Turmoil within the credit and equity markets continued during the first quarter of the year. The fragility of our financial system was highlighted by the failure of Bear Stearns and subsequent acquisition by JP Morgan with the Federal Reserve’s help.

The majority of the economic trends are negative. Lower housing values have restricted the supply of credit. Less credit in turn has caused the consumer to reduce spending and slow the economy. Unemployment rates have increased further depressing growth during the first few months of the year. Finally, high energy and food prices are keeping inflation levels higher than we have seen in a generation.

We do not have any unique insights into how deep or long this volatility will persist. Equities will not recover until the banking system becomes cleared of its bad debt and is able to lend freely. Ironically, UBS’s $19 billion write-down was one of the positive catalysts that sparked the market to rebound strongly on April 1^st. The government has also acted very aggressively to address these problems as we will discuss later in our commentary.

Our strategy in client accounts has been to try to preserve capital by avoiding the highly leveraged firms that are bearing the brunt of the market correction. We are also opportunistically buying positions that appear to be good values. On the equity side, we have added companies such as Noble Corporation and Danaher that are trading near historical lows relative to their earnings and cash flow multiples. With the fixed-income portion of portfolios we have reduced our allocation to Treasuries since the panic has pushed up prices to unsustainable levels. The two-year Treasury Note is only yielding 1.8% and the ten-year Note is yielding about 3.5%. These yields are incredibly low since inflation is roughly 4% year over year.

We continue to believe that much of the bad news is already factored into the current depressed prices for common stocks. We do not recommend reducing equity allocations now since stocks are more attractive than bonds and commodities based on their respective long-term potential.

Bear Stearns’ largest business involved packaging mortgage-backed securities and selling those bonds to investors. Weakness in the housing market has led to defaults and huge markdowns in the value of these mortgage-backed securities. Given these issues, Bear was not able to sell these bonds to the investment community. Therefore, Bear retained toxic assets on its balance sheet. The presence of these low-quality bonds then led to a “run” on the brokerage house.

The classic “run on a bank” (as depicted in the movie It’s a Wonderful Life starring Jimmy Stewart) occurs when a bank’s depositors rush to withdraw all of their funds fearing the institution is in financial trouble. Northern Rock in England experienced this recently and the government nationalized the bank to maintain solvency. In the case of Bear Stearns, many of Bear’s multi-billion dollar hedge fund clients that used the firm as a prime broker withdrew their accounts and began conducting business with other brokers. Other banks and brokerages also refused to trade with Bear fearing that Bear would not be able to stand behind the trade.

The combination of lost trading revenues and failure of other firms to buy their short-term securities caused all of Bear’s liquidity to vanish. On March 10^th, Bear Stearns had $18 billion in cash and equivalents. Three days later, on March 13^th, the brokerage only had $2 billion in cash on its balance sheet.

The Federal Reserve was monitoring the situation and did not want Bear Stearns’ imminent failure to cause a financial panic which would have spread to other brokerage firms such as Lehman Brothers. Therefore, the Federal Reserve engineered JP Morgan’s acquisition of Bear Stearns.

JP Morgan agreed to stand behind all of Bear’s existing obligations. In return, the Federal Reserve provided $30 billion in financing by agreeing to swap $30 billion in US Treasuries for $30 billion in low-quality mortgage-backed securities that were held on Bear’s ledgers. JP Morgan is only assuming $1 billion in liabilities on the $30 billion package while the government (and the taxpayers) is assuming the remaining $29 billion in risk.

Subsequent to the original $2 per share price, JP Morgan increased its offer to $10 per share to acquire enough shares to ensure that it obtained shareholder approval. Bear Stearns did not go bankrupt and the unknown repercussions were avoided. The equity holders of Bear also suffered for their risky investment with investors such as Joseph Lewis losing close to $1 billion.

Every major market upheaval brings new regulatory initiatives to try to prevent future problems. The stock market plunge and bursting of the technology bubble in 2000 ushered in Sarbanes-Oxley which imposed strict controls concerning the accuracy of financial reporting. In response to the current credit crisis, the Treasury Department has proposed a radical reorganization of how financial entities are regulated at the Federal and State levels. These plans were first proposed in blueprint form in June of last year and the main focus of the original proposal was to increase the competitiveness of US financial markets.

Treasury Secretary Paulson recommended that a future regulatory framework consist of three agencies with broad powers according to an “objectives-based approach.” These agencies would include a Market Stability Regulator, Prudential Regulator and Business Conduct Regulator.

The Market Stability Regulator would expand the Federal Reserve’s function to insure the smooth functioning of the overall financial system and allow it to oversee all other regulators within the system. The Prudential Regulator would oversee all firms with explicit government guarantees such as Federal Deposit Insured banks to make sure their capital is adequate to cover their liabilities. Finally, the Business Conduct Regulator would include the functions assumed by the Securities and Exchange Commission and the Commodity Futures Trade Commission. This entity would regulate business processes and ensure adequate disclosure within the system.

Paulson’s plan goes further in that it provides for streamlined regulation of state-chartered banks. It also allows for federal regulation of insurance companies which are now regulated by each of the 50 states. Responding to the mortgage crisis, the Federal Reserve also recommends an agency to oversee mortgage origination.

