 Investment banks levered pools 40 to 1 Fannie and Freddie purchased pools using

significant debt (Fannie & Freddie hold 50% of all household mortgages)

Households Bought houses they could not afford Excess consumer debt – since 1980s consumer spent more

than they earned

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Leverage in system was not transparent - previous checks and balances missing from financial systems (Republicans) SEC and CPAs (FASB) allowed off-balance sheet

accounting Investment banks financed pools with CCP off-

balance sheet (footnote disclosure only) Rating agencies gave high ratings to investment

bank bonds and pools even with 40 to 1 contingent liability that showed up in footnotes

Investment bankers had no equity at risk & structurally flawed deals received upfront fees

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Economist and CFM conclusions one year ago without transparency of excess leverage Housing slow down was insufficient

contributor to GDP – would slow economy but not create recession

Subprime and alternative mortgages Approximately 4.5% of total mortgages Insufficient to create recession

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Beginning of the end Investment banks and others financed their

pools using short term commercial paper collateralized by pools (CCP)

One year ago spread between pools and CCP narrowed and then turned negative (Fed began raising rates in 2004)

Non-qualified lending stopped and housing values turned south – homeowners had no “skin” in the game and walked

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Beginning of the end 2008 Fed again lowers rates dramatically

Europe does not lower rates so dollar weakens further – down 30% over three years

Commodity prices surge Weak dollar Emerging markets (China and India) increased

consumption Result - consumer and corporations stressed

because of too much debt

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Beginning of the end Banks, Investment Banks, Fannie and

Freddie particularly stressed by too much debt

Housing values, foreclosures, etc. weigh on value of subprime pools Complexity and locating toxic portions of

pools make valuation impossible Mark to Market accounting forces huge

write downs – values indeterminable

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Beginning of the end Asset to debt ratios worsened because of

valuation issues Theory of spreading risk via pools proved

incorrect – risk in pools indeterminable (poison particles in the soup – throw it all out)

Banks, Investment Banks quit accepting each others’ CCP Collateralized by the pools Liquidity crises begins

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Beginning of the end Bear Sterns first to bankrupt

Asset to debt ratio (30 to 1) became insurmountable

No source of even short-term funds because of liquidity crisis

That’s when the public got first glimpse of the huge amounts of off balance sheet debt, greed and mismanagement

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Beginning of the end Value of subprime pools continues to

erode forcing recapitalization or bankruptcy by major entities Fannie and Freddie Lehman Washington Mutual AIG, etc.

Fed & Treasury selective - entities saved, not saved

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Culmination Fed & Treasury allowing Lehman to fail sent

shock waves through international markets (A3 rating day before bankruptcy)

Credit markets totally locked up Slowness of Congress to act and slow

implementation of ill-defined plan worsened situation – move from asset purchase only to include capital injection

Became a crisis of confidence (modern day equivalent of a run on the bank)

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Culmination Irrational and rational fear spreads

throughout world markets If banks and other financial institutions

continue to fail, wide spread unemployment will drive world economies to 1930s era depression

What’s different than in the 1930s? Significant government intervention – world

governments working in coordination will not allow banks and key financial institutions to fail

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Culmination What’s the same as in the 1930s?

Excessive debt (leverage) at all levels caused the crisis

Housing and subprime loans were the “straw that broke the camels back”

It is still estimated that there are only $225 billion in toxic mortgages (poison pills in the soup) spread among the subprime pools

Contrast that to the $700 billion bailout package – the difference in part is the recapitalization or deleverage process

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Current Data Total Mortgages Total Alt A & Subprime

Troubled Alt A & Subprime

National Debt GDP Bailout

$10.6 Trillion $ 1.3 Trillion 11.92% of Total

$ 224.5 Billion 17.76% of Alt A & Sub 2.21% of Total Mortgages

$10.2 Trillion $14 Trillion $ 700 Billion – 5% GDP &

7% National Debt

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Current Data

Coordinated world wide government intervention Acquisition of troubled debt to be restructured and sold

when markets stabilize Acquisition of commercial paper Lender of first and last resort Direct temporary capital injections – preferred stock,

warrants, etc. – US government moved strongly towards this approach last weekend

Coordinated rate cutes (avoid currencies issues) Deposit guarantees Etc.

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Current Data

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Consumer Debt

From 80% - 130% in 20 years

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Consumer Carrying Cost

Consumers maxed out?

