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Quarterly Letter to Clients

October, 2008

Indices at quarter-end (September 30, 2008):

Dow Jones Industrials: 10,850.56 3Q'08 -4.32% YTD -18.13%

Standard & Poor's 500: 1,164.74 3Q'08 -9.00% YTD -20.68%

A recent cartoon shows the White House festooned with a sign that reads “$10 Trillion Debt” and voices coming from within saying, “We’ll show Wall Street how to run a business”.

Let me state right up front that no one knows how this whole problem will resolve, what the consequences of any bailout will be, or how you can protect yourself. All will be crystal clear in the rear-view mirror, but for now we are in totally uncharted waters.

What we are experiencing is a loss of confidence. Credit and confidence are inextricably linked: lenders do not want to lend because they have no confidence in the ability of the borrowers to repay, or in the value of the assets pledged against loans. Home values drop to a point where they are no longer worth what the bank has loaned against them. Inter-bank dealings in esoteric securities have exacerbated the situation, as those securities are unable to be priced accurately, and there is no liquid market for them. Bank failures lead to reticence in making the deals that keep our world spinning. Everything is interconnected.

There’s no paucity of things to write about this quarter. The news in the financial world has been stunning, with Lehman, as expected, failing, and Merrill Lynch running to the arms of Bank of America. Today we are left with only two major brokers that are not owned by banks: Goldman Sachs and Morgan Stanley. Insurance companies have not been immune, as witness American International Group. We have even seen a large money market fund “break the buck”, an action that was previously inconceivable. Fear grips our capital markets.

The securities business has historically been highly cyclical, and we have experienced these upheavals on a regular basis. In the 1930’s a large number of brokers failed, leading to laws restricting banks from owning brokers. Today, the laws keeping banks and brokers separate have been overturned. None too soon, some would say, as brokers today seem to need the capital that a large banking parent provides. But do we really want our banking system’s capital positions exposed to the vagaries of the securities markets? Our banks seem to have problems enough of their own.

People are asking me how we could be in such a situation. My comment is that these fiascos have always been with us, from Enron to Long Term Capital Management to Drexel Burnham to the Resolution Trust, you can continue the line back to the tulip mania of the 1600’s. It’s just that sometimes the fallout is wider than at other times. It’s pretty widespread this time.

During my early tenure on Wall Street, in the 1970’s we saw a host of respected firms disappear either through merger or dissolution. Remember my old firms, Hayden, Stone; Walston; and W. E. Hutton? And how about Shields; Hornblower & Weeks; Eastman Dillon; Estabrook; DuPont; E. F. Hutton; Dillon Read; Glore Forgan; Bache; Loeb Rhodes; MacDonald; Goodbody; Purcell & Graham; White Weld; Edwards & Hanley; Kuhn Loeb; Reynolds? All major firms, all subsumed or liquidated, all during a relatively short time period. None were saved by the government, though some were merged at the government’s insistence.

But it is not all that unusual for the Federal Government to step in to save a private company or protect depositors. In fact, here is a list of some of the government bailouts since around 1970: Penn Central; Lockheed; Franklin National Bank; New York City; Chrysler; Continental Illinois National Bank; and last but not least, more than 3000 Savings and Loans institutions via Resolution Trust.

And there is one good thing that has arisen from the current miasma: insurance for money market funds, similar to FDIC bank insurance. I am not certain that every fund has it as yet, but it is available, and it is a boon.

Three months ago I wrote about oil. Oil may now seem but a grace-note on the current situation. It traded at $141 a barrel immediately after I published that letter. Since then, it, too, has plummeted, falling as low as $91, for a twelve-week loss of 35%. Many other commodities have also dropped sharply. This might have been a positive for the economy if so much else was not happening.

Enough of this: you want to know where we are going from here. Sorry, the battery on my crystal ball just died. Of course, next quarter I will be able to tell you what just happened. But no one has been through anything like this before, and no one knows what to do or what will come next. The only thing that is certain is that there are no easy answers. By the time you read this a bailout plan may have been passed. The effect of its passage (or failure) will be obvious in the headlines and in securities prices.

Given the unknowns and the overall situation, I feel that we are as well positioned as possible.

Our currency says “In God We Trust”. I guess that is the best hope after all.

Jim Pappas