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Bond Market Weekly Week of September 22, 2008    |   Municipal and Corporate Review

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Supplemental Commentary A Brief Commentary on Recent Market Volatility, Credit Markets and the Financial System

Supplemental Commentary 

Last week delivered a number of watershed events for the capital markets, if not capitalism in general. Political influences have worked their way into the core of the economic policy and financial system debate. With the generall election l i just j six i weeks k away, and d both b h the h White Whi House H and d Congress C i play, in l these h hi historic i policy li moves will likely reverberate for years to come. Certainly, at a bare minimum, there is increasing pressure for tighter regulation of the financial services industry. Absent from the proposed “bail‐out” legislation being negotiated this week is meaningful oversight and regulation of the OTC derivatives markets, which in our view, is a key contributing variable to the current crisis. The deleveraging that is gripping the economy and the markets, it is argued, could lead to lower asset values – a major factor in the Fed and Treasury’s decision to provide up to $700 billion in liquidity to buy troubled assets f from b k and banks d brokerage b k fi firms. Al a run on money market Also, k funds f d and d bank b k deposits d i was an outcome the h system was not prepared to accept, as it would have surely led to unquantifiable and, perhaps, unstoppable consequences on an order of magnitude not seen since the Great Depression. We feel the leadership in Washington acted appropriately in selecting the least unfavorable course of action, despite the ultimate impact of significantly higher leverage at the federal level. Of course, systemic risk is not an unfamiliar concept for our nation’s financial system. Recall the Panic of 1792, which shook the foundations of our newly‐conceived nation, and was ultimately overcome with the help of policies li i instituted i i d by b George G W hi Washington and d Alexander Al d Hamilton. H il Si Since then, h the h United U i d States S h has experienced, managed and overcome a number of financial panics, survived world wars, and navigated through 43 peaceful transitions of executive power. In the process, our political, economic and social systems have evolved, adapted and even thrived to the point that the U.S. remains the pre‐imminent world leader and dominant global force. Our collective willingness and ability to assimilate quickly the requisite changes, enhancements and controls, and the transparency and freedom of our media/press sets us apart from other countries, and this, we believe, cannot be altered by the events of the past several weeks. If anything, the current episode provides another opportunity for America to demonstrate her resilience. WSC has distributed information to clients about the protections available to them as account holders at financial institutions who serve as third‐party custodians for their investments, such as Fidelity. We recognize that many clients are concerned not only about the safety and liquidity of their respective brokerage accounts, bank accounts or trust accounts, but also the underlying investment portfolios and securities holdings. We encourage clients to contact us with specific questions, and we will provide updates on our view of market conditions as developments warrant. In the meantime, we at Wasmer, Schroeder & Company will continue to act as diligent dili stewards d off your assets, and d with i h your financial fi i l safety f and d peace off mind i d remaining i i our first fi and d foremost consideration.

Bond Market Weekly Week of September 22, 2008    |   Municipal and Corporate Review Market Overview

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US Treasury Yield Curve 9/12/200‐9/19/2008; Source: Bloomberg L.P.

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4.5% Treasury Secretary Paulson and  Fed Chairman Bernanke along,  4.0% with the executive and legislative  3.5% branches of the government,  3.0% 9/12/2008 announced indefinite changes to  d i d fi it h t 2.5% 9/19/2008 the free market rules of US  2.0% capitalism last week.  By  1.5% backstopping money market  1.0% mutual funds, limiting short  0.5% selling and announcing plans to  buy securities in the market, US  authorities decided to take dramatic steps to avert a significant recession or depression by supporting asset prices and avoiding potential  failures at Morgan Stanley and Goldman Sachs.   It is now the job of investors to understand the new rules and  anticipate the ramifications for the spectrum of assets.  It will take time to do so.

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While details are debated, the plan’s initial accomplishments were higher prices for risky assets across the  globe.  Indeed, equity (S&P Beginning 1,252 – bottom at 1,133 – End 1,254), mortgage and credit derivatives  markets largely reversed steep losses observed early in the week, but at the expense of the Treasury safe‐ haven.  The benchmark 10‐year note rose 9 bps in yield to 3.82% over the week after falling 30 bps through  Wednesday.

