a. Statistics

          Details of the overall portfolio are as follows:
 

    Details of the individual years are as follows:
 

Year	Rate of Return	Inflation	Real Rate of Return
1981	15.0%	8.0%	7.0%
1982	15.4	3.0	12.4
1983	16.0	4.0	12.0
1984	9.8	4.0	5.8
1985	18.3	4.0	14.3
1986	13.8	1.5	12.3
1987	9.7	4.0	5.7
1988	18.0	4.0	14.0
1989	10.7	4.5	6.2
1990	0.7	6.0	-5.3
1991	14.9	3.1	11.8
1992	10.0	3.0	7.0
1993	13.7	2.6	11.1
1994	0.3	2.7	-2.4
1995	13.2	2.7	10.5
1996	15.5	3.0	12.5
1997	6.9	1.8	5.1
1998	-4.5	1.5	-6.0
1999	-2.3	2.5	-4.8
2000	15.3	3.3	12.0
2001	19.2	1.5	17.7
2002	-0.6	1.5	-2.1
2003	25.2	2.2	23.0
2004	9.9	3.3	6.6
2005	8.7	3.5	5.2
2006	11.7	2.0	9.7
Average 26 years	10.9%	3.3%	7.6%

 

             Over the life of the portfolio it has performed in the following fashion:

            You can review the third quarter report for my usual caveats about performance and what to reasonably expect in the future.
 
 
d. Commentary

         I want to expand on the points mentioned in my brief email and to give a clearer picture of where I think we currently are and the kinds of problems that we face in the near and medium term.

         Here are the five points I mentioned with further comment. My comments are in italics.

1. Wrapping one's arms around the depth and breadth of this credit crisis remains a difficult thing, if only because it seems to require bigger arms every week.
 
          It started with the problems in the sub prime mortgage market and it has spread to the banks, the pension funds, insurers and the whole mortgage industry. The problems have uncovered all types of excess and it appears that the overall bill for this foolishness will, if all goes well, result in losses in the area of $200-$300 billion.

        It all arose because of abysmal policy decisions by the Federal Reserve Bank/Federal Government when they created the enormous property bubble by flooding the market with cheap liquidity and allowing the liberalization of the mortgage market. Mr. Greenspan actually came out several years ago and suggested that adjustable rate mortgages were an excellent idea. No down payment, no problem. No documents proving the ability to pay – Don’t worry we will take your word for it.!!!

         An avalanche of these adjustable rate loans will have dramatically increased interest rates next year and it is estimated that 1.7 million homeowners will lose their homes in the next year. I don’t believe that Mr. Greenspan is included in that number.

 
2. The end result of all this was summed up well by Goldman Sachs Jan Hatzius today, in a report where he estimates — due to leverage — that about $200 billion or so in mortgage-related losses on the bank balance sheets could result in a pullback of about $2 trillion in lending . "This is a large shock and could produce a substantial recession (if it occurred over a single year) or a long period of very sluggish growth (if it occurred over 2-4 years)."

        This is what we are currently starting to experience and it is very visible in the banking and real estate industry. I don’t believe that we will have the luxury of deciding whether it occurs over a year or over a prolonged period. I think it bodes ill for the real estate market, both commercial and residential and for any leveraged endeavor that needs financing to exist or to create value. It probably means the whole domestic leveraged buyout/private equity industry will not only grind to a halt but, more significantly, that a lot of the deals executed in the last few years will experience trouble. One saving grace that might help here is that we might experience a surge of foreign investment if the $ continues to weaken but I suspect that this investment will be selective.

3. Economist Nouriel Roubini says the next stress point for the economy is commercial real estate. "The reasons for this coming bust are clear.

        Financing difficulties, the potential for recession and historically expensive valuations suggest that this area is an accident waiting to happen.

4. "Add GE to the seemingly endless set of companies that was stupidly chasing yield," says Mike Shedlock. GE Asset Management, which oversees the $5 billion GE AM Trust Enhanced Cash Fund, has seen value fall in its short-term fund, an investing vehicle designed to preserve capital and maintain a $1 asset value while still chasing after yield. Still, falling below $1 NAV is a rare event — the fund flew too high on broken wings, it seems, and now they're offering investors 96 cents on the dollar .

        This stands in contrast to actual money-market funds, such as those run by Bank of America, SEI, Legg Mason and a number of other asset management firms that bit the bullet and announced they were swallowing losses to preserve the value of a fund. "If we see widespread losses in money market funds, and therefore widespread incidents of redemptions below par, the political heat will turn up to high as mom and pop start screaming," he writes. "It could precipitate a widespread withdrawal of cash from money market funds, a bit like a run on the banks, which would cripple the entire short term funding market."

        Part of the carnage this year has resulted from the troubles in the SIV market. Before the summer few people had heard of SIV’s. They are, in essence, ways for the banks to do rather risky ventures outside their balance sheets (think Enron :) ). Well it worked just fine until liquidity dried up and suddenly there is a big problem. I suspect, but cannot guarantee, that the problem will be solved with a lot of pain to the banks and others but without damaging the public’s faith in money market funds. I think the action of GE was VERY shortsighted.

        There is always the chance, however, that the confidence of the public will be lost and then we will be in all kinds of trouble. This is the reason I have been in Money market funds of Treasury securities for the past three months. These funds are completely safe.

