Newsletter

March 30, 2007

To Our Valued Clients and Friends:

1. Risk and the 1st Quarter
2. Subprime Lenders: Their Clients and Why You Should Care
3. The Good News and the Bad News

I. Risk & the 1st Quarter

It is the final day of Spring Break and I have had the opportunity this week to catch up on my reading and reflect on the last nine months of market activity before writing to you. Reflecting on the last nine months is important, I feel, because it was approximately nine months ago, at the end of the second quarter of 2006, that virtually all indexes were in decline. Both domestic and international markets were falling while commodities were negatively correcting for the first time in more than 24 months. It was also the time I reemphasized the R WORD, suggesting that a combination of events could contribute to a downturn in the U.S. economy. Nevertheless, the markets pleasantly surprised many and provided a wonderful steady rise in values from July of last year to mid-February 2007.

The month of February started well but soon turned into a rollercoaster with the market dropping 415 and 250 points respectively in two bad trading days. Nevertheless, by mid-March the markets began to rebuild and recovered most of the losses that had occurred when the Dow dropped below 12,000 in the early portion of March.

During the first quarter of this year, Alan Greenspan mentioned the possibility of recession being one in three. Other minor economists are now suggesting the possibility of recession might be a bit higher. I believe that depends on the possible “snow balling” effect that the problems generated by subprime lenders may have on both the financial sector and housing markets. In the second section of this newsletter, I am going to draw this group to your attention and suggest why you will want to observe their progress closely over the next year. The bottom line regarding risk during the first quarter, however, is that volatility has returned to the market, warning us that risk to principal is real and that our portfolios need to be positioned to reflect that risk—and they are.

II. Subprime Lenders: Their Clients and Why You Should Care

Definition of a subprime borrower: A person or company that does not qualify for a traditional mortgage, loan, or credit card normally offered to those who have outstanding or prime credit worthiness. A subprime lender is the provider of loans to subprime borrowers.

As you know, there has been much talk of a housing bubble over the last couple of years, but fortunately, here in central Alabama, we are not overly affected by the commotion. While the number of homes on the market in Birmingham has increased (related to both the number of houses and the time they stay on the market unsold), this area has not experienced the dramatic decline in housing prices that many areas have already experienced. In a few of the more overbuilt and speculative areas of the country, price reductions of as much as 40% have occurred during the last 18 months. The only area we observe closely with the potential for this much of a possible decline is our Panhandle area in Florida where prices in the non-premium areas have fallen 25%, and absolute auctions by developers are beginning to be talked about. (When these absolute auctions begin in the Panhandle area, and I believe they will soon, a new per square foot pricing figure will be established. I do not know how deeply this may affect real estate pricing in the Panhandle, but I do believe that the Panhandle will take years to work through its massive inventory. So, do not get excited about what may appear to be a buying opportunity for I believe this opportunity will be around for a long while, similar to the Panhandle real estate market of 1986 through 1993.)

It is against this backdrop of over-building in specific areas that we begin to consider subprime lenders and their clients. Because of the boundless creativity of lenders over the past several years, many folks who had no business qualifying for large mortgages to purchase properties were able to make home purchases without meeting the traditional qualifying standards of home ownership. Verification of income, credit histories and tax returns were apparently not asked for by many of the subprime lenders who were far more interested in generating the loans and collecting fees than placing a good loan on the books.

I believe the reason for this suspension of sound credit practices was the result of the enormous amount of liquidity provided by hedge funds and private equity that were desperate to get that liquidity “out the door” and into some form of interest-bearing production. Unfortunately, many of these subprime borrowers began to default on the loans that were made in amounts equal to 95% to 105% of the properties’ appraised value within months of the loans closing. As default rates began to rise, the traditional bank lines provided to the subprime lenders to fund the subprime loans were pulled. The subprime lenders were no longer able to make loans, and now they are unable to collect fees and are going out of business. (Some subprime lenders stocks are now selling at only 5% of the values that these stocks demanded in 2006.) It is suggested that 20% of the mortgage loans made over the last three years were to subprime customers, but I believe this is only the “tip of the iceberg.”

A subprime client is not just someone that slipped through the loosened credit standards, but I suggest this definition be expanded to cover loans made in excess of the traditional 80% amount that can be borrowed on a home without paying private insurance. These borrowers, and it is a very large number, chose to drink at the creative lender trough, as well, by choosing larger mortgages through a variety of adjustable rate options that allowed them to pay the lowest possible payment for the greatest amount of house. I cannot tell you how many of my clients have commented over the last several years, “Where is all this money coming from?” or “We see so many young people in such large homes.”

I believe that a good portion of the housing boom has been funded by creative financing to subprime borrowers, and the only questions that now remain are how far will real estate prices fall, how long will the decline last and how far upstream will the problems caused by defaulted loans and falling collateral values flow.

