The Markets	09/30/08      Close	06/30/08    Close	3rdQtr. Change	09/30/07 Close	12 Mo. Change	YTD       Change
Dow	10,851	11,350	-4.40%	13896	-21.91%	-18.41%
NASDAQ	2,082	2,293	-9.20%	2701	-22.92%	-21.61%
S&P 500	1,166	1,280	-8.91%	1527	-23.64%	-20.84%
10-yr Treas. yield	3.83%	3.98%	-0.15%	4.58%	-0.75%	-0.21%
Fed funds rate	2.00%	2.00%	n/a	4.75%	-2.75%	-2.25%

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

The markets did not limp, did not crawl, but barely dragged themselves through the end of the quarter. Indeed, the Dow suffered its largest one-day point drop ever on September 29, plunging 777 points on the crushing defeat of the credit bailout package in the House. Even a solid recovery the next day to close the quarter could not soothe the pain, as concerns about the markets intensified. As painful as the drop in the Dow was, both the NASDAQ and the broader S&P 500 fell further, and the twelve month drops for all three measures were in the range of 20%. Small consolation that a year ago was near the market top.

The list of major companies that have ceased to independently exist makes the head spin. The failure of IndyMac Bank, taken over by the FDIC, was exceeded by the demise of Washington Mutual, the largest bank failure ever, which was absorbed by JP Morgan Chase. The government seized Freddie Mac and Fannie Mae, Merrill Lynch was forced into the arms of an acquisition by Bank of America, Lehman Brothers went bankrupt as the government declined to intervene, Wachovia was taken over by Citigroup and AIG required a government loan of $85 billion to remain solvent.

The government has used a wide array of tools to address the credit crisis, recognizing that the drying up of credit affects the entire economy and every player in it. They have made secured loans, guaranteed loans, brokered takeovers, directly taken over companies, injected hundreds of billions of dollars into the monetary system and guaranteed securities. (Government intervention is not restricted to the US, as European governments were also very active in using many of the same tools.) Still, the piecemeal approach did not restore confidence, and at quarter’s end a comprehensive financial system bailout package was defeated by the House, shocking the market. Congress assured the public that some comprehensive measure would be passed, but with every passing day economic data supports that the problems are rippling through the economy.

Jobless claims rose steadily through the quarter, and the unemployment rate rose to 6.1%. Several hurricanes did not help the employment picture, and initial jobless claims hit 7-year highs. Oil bounced around the $100 mark, down 30% from the beginning of the quarter, and the dollar staged a short-term recovery of around 10% to the euro and advanced against other major currencies. Housing sales and prices continued to decline and certainly will not stabilize until the credit crunch is relieved; new home sales are at the lowest level since 1991. Consumers pulled back on spending, factory activity weakened, and inflation concerns took a back seat, allowing the Fed to leave rates unchanged. To add insult to injury, second quarter growth was revised downward to 2.8% from the original 3.3%.

Another shock was that a major money market fund, typically seen as a safe haven, “broke the buck” by lowering its share price below $1.00 because of a large holding of Lehman Brothers commercial paper and large redemptions by shareholders. That was followed by an emergency government plan to guarantee money market funds to prevent further panic. Announcement from money market funds that they do not own securities issued by high-profile struggling companies became routine. By default, most funds are now heavily invested in Treasury securities as the commercial paper market dries up like so many others.

Looking Forward

The immediate focus, of course, is whether Congress can come to agreement on some relief package for the credit markets. The final package will likely be more comprehensive and complex (and more expensive) than the original proposal, with add-ons to appease both liberal and conservative objections. This makes sense only by Washington standards; the original proposal, while arguably far from perfect, could well have done the job.

The short term test of the relief effort will be whether it succeeds in calming the credit markets and allows reasonable lending to resume. Borrowing will not be as cheap or as easy as before, even for strong borrowers, but routine lines of credit and worthy capital projects should be funded.

