Given the dramatic financial events of the last few days, I thought it would be good to let everyone know how we have been proceeding at Secure Retirement. A little background may be helpful. Last Sunday the U.S. Treasury Department took over Fannie Mae and Freddie Mac. These were private companies that presumably had the full backing of the Federal Government. They were therefore able to access almost any amount to buy mortgages. Not surprisingly, they bought and sold large numbers of questionable mortgages. With losses mounting, the Government had to step in and guarantee these mortgages. Had they not done so, there could have been a huge stampede out of U.S. debt, and the debt rating of our entire country could have been in question. In addition, people throughout the country would have had a nearly impossible time getting mortgages. Our economy would grind to a halt – quickly. That one had to be done.

Last Monday this takeover was announced, and the stock market roared, going up over 300 points right away. But last Tuesday I heard that Washington Mutual might go under. I looked on my computer screen and saw it going down over 20%, Lehman Brothers going down 45%, and AIG going down over 20%. These are major financial institutions. Plus, Lehman and AIG were involved in literally hundreds of billions worth of financial transactions with other institutions, including Morgan Stanley, Merrill Lynch, and numerous other large banks. There was a chance that, if Lehman went down, they would all fall together.

But even if one of the four remaining investment banks, Lehman Brothers, a major retail bank, Washington Mutual, and what was the largest insurance company in the world until recently, AIG, were to go out of business around the same time, it certainly seemed probable that this could lead to large losses in markets throughout the world. It could be one of the largest financial disruptions in our history.

Seeing this, last Tuesday I wrote a report detailing how Lehman, Washington Mutual, Merrill Lynch and AIG might all go under very quickly.

In response to these concerns, last week I sold our riskiest investments. Specifically, I sold all of our international investments, plus our global basic materials fund. Global basic materials was plummeting in price in Asia and Europe as I wrote this. It was time to have sold it, given the risk level.

In terms of our international sales, while the financial problems were all caused here in the good old U.S.A., international investing is still substantially riskier than our stock market. While our market is now down 17.52% this year, the major international stock index (EAFE) is down 22.49%. The Chinese stock fund we had held and then sold for some clients in December was down over 46% through Monday, and Chinese stocks were tumbling again as Asian markets opened this morning. Watching this, I was certainly glad we sold our international funds last week.

Plus, the international funds are the only ones about which I cannot know fairly precisely what they are doing. The fund managers simply don’t share enough information, which adds more risk to me – and it is risk I can’t measure. In this type of market, I cannot take any risks I cannot carefully measure and account for as closely as possible. Uncertainties won’t do.

On the other hand, the stock funds that remain are all managed by people who are the best of the best, and I know precisely how they are investing our money. As I will try to describe below, I believe their success is assured.

Going back to our story, as you have probably heard by now, on Sunday Lehman Brothers announced they were filing for bankruptcy. And by Sunday evening Bank of America had purchased Merrill Lynch. I pretty much expected markets to go way down. Watching Asian markets open Sunday night, I saw a fairly muted response, as they went down 4%. European markets also opened and stayed down around 4%. Then our market opened yesterday morning, but down only a “modest” 2% or so. Of course, by the end of the day yesterday the Dow was down just over 500 points, its sixth largest point drop ever.

Fortunately, our changes from last week definitely helped us. With about 20% of our (your) stock money in cash, that lowered our risk 20% from the start. But keep in mind I sold our riskiest funds. I kept the safest stock funds in the country. Berkshire Hathaway, one of our two largest stock holdings in all accounts, actually went up .88% on Monday, as the market plunged 4.7%.

