SLUGGING IT OUT.

Sometimes You're The Windshield, Sometimes You're The Bug. I've been the bug lately. The markets have been difficult with exceptional gains one day followed by exceptional losses another. In general, the trend has been down especially in some of the high dividend issues we've emphasized. The main culprit has been fear in the sub-prime mortgage market. While this is only a relatively small segment of the mortgage market, the overall market is so large that problems in even a small segment can run over into other sectors like banking, real estate, and construction. Delinquencies among borrowers who obtained these sub-prime loans have been running around 10%. As I posted last March, this is a prime example of stupid lenders and stupid borrowers with greed being a prime motivator. Its hard to identify the main culprit in this fiasco. Investment bankers were driven by greed as they earned huge fees by packaging these loans and selling them to investors willing to take risks they didn't understand in order to get above market yields. Most of these investors should have known better. Borrowers bought houses which were outside their affordability range because they could borrow almost all the purchase price at initial interest rates below market. When these rates increase to the true market rate, the natural consequence is delinquency. Neither the borrower nor the lender has a clue as to how to deal with the consequences.

A typical example is a transaction I participated in three years ago. The borrower received a loan of 101% of the $290K purchase price. After occupying the property less than a year, the borrower stopped paying and moved out after 3-4 more months of free occupancy. The lender did nothing for several more months and then filed foreclosure proceedings. After finally gaining title to the property in a foreclosure sale, the lender did nothing for several more months before finally putting the property on the market and selling it for $40,000 below the loan balance. The lender suffered a large loss made even larger by delaying action recover possession and locate a buyer to mitigate the loss. Anyone who has tried to contact a lender in an attempt to purchase a foreclosure property knows how inefficient they can be.

The Fed Comes To The Rescue? The market reacted well to the Fed's lowering of the discount rate from 6.25 to 5.75% last Friday. Does that mean the crisis is over. Not exactly. For one thing, not a lot of money is borrowed through the discount window. Although it is sometimes the most visible to the public, the most utilized rate controlled by the fed is called "the fed funds rate." For now that rate remains steady at 5.25%. The Fed will probably lower that in September but they may decide to hold it where it is depending on the reaction of the markets between now and then. My opinion is that the Fed needs to be exceptionally cautious since the liquidity they poured into the system over the past 2-3 years is at least partially to blame for the situation we find ourselves in at present.

Where Do We Go From Here? Despite the fact that we have been managing our portfolios cautiously this year, many of our high dividend portfolios have been hit harder than the rest of the market. We are concerned about this but we hardly ever sell stocks because the market opinion of value changes. We are the first to bail out when we see a fundamental change that makes a stock less valuable but reacting to market hysteria is seldom conducive to sound wealth management. The good news is that September and October should see some substantial dividend payments. We can either hold this cash is a hedge against volatile markets or invest in some of those issues that we think have been adversely affected by the current correction. It is my opinion that the current correction has been healthy and not unexpected. Much of the selling has been due to aggressive investors who were heavily leveraged and forced to sell to meet margin calls. My advice is to keep a bit more cash and look for bargains that almost always exist after a correction such as the one we've just experienced.