Peter Anderson, CIO RCM	Scott Migliori, Deputy CIO RCM

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RCM’s CIO Peter Anderson and Deputy CIO Scott Migliori outline their thoughts on the global financial crisis.

Perspective: A crisis in the financial markets

The current crisis in the financial markets is far bigger than the others we have seen over the last 40 years:

• Prior crises—such as the problems the banking system had with agricultural loans, sovereign lending in the commercial mortgage market, and oil and gas financing—were relatively localized over one small portion of banks’ balance sheets and relegated to the U.S.
• In the current crisis, what we’re facing primarily is a deterioration in credit across almost the entire spectrum of global bank lending.

This crisis is coming at us in waves—not just one housing-related crescendo.

• The first wave of credit deterioration is associated with subprime and prime lending. It took the form of mortgages themselves, but also derivatives that were spun off of that mortgage pool. While there is light at the end of the tunnel, the problem continues to worsen.
• Subsequent waves are coming at us in the form of:
  • the deterioration in auto lending, both prime and subprime;
  • deterioration in credit card receivables;
  • deterioration in commercial mortgages, which is a very serious problem;
  • a virtual freezing of the student loan market and the abandonment of that market by a number of lenders; and
  • deterioration in the commercial and industrial loan portfolios of many banks, which for many midsize banks is the heart of the business.

Financial institutions have already been weakened by the first, housing-related wave. Their capacity to withstand the oncoming problems that have not fully developed in other asset classes is therefore in question.

Compounding this problem is that many financial markets are simply frozen.

• You can see it in the interbank lending market, reflected in LIBOR, where spreads suddenly gapped out to historic highs.
• The credit swap market is largely frozen.
• Portions of the bond market, particularly the junk bond market, are frozen. The capacity to move obligations that still sit on the balance sheets of many brokers is greatly impaired.

With the whole system frozen and fear rampant, we’re in a massive credit crunch, both in the U.S. and abroad.

The Fed and the Treasury, acting in coordination, have taken a number of steps to deal with this multi-faceted problem. We at RCM believe that these steps are appropriate and have been effective, yet we believe more must be done to establish a structure of stability:

• We will see a new government entity, where the government buys billions or even trillions of dollars in assets from distressed financial institutions. These assets will not only include mortgage obligations, but also other toxic assets such as credit card receivables, auto loans, commercial mortgages, student loans, etc.
• We will likely see further easing from the Fed.
• We anticipate seeing additional fiscal stimulus in the form of another package of stimulus, most likely early next year.

Analysis: The credit crunch’s impact on the economy

To date, the country is holding up remarkably well, considering the stress that is in the financial system. The economy has been continuing to grow—at least until the last month or two—at a moderate rate. However, there are four primary economic challenges ahead of us.

1. The consumer—who actually provides about 65%-70% of real GDP—is under enormous pressure from:
   • rising inflation associated with food and fuel;
   • mortgage resets and rising taxes;
   • a stagnation and even shrinkage in employment;
   • declining growth in wages and benefits; and
   • a worsening consumer mood that is not conducive to continued growth in consumption. In fact, for the first time in a long time, consumption actually fell in August.
2. State and local spending, another component of real GDP, is also under considerable pressure, particularly on the West and East coasts. In the center of the country, the oil and agriculture boom is producing revenues that have alleviated those pressures, but states like California and New York are running massive budget deficits. That means state and local spending on goods and services will slow, though not necessarily turn negative.
3. Capital spending, another component of real GDP, is holding up extremely well. However, this comes on the back end—not the front end—of the economic cycle, so we should anticipate weakness in capital spending in coming months.
4. Net exports have been an enormous source of growth for this economy, but given the very rapid deceleration we are seeing oversees in Europe and Asia, we should anticipate that the growth in exports will slow, though not necessarily turn negative. In 4Q08 and 1Q09, we could definitely see real GDP head downward, so there’s further weakness ahead of us.

Outlook: What RCM Sees on the Horizon

Obviously, the current bear market has been grinding on for more than a year. Most market indexes in this country are down approximately 25%, and the carnage overseas is far more severe. However, there are glimmers of hope in the economy.

• Housing prices have continued to decline in a number of different sections of the country, but those declines are slowing and in some places have come to a halt.
• In addition, aspects of the Freddie Mac/Fannie Mae restructuring are very positive for home buyers, as they have removed uncertainty and should drive mortgage rates lower. So just as these problems started in housing more than a year ago, the resolution of our difficulties may also start with housing.
• We believe that signs of stabilization within the economy, and the beginning of a recovery, is likely to occur in 2Q09.

In summary, we have been in the meltdown phase of this market, where people finally give up and head for safety wherever they can find it. However:

• We believe the end of this decline is very close—it could be a matter of days or weeks.
• We believe this is not the time to reduce your risk profile and throw stocks over the side.
• We believe that what is unfolding is an enormous opportunity to buy attractive, high-quality growth stocks at modest valuations.

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