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:
|
12 mo |
3 YR ave. |
5 YR ave. |
| US Equity Performance |
5.3% |
9.9% |
12.5% |
| S&P 500 |
(5.1%) |
5.8% |
11.3% |
| Difference |
10.4% |
4.1% |
1.2% |
| Total Accounts |
5.4% |
7.9% |
8.9% |
| Blended Benchmarks |
(0.3%)
|
5.7%
|
8.3%
|
| Difference
|
5.7% |
2.2% |
0.6%
|
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.
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