(or, WHAT THE HECK IS GOING ON WITH THE STOCK MARKET LATELY?)

August 13, 2007

Homebuyers receive cash from a primary lender in exchange for making a promise to repay principal and interest by signing a mortgage.

The primary lender sells the mortgage to a mortgage company. The primary lender uses the sale proceeds to make additional loans to homebuyers and a small profit.

Some large mortgage companies such as Countrywide Financial Corporation act as both primary lender and mortgage company, but most often the primary lender sells the mortgage to a separate mortgage company.

The mortgage company packages many loans together to create a single bond. The bond is sold to an investor, typically a mutual fund, hedge fund, or pension plan. The investor is then the bondholder.

From that time on, the mortgage company is obligated to make interest payments to the bondholder and to repay the bond principal, or face value, at the bond's maturity date.

Homebuyers make monthly payments to the mortgage company. The payments are passed along to the bondholder as interest payments on the bonds and as a source of cash for the mortgage company to buy additional mortgages.

Part 2 - The Last Four Years

Housing prices increased sharply in recent years, pushing homebuyers to take on more mortgage debt.

Interest rates declined, making it possible for homebuyers to take larger loans.

Mortgage companies offered more exotic loans to entice homebuyers to borrow more, and primary lenders lowered lending standards to allow homebuyers to qualify for loans based only on an early low-interest "teaser" rate.

Investors discounted the riskiness of the loans backing the mortgage bonds. They were willing to pay such high prices for the bonds that the interest rate promised barely exceeded the rates offered by Ginnie Mae, Fannie Mae and Freddie Mac, the more traditional, safer bonds.

Compounding the risk, investors leveraged the expected returns with margin loans. They borrowed against their bonds, expecting the returns of the bonds to exceed the interest they would pay for the margin loans.

Market interest rates increased, and many of the adjustable loans "reset", making it harder for homebuyers to make their mortgage payments. At the same time, housing prices stopped climbing, and homeowners could no longer refinance their loans to maintain their current level of payment. Homeowners defaulted on mortgages at an increasing rate.

Part 3 - The Effect on Investors

Bonds normally lose value as market interest rates increase. Their price declines to the exact value where the combination of the price paid plus the lower-than-market interest payments to be received make the total return to the buyer the same as if they bought a brand new bond at the current market rate. Since market interest rates have increased recently, the value of mortgage bonds has decreased for all investors.

In addition to the normal decline, bondholders of the risky mortgages experienced even larger price decreases, as the number of homebuyer defaults increased. It became apparent that bondholders had underestimated the riskiness of the bonds.

Since the bonds themselves were the collateral for margin loans, as the value of the bonds declined, margin borrowers were forced to sell the bonds to reduce the loan-to-value ratio of their margin loans.

The increased supply of the risky bonds pushed prices down tremendously. The investment bank Bear Stearns announced that two of its hedge funds had lost so much value that they would not be able to return anything to their investors.

Part 4 - The Effect on Mortgage Companies

As described above, the combination of interest rate and bond price has to equal current interest rates. But as investors have become more aware, they have demanded higher than market rates to purchase new bonds from the mortgage companies to compensate for the increasing risk of the bonds. In many cases, institutional investors have completely stopped buying bonds backed by riskier mortgages.

Mortgage companies cannot survive if they are required to pay out more in interest than they will receive from homebuyers, or if they are not able to package and sell their new mortgages to investors. In addition, while the market adjusts to the new information, the purchase and sale of their bonds has virtually stopped. During this time, the mortgage company continues to incur normal business expenses. Without new loans, they will need to cover their expenses from cash reserves, which obviously have limits.

Part 5 - The Last Two Weeks

Several factors are coinciding now:

Valuation. These risky mortgage bonds are often traded privately, not through market exchanges. The prices are not reported on exchanges, and in fact, are often valued only at the time of purchase and sale. This creates an incentive for investment funds to hold the bonds to avoid having to report their greatly reduced value, and by extension, reducing the funds' value in the eyes of its investors.

