1. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
PACIFIC INCOME ADVISERS
1299 Ocean Avenue, Second Floor Santa Monica, California 90401 Telephone: (310) 393-1424 ▲ www. PacificIncome.com
T he world, or certainly the United States has think of one person I would like to see in an orange
entered the “Anger” phase of the grieving jumpsuit with matching stainless steel bracelets.
and mourning process for the losses and
Admittedly, there is plenty of blame to go around.
indignities we have all suffered during this financial
Credit rating agencies are near the top of my list.
crisis. The losses have been enormous -- almost hard
Paid by the issuers of debt and other obligations,
to fathom. Losses in the value of our homes and
they have an inherent and insurmountable bias.
our portfolios; losses of freedoms and flexibility;
Rating agencies took issuers’ assumptions as gospel,
losses of the ability to retire or support oneself;
and gave virtually every security their highest rating.
losses of a job, a home, the ability to send a child to
While there were only five corporations that had
college; losses of confidence and trust; and,
importantly the loss of our sense
CPI – Inflation
of invulnerability, a loss of our
belief that we were on the right
January 1995 to Present
track, and that financial
Source: Bloomberg Data Systems
engineering was part of the 6.0%
solution. With the tally of losses
being so incalculable, it is easy to 5.0%
see why we must go through a
grief and mourning process, just 4.0%
as if we had lost a loved one.
3.0%
The Anger stage manifested
itself in our desire to blame 2.0%
someone, anyone, for the pain
we are suffering. Not only do we 1.0%
Last Report Was Negative
not want to pay bonuses to
0.0%
employees of banks and financial
institutions that must have
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caused our misery, we have also Chart #1
threatened to retroactively tax
those miscreants who might have been fortunate previously earned the highest credit rating, the
enough to receive a bonus in 2008. How dare they vaunted Triple-A (four now that GE has been
get a bonus when I am suffering, and they have downgraded), every bond backed by mortgages, no
matter how risky, was able to receive a Triple-A
surely caused my pain!
rating as long as there was some extra collateral
The blame game is an easy one to play. Anyone
there to help absorb losses. Rating agencies are part
doing well in this environment must be doing
of the problem, and unless their business models
something counter to the needs and desires of
change, they will continue to be part of the
society at large. The blame game does not help
problem.
anyone, and yet it is so compelling that I must take
a moment to vent some of my frustration at those I also find plenty of blame for those witless buyers
who deserve the greatest and loudest Bronx cheer, who claim to “not understand the obligation” they
or worse, for causing us so much pain. In fact I can were getting themselves into. How dare you sign a

2. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
multi-hundred thousand dollar contract without mandate reserve requirements for life, health,
understanding! Push the stop button and ask property, auto, and other insurance products,
questions. It is, after all, your home, and your life there were no requirements for AIG to hold any
you have signed away. We can also blame the easy reserves against the potential liabilities created by
these instruments. When Lehman went bankrupt,
money available to make loans to those whose only
holders of these CDS insurance products received
ability to repay was based on a pulse that was
only 28 cents for every dollar of insurance they
greater than zero. We can also blame Wall Street
thought they had. What kind of actual protection is
firms that made hay issuing these loans and then
this if the first bankruptcy pays only 28 cents? What
selling pools of those loans to investors who did not
happens if there are several bankruptcies? Will there
do their own homework, and instead based their
decisions on the Cliffs Notes issued by credit rating be any money to pay off in the event of catastrophe?
agencies. All share blame. We did not get into this
Some of the “odd” features of the CDS market are
that there are no limits to how
Money Supply (M1) much insurance can be issued,
and no requirement that you
Annual Percent Change hold any of the securities you
December 1975 to Present are attempting to insure
Source: Bloomberg Data Systems
against loss. For example, if a
company has $1 billion of debt
20%
outstanding, the amount of
insurance that could be written
15%
to protect against a default of
that $1 billion of debt remains
10%
unlimited. It is conceivable for
5%
there to be $10 billion or more
of insurance outstanding. AIG
0%
was happy to write more
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-5% insurance because they did not
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really think they would ever
-10%
really have to pay, and they did
Chart #2 not properly reserve against the
potential loss they had insured.
