PERFORMANCE ANNOUNCEMENT

As Of: September 1, 2007

FORCING THE HAND OF THE FED

Why the Federal Reserve will lower rates

   The mortgage market is a multi-trillion dollar market (estimated at around ten trillion dollars), large by any measure. Over the past two decades, the mortgage market has worked like a well oiled machine. Mortgage originators sold new loans to investors. Investors could depend on duration calculations (the average period of time before a mortgage is paid off) to match their assets with liabilities, and there was an active and efficient resale market. But the well oiled machine has broken down. Forget about the subprime mortgages that are going to default; they are a relatively small percent of the whole market. The larger problem is comprised of all the mortgages that are not going to default, but are also not going to be paid off on a previously predictable schedule. If houses are not selling, and if housing prices are not going up, new loans are not going to be originated at the same rate the market was used to. As the rate of new mortgage creation and the rate of refinancing falls, the rate that existing mortgages get paid off is also going to decline. In short, mortgages that might have been paid off in three, five, or seven years, are now going to be held longer.

    Large institutional investors that buy mortgages are constantly engaged in matching the duration of their assets and liabilities. If the mortgages they hold will not be prepaid as predicted, and if the mortgages cannot be sold for a fair price in the secondary market, the investors have no choice but to retain the mortgages and hedge their interest rate risk due to a mismatch of duration. How do they hedge? Typically they sell short U.S. Treasury bonds. Thus, if the Federal Reserve does not reduce interest rates and/or make it clear that interest rates are not going to go up, institutional investors will rush to sell Treasuries to hedge their mortgage portfolios. What happens when trillions of Treasuries are sold? When bond prices go down, interest rates go up. If the Federal Reserve does not make it clear that they are going to fight a rise in interest rates by lowering the Fed fund rate, the U.S. economy will become a victim of a spiraling increase in interest rates due to an illiquid mortgage market and giant portfolios that need to be hedged. Huge hedging programs that rely on derivatives (that didn't even exist in the recent past) are now the tail that can wag the dog.