Dear clients,

This has been a rough year. If someone had told me a year ago the S&P 500 index would be down 40% for the year I would have thought they were nuts. If someone had also told me that the yield on U.S. treasury bills would go negative, I would also think they were nuts, but it just happened yesterday. Think of it – investors were paying the U.S. government to hold their money!

I share your frustration, as do many others. I also feel anger at many of the revelations that have come out this year – and feel that this shows why we need complete transparency in our marketplace. Let me give you a brief overview of my version of what has transpired, and what I hope for going forward.

Our saga started about the time when problems began to show at our quasi-government (now government guaranteed) agencies – Fannie Mae and Freddie Mac. Apparently they were large investors in pools of mortgages that included so called “liar loans” – loans being made to homebuyers and speculators without any sort of verification! Many of these buyers took out two loans, one for 80% of the value, and another for 20%, so they were putting nothing down. So we had individuals buying homes just on their word, and with no equity stake. Did you know this was happening? I sure didn’t. And this is just the beginning of the story.

Traditionally we think of a local bank loaning money to people in the community, so there is a direct link between the bank and the borrower. The bank decides what criteria they have for making a loan and only loan money if a borrower meets the criteria, which is verified. Then if there are any problems with payments down the road the bank and borrower would need to work it out, and foreclosure would be the last resort. Now here is where the geniuses of Wall Street went to work. They decided to start “packaging” these loans and selling them to other investors. So now the loan has moved from your local bank to an investor located who knows where. And they didn’t just package these loans in a straightforward fashion – this is where the financial wizardry comes into play. They took blocks of loans and packaged them into what are called “tranches” – which is French for “slice.” So the a block of loans was sliced into various pieces - and how this was does done could vary - but a simpler form was having the top or senior slices being paid off first, and the lower slices last – and allegedly investors could chose based upon the yields they wanted and the amount of risk they wanted to take.

These are one of the types of “derivatives” that you have been hearing so much about. A derivative is an investment product that derives its value from an underlying asset – so in this case the underlying asset would be the original loans - and when they are sliced up Voila! Derivatives are created!

Amazingly, bankers ended up treating the top tranche of these derivatives as “super-senior” debt, and dubbed it as having a higher rating than even triple A debt, implying that it was safer than U.S. Treasuries! It was this kind of debt that helped to bring down mighty AIG, among others. So we went from a sound system of a direct relationship between a borrower and his or her local bank, to a system where it didn’t matter what you actually made, just what you put on paper, and after you borrowed more money than you could afford to your loan was bundled with others, sliced and diced, and pieces ended up who knows where, including with Fannie Mae and Freddie Mac. Anything wrong with this picture?

Wall Street still had time on its hands, and there were trillions of dollars being created in another derivative – credit default swaps (CDSs). In its simplest form a credit default swap is a type of insurance, and is a viable instrument. For example, an investor might own debt from a company, or even a mortgage tranche discussed above, but want some insurance in case the bond defaults. The investor could then arrange a credit default swap with another party. The seller of the CDS would receive payment from the buyer, and if the bond or mortgage tranche did default the seller of the CDS would have to pay the buyer the lost value. Wall Street became enamored with CDSs, and many firms and investors began using them not only as insurance but as speculative investments – meaning they did not own any of the debt, but either bought or sold CDSs speculating on companies going out of business, or other debt failing, such as the tranches we talked about above. The market in CDSs reached a peak of about $62 trillion, nearly four times the value of all the stocks on the New York Stock Exchange! And since these CDSs were privately negotiated contracts between the two parties involved, they were not regulated and there was no central reporting system in place to determine their value. In other words, there was no transparency – and investors in companies that held or sold CDSs generally had no idea of what was going on, the value of the CDSs – and the enormity of the amount of dollars involved. And even if a company owned CDSs on debt of another company that went out of business, it didn’t do you much good if the company you purchased the CDS from can’t pay you because they have also gone out of business!

