First Quarter Investment Commentary 2008

The first quarter of 2008 provided ample financial headlines: the S&P 500’s worst quarter in five years, inflation percolating with oil topping $110 per barrel and gold topping $1,000 per oz., the US dollar falling to record lows, large investments in our financial institutions from Sovereign Wealth Funds, mortgage delinquencies and foreclosure rates soaring, the un-employment rate on the rise, consumer sentiment at the lowest level in over twenty-five years, the Federal Reserve providing aggressive interest rate cuts and intervening in new ways to help shore up the credit markets, and the end of the line for the storied life of Bear Stearns are just a few of the attention grabbers that come to mind.

FOMC Cuts Fed Funds Rate Aggressively

In a surprise move, which has been freely termed an “Emergency Cut”, the Federal Open Market Committee reduced the Fed Funds Rate by ¾% on Tuesday January 22nd. The FOMC then held a regularly scheduled meeting on January 30th where they cut the rate another ½%. These two moves were followed by a ¾% cut at the March 18th meeting. During the first quarter of 2008, the Federal Reserve has aggressively cut the Fed Funds rate by a total of two percentage points, from 4.25% to 2.25%. Currently the futures markets show an implied probability that the FOMC will cut the Fed Funds rate by yet another 1/4% when they meet next week on April 30th.

Meanwhile, bending under the pressures of global price inflation, the other end of the yield curve finds the long rates are just now starting to trend upward. The threat of runaway inflation is only being stoked by these lower short-term rates. While there is certainly a growth in the demand for commodities worldwide, lower borrowing rates have given speculators additional ammunition to shoot the commodities prices higher.

New Tools for Liquidity

A pernicious spiral emerged in the first quarter as declining values on fixed income securities caused financial institutions, who are required to mark their assets to market prices, were being forced to sell the same securities in order to bolster apparently weakened capital positions. The selling begets selling and valuations began to slide down even farther, producing a selling loop. That loop in turn weakened confidence and spurred the Federal Reserve to take some innovative measures.

In December, the Federal Reserve established the so-called Term Auction Facility (TAF) whereby it would loan funds to banks in exchange for a wide variety of collateral which it had previously chosen not to accept, including mortgage debt issued by Fannie Mae and Freddie Mac. Then in March, the Fed increased the size of its planned TAF auctions from $60 billion to $100 billion.

On March 11th, the Federal Reserve came forward with an additional plan, referred to as the Term Securities Lending Facility (TSLF). The loans in this program are to be made to the 20 banks and securities firms known as “primary dealers”, those who can trade treasuries directly with the Federal Reserve. These loans will allow the primary dealer firms to pledge agency and private mortgage debt as collateral against as much as $200 billion in treasuries. Borrowing at the weekly TSLF auctions began on March 27th and are being made for 28 day periods. According to the Federal Reserve Bank of New York, the borrowing averaged $32.6 billion last week.

In addition to the TAF and TSLF, the Federal Reserve further expanded its role in the arrangement of a buy-out of Bear Stearns by JPMorgan. As part of the JPMorgan buy-out, the Fed has set up a new company to manage and sell some $30 billion of Bear Stearns assets and has hired BlackRock to manage those liquidations. It has also provided a loan to JPMorgan at a rate of 2.5% (the current rate charged to banks at the discount window) and a term of 10 years to fund the purchase of $30 billion of Bear Stearns assets. The structure of the new company resembles that of the Resolution Trust Corp., created in 1989 to dispose of the assets of insolvent savings and loans.

While all of these new arrangements have done wonders to add liquidity, and more importantly confidence, back into our financial framework, at the end of the day a troubled mortgage is still a troubled mortgage regardless of who is holding the note. Stability being re-established in the marketplace, the worry of bad loans going into default or being foreclosed on still exists. The Federal Reserve is now holding the questionable collateral, which theoretically they can put back to the borrower. One year ago, Treasury securities accounted for 92% of the Fed’s assets. Now it is down to 65%.

Home Foreclosure Filings Headed Higher

In the twelve month period that ended March 31st, home foreclosure filings surged 57% and bank repossessions jumped 129% according to data produced by RealtyTrac. Their data suggests that the peak of foreclosures has yet to be reached. From Rick Sharga, vice-president of marketing at RealtyTrac, “We’re going to see quite possibly a record amount of foreclosure activity in the third or fourth quarter,” attributable to sharp payment increases on adjustable rate subprime mortgages in May and June.

The RealtyTrac data show that one in every 538 single family dwellings (which includes condominiums) received a foreclosure filing in March. Those filings would include initial default notices, notices of a scheduled auction and filings of repossession. While default notices and repossessions soared in March, auction notices did not rise as significantly. “More defaulting homeowners are simply walking away and deeding their properties back to the foreclosing lender. This deed-in-lieu-of-foreclosure process allows the lender to take possession of a property without putting it up for public foreclosure auction,” said James Saccacio, CEO of RealtyTrac.

Here are some of the specifics from their data: At the top of the list, for the 15th straight month, is Nevada where one in every 139 households received a foreclosure filing. In March, 7,659 properties received some form of foreclosure filing, representing a 62% jump from March of 2007. California had the second highest rate of foreclosure filings with one in every 204 households and Florida finished the top three where the statistic was one in every 282 households. The absolute number of foreclosure filings in California was 64,711, which is up almost 106% from March of 2007. In Florida, the total number of notices was 30,254, representing a 112% increase over March of 2007.