The intermediate term test will be the extent to which the contraction in the financial sector, the hopefully temporary credit freeze and the new, tougher credit environment bogs down the rest of the economy. The economy is already dealing with higher energy prices, slowing consumer sending, rising unemployment and rapidly softening growth in foreign economies. It is hard to imagine that simply restoring confidence in the credit markets will be enough to overcome all that headwind.

Only a considerable amount of time will tell how the government (and all of us as taxpayers) fares from all these actions. There is a great cry for more regulation, and it is obvious that it is needed in the short run. Eventually the government could unwind all its ownership positions and either recoup some if its investment or even profit. Or it could solidify close ties and heavy regulation and perpetuate its involvement in matters of credit, even becoming a direct lender in more areas. I hope for the former, as the latter would simply replay the experience of well-intentioned actions run wild (entitlement programs, anyone?) The market may be flawed in many ways, but in comparison to government administration it is the lesser of two evils.

Our Portfolios

Even well-balanced portfolios, as we consider ours to be, suffer in this environment. The real challenge is that there is literally almost no place to hide. One of the few positive areas has been gold, and to rush into a large gold position is flirting with disaster, as gold is notoriously volatile and can turn on a dime. Our precious metals exposure is primarily through a broadly diversified commodity fund, and it has suffered from the decline in oil prices.

Another disappointment has been the decline in our usually reliable defensive short bond positions. While such a decline would be expected if interest rates were rising, this decline has been due to the frantic flight to quality, leaving only Treasury securities as an acceptable option. We do expect these bond funds, which are still of high quality, to recover with the passage of relief legislation, but it could take a while for the market to return to some rational behavior.

Still, there are some reasons to take heart. Our portfolios are typically underweighted in international stocks, which have suffered from the stabilization of the dollar and slowing foreign growth. For those portfolios with a position in a long/short fund, it has provided a small bright spot. And in a sign of just how difficult these times are, our money market funds did not break the buck. Woo-hoo!

This is, again, a time when an investor must ask himself precisely what the goal is. If the goal is to avoid all loss, then cash investments in various forms are the only answer. If, however, the goal is longer term and includes some opportunity for growth, then it’s time to take a deep breath and try not to overly focus on each day’s volatility.

Wisdom of the Ages

When an issue is as significant and encompassing as the current credit crunch, the constant attention and news can become quite wearing. Sometimes it is a welcome relief to either take a step away or take a look at the issue from a different angle. As Congress grapples with ways to deal with debt, here’s a look at how creditors in ancient civilizations dealt with the problem. (from an article by Juliet Chung in the September 20, 2008 edition of the Wall Street Journal)

• In Mesopotamia around 4000 B.C., debtors who defaulted on loans of items like food became indentured servants to creditors. “It was through a consensual relationship on the front end so it’s different than slavery,” says Jack Williams, a bankruptcy professor at Georgia State University law school — but it sometimes came close to peonage, or the commitment to work for life.
• Creditors in ancient India and Nepal “fasted on” debtors. The creditor would fast on the debtor’s doorway until the debt was paid, bringing humiliation to the debtor. If the creditor died, “public opinion would have taken the debtor out and beaten him to death,” says Charles Tabb, a University of Illinois law professor who specializes in bankruptcy.
• Ancient Egyptians performed elaborate burial rituals to ensure passage to the afterlife, and debtors customarily pledged the body of their nearest deceased relative. In cases of default, the creditor could remove the body and close the tomb to prevent future burials.
• Around 1000 B.C., in some North African tribes, failure to pay a creditor was viewed as a sign of dishonesty that affected the entire tribe. The group could then push out the debtor, putting an end to his familial relationships as well as to his protection by the tribe.
• In ancient Greece near 600 B.C., defaulting debtors would forfeit their citizenship. “It was sort of the worst possible thing because that was a matter of great pride” to the Greeks, Prof. Tabb says.
• Debtors in Rome around A.D. 450 pledged themselves to creditors. Those who didn’t pay up could be taken into slavery, and the language of the law suggests the debtor could be carved up into pieces. Scholars debate whether this dismemberment was literal or figurative.