Even though no regulatory framework will prevent future financial problems, this reorganization makes sense from an oversight and efficiency perspective. To handle the current problems, the government and Federal Reserve have basically been stretching their mandates to prevent panic in the markets in ways far beyond their charters. For example, the Federal Reserve has never put $29 billion of its capital at risk to bail out a broker-dealer as it did with Bear Stearns.

The current system is also redundant and it is very difficult for the firms themselves to comply with all of the various regulations issuing forth from various agencies. Many financial services firms are regulated by numerous federal agencies and state regulators. For example, our business is regulated by the SEC, the CFTC, the Department of Labor, the Financial Industry Regulatory Authority and the states of New York, Delaware, Connecticut, California, Texas and Pennsylvania. Any system that streamlined the process and allowed for better oversight should be welcomed by the public and the regulated entities. However, the bureaucratic turf wars that will result from this proposal suggests that nothing will happen quickly since those regulators losing their influence will fight the hardest to maintain the current system.

Paul McCulley presented a very elegant analysis of the reason for financial meltdowns which appeared in last month’s CFA Institute’s Quarterly. McCulley’s piece borrowed from the work of economist Hyman Minsky and applied Minsky’s paradigm to the problems associated with mortgage backed securities.

Minsky analyzed what causes economic booms and busts. His theory centers around the idea that stability itself produces speculative bubbles as market participants take greater and greater risks since the assumption is that stable conditions will persist. These risks then become insupportable and cause dramatic unwinding.

Minsky describes different types of “units” that contribute to stability or instability. The first unit is a hedge unit that aids stability since it allows market participants to reduce their risk overall. McCulley labels conventional 30-year mortgages as hedge units since they allow home buyers to reduce their risk to house prices fluctuations by paying off interest and principal over extended periods of time.

Hedge Units are then succeeded by “Speculative Units” where investors borrow funds to invest, but the investment cash returns are only sufficient to pay interest on the borrowings, but not principal. An interest-only mortgage loan is an example of a speculative unit since borrowers are only paying interest and not principal. The appearance of speculative units is destabilizing.

The final unit in Minsky’s framework is a “Ponzi Unit.” With Ponzi units, the investor buys an asset, but is unable to pay back principal or interest without the appreciation of the underlying asset. Applied to the mortgage market, a Ponzi Unit would be mortgage loan where payments do not cover interest or principal and then require a balloon payment to settle the accrued interest debt. These types of loans are very destabilizing since the only way the loans can be paid off is if the underlying asset (here the residence) appreciates and somebody buys it at a higher price.

During 2005 through mid-2007, most lending in the housing market was of the destabilizing variety. The decrease in housing prices led to the collapse we have seen in the credit markets.

Wall Street’s compensation structure for firms and individuals has contributed greatly to instability in our financial markets. Wall Street’s banks and brokerages take anything that produces cash flows such as a company or a mortgage and packages it into a security which it sells. The firms that do this get paid on a transactional basis for the sale of that security and the individual brokers and bankers themselves get paid commissions for this sales activity.

This payment mechanism adds to risk within the financial system since armies of brokers and bankers are incentivized to create and market new securities; however, they themselves have very little “skin in the game.” So if a Wall Street banker creates and sells hundreds of millions of dollars worth of mortgage-backed securities and then collects his bonus, what difference does it make to him whether or not the security flames out since he has already been paid.

Slowing consumer spending has received much press lately as economists fear a decline will send our economy into a recession. Consumer spending accounts for two thirds of GDP. Business investment, government spending and net exports make up the last third.

When consumers don’t spend, businesses stop selling products, resulting in lay-offs and further slowing consumer spending. A vicious downward cycle can result. This cycle motivated the government’s $168 billion stimulus package put through last month.

A simple mathematical formula, based on the limit of sequences, can be used to explain why consumer spending is so important to our economy, and why the government wants you to spend your rebate checks.

For every $1 I earn, I hypothetically save 20% (or $0.20) and spend 80% (or $0.80). The $0.80 I spend is part of our consumer spending total. But the $0.80 also accounts for earnings for someone else. And let’s assume they also save 20% ($0.16) and spend 80% ($0.64). This $0.64 is also earnings for a third person, who then spends and saves at the same ratio.

Before you know it, we have a sequence of numbers: $0.80, $0.64, $0.51, $0.41… and so on. The aggregate sum of this infinite sequence approaches $4. In fact, any infinite sequence of numbers summed in a similar fashion where the “spend” percent is less than 100% will approach a finite number. The generic formula for finding the sum is: r/(1-r) where r is your ratio (80% in this case).

If we assume that all consumers spend less than 100% of their earnings, which ideally is the case, we can see how consumer spending becomes such a big portion of the economy. Every dollar spent feeds many more dollars into the economy.

This is part of the power behind the $168 billion stimulus package—in the example above the $168 billion could feed $672 billion ($168 billion times 4) into the economy.

However, if consumers spend a smaller portion of their rebate checks, the effect of the stimulus will be much less. When “r” is 50% the sum is 1 and when “r” is 20% the sum is 0.25. In other words, at 50% spending the stimulus package feeds only the original $168 billion into the economy. At 20% spending the stimulus package contribution falls to $42 billion.