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CFM Client Presentation
October 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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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
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Assessment of Downturn
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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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Assessment of Downturn
 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
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Bought houses they could not afford
Excess consumer debt – since 1980s consumer spent more
than they earned
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Assessment of Downturn
 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 offbalance 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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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
 Beginning of the end
 Value of subprime pools continues to
erode forcing recapitalization or
bankruptcy by major entities
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Fannie and Freddie
Lehman
Washington Mutual
AIG, etc.
 Fed & Treasury selective - entities saved,
not saved
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Assessment of Downturn
 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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Assessment of Downturn
 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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Assessment of Downturn
 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
 $10.6 Trillion
 $ 1.3 Trillion
 11.92% of Total
 Troubled Alt A &
Subprime
 $ 224.5 Billion
 17.76% of Alt A & Sub
 2.21% of Total Mortgages
 National Debt
 GDP
 Bailout
 $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?
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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
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Earnings Outlook
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S&P 500 Valuation
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Valuation
Assumptions
 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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Outlook
Positives
 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 During
Downturn
 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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Managing During
Downturn
 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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Managing During
Downturn
 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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Managing During
Downturn
 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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Managing During
Downturn
 Is it different this time?
 http://www.dimensional.com/library/
videos/different/
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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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