The reduction of leverage is a painful process, particularly against the headwind of declining asset values. Consider your personal finances. To reduce your debt you have to spend less to pay down that debt. While your debt increased, you had your income plus the debt you incurred to consume more goods. When reducing your debt, your available funds contract. Debt interest and the repayment of debt principal must be subtracted from your income. The amount of discretionary funds available diminishes significantly. In the 1990’s and early 2000’s strong economic growth was fueled by the availability of capital. Wages increased, common stock values increased, then housing values increased and borrowing expanded dramatically. As economic growth has slowed, the ability to service the increased debt that both consumers and corporations amassed has faltered. As a result, we are witnessing a perfect storm - slower growth, an inability to borrow and a considerable reduction of debt, which are driving down asset values and further reducing wealth.

Our financial system now appears broken. Brokerages, banks and other institutions are hoarding cash in an effort to increase their capitalization in the face of declining asset values. Financial companies are scrambling to reduce the leverage that brought large profits in the good times and bankruptcy when things turned tough. Conventional wisdom on Wall Street is that the financials will lead the direction of the market. Often it’s the financials that decline even before economic data turns negative. The financials are also the first to recover from any recessionary period leading the rest of the market higher. Many professional investors consider the financial sector to be an early indicator of the direction of the market. The financial sector provides the critical foundation of our entire economy. The access to cost effective capital that make business possible is dependent upon a healthy financial sector. Without this lubrication, the economy grinds to a halt. What has caught so many professionals off guard in this crisis is that the overall economy looks relatively healthy. The recession predicted at the start of the year never materialized and while growth hasn’t been particularly strong, it has been positive despite declining home values and commodity price spikes. However, the continuing collapse of the country’s financial sector is a harbinger of declining economic growth in the next few years.

The meltdown in the financial sector is due to a massive readjustment from an excess in available capital. And it’s not just a U.S. phenomenon, this bloodletting is affecting the economies the world over. We believe that this readjustment will take years to process and will be painful for equities and even some fixed income values, particularly high-yield. We are now down to only two remaining major independent investment banks in this country, Goldman Sachs and Morgan Stanley and both are unsure they can continue as such. The reduction of leverage, the reset in value in several derivative assets and numerous bankruptcies of several “too big to fail” firms has shaken Wall Street’s confidence. Despite this, the U.S. economy continues to grow though at an anemic pace. We are concerned that the deleveraging will necessarily further weaken the overall economy in the near-term. In the longer-term we believe that we will see a protracted period of slower growth worldwide as we right the ship. In the meantime, our clients’ equity exposure is at a record low, we are increasing high quality corporate debt and hoarding cash. We have begun looking at selective investments in distressed housing values, anticipating long-term gains, though we do not anticipate a quick bounce.