The Markets	03/31/07 Close	12/31/06 Close	1stQtr. Change	03/31/07 Close	12 Mo. Change	YTD Change
Dow	12354	12463	-0.09%	11109	+11.21%	-0.09%
NASDAQ	2422	2415	+0.30%	2340	+3.50%	+0.30%
S&P 500	1421	1415	+0.44%	1295	+9.73%	+0.42%
10-yr Treas. yield	4.65%	4.71%	-0.06%	4.85%	-0.20%	-0.06%
Fed funds rate	5.25%	5.25%	n/a	4.75%	+0.50%	n/a

(stock indices are before dividends; yield and rate changes are absolute changes)

Well, market watchers warned that the market’s run without a 2% decline could not continue, and sure enough, we got the long overdue decline. The market started the quarter hitting a series of new highs, topping out with a gain of 2.5%. On Feb. 27, following a precipitous 9% decline in Shanghai, the Dow was down over 3.2%, more than wiping out the year’s gain, and continued to drop, trading (but not closing) below 12,000. As more data on the economy came in supporting continued, if slower, growth, the market found its footing and recovered to end the quarter right abut where it started (and Shanghai returned to its highs). Still, the 12 month returns, particularly for large cap stocks, are very solid.

Economic data is inconsistent, leaving persuasive arguments for both bulls and bears (although there are very few roaring bulls; most seem content simply to offer counterpoints to the bears). Business investment has been the hope to pick up the slack from a tired consumer, but durable goods orders have been disappointing. Consumer confidence has been softening and energy prices and inflation show little signs of retreating. Productivity growth for the fourth quarter was only 1.6%, the same as the full year 2006 gain, trailing labor cost increases of 6.6% for the quarter and 3/2% for the year. The trade deficit remains huge, and for the first time in many years investment showed a negative figure, indicating that we are investing more overseas than foreigners are here. On the other hand, exports are at record highs, wage growth has been solid, unemployment is low and job growth is steady if not booming. Indeed, jobs and wages have been the pillars supporting the economy through the housing downturn. With bond yields stubbornly low, there remains plenty of liquidity in the economy as well.

If he had more, Fed Chairman Bernanke would surely be pulling his hair out. He has simply been unable to convince the market of whatever it is he is seeing in the economy. Interest rates began the quarter by going up, but the stock market decline spurred a “flight to quality” and forced rates back down. As the stock market recovered, so did interest rates, but the yield curve remains inverted. Bernanke emphasized in his latest congressional testimony that the risk of core inflation remains “uncomfortably high”, dashing renewed hopes that the Fed would cut short-term rates. To make matters worse, Bernanke’s comments continue to be overshadowed by those of former Fed Chairman Alan Greenspan, whose Feb. 26 warning of a likely recession due to continuing deficits (which was supposed to be off the record) contributed to the Feb. 27 market slide.

After fading as a top economic story and dropping precipitously to nearly $50 a barrel at the beginning of the quarter, oil prices bounced back up to over $66 just as the summer driving season is on the horizon. The capture of 15 British sailors by Iran, and Iran’s claim that they were in Iranian waters, has heightened concerns about supply disruptions from the Middle East. As is often the case, the price increase is driven by speculation rather than by actual reductions in supply, but the pain to consumers is real nonetheless. Despite their bluster, Iran simply cannot afford to cut off oil supplies, and ironically they import gasoline and finished petroleum products, so they are squeezed on both ends. Look for oil to settle back under $60 but not to sink much further.

Looking Forward

The real estate market moves to the fore with the emergence of the subprime “crisis”.
There is plenty of data, such as the number of loans with interest rates that will increase in the next year, to support a spreading meltdown, while other data argue that the loans in jeopardy are a manageable minority of the overall mortgage market and economy. The optimistic position relies heavily on stabilizing home prices, moderating inventories of homes for sale (of course, many sellers have just given up) and the possibility that borrowers with adjustable rate mortgages can refinance to a fixed rate loan. The doomsayers counter that it is simply common sense that foreclosures will increase, strapped homeowners will be unable to sell their houses in a soft market and the glut of foreclosed houses will lower all prices. If the housing market can weather the next six months with only minor decline, it should be able to survive the entire storm.

The next great bust will likely be in corporate debt. The long period of lenders and investors willing to take on ever greater risk for ever lower returns cannot go on much longer. Private equity firms are getting such favorable terms on their loans that a new term has been coined, “covenant lite”, which means that the borrower no longer has to meet the financial criteria and performance as in the past. As sure as the borrowing binge gained momentum, a few high-profile blow-ups will send it down just as fast. Stick with pure-vanilla, investment grade debt.