situation without a cascade of events that created a What a great business, and a huge profit center for
perfect storm. them! An investor seeking insurance did not even
My nominee for the poster child of excess is none have to own the underlying security to purchase
other than the Notorious AIG (with apologies to insurance. That is akin to me buying insurance on
the rapper with a similar name), the large insurance your home. Don’t mind me if I play with matches
company. Credit Default Swaps (CDS) were issued behind your garage; after all, I have every incentive
by the unregulated part of Notorious AIG, and an for your house to catch fire. Try insuring a car that
investor could purchase CDS that were designed to is not registered in your name. It is impossible
protect them against the risk of a default of any because you do not have an “insurable interest.”
number of questionable securities issuers. Sadly, Yet, I can buy insurance protecting me against the
there was no regulation of the CDS market. The default of a security whether or not I own that
lack of any regulation allowed AIG and other CDS security. Does anyone else think something is wrong
Despite rules that with this picture?
issuers to “self-regulate.”
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3. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
Don’t get me wrong. I understand that some strategic thinking to be involved in the details of
investors have made huge profits speculating that each and every division. The buck must stop
the prices of various securities would decline. Short somewhere, and that somewhere is ultimately the
selling is one method for profiting from a decline in executive suite.
the price of a particular stock. While we do not sell Banks, financial institutions, hedge funds and other
short for our clients, we do recognize this as a viable investors have utilized the CDS market to help
strategy. However, the number of shares that are reduce risks. This is the primary reason why AIG is
sold short cannot be greater than the number of considered too big and interconnected to fail.
shares of stock that exist. Additionally, investors Where was the government regulation that
using the options market to speculate on the decline prohibited any firm from getting too big to fail?
of the price of a particular security through the
Regulation for regulation sake is not inherently
purchase of put options have
good, but preventing systemic
position limits that prohibit
failures and mitigating risks
them from taking a position Some of the “odd” features of
are why we require some
that is too large relative to the
size of the entire company. the CDS market are that there
government regulations.
are no limits to how much So Notorious AIG sold CDS
There were no limits on the
size of the CDS market for insurance can be issued, and no insurance to financial
institutions across the globe,
any particular issuer.
requirement that you hold any and the U.S. Government has
Even without regulation, AIG,
of the securities you are determined that a failure of
being the largest insurance
attempting to insure against AIG would cause ripples to of
company in the world, should damage so severe as
loss... An investor seeking
have had some idea about the threaten the entire world
reserves that should have been
insurance did not even have to financial system. Our
maintained to support the government has invested
they own the underlying security to hundreds of billions of dollars
potential liabilities
purchase insurance. That is to prevent a financial system
insured. It is certainly
possible that a natural disaster
akin to me buying insurance on failure. If, however, we
is so great as to cause an
consider that CDS insurance
your home.
insurance company with
was really a fraud, sold with
ample reserves to deplete its
the knowledge that there was
resources, and perhaps even fail. But the
no inherent ability to meet the potential liabilities,
management of AIG permitted risks so large that it then why should we not recognize it for what it is?
put the entire firm in jeopardy. Investors who used Bernard Madoff to manage their
Management is also responsible for agreeing to portfolios were told that the firm was a large fraud,
contracts to pay employee bonuses regardless of the and they have lost everything. How much different
profitability of the employee, the division, or the is the potential fraud that AIG perpetrated on the
entire company. It is easy to consider the hapless financial system at large?
employee who is getting a bonus while the rest of us As much as I would like to see the former chairman
suffer as part of the problem. Surely, however, it is of AIG in an orange jumpsuit, I also must recognize
the management of the firm that agreed to those that anger is just one phase of my mourning process.
contracts, and did not even consider the idea that It is time to move on to depression, resignation, and
people would be paid in years when their division or then acceptance. Our problems are serious, and
the entire firm was not profitable. I do not buy the serious actions are necessary to prevent the systemic
excuse that the chief executive is too busy with
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4. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
failures that threaten us. America and the rest of the from banks. Bidders will have access to non-
world can only move forward by working together to recourse loans from the Federal Deposit Insurance
find solutions to our crisis. At the peak of the Corporation (FDIC), and each dollar of equity
invested by the partnership will be matched by a
Great Depression there were only 16 Republican
dollar of equity from the Federal Government. Let
senators remaining in the Senate. The Democrats
us say, for example, that a bidder seeks to buy a
were so successful in pinning blame for the
package of loans from a bank that has a face value of
economic crisis on the Republicans that the GOP
$100 million. The bidders agree to pay $70 million
was virtually trivialized. Politicians, regardless of
for this package. Of that $70 million, the bidder
their party affiliation, must work together to find
would need to put up $5 million of its own money,
solutions. We simply cannot tolerate partisanship
and they would receive another $5 million of equity
for the sake of trying to regain power. We must try
from the TARP. The remaining $60 million of the
to regain our financial footing first and foremost.