Instability of Mortgage Companies. Countrywide Financial Corporation is now the largest buyer in the world of loans from primary lenders. Although Countrywide has been in business for a few decades, it has tripled in size over the last five years. More recent entrants to the business have even more exposure than Countrywide. Accredited Home Lenders issued a bankruptcy warning on August 2nd, following New Century Financial's default of its loans in March.

Quantitative Models. Many investment funds are now based on mathematical models designed to take offsetting positions that should reduce risk in the overall fund. However, many of the funds' models are flawed, and the funds are having to quickly sell positions at greatly discounted prices. Long Term Capital's implosion in 1998 was due to similar circumstances relating to the behavior of long term government bonds.

Markets are mostly rational, but there are periods of irrationality, in which valuations move well above or below intrinsic value. Corrections are generally painful for direct participants, but normally they are contained.

The concern now is that the correction will create costs that will affect non-participants. Already, banks have increased the lending rate for short term loans, which ripples throughout the economy. And last week the French bank BNP Paribas stopped making redemptions of three of its investment funds.

Investors become very anxious when told they can't access their money, which has quickly driven down prices and raised interest rates globally.

Part 6 - Government Intervention

Higher interest rates cause lower security prices, and abrupt changes of any nature are destabilizing to financial markets.

There is an immediate crisis because short-term interest rates have increased sharply. Banks are required to maintain certain capital reserve levels, and do so by lending between themselves nightly. The Federal Reserve Board sets a guideline for the nightly interest rate (the "Federal Funds" rate) which is currently set at 5.25%.

Despite the Fed's guideline of 5.25%, the market rate opened on Friday at 6%. In order to reduce the market rate and provide sufficient cash for possible withdrawals, the Fed has purchased large amounts of bonds from banks, effectively flooding them with cash (about $38 billion on Friday August 10, $24 billion on Thursday, compared with an average daily amount of $9 billion this year).

Obviously the ability of the Fed and the European Central Bank to subsidize the banking system is finite. Their objective is to provide liquidity and help relieve market tension, while the market determines the correct value of securities, in light of recent information and developments.

The SEC announced on June 27th that it was auditing 12 investment banks to determine whether securities backed by subprime mortgages were properly valued and disclosed.

Part 7 - What This Means to You

You do not own of any of the risky mortgage bonds in accounts managed by GFC.

The mortgage bonds you do own, either directly or through a mutual fund, are traditional high quality bonds such as Government National Mortgage Association, Federal National Mortgage Association, and Federal Home Loan Bank.

Your portfolio's allocation to Fixed Income (bond) investments is diversified across mortgage bonds, inflation bonds, high quality corporate bonds and foreign high quality bonds.

Obviously, the larger effect on equity markets has had an effect on your portfolio. The S&P 500 has declined 6% since July 13th and EAFE has declined 9%. Even with this decline, the S&P 500 index has increased 16% and the EAFE foreign stock index increased 19% over the last twelve months, since July 31st, 2006. Aggregated, the portfolios we manage have lost 5% since the market high on July 13th leaving them up 14% over the last twelve months.*

The proportion of mortgages at risk of default is a very, very small proportion of total outstanding mortgages, and thus, we are puzzled by the extent of the volatility.

The interaction of variables that are causing current volatility is complicated. The cause of most market crises is not known at the time, and sometimes it is never proven conclusively. There may be factors at play that we are not even aware of. But as Ben Stein writes in the Business Section of yesterday's New York Times, if we are not aware of the factors, then why are the markets reacting to them?

Whether stock prices will continue to decline, to what extent, and for how long, is not knowable. We will continue to invest your portfolio according to the same principles of asset allocation and correlation, maintaining the appropriate mix of equities, bonds and cash, and diversifying to minimize risk to the extent possible.

By now you know that Grubman Financial does not, can not and will not predict the outcome. We can say that market returns over the last four years have been so tremendous, that a setback of 10% or even 20% will still leave investors with higher than normal returns over this period.

*Returns have been rounded to the nearest whole number.