Stephen Clinton, President, Capital Market Securities, Inc.

11/2008

Market Update

The U.S. financial system has been rocked by the biggest crisis it has faced since the 1930s. The government has responded with a multi-pronged intervention not seen since the New Deal. The government has taken various actions to inject liquidity and confidence into the financial markets.

Recent events that demonstrate the depth of the crisis include:

• July 11 – FDIC seized IndyMac which reported $32 billion in assets. Cost estimates are that $4 billion to $8 billion will be lost by the FDIC fund wiping out 10% of the FDIC’s $53 billion deposit insurance fund.
• September 7 – FNMA and FHLMC were placed under government conservatorship.
• September 15 – Lehman Brothers filed for bankruptcy protection after the regulators decline to participate in a bailout similar to the Bear Stearns March 16th deal with JPMorgan Chase; Merrill Lynch announced its sale to Bank of America.
• September 16 – The Federal Reserve agreed to provide an $85 billion bailout for AIG.
• September 21 – The Federal Reserve approved Goldman Sachs’ and Morgan Stanley’s request to become bank holding companies.
• September 25 – Washington Mutual, with assets of $307 billion, became the largest bank failure in U.S. history after JPMorgan Chase acquired the thrift from the FDIC.
• September 29 – Citigroup announced a planned purchase of Wachovia’s banking operations, including a government guarantee on loan losses.
• October 3 – Wells Fargo announced an agreement to purchase Wachovia at a higher price than Citigroup without government assistance.
• October 3 – The much discussed modified $700 billion financial rescue bill (Troubled Asset Relief Program “TARP”) was passed by the House of Representatives and signed into law by President Bush. FDIC deposit insurance coverage limits were raised from $100,000 to $250,000. TARP also moved up the date for the Federal Reserve to pay interest on bank reserves from October 2011 to October 2008. An additional provision of TARP is commentary that the SEC has existing authority to suspend market-to-market accounting rules.
• October 6 – The Dow Jones Industrial Average fell below 10,000 for the first time in four years.
• October 6 – Bank of America entered into an agreement with various states regarding alleged lending violations of Countrywide Financial Corp (which was purchased by Bank of America in January). The settlement, which covers subprime lending activities of Countrywide, could cost Bank of America more than $8.4 billion.
• October 14 – The Treasury Department announced plans to use a portion of TARP to buy preferred equity in banks to strengthen bank equity positions and to promote lending.
• October 24 – National City, the 11th largest U.S. bank in terms of deposits, announced a sale to PNC, with a purchase price of approximately 35% of tangible book value. PNC indicated that National City’s loans are being written down an additional 17.5%.

There are numerous areas of concern that the financial crisis poses to community banks. This publication does not provide the space to address all of these concerns and their respective ramifications. We are especially concerned about the following:

• Interest Rates – The passage of TARP, along with funding the other bailouts (i.e., AIG), is expected to cause the budget deficit to reach $900 billion in fiscal year 2009. That is double the projected deficit for 2008. Adding debt that must be refinanced, the Treasury’s total funding needs will be at least $1.5 trillion. This funding will create large government auctions at a time when fear and uncertainty prevails in the market. We anticipate longer-term interest rates will move higher as a result.
• Economic Activity – Consumer spending has long been the driver of the U.S. economy. The decline in consumer wealth (due to declining real estate values and the lost value of investments) is expected to slow consumer spending. A look at September auto sales provides an example of consumers “tightening their belts.” In September, U.S. auto sales reached a 15-year low. Sales of cars and light trucks fell 27% for the month. We suspect that the economy has entered into a recession, our first since 2001.
• Deposit Insurance Cost – The FDIC fund has fallen below the mandated 1.25% level of insured deposits. The rise in the deposit insurance level to $250,000, along with expansion of insurance coverage to all demand deposit accounts, will reduce the ratio even further. Future anticipated bank failures will further tap the FDIC insurance fund. Banks are expected to see higher deposit insurance premiums in order to restore the health of the FDIC insurance fund.
• Real Estate Values – The TARP envisions the government spending a portion of the $700 billion on purchases of mortgage assets. This plan creates a variety of problems. The first will involve how and at what price the purchases occur. Thereafter, what actions the government takes to modify the loan terms of these troubled borrowers could be troublesome. Lower rates or other concessions will reward delinquent borrowers. Other borrowers who have struggled to keep their loans current are expected to seek similar assistance and concessions (from their lenders or the government) that their delinquent neighbors receive. We also wonder how the government will divest itself of these loans (assets). Historically, government sales occur at significant market discounts (i.e., the 1990’s thrift crisis handled by the RTC). The government’s holding of these assets and the disposal of them in later years may in fact keep home values (and related mortgage-backed securities) depressed for a longer period of time as a result of government sales activities in the future.
• Commercial and Commercial Real Estate Loans – The credit crisis has been principally related to declining residential real estate values. Should this decline be followed by a material fall in commercial real estate values, additional losses can be expected from the banking sector. The state of the economy will be the deciding factor in whether the credit crisis spills over to the commercial real estate market.

On a positive note, oil prices have fallen dramatically. Oil prices declined to near $60.00 in late October, falling to a level not seen since the spring of 2007. The decline is attributed to concerns that the spreading financial crisis will exacerbate a global economic slowdown and lower demand for oil and oil-related products.

The Federal Reserve lowered the Fed Funds rate 0.5% to 1.0% on October 29. This is the lowest this rate has been since 2004, and the rate has not been lower since 1958. Short-term interest rates have fallen significantly this year with the 3-month T-Bill ending on October 30, 2008 at 0.41%, down from 3.36% as of December 31, 2007. The 10-year T-Note as of the same date was at 4.00% compared to 4.04%, at year end 2007. The yield curve has steepened as short-term rates have fallen more than longer-term rates.

As of October 30, 2008, the Dow Jones Industrial Index had fallen 30.79% in 2008, compared to the Nasdaq Composite Index decline of 35.96%. The banking sector has also declined with the SNL Banking Index posting a decrease of 32.53%.

As a result of the price declines that banks have experienced, many banks are now trading at levels not seen for years. We consider this downturn an excellent opportunity for making bank investments. Bank investors need to be cautious and choose banks that are well capitalized and that have managed to avoid significant credit quality issues. Merger and Acquisition Activity Through September 30, 2008, there were 120 bank and thrift announced merger transactions. This level of activity is significantly lower than in prior years. The median price to tangible book for transactions involving bank sellers was 180%, with a trailing 12-month price to earnings multiple of 23.5. These multiples compare to 233% and 22.9 respectively for 2007.

Capital Market Services Young & Associates, Inc. has a successful track record of working with our bank clients in the development and implementation of capital strategies. Through our affiliate, Capital Market Securities, Inc., we have completed transactions totaling over $350 million in deal value. For more information on our capital market services, please contact Stephen Clinton at 1.800.376.8662.