I understand if this is starting to give you a headache – but I wanted to give at least a slice (pun intended) of what has been going on. And the reason we have seen the stock market go down and become so volatile with wide price swings on a daily basis is because investors have been trying to get a handle on exactly what has been going on. The market can price any news, good or bad, but what the market really does not like is uncertainty and surprises, and we have certainly had a large dose of surprises this year.

The bottom line is that our financial system had become extremely leveraged – creating derivatives on top of derivatives, and had strayed away from the basics of a sound economy. Loans were being made that should not have been made, causing inflated real estate prices, and trillions of dollars in transactions were being done that were not visible, and speculative in nature. Dealing with this “deleveraging” is what the Federal Reserve and the U.S. government are currently wrestling with. Falling prices (called deflation) is not a good thing if it continues unabated. Businesses fail, and the economy contracts. Bernanke, the Federal Reserve Chairman, is a student of the depression, and is going to do everything in his power to make sure our economy turns around sooner rather than later. The economy is also the top priority of the new administration, as it should be. Things will turn around; it is only a matter of when. And by the time the economy does turn around the stock market will already be higher, because the market is a leading indicator. That is why a strategy of waiting for confirmation of a turnaround before investing will be too late, because the market will have already moved up substantially prior to the turnaround. My hope (and expectation) is that transparency will be instilled back into our markets, despite the whining of others, such as hedge fund managers. The players in the marketplace were given free reign and they screwed up - it is time for more transparency, and more regulation. Trust needs to be restored, and this will not happen unless we know what risks are being taken when we invest.

Measuring risk – this is something that is taught academically and to individuals who obtain the Certified Financial Planner designation. The problem we had this time around was that individuals investing in the stock and bond markets were taking risks that they were not aware of – and this caused securities to be overpriced. In addition to all the derivatives that were trading in some phantom land, we had other financial shenanigans going on – such as “off balance sheet” items. What does that mean? If you or I have a business then any assets and liabilities are part of the business, and it should show up on our balance sheet. I find it both ironic and sad that I am currently pursuing the Chartered Financial Analyst (CFA) Charter, and we spend so much time learning how to price all sorts of investment vehicles (including derivatives) but then we have a marketplace that allowed so much to be hidden from view. Where were all these analysts who look long and hard at companies before they make recommendations for investment? Shouldn’t they be demanding full transparency in our marketplace?

What is the major reason we have the capital markets? To provide capital for businesses and individuals that will enable our economy to grow and provide an opportunity for the “pursuit of happiness” for individuals. We need to get back to that kind of market. We had too many people working in the financial field, and too much effort being put into designing derivatives and vehicles that were not productive for our overall economy. Good riddance! And this will be for the better.

One of my frustrations this year, as it was for many advisors, was how little diversification worked. Normally when one part of the market goes down, another does not go down as much, or goes up. We essentially had all markets going down this year. Bond funds went down, although not as much as stocks. But every major asset class suffered. Stock funds, whether large companies, small companies, gold mining companies, international companies, real estate, energy, etc. - they all went down together. Going forward this has reinforced my thinking on the importance of the entire financial picture, not just investments. The problem with the type of market we have experienced this year is that we can literally see our hard work disappearing in front of us as retirement accounts and home values decline, and it can be demoralizing. But this will change.

It is important to prepare for the future, but financial planning is a means to an end, not the end itself. In my “The Music Inside You” I have five areas that I address – dreams (goals), life’s work (jobs), protection (insurance), lifetime saving and investing, and memories (living in the moment). If other parts of the financial planning picture are working, then it is not as bad if another part is going through some rough times. I can remember a few times in my life when all cylinders were running, and I treasure those memories. Oftentimes we don’t realize or appreciate how special those times were until later.

I wish you a happy and stress-free holiday season, and to be thankful for areas of your life that are going well. As always, I am hear to address any questions or concerns you may have. We will save being thankful for the market for another year!

Peace, Jim Pasztor MS, CFP