Warren Buffett is again showing why he is the best. When things are at their worst, he is going out to create huge profits for his company. AIG is wavering right now, and has a good chance, I would say, of going under by the end of the week. Their stock has been going down 20-60% regularly the last few days, and I believe I just saw it is down over 70% today. When financial stocks do this, they hardly ever recover, because large financial companies cannot continue to remain solvent when everybody else loses faith in them. Their bonds plummet in value, and sources of additional capital stop – often completely and suddenly. But the insurance regulatory authorities require a certain amount in reserves. AIG was $40 billion below those reserves at the start of the day yesterday, Monday. The regulatory agencies had told them on Sunday that they had until the end of the day on Monday to come up with the additional money or they would be downgraded. This could be their death knell.

So AIG spent all day on Monday trying to get their $40 billion. They first begged the Federal Reserve Board to lend them the money, but the Fed refused. AIG then went to Warren Buffett and begged him to bail them out. Instead, I imagine Mr. Buffett may have offered to buy at least several of AIG’s larger insurance subsidiaries – at very low prices. Of course, Mr. Buffett knows that these may be purchased even lower out of a bankruptcy, which may be inevitable and imminent for AIG.

AIG had already told the Fed that they could go under if Lehman Brothers was allowed to go under, because they shared risk in a huge number of derivative contracts, the financial transactions mentioned previously, worth massive amounts of money.

After not receiving their financing, last night the ratings agencies made major cuts to AIG’s credit rating. Also, last night the Fed asked Goldman Sachs and J.P. Morgan Chase, two of the best large financial institutions left standing, to offer AIG a $75 million line of credit. The fear is that they and perhaps numerous other large financial institutions could all go down together due to these derivatives.

As of this Tuesday morning, no other company has come forth to back AIG. I therefore expect AIG to fall tomorrow, Wednesday. We’ll see, but it doesn’t look good for them. They did a huge number of risky, stupid things. They deserve to fail, having lost tens of billions of dollars, mostly in the derivatives. We’ll see if they take down any of the others, as AIG says is going to occur. I certainly hope not. If Goldman and perhaps Morgan Stanley take cover like Merrill Lynch did in a large, highly capitalize bank, they can also be safe and valuable again. Goldman is the prize in this group, so I’m not really worried about them very much. Morgan Stanley does worry me, perhaps the most, as it is so large and would disrupt our markets so much. People would very likely panic if this occurred. I doubt that Morgan Stanley will fail, but I am paid to worry about these things.

Warren Buffett warned about this massive derivative contract monstrosity the investment banks were creating nearly four years ago, implying these derivates would some day bring down the financial sector. This certainly seems to be happening before our eyes. Bruce Berkowitz of the Fairholme Fund has been talking about the dangers in this huge, risky derivative contract market for years, warning again in his recent article. These derivatives were very risky, involving hundreds of billions of dollars, and if they go bad together, everyone near them is in serious trouble.

If Goldman and J.P. Morgan don’t walk away from the Fed’s idea for them to be financially liable for AIG’s mistakes, we should be very, very concerned. If they would put up to $75 billion to cover potential debts of a company verging on bankruptcy, this could only mean that Goldman and J.P Morgan have enough counter-party risk themselves that they could lose a whole lot of billions if AIG goes under. If this is the case, the only major investment bank that would be safe is Merrill Lynch. While I continue to think somewhat unlikely, this could happen.

Merrilly Lynch was, again, purchased today by Bank of America, a very conservative bank that has huge reserves to keep Merrill protected from the carnage around them. Once again, the conservatives are winning the long race. I’ve been told B of A may not always be a model of great business management, but that they tend to prefer safety. When things are bad like they are now, safe works really well. They have been able to scoop up Merrill Lynch at a time when all Merrill’s major competitors are either out of business or potentially going out of business. I would love to be in their shoes. I suppose I am, as Berkshire Hathaway owns I believe 9% of Bank of America, and we own Berkshire stock.