I believe that the first to begin taking financial hits will be the hedge funds and private equity pools. Barron’s reports that many hedge funds will report losses in the hundreds of millions of dollars in writing down their investments in subprime funding of mortgages and credit card funding. (You will remember that hedge funds operate with little oversight by regulators.) The snowball effect here, and believe me, I believe that all of us will be affected by this issue, will begin when the hedge funds need to raise cash for redemption purposes. Hedge funds will begin to sell whatever they can to raise cash. This selling will occur with traditional investments in the market, and this will begin to effect market value and individual investors who have nothing to do with hedge funds. I believe that it will be a combination of the hedge funds that are in need of liquidity for redemptions combined with hedge funds that benefit from an increase in market volatility that will contribute to the increase in market volatility for the remainder of the year.

Let’s return to the individual borrowers for a moment. Against a backdrop of falling housing prices, there are many adjustable rate mortgages that are beginning to reset. This is resulting in substantially higher payments that must be paid by homeowners. There are a lot of these folks that borrowed more than 80% of the value of their homes, so they are unable to switch to the traditional 15- to 30-year, fixed rate mortgages which require a minimum of a 20% equity position. The traditional rates have remained historically low, but these adjustable rate borrowers tied their payments to short-term rates secured several years ago to keep their payments as low as possible. Let me remind you that while the 10-year Treasury Bill rate has remained at about 4-½% for the last 18 months the prime rate, a short term rate, has more than doubled over the last 18 months from 4% to 8.25%. This increase in short-term rates and now mortgage payments is leading to a rapidly accelerating mortgage delinquency rate. It is this group that is having trouble making their adjusted monthly payments. I believe the issue of adjustable rate borrowers combined with the problems of the subprime lenders and their clients will possibly contribute to a slowing of the economy and potential economic recession. If you think that the world economy can disconnect itself from U.S. housing problems, all you would have had to do is observe the international markets over the last six weeks to see how dramatically they corrected when it appeared that America might be moving into a recession. The American consumer continues to fuel the world economy, so we must not be complacent about our international investments in regard to the potential for a recession in the United States.

Well, now that my reputation as being a curmudgeon has been restored, I want to mention that we have made several changes in our portfolios during the quarter. As I had mentioned in earlier e-mails to our clients, at the end of January, I raised cash by selling our positions in the Fidelity Canada fund and eliminated the residual of a small growth fund that we sold in mid-2006. The increased cash position allowed us to weather the last six weeks with reduced volatility because of this “oversized” position. The cash has now been re-invested in a long and short fund, which will allow us to “hedge” the account slightly due to the prospects of continued volatility. Our major emphasis continues to be in balanced U.S. funds with all balanced managers having the capacity to move the majority of their funds into bonds and cash if necessary. At this time, those balanced managers continue to be 65% to 68% invested in the U.S. market.

III. The Good News & the Bad News

I continue to be surprised by the divergence between the front page news stories I read and the progress of the market in the business section. On the front page side, we seem to be spending our grandchildren’s future on a war for which I see no financial end. We see housing values beginning to fall, and some economists suggest that this fall could last for as long as 10 years, at about a 2% a year, for a total of 20%. It will be interesting to see if the U.S. consumer can continue to drive the economy if home equity lines are maxed out because of past borrowing, no increase in “appreciative equity,” and lenders return to tightened credit standards for all.

Americans have no savings on which to rely—the country has just finished a second year of having a negative savings rate. And, a reduction in consumer spending could cause a downturn in the economy that may snow ball into a real problem. Yet our markets continue along their merry way without a major correction—yet! Corporate earnings have continued to climb in many selected industries, yet I have a feeling that the U.S. consumer and a number of hedge funds have already stepped off the cliff. We now wait to see how damaging their fall will be and how those fall will affect the rest of us.

While the markets may not be terribly overpriced and seems to be positioned so that the economy will avoid recession, I do not believe the markets have correctly considered the impact of a prolonged stagnation of housing prices and of a tired consumer. That is why we continue to position the portfolio in a conservative manner. Oh, where are all those optimists that were here in March of 2000?

We have had a very good year, and we appreciate your faith and support in our firm. Thank you from all of us.

M. Brooks Clark

MBC/lh

A Bit of Housekeeping

It is our goal to improve our service to you each year. Would you take a moment to assist us in achieving this goal by completing the enclosed survey? It asks, “What one thing can we do to serve you better?” I thank you in advance for your help in helping us improve our service to you.

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The numbers:

Index	12/29/06	3/30/07	YTD % Change
Dow	12,436	12,354	(.6)
NASDAQ	2415	2421	+.2
S&P	1418	1420	+.1
Russell Value	818	823	+.6
Russell Growth	554	558	+.7
Treasury	88.47	88.35	(.1)
REIT Index	83.82	85.27	+1.7

Conclusion: You could have been gone for the quarter and not missed much!

PLEASE NOTE: All checks to be added to your accounts should be made payable to: Fidelity

*Clark Financial Advisors is registered with the Securities and Exchange Commission (SEC) as a registered investment advisor and annually files an ADV with the SEC, as required. The ADV II form provides background on the firm and its principals. If you would like to receive a copy of this form please contact Amanda McCollum via email at Mario@clarkfinancialadvisors.com to receive a copy. You may also return this page of the letter with a note signifying your request for a copy of the ADV II filing for Clark Financial Advisors.