5. The CEO of Wells Fargo bank said that the current real estate environment is the worst since the great depression.
 
        I completely agree and the confluence of factors mentioned above (the sub prime problems, the collapse of liquidity, the explosion in foreclosures etc) makes it a very difficult market for real estate. Many of the mortgage lenders have simply disappeared and the rest will employ FAR stricter methods in the months and years ahead until this debacle has been forgotten. So it will be harder to get a mortgage, reducing demand, and there will also be a huge surge of supply with the wave of foreclosures. If you add in an economy that will be, at best, shaky you are faced with very grim prospects for the real estate markets in the next couple of years. They key will be affordability and with the new stringent loan requirements the gap between price and affordability, already wide, will be daunting.

        There are two ways to bridge the gap – real incomes rise or house prices fall. Given the abysmal record of real incomes over the last 10 years (pressured by many things including the wonders of free trade and low wage competition).  I certainly know which outcome I am betting on.

        I should, once again, reiterate that I am not against real estate as an investment – just overpriced real estate. I imagine that sometime in the next 5 years we may be faced with an environment where real estate is very attractively priced and, at that time, we will be buyers.
 

6. The $2.5 trillion market for tax-free municipal bonds, a popular investment for many individual investors, is the latest unlikely corner of Wall Street to be roiled by the nation's real-estate and credit-market woes.

       In recent weeks, prices on municipal bonds have moved lower while their yields have been rising, making them cheap in some investors' eyes. Meanwhile, several new municipal-bond issues have been hung up. Bond insurers -- important participants in the muni market -- have also seen their share prices tumble, and the market's assessment of their own likelihood of default has worsened dramatically. Ratings downgrades may have a direct negative impact on the muni debt they also insure, potentially even triggering forced selling by some investors. Forming one especially vulnerable part of the market are complex short-term securities owned by tax-exempt money-market funds that are guaranteed by the insurers and backed by brokerage houses that have mortgage-backed security woes of their own.

            Each week the troubles spread into different areas. It is a fundamental crisis of confidence and it will result, at minimum, in significant reforms. We cannot afford to have people also start questioning the other large sector of money market funds – the municipal money market funds. We own none.

7. The $ and the ongoing foreign exchange crisis. The problem here is to know where to start. It is in some ways better than it seems and in other ways worse.

        The currency markets tend to move in relatively mysterious ways which often don’t track economic reality in the short and medium term i.e. they are impossible to consistently predict. Everyone is very aware of the recent weakness in the US $, but aren’t aware of the longer term picture which shows several long eras of advance and decline over the last 20 years with only relatively modest changes on a net basis.

      On the other hand the very bad news is that the US $ is the World’s main reserve currency and has been so for at least 50 years and we may have, foolishly and accidentally, started to lose that status. When people are less happy to hold our currency as a reserve there will be a LOT of consistently downward pressure on the $. Luckily for the $, there aren’t any obvious alternatives except the Euro, which is already sharply overvalued versus the $ by most normal measures.

        This is very much a work in progress and it is something I am watching with great interest.

 e. Conclusions

 The key conclusion is that we will continue to be very cautious and aware of the unusual risks, but we will take advantage of opportunities as they occur. But we will always have an eye on the exit and we will be even more demanding when we evaluate our purchase candidates.

           I wrote this in the early fall, but it is worth repetition:
 

 The chorus of worriers has been joined by some fairly august bodies in the last few months. The Bank for International Settlements is very influential and just issued the following comments as reported in the media:
        The Bank for International Settlements issued a warning this week (July) that the Federal Reserve's monetary policies have created an enormous asset bubble which could lead to another “Great Depression”. The UK Telegraph says that, “The BIS--the ultimate bank of central bankers--pointed to a confluence a worrying signs, citing mass issuance of new-fangled credit instruments, soaring levels of household debt, extreme appetite for risk shown by investors, and entrenched imbalances in the world currency system.
        The IMF and the UN have issued similar warnings, but they've all been shrugged off by the Bush administration. Neither Bush nor the Federal Reserve is interested in “course correction”.

        (November update - since that time of course some of these areas have been under considerable pressure, but I suspect we have much more pain to come as the vast asset/credit bubble unwinds).

        It is quite startling to see warnings of the possibility of another “Great Depression” emanating from the Bank for International Settlements and from the International monetary fund.

         We are still talking about possibilities here and not probabilities, but the possibility is too significant to ignore. Our goal is to shepherd you through the good times and bad and to make sure that any risks taken have manageable losses as a potential worse case outcome. Many people discovered the problems with a riskier portfolio in the high technology boom of 1998-2000 and in the real estate boom of 2003-6. Losses in these kinds of situations are devastating, life changing and can be permanent.

        This will mean that in years like this we may lag the market as a penalty for the risk averse nature of our portfolio. This is a penalty we are happy to pay as we want to survive and prosper in the long run and we have seen numerous instances of fortunes won and lost. That is not our way.

        We truly do believe, and the evidence supports us, that “Slow and steady wins the race”.  As always we are here for your questions and we really enjoy all of your visits – both planned and impromptu.

           Let me finish on an upbeat note that also reflects my views.

          The world economy is remarkably resilient and so is the U.S.A. We will overcome these imbalances and, in the longer run, continue to grow. Capitalism, as experienced in the 21st Century, is a remarkably resilient process of creative destruction. Our job is to avoid some of the excesses in the destructive part of the process while we capture much of the growth.