Hopefully Goldman Sachs & JP Morgan will turn down the Fed’s offer completely, and it now looks as if they are going to walk away. AIG will then most likely go out of business this week without, hopefully, bringing other large financial institutions down with them. I don’t know if they will, and it appears as if perhaps no one in the world knows, as the financial instruments they all used were too complicated for anyone on the planet to understand, and there were too many of them. The investment banks, except Goldman for the most part, sold them for huge commissions, presumably to control risk! What a fraud. AIG deserves to fail, if you look at the outlandish risks they took, and the massive, massive losses they are sustaining as a result. Remember, it’s the conservative ones that win – those that embraced risk like AIG lose fortunes, as AIG has and is losing. If Goldman indeed isn’t connected to much if any of that stupidity, they will not only continue to compete with Merrill but will continue to do a much, much better job. Goldman will roar – as will B of A – as AIG collapses, and both may be able to pick up valuable pieces of AIG’s huge business at lovely discount prices. Goldman and B of A will then control the entire investment banking industry, along with, hopefully, Morgan Stanley.

Even with all this being the case, the good companies in this market, the few survivors, should flourish. It may take a bit of patience, but these companies are getting poised to potentially roar. I would not take the risk of investing in them myself in this volatile market, but I am pretty sure they will make excellent profits over the next 5 years or so – no matter how ugly things could get along the way. They’re a pretty safe bet, at good prices. But all the independent brokerage firms, almost certainly I would say Goldman Sachs and probably, though perhaps not, Morgan Stanley, are most likely going to be consumed by other very large banks as B of A just consumed Merrill Lynch. I guarantee you Goldman Sachs is the prize. They are by far the best, in profits, judgment, risk control, etc., etc. There isn’t a second in their group. Of course, the bar isn’t set particularly high in their crowd, as half of them are going out of business, having lost more money than most nations would see in a decade in their entire economy. Some of them have lost from $40 – 75 billion in the last few weeks. Many of these companies have and perhaps are going under before our eyes, and they are some of the largest financial institutions in the world. What fools.

Fortunately for us, this market is now so much tilted towards Berkshire Hathaway as to be nearly unfair! Berkshire owns the best insurance companies in the world, with the highest credit rating in the world. And their CEO Mr. Buffett is both the greatest investor in the country and the greatest operator of insurance companies in the world. And he has something like $30 billion to invest when huge insurance companies are going out of business or selling themselves – in parts or in whole. It’s like a smorgasbord of great insurance companies for Mr. Buffett. The moment he buys a new company, their financial problems disappear completely, as they are now backed by the highest-rated company in the world, Berkshire Hathaway. If they were good insurance companies merely suffering from being owned by a parent that had a bad credit rating, they automatically are worth a higher amount. This is a recipe for large gains going forward for Berkshire’s insurance division. It’s the best in the world, and in the process of getting better – at rock bottom prices, most likely literally out of bankruptcy.

Our other stock funds are similarly poised. They own stock in the best companies – companies that continue to make money in today’s economy. And they are now able to buy the stock of great companies like this at basement-bargain prices.

We recently published excerpts from an article with Bruce Berkowitz of the Fairholme Fund, who in many ways I consider to be the best investor in the country at this time. A student of Warren Buffett, Mr. Berkowitz has a nearly unparalleled track record of safely making large returns. In the article, Mr. Berkowitz explains how he loves this particular type of market. He prefers times like these, as he wants to buy the best companies at the lowest possible prices. When he does that, he makes substantially larger returns. As a result, he will make more money if the market goes down than if it goes up. He has tripled his principal in the last eight years, while the stock market has gone down 18.6% (the S&P 500 was at 1465 on 9/15/00 and had dropped to 1191 on 9/15/08). And this year he is down only 27% as much as the stock market. Everything I see from him, and all his actions, point to him as the best investor – particularly for retirement money – in the country.