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Of course government bailouts are not entirely positive as the cash must come from some source and the  ultimate success is debatable.  The source of cash is likely to come from additional Treasury borrowing and  higher taxes.  The prospect of additional supply is weighing on longer maturities in the Treasury market and  pushing the yield curve steeper as 2‐ to 10‐year spreads jumped 13 bps to +164 last week, while 2‐ to 30‐year  spreads jumped 11 bps to +221.  Momentum toward a steeper yield curve is likely to continue as fears of supply  as well as additional Fed easing remains the focus.  Perhaps as the likely long term contraction of the US  economy is realized, long dated Treasuries will find support, but this may take time to realize.

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Breakeven inflation shot higher on the news, but did not manage to make up all the ground that deflationary  fears traversed earlier in the week.  The current 5‐year horizon inflation expectation dropped 13 bps for the  week to 1.37% and as low as 1.03% on Tuesday of last week.

Tax Exempt Markets ‰

Municipals sold off sharply last week in the rush to buy Treasuries with 10‐ year yields up 18 bps and long bonds  up 26 bps.  While municipals rallied sharply on Friday it was not enough for them to retrace their losses from the  beginning of the week.

Bond Market Weekly Week of September 22, 2008    |   Municipal and Corporate Review

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Tax Exempt Markets ‰

According to the Bond Buyer, new issuance dropped sharply last week due to market liquidity, only $2.4 billion  were issued compared to $8.3 billion last year at this time.  With the Lehman bankruptcy filing as well as the  possibility of forced sales from AIG, issuers were tentative about trying to float deals.  Potential deals this week  include Wake County, NC and Athens‐Clark County, GA both of which were postponed from last week.

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Amid last week’s instability, the short‐term market also suffered a severe shock as the rates on weekly floaters  skyrocketed from 1.79% to 5.15%, according to SIFMA.  This was due to a rush of redemptions in money market  funds as well as Lehman pricing its inventory to move.  The difference between last week and February’s  auction market is that even with rapidly rising rates investors were able to get their cash from either the  remarketing agents or the LOC providers.

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Both Ambac and MBIA were put on downgrade watch last week by Moody’s who stated that their stress case  g g p y g y loss scenarios for their mortgage positions has increased materially and could significantly weaken both  companies’ capital positions.  On this news, Ambac decided not to go forward with the recapitalization of  Connie Lee at this time and MBIA’s deal with FGIC will be in jeopardy if they get downgraded.  The effect of the  government’s mortgage bailout on the bond insurers’ portfolios is still unknown.

Taxable Markets ‰

The tumult of the Lehman bankruptcy and the AIG last‐minute government bailout had a profound effect on the  corporate market.  The Lehman U.S. Corporate Investment Grade Index widened 58 bps to a +385 option‐ adjusted spread.  As expected, the Financial sector of the Index weakened the most with a 112 bps widening to  +522 OAS, but it also had a specific influence on the Utility sector with the counterparty risk of Lehman’s energy  and commodity trading units.  Utilities widened 38 bps to +304 OAS as companies were assessing their exposure  in the aftermath of Monday’s filing.  Industrials ended the week 24 bps wider at +291 OAS.

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Lehman s position in the corporate index amounted to a $28.2 billion loss or 1.6% of the par value.  This loss  Lehman’s position in the corporate index amounted to a $28.2 billion loss or 1.6% of the par value. This loss exceeded the 0.7% loss that occurred to the index from the WorldCom default in 2002.  

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As the commercial paper market froze, causing disruptions to the money markets mid‐week, agency discount  notes cheapened to Treasuries.  The 3‐month agency yields got as high as 2.8% Thursday (from 2.20% at last  week’s close) even as 3‐month T‐Bills were essentially yielding 0%.  A flight‐to‐quality in T‐bills, compounded by  agencies being sold for redemptions in money market funds, caused the disparity in agencies to Treasuries.  By  Friday, agency discounts settled at 2.35%, still cheap to T‐bills.

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The mortgage‐backed securities market continued to tighten after the Fannie and Freddie intervention by the  Fed the prior week, and the news of the government’s latest plan to create a new RTC‐like entity (being called  TARP – Troubled Asset Relief Program) helped buoy the mortgage market.  The Lehman U.S. MBS Index  tightened 5 bps to +112 OAS.