Current Data

Too much debt As a nation As individual consumers Corporations – particularly financial

sector

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Current Data The painful process of deleveraging is

occurring right now Recapitalization and mergers of corporations

Financial sector Domestic auto – 30 years of non-competitive labor

structure Government and foreign money will provide much of

the capital

Too much government debt? - Keynesian vs. Freidman Economics

Slower consumer spending

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GDP Historical

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GDP Forecast

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Unemployment

Earnings Outlook

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S&P 500 Valuation

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ValuationAssumptions Forward Earnings $87 2009 GDP .05%

Forward Earnings $80 2009 GDP -1.0%

Over (Under) S&P 500 Undervalued

(7%)

S&P 500 Overvalued 18%

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OutlookPositives International gov.

intervention will not allow 1930s style depression

Interest rates low Still econ resilience –

exports Energy prices down Globalization

Negatives Huge hangover

Deleveraging Slowing consumer

Auto industry restructure

Government Spending – Medicare,

Medicaid, SS, etc. Nationalization –

temporary?

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Outlook

Looking for a stock market bottom Credit and liquidity crisis will most likely

subside over next several months Probability of recession contributed to

credit and liquidity crisis – now recession is a certainty

Automotive sector challenges may culminate soon adding to stock market challenges

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Outlook

Looking for a stock market bottom Markets generally do not turn positive in

first quarter of recession which will be 4Q 2008

Stock markets do anticipate – so perhaps beginnings of recovery by mid 2009 IF GDP turns positive

There is significant liquidity waiting to enter the market – may be some tactical (near-term) snapback

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Outlook

Looking for a stock market bottom Unemployment needs to peak at 8% or

less (lagging indicator) The challenges are significant and

fundamentals indicate that it will take 3 to 5 years for stock markets to return to the 2007 valuations

With credit crisis subsiding stock markets should become more stable – volatility with reasonable trading ranges

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Managing During Downturn

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Managing risk Broad asset allocation: stock – bond most

important Time

The beauty of bonds Hold value much better in downturn Stabilize portfolio Source of distributions – 3 to 5 years minimum Allow time for stocks to recover


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CFM Investment Policy (Prudent and Fiduciary Investment Standards) Strategic (stock-bond) allocation – 90%

of policy Tactical (sectors, regions, cap

weightings, etc.) allocation – 10% of policy


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Appropriate strategic allocation (determined prior to downturn) Based on goals: time-line and distribution rate

for each portfolio Lessens emotional impact – distributions covered

3 to 5 years Highest probability of successful investing

When investing becomes speculating Timing – there are no consistent methods to

predict the future Emotions


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If your emotions are winning Set an appointment with Gary or Josh ASAP

Re-assess your cash needs for next 3 to 5 years Compare to cash and bond holdings Determine if partial move to more cash and

bonds is necessary To cover cash needs 3 to 5 years To allow you more emotional piece of mind

We do understand the emotional aspects and want to give you all necessary information to make good decisions

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Fixed Income Biggest CFM disappointment is the

volatility in certain fixed income investments and investment in Lehman

Majority of our remaining bonds of high quality, but we do have exposure in companies in headlines:

GMAC, Ford, American General Finance (AIG) and Morgan Stanley

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Fixed Income CFM is waiting for credit markets to

improve and bailout/investments to help some companies before reducing or eliminating exposure to these troubled companies

Plenty of sellers, not buyers Other bond exposure is to the “good” banks

and to non financial entities Mutual Funds utilized have diversification

and high credit quality


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Is it different this time? http://www.dimensional.com/library/vi

deos/different/

Healthy Changes Bank reserve requirements will increase No more Investment Banks with 40 to 1 leverage

– they’re gone! Fannie and Freddie will be totally restructured Higher borrowing standards (qualify to get a

loan!!) Bigger mortgage down payments Lower credit card limits Transparent and simpler debt structure Move to on balance sheet accounting

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Healthy Changes Greater scrutiny of executive compensation More oversight of markets & players

Monitor short selling Viable credit ratings

International coordination of financial systems Higher long term interest rates – steepen yield

curve Higher taxes and/or bigger deficit More government

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Thank you

Thanks for – Your business Your trust and confidence

We will strive to constantly earn it Your financial security is our reward too

Questions

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CFM Client Presentation October 15, 2008 Assessment of Economic and Market Down Turn, Outlook and...

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