So we have much of our stock money in what we believe are the two safest stock funds in the world. One (Berkshire) went up .88% on Monday, while the other went down 3.3% (Fairholme), as the stock market stumbled over 500 points or 4.7%. Hardly the end of the world for us. Our other stock funds went down more, but they are basically just as good. In our upcoming quarterly report I will include a special article on Third Avenue Value. The short version is that they are poised to do remarkably well over the next 2-3 years. They always have in the past after bad times, and a person can see how they are doing the same things again. Although they have gone down the most for us this year, they are probably more likely to deliver higher returns – safely – over the next few years than any of our other managers. Combined with our other holdings, we are certain our managers are continually increasing the value of what we own. And will do exceptionally well price-wise when we are nearing the end of the housing downturn – probably at least 9 months before housing hits bottom.. Unfortunately, I assure you I do not know when this will occur! I’m still not able to predict the future, though I can see some obvious things. One is that this is a time of unusual risk, requiring more safety.

When you own great companies that always make money, they basically always go up over time. When you purchase them at low prices, you pretty much always end up making a lot of money. This is quite safe, such that I am not worried at all about the stock holdings we have kept. They will end up worth substantially more, regardless of how difficult it may be for our economy along the way.

As previously mentioned, last week we lowered the risk level of all our portfolios. For example, our growth portfolios were lowered such that they have nearly 40% in bonds and cash. Conservative portfolios were lowered such that many have had 75% or more in bonds and cash. With bonds going up, they continue to be quite safe. Of course, we have many portfolios at different levels, depending on the needs of each person. But wherever you began on our risk “scale,” every portfolio got safer last week, before Monday’s steep losses. Should it continue, our safety measures will continue. Then, we will be buying more of the great funds we presently own, at low prices, plus adding one called Third Avenue Small-Cap Value. I have been looking for a good small company fund for some time, but the best ones were closed. This fund reopened recently. It is an excellent small company fund that has 30% in small international companies. They’re down 6% this year, and have done very well over time. Plus, like Third Avenue Value, they are some of the best ever at finding great deals during bad times. They will make a lot of money over the next few years, more safely than nearly anyone – except our other fund managers.

I basically recalculated the risk level in our portfolios to protect us at the 99.9% probability level. More cash does the job quickly and certainly. My goal is to make sure my clients never touch the number we agreed upon at the 99% risk level. But we may be in the midst of an economic event beyond the 99% level, so I needed to account for the extra risk and lower the overall level. We’ll be safe, most likely never touching our original lower risk level. And if we do touch it, only briefly, and only going down a small amount below the original risk level selected.

But I still doubt our worst-case scenario will happen, and I certainly do not herein wish to imply that I think we are going to have a terrible meltdown as I’m describing. It’s up close enough that I can see a meltdown occurring in many areas or finance, but I don’t know how many other companies will be injured, and which ones. I see enough to obviously be very concerned, but it could get resolved tomorrow or spread. It probably won’t spread, and we’ll look back at this time as a great time to have been buying stocks – which is precisely what we’ll begin to do when this truly gets resolved. That could take some time, most likely until the underlying asset beneath the whole mess – residential real estate – begins to at least stabilize. I know it will recover, but I am pretty sure I don’t know when. It looks like it may take a while, so I’m not in a big hurry to invest our cash. I like the extra safety until I’m sure this storm has passed.

For me, all the above means I basically get to monitor the market like a doctor would a sick market – pretty much 24/7. I watch the Asian markets when they open and watch Europe open later in the night. I get to hear thoughts of some pretty good economists discuss what our financial stocks are doing in their markets, hours before it is reflected in our market. While I seriously doubt that I would ever need to make a change in so short a time as 5 ½ hours, by knowing that much in advance I could act as quickly as possible if it should ever be needed.

I’m sure it won’t. But I still prefer to monitor this market pretty much constantly until it settles down. This is an unusually dangerous time, and my job is to make certain my client are protected. Note the word “certain.”

I will keep everyone informed. Of course, please call me with any questions. I assure you I am monitoring this around the clock. We are on a safe, stable course that will end well for all our clients.

Sincerely,
Richard Morey
President, Secure Retirement