purchase price would come from a loan from the
A 12- STEP PROGRAM FDIC. In this example, the investor and the
In addition to the regular tools of fiscal and government share losses on the first $10 million.
monetary policy, this administration and the one
that preceded it have come up
CAPACITY UTILIZATION
with a significant number of
programs to prevent our
Januuary 1967 to Present
current financial crisis from
becoming Great Depression 90.0
II, the sequel. Those
programs are far reaching, 85.0
and will most certainly help
alleviate the existing malaise.
80.0
Among the steps taken
include the following:
75.0
1. Troubled Asset Relief
Program (TARP) – This is the 70.0
original rescue package At a Multi-Decade Low
championed by former 65.0
Treasury Secretary Paulson
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which provided $700 billion
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to help rebuild liquidity for
Source: Bloomberg Data Systems Chart #3
the banks. Fears that banks
have taken funds but are not lending are generally
unfounded. The largest banks are making loans. They also share any potential profits equally, while
Unfortunately, the loss of the credit available the FDIC receives interest and repayment on its
through secondary sources such as loan brokers loan.
overwhelms the amount of lending being completed (Sadly, the government has effectively soiled itself by
by the banks. Details were non-existent, until the mandating limits on compensation paid to bank
current Treasury Secretary provided greater visibility executives who have taken TARP funds. Those
on how this might work through the PPIP. limitations have caused potential bidders to worry
2. Public – Private Investment Partnership (PPIP) that they will also be asked to reduce their
- Bidders are encouraged to try to buy troubled assets compensation if they are successful and make
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5. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
significant profits through their PPIP investments. consumers. This spending includes reductions in
Citibank employs 323,000 employees. Do we tax withholding, and people will see the benefit of
really care how much money the management those plans beginning in their paychecks in early
team makes if they lead Citibank back to April.
profitability? How much tax will a profitable 5. Increases in FDIC Deposit Insurance - The
Citibank pay? The government argues that there are
government temporarily increased the available
huge numbers of effective government employees
deposit insurance to $250,000 from $100,000. This
willing to work for a fraction of the pay historically
prevented a run on the banks because people were
offered by large financial
comforted by the government
institutions. Those same
insurance on their savings, and
government employees failed to
did not feel the need to remove
find the fraud perpetrated by This administration and the
their funds.
one that preceded it have
Bernard Madoff, even as
6. Commercial Paper Funding
whistle-blowers screamed about
come up with a significant Facility (CPFF)- The
numerous telltale signs that
number of programs to government provided a
Madoff could not legitimately
provide the returns he had prevent our current financial backstop to issuers of
commercial paper. This
been “generating.” The
crisis from becoming Great prevented the failure of
government will need to find a
Depression II, the sequel. companies that rely on short-
way to ensure that participants
term funding for their survival.
Those programs are far
in the PPIP will not be
penalized retroactively, and 7. Temporary Guaranty
reaching, and will most
trust will need to be regained Program for Money Market
certainly help alleviate the Funds (TGP for MMF) – The
for this program to be
existing malaise.
successful.) government has also decided to
guarantee all money market
3. Term Asset Backed
funds. This was also designed
Lending Facility (TALF) - The market for securities
that represent pools of loans such as automobile to prevent runs on banks caused by losses of
loans has dried up. The TALF plan is designed to confidence.
provide liquidity to the system so that loans can 8. Temporary Liquidity Guarantee Program
once again be packaged and sold. These loans will (TLGP) – The government has agreed to guarantee
be financed by the Federal Reserve Bank of New new debt issued by financial institutions to provide a
York. The first sales under the TALF program were facility for these institutions to raise additional
completed in late March, and while they were small funds. These guarantees continue for all debt issued
compared to the size of that market more than a year through the end of 2009 with maturities through
ago, they were successful, and there is hope that the June 30, 2012.
securitization of loans will be brought back to life.