Old Point Trust Equity Model Performance

Despite the turbulent swings of stock prices in the first quarter, the markets are showing some resiliency and resolve. We remain over-weighted to Energy stocks and under-weighted to Financials. The following numbers show the actual performance of a composite of 40 fully discretionary accounts managed by Old Point Trust worth approximately $60 million. Data is through March 31st, 2008:

Unemployment Trending Higher

The most recent reading of unemployment came in at 5.1% for March. This was the third consecutive month that the unemployment rate has risen. Economist’s forecasts call for these numbers to continue to climb over the next several quarters.

The Forgotten Man

Recently I finished reading a most insightful book entitled The Forgotten Man by Amity Shlaes. In it she chronicles the history of the Great Depression. With fresh insight on a not too distant past, Shlaes relates the compounding effects of higher taxes in the midst of an economic slowdown. She tells of the “Undistributed Profits Tax” devised by FDR to keep companies from holding their cash. I highly recommend this book to everyone, especially anyone under the age of 75.

I suspect that in the years to come we will hear many analogies between our current situation and the days of the New Deal. Some politicians are already professing to offer the “New New Deal” with promises of Change. For instance, I recently heard two candidates propose a new windfall profits tax plan for oil companies. While this may sound good to folks who are tired of paying $3.50 for a gallon of gasoline, it will ultimately have the effect of reducing exploration and production and will lead to even higher oil prices as a result of diminished supply. This in turn will lead to higher gas prices. And don’t get me started on the $150 billion “Fiscal Stimulus Package”. Have we learned anything from our past or are we just taking a nap on the railroad tracks dreaming of a chicken in every pot? A car in every garage? A house for every family?

Happy Birthday!

Edna Parker, who was recently recognized as the oldest person alive, turns 115 years old today. According to the Gerontology Research Group, there are only 75 people who are 110 or older. Apparently, 64 of those are women and only 11 are men. When asked why his grandmother had lived so long, Edna’s 59 year old grandson Don said, “We don’t know why she’s lived so long but she’s never been a worrier and she’s always been a thin person, so maybe that has something to do with it.” Whatever it was, I’d like to wish Edna a very happy birthday!

Something New

The 111 year old Dow Jones Industrial Index had an update on February 19th. New to the list of the 30 component stocks were Chevron (CHV) and Bank of America (BAC). Leaving the list were Honeywell (HON) and Altria (MO).

Household Deficits

Households have been spending more than their after-tax incomes for nearly seven years, since 2001. The most obvious way to accomplish this is to borrow money. It can also be done by selling assets and through mortgage equity withdrawal. Prior to 1999, there were only six years where households ran deficits, going back to 1929.

Those years were 1932, 1933, 1947, 1949, 1950 and 1955. Household deficit spending during the Great Depression would be understandable. Folks were trying just to survive. In the late 40’s and early 50’s a tremendous amount of spending occurred to satisfy purchases that had been delayed during the World War II years, when most of the GDP was tied up in the war effort. Households had built huge surpluses from 1940 to 1946 and so they had a cushion of dollars to spend in ’47, ’49 and ‘50.

From 1956 to 1998, households consistently ran surpluses. That could account for some of the funding for these current record deficits. Another source of funds for this spending has been mortgage equity withdrawals, where people have refinanced and converted accumulated equity into cash or more simply borrowed against their home equity. During each of the years from 2001 to 2007, this mortgage equity withdrawal has amounted to more than 3% of a household’s disposable income. In 2005, at the height of the real estate bubble, it amounted to 5.4% of disposable personal income. Going forward, very little money will be available from mortgage equity withdrawals.

We will be keeping a close watch on the default rates of credit card and car loans.

CONCLUSION

With all of the bad news we have had on the plate in front of us, it is not surprising that some clients are nervous about the economy’s near-term prospects. I too have some concerns. Negative housing wealth trends, the tightening of lending standards by lending institutions despite a massive wave of liquidity and most importantly the corrosive effect of higher food and energy prices on the consumer’s ability to spend are just a few. However, I don’t think we are living through the second coming of the Hoover Administration. Perhaps a little perspective would be useful.

First, at the end of the first quarter, the S&P 500 was only down 12% from its all-time high of early last October. Since then, it is up more than 5% in the month of April. During the Great Depression, the Dow Jones Industrial Average dropped more than 80% from its high.

Secondly, while we are seeing an unemployment rate that is trending higher (it’s now at 5.1%) unemployment in 1982 and 1983 was over 10%. During the Great Depression it was over 20% for almost the entire first half of the 1930s. Our employment marketplace is in search of talent and with the swelling ranks of retiring baby boomers, I expect that search will only intensify and will keep a lid on runaway unemployment.

Thirdly, while the Federal Reserve has resorted to the greatest expansion of lending authority since the 1930’s, and has helped to arrange the “take over and out” of the country’s fifth largest investment banking firm in Bear Stearns, financial crisises will continue to occur with variable frequency. Remember that in 1998 we saw the unwinding of the Long Term Capital Management hedge fund with the gentle hand of Federal influence (a deal to which, I will add in an ironic twist of fate, Bear Stearns refused to participate). While certainly high profile, today’s news is far from dire.

Meanwhile, we here at Old Point Trust will continue to shepherd the resources that have been entrusted to us in a thoughtful and conservative manner.

PS – Don’t Kill the Messenger

One last note, the cost of mailing a letter will go up by 1 cent to 42 cents on May 12th.

McKim Williams, Jr. Chief
Investment Officer
April 20th, 2008

_{The opinions contained herein are those of McKim Williams, Jr. as of the date of publication and are subject to change without notice. The contents have been compiled or derived from sources believed reliable, including Bloomberg Professional. Old Point Trust makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Old Point Trust, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein.}