September, 2008
Dear Investors,
Simply and
directly, here’s an economic update.
Are we in a
recession? If you ask 100 economists to define the term recession, you’d get 100
different answers. Business cycles (recessions included) are a normal part of a
world of inexact balances of supply and demand. In the last 150 years, the U.S.
has gone through 32 economic cycles; an expansion averaging 38 months, a
recession averaging 17 months.
Recessions are ultimately good for the economy. For example, they eliminate
unnecessary employment and pave the way for expansion with new and better future
employment. The stock market has increased on average 2.5% during a recession.
Charles
Schwab & Company has no exposure to
any of the sub-prime mortgages, illiquid securities and other “toxic”
investments troubling many firms. Schwab has an extremely strong corporate
financial position. Net capital balance is $1.1 billion, $912 million in excess
of the regulatory minimum required regulatory net capital. Schwab has extra SIPC
insurance through Lloyd’s of London to cover $149.5 million for each customer.
Customer assets are always kept separate from corporate assets.
Funds such as the iShares Lehman 7-10 Year Treasury Bond Fund, iShares Lehman
20+ Year Treasury Bond Fund and iShares Lehman Inflation-Protected Government
Bond Fund are valued on the treasury bonds and cash held in each fund. Based on
the independently calculated Lehman bond indices, they are not managed or
controlled by Lehman.
The
financial challenges facing Lehman, Merrill Lynch, Bear Sterns, AIG and others
are stemmed from owning certain mortgage-backed securities, such as “sub-prime
collateralized debt obligations”. They borrowed and re-borrowed to own these
risky assets to attempt to boost their corporate bottom line. When the
unraveling began, they were caught holding the bag, resulting in a myriad of
credit and balance sheet problems. Their management was unwilling to understand
and face the risks in an overheated real estate market. Thus, tens of billions
of these securities are being written off with losses totaling up to $1
trillion.
The current
turmoil in the financial world will reshape and reorganize the financial
landscape with the ordinary cost of financial change having winners and losers.
The
good news is this was not caused by
a lack of demand for products and services.
It’s now truly survival of the fittest;
the companies making the most prudent, time-tested choices are being rewarded
now and in the future.
Should the
government intervene? Yes, and only if a case is in the best interest of the
American people. The government took over Fannie Mae and Freddie Mac; also
temporarily took over control of AIG with an $85 billion loan and an 80% equity
stake. More government action will be necessary; an overhaul of mortgage
regulation should have happened years ago.
Stock
market pullbacks happen quickly and they don’t follow a recession - they come
prior to a recession. In just four trading days the Dow lost 30.7% of its value,
culminating with a 508 point Dow drop on Black Monday, October 19th,
1987. That’s an equivalent of over a 3,500 Dow point drop today. The lesson
learned is the Dow ended up 2.6 percent for the year in 1987, and
it was best to stay the course.
Ten years
ago the same type of financial pullback occurred, with the Dow backtracking 20%
in less than six weeks, culminating with a 6.4%, 513 point drop on August 31st,
1998. The Dow went up over 55% from there in 17 months. Again,
attempting to jump out and back in is
not the answer.
Thank you very much for your business; it’s a pleasure to serve you!
Sincerely,
Les Jepsen,
MBA
Jepsen Consulting
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