9. Primary Dealer Credit Facility (PDCF) –
4. American Recovery and Reinvestment Act of Following the failure of Bear Stearns, the Fed
2009 - The government is providing more than $800 decided to permit investment banks to have access to
billion in spending to help prevent the economy short-term funding through the Fed’s discount
from getting worse. While some people do not window. While many believe that access to the
believe that enough has been done, or that the right discount window might have prevented the failure of
things are being done, the fact remains that Bear Stearns, the facility is now available to prevent
spending $800 billion will replace some spending further institutional failures.
that was previously made by businesses and
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6. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
10. Federal Reserve to Purchase Treasury Bonds more? Are we just exacerbating the problem?
to Provide Liquidity – The Fed has indicated its
The most commonly heard criticism of the
willingness to purchase treasury bonds in the open
government’s actions is that such an enormous
market to provide liquidity and encourage interest
expansion of the Fed’s balance sheet must cause
rates to fall. Lower interest rates should permit
inflation. Inflation is currently quite low, as shown
more homeowners to refinance their existing
in Chart #1. The Nobel Prize winning economist
mortgages to reduce payments. Milton Friedman is frequently quoted as saying
“Inflation is always and everywhere a monetary
11. Government Plans to Encourage Financial
phenomenon.” The implication is that the
Institutions To Restructure Existing Mortgage
monetary expansion used to fund the myriad of
Debt – By working with banks and homeowners to
reduce mortgage payments to a specific percentage of programs will cause inflation, and that this monetary
total income, it is hoped that fewer people will lose inflation will also manifest itself in a declining value
of the U.S. dollar as inflationary pressures build.
their homes through foreclosure.
Growth of the money supply is shown in Chart #2
12. There are many other programs that officials
have put in place to prevent the failure of more The causes of consumer price inflation (CPI) are
financial institutions. Accounting rules are being difficult to quantify, and there is some consensus
changed to reduce the pressure exerted on banks that increases in CPI are caused by increases in
and financial institutions to incur losses on labor costs, and by a lack of excess capacity in our
securities held on their balance sheets. Short-selling ability to manufacture goods. Capacity utilization is
rules are also shown in Chart
being changed to #3. Recognizing
reduce the ability that we disagree
of speculators to It may, however, be time to consider that all the with Professor
drive share prices Friedman at our
endlessly lower. bad news is out. Companies are reporting weak own peril, we do
earnings for the first quarter of 2009, but stock not believe that
In recent
testimony, both prices so far have been able to absorb the bad news labor costs will be
the Treasury rising any time
Secretary and the without swooning. The fact that we have been in soon. Factory
recession for 16 months indicates that a weak
Federal Reserve utilization rates
Chairman have are at multi-
economy is not new news.
indicated they decade lows,
will do everything indicating that
within their factories can
power to prevent additional financial institution increase production for many years before creating
failures. (One critic suggested these programs be inflationary pressures. Companies do not have any
renamed Bank Asset Reliquification Facility, with pricing power, anywhere. The idea that inflation
the appropriate acronym, BARF.) will return is valid, but expecting it to occur in
There are many criticisms of the government’s 2009, or even in 2010, seems quite remote to us.
efforts to prevent this economic crisis from The same may be true of the U.S. dollar. In the
land of the blind the one-eyed man is King. The
becoming more severe. One appropriate criticism
dollar may succumb to inflationary pressures and fall
is the fact that the government is trying to borrow
in value. However, this credit crisis is a global
its way out of a debt bubble. Is the way to help a
system burdened with too much debt to borrow event, and other nations are facing similar difficult
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7. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
economy is not new news. Corporations have very
choices: try to inflate your way out of this mess, or
little visibility in their business looking into 2009,
languish with sub-par growth for many years, or
even decades, as have the Japanese. It is hard to but earnings estimates are already down by 50%, so
make the case for a strong dollar in the face of rising weak corporate earnings can no longer be
inflationary pressures that are likely over the next considered a surprise to anyone. Yes,
few years, but it is even harder to find a currency unemployment continues to climb, but as we have
pointed out, increasing unemployment reflects what
that is in a materially stronger position right now.
has already happened, and has been a very poor
There are many reasons to remain negative. Credit
indicator of whether the economy is beginning to
problems at banks are expanding into credit cards,
bottom, or perhaps even
starting to improve. The
Existing Home Median Price weak March employment
report was widely expected,
January 1968 to Present
and stocks were able to rally
Source: Bloomberg Data Systems
despite the dire news. This
250
Great Recession is already the
Year-over-year prices have declined for 31 months
225
longest since the early 1970s
in a row. Since 1968, existing home prices had
200
and is likely to be the longest
never fallen for more than two consecutive months.
