09/30/08 Connecting the Dots Part I

Good evening,



Over the last year and especially the last 2-3 weeks understanding the credit markets has been tough. This is not intended as a political statement. I believe in a Democracy and I believe in Capitalism. Neither ideology is an advocate for the other.



I want to bring more clarity to what’s going on and why there is so much urgency from not only our central bankers but also from central bankers around the globe. I’m going to hit the highlights so if you want more detail please don’t hesitate to call or email.



In the 1970’s mortgage backed securities (MBS) were introduced to the market. So let’s define a mortgage backed security. A mortgage-backed security is a claim to the cash flows generated by a specific pool of mortgages. Most mortgage-backed securities are issued by one of the three government-sponsored enterprises or agencies known as Ginnie Mae (GNMA), Freddie Mac (FHLMC) and Fannie Mae (FNMA). A growing trend in 2005 saw mortgage-backed securities being issued directly by large mortgage lenders. Since their inception in the 1970s, mortgage-backed securities became very popular as an investment vehicles among individual and institutional fixed-income investors. Key reasons for this popularity are that mortgage-backed securities offer attractive yields, have little or no credit risk and trade in a liquid secondary market.



In the 1980s, housing market analysts and policymakers were concerned that Freddie Mac and Fannie Mae were not adequately facilitating the financing of affordable housing for low- and moderate-income families. To address these concerns, the Department of Housing and Urban Development established quantitative Affordable Housing Goals requiring the Government Sponsored Enterprises (GSEs) to increase their purchases of mortgages originated by low- and moderate-income households and for homes located in low-income neighborhoods. Analysis indicates that the goals increased the supply of mortgage credit available to low- and moderate-income households, after controlling for other mortgage market factors. Analysis suggests that the increase in the supply of low-income mortgage credit occurred primarily in 1998.



Simultaneously in the late 1980’s the creation of collateralized debt obligations (CDO’s) entered the market.



During the Clinton Administration there were additional pieces of legislation to further open the American Dream of home ownership to more Americans. As a result credit standards were expanded and relaxed.



During the current Bush Administration there has been little to no request for any reigning of the deregulated markets. Both MBSs and CDOs have evolved in their 20 and 30 year existence respectively – more complex. What the secondary market bought and sold up until last year was in part very different than its origins. Some of the most significant differences were credit instruments that were introduced into or expanded in the market. For example, adjustable rate mortgages, car leases, student loans and most of availability of credit. These debt instruments were sometimes pooled together and separately and sold, re-pooled and sold again on the secondary market.



When you buy and sell any security there is an assumed underlying value to what you’re buying. As a buyer or seller of a security you should be able to determine what you’re buying. When you buy GE as a stock, you know you’re buying a company that makes light bulbs, they make jet engines, they sell life insurance policies and so on. For the buyers and sellers of CDOs and MBSs they stopped looking at what they were buying and selling and if they could even discern what they were buying and selling. Capitalism said there was a market and democracy didn’t intervene.



END PART I



Commentary on today – The stock market is just a sideshow to the circus. Credit markets are very, very nervous. They seem to expect more shoes to drop than were in Imelda Marco’s closet. Credit is the battlefield. The Fed added $330 Billion to its currency credit swap lines with foreign banks. Mid-morning yesterday, the Fed made available $630 Billion to the world financial markets. Mr. Bernanke has made it clear he “would like to get out of the business of crisis management (for which the Fed really lacks authority and broad support) and get back to monetary policy, which is our function, our key mission.”







Sources: Art Cashin-UBS, The Economist, Library of Congress,, St Louis Federal Reserve. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of September 30, 2008, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Merrill Lynch to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments. The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments. Index performance is shown for illustrative purposes only. You cannot invest directly in an index.