Our Portfolios

In light of the above, we will once again review all our positions to make sure the exposure is consistent with each client’s goals. Likewise, even though emerging markets have recovered from the recent decline, it is an area to view with concern. (We typically look upon technical analysis with disdain, but it doesn’t hurt to consider all points of view. Emerging markets appear to be forming a “head and shoulders” pattern which would predict another short-term decline, a partial recovery, and then a larger, longer-term decline.)

In the last review we were content with maintaining a slight overweight position in stocks. At this point we are more seriously considering a return to a “neutral” weighting for stocks. The risk of a slowdown in the economy has increased and there is a distinct possibility that a Democratic administration will contribute to a slowdown. On the other hand, inflation is not totally dead, though wounded, and stocks will outperform bonds if inflation strengthens.

Home Is Where the Mess Is

Many opinions have been offered on the impact of the recent difficulties in subprime mortgage lending, with some believing it will cause the sky to fall and others pointing out that these mortgages are but a small part of mortgage debt and will prove to be merely a bump in the road. We think the truth is somewhere in the middle, as tightened lending standards for entry-level homebuyers will surely have a ripple effect on move-up buyers and the overall housing market. The worst part of the situation is the over hyped media coverage and the obligatory Congressional hearings where lenders are the bad guys, borrowers are the helpless victims and nothing actually gets done.

So, in our idealistic (some may say naïve) opinion, here is how the various major players would fare after the dust has settled.

• Investors – Investors should, by definition, be better qualified to assess the risks associated with an investment or loan. So, except for the existing recourse against brokers for suitability of investments (if mortgage securities were sold) and against borrowers for fraud, investors should take the hit and hopefully learn a lesson. We doubt they will.
• Wall Street – As much as it galls the average person, this is another situation where Wall Street as a whole will profit from both the boom and the bust, although some players will indeed get hurt. There are already reports that the “smart money” is buying, rather than selling, mortgage and lending-related securities. Still, there is little reason to demand or expect that the rules will change, and Wall Street will simply move on the next wave.
• Mortgage lenders – To the extent that lenders made foolish loans, they should bear the full consequences, including buying back from investors packaged loans that did not meet the advertised criteria. If some lenders go under, the market will naturally tighten, helping fix loose lending practices without undue regulation.
• Mortgage brokers – These small businesspeople are simply the go-between for lenders who offer lending products and set lending guidelines and consumers who demand loans and who may not be able to own a home otherwise.  Puh-lease. If these brokers are not capable of looking beyond their commissions to the financial damage aggressive loans can cause, they have no business in lending. Even a bartender is not supposed to serve a drunk another drink. While not perfect, the securities industry at least has self-regulatory mechanisms that enforce a standard of suitability for investors. If the mortgage industry is not willing to do more to police itself, the regulators will do it for them.
• Borrowers – As harsh as it seems, there are plenty of borrowers, such as those who took all the equity out of their home or who took out “liar loans” with no proof of income or ability to repay, who should not get relief from unwieldy loans. If lending guidelines tighten due to new regulations or just better lending practices and homebuyers find it more difficult to borrow, that could be a good thing. Home ownership is a wonderful thing and an admirable goal, but it should not be swept up in our instant gratification culture. Sometimes you just have to work longer and harder to reach a goal.
• Regulators – Politicians are remarkably consistent at overreacting and overcompensating for crises, and this one promises to be more of the same. The market is still the best referee and punisher of bad business practices, and hopefully the market will still be allowed to work. There is certainly some room for improved lending guidelines, but regulations should not become so stringent that fully informed borrowers are unable to obtain loans, even if at higher rates. Still, we would like to see three changes. First, lending guidelines should consider the likely interest rate over the initial five and ten years of a loan rather than simply the initial rate. Second, a new simple disclosure document should be created that compares a borrower’s old loan to the new loan, again over a five and ten year period, so the borrower can clearly see the risk of the new loan. Third, for loans made in excess of appraised value, lenders’ recourse should be limited to the greater of the appraised value or the property itself.

For a final consideration, the state of Ohio is issuing $100 million of taxable bonds to bail out homeowners by refinancing subprime adjustable rate loans with fixed rate loans. The fixed rate will be 6.75%, which is more than the state’s borrowing costs, and homeowners can refinance their entire mortgage balance even if it exceeds the house’s value. The state will evaluate credit problems over the past 12 months but will not take on chronic credit problems. If house prices moderate and borrowers pay back the loans, borrowers, lenders and politicians all win. If house prices decline or stay flat, or if borrowers default, taxpayers will have to pick up the slack. Several other states are considering similar programs. Is this an appropriate solution, and is this how the borrowing power of the government should be used?