175
since the great Depression.
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The definition of a declining
125
stock market is one where the
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recent lows are lower than the
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previous lows. The definition
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of a rising stock market is one
25
where the recent highs are
0
higher than the previous
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highs. By this definition, the
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Chart #4 stock market continues to be
falling. While stock prices
real estate loans, and high quality mortgages. Credit continued their descent, there have been some very
losses will continue to expand for quite some time. interesting underlying trends. As the S&P 500
reached a panic low on October 10th, there were
Home prices continue to fall and the number of
foreclosures continues to expand. Home prices are 6,762 stocks on the New York Stock Exchange
shown in Chart #4. Since most of the problems we (NYSE) with prices at new 52-week lows. As the
S&P 500 made a new low on November 21st, only
face resulted from weakness in the housing market,
many market prognosticators believe that housing 3,600 stocks printed at new 52-week lows. More
must bottom before a meaningful bottom can be recently, as the S&P 500 hit a new 12-year low on
March 6th, only 1,793 stocks made new 52-week
reached in the financial services sector, and
lows. This is a very important trend. Despite
ultimately in the real economy.
lower prices for the stock market index, fewer and
It may, however, be time to consider that all the
fewer stocks are actually participating in making
bad news is out. Companies are reporting weak
new lows. At some point the ability of stocks to
earnings for the first quarter of 2009, but stock
withstand bad news, and stop going down should lay
prices so far have been able to absorb the bad news
the groundwork for a meaningful bottom that can
without swooning. The fact that we have been in
lead to higher prices.
recession for 16 months indicates that a weak
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8. APRIL 2009 QUARTERLY REVIEW & OUTLOOK
We mentioned that the stock market hit a 12 year By our thinking, the Treasury market remains one of
low in early March. This is important because since the most overvalued markets. We do not expect
the beginning of the 20th century there have been inflationary pressures to become apparent for several
more quarters, but with 10-year interest rates well
only three times in history that stock prices have
below 3%, we find Treasury prices very
susceptible to any increase in inflation.
Corporate bond markets remain far
more attractive relative to the rates
available in the Treasury market, and
high yield markets remain very
attractively priced, although the
potential for increased credit problems
and defaults suggests some caution is
warranted with regard to high yield
bonds. For taxable clients, the
municipal bond market, particularly
the California municipal bond market,
remains a very attractive investment
alternative. In our stock portfolios we
continue to favor those stocks that can
survive and thrive in a recessionary
environment. However, we recognize
that our clients’ portfolios will soon need to have
retreated to a 12-year low. See the chart above.
changes made to reflect prospects for more robust
The first was the period from 1921 through 1932.
economic growth over the next several quarters.
The second was 1962 through 1974, and the third
was the last 12 years, 1997 through 2009. In the
It is important that we know of any changes in your
first two periods stock prices were materially higher
financial situation. If you are nervous or
in the years that followed. While history does not
uncomfortable with any aspect of your investment
repeat itself, it does frequently rhyme, and it may
portfolio, or if you simply have questions, we
once again be the case that stock prices could be
encourage you to make an appointment for us to get
higher over the next couple of years.
together.
Stock prices are forward looking, and have almost
always begun a new advance prior to the end of the If you would like a copy of our Form ADV Part II,
recession. While it is entirely possible that the free of charge, please contact Robin Campbell at
recession will last through the rest of 2009, it is also 310.255.4469, or at
likely that some modest but overdue economic RCampbell@PacificIncome.com.
improvement will be palpable by 2010. Stocks will
Bennett E. Gross, CFA
anticipate the economic improvement and should
Director of Equity Investments
begin to improve within the next several months. It
is entirely possible that the lows for this terrible Marla L. Harkness, CFA
bear market have already been made. Portfolio Manager—Equity Investments
PACIFIC INCOME ADVISERS
1299 Ocean Avenue, Second Floor Santa Monica, California 90401 Telephone: (310) 393-1424 ▲ www. PacificIncome.com