“These revered institutions failed because they were not soundly financed. They are not representative of the financial picture of sound businesses.” Robert A. Schwarzkopf, CFA Chief Investment Officer & Portfolio Manager

Not surprisingly, markets were down in a quarter marked by bankruptcies, forced mergers, and government takeovers of leading financial institutions worldwide. The S&P 500 Index of large-cap stocks declined 8.37% for the quarter and 19.29% year to date; the Russell 2000 Index of small-cap stocks declined 1.11% for the quarter and 10.38% year to date; the MSCI EAFE Index of international stocks declined 20.56% for the quarter and 29.26% year to date; and the Lehman (now bankrupt!) High Yield Bond Index declined 8.56% for the quarter and 9.54% year to date. The safe haven has been U.S. Treasury securities with the Merrill Lynch (now forced to merge with Bank of America!) 3-5 Year Treasury Index returning 2.68% for the quarter and 5.03% year to date.

Too Much Debt!
The current financial market turmoil can be attributed to a number of causes: Regulatory lapse, poor loan underwriting, “liar loans,” and hard to analyze financial innovations, among other things. But the simple truth is that there is too much debt and debt has become less productive of income. This burden of debt has been driven by the separation of risk from return by the “securitization” process where banks originate loans (earning a return) and then sell them to investors (who bear the risk).

The following chart, U.S. Consumer Debt as a Percentage of GDP, shows the near quintupling of debt-to-GDP from just over 20% to nearly 100% since the year 1950. We believe this upward trend has a limit and we may be approaching it.

Source: ISI Group Data is assumed to be reliable.

The next chart, GDP Growth as a Percentage of Total Debt Growth, details the incremental debt required to drive incremental GDP. This chart illustrates that in 1960 a dollar increase in debt produced a dollar increase in GDP. But today, a dollar increase in debt produces only an increase of 37 cents in GDP. Debt has much less utility in producing income. This longer term issue, which we expect to resolve in favor of businesses that do not depend on debt to grow, creates hurdles in the resolution of the current credit problems.

Source: ISI Group Data is assumed to be reliable.

Troubled Asset Relief Program (TARP)
TARP legislation has been signed into law in response to the seizing up of the securities markets (mortgage backed securities, commercial paper, junk bonds, credit default swaps) and bank lending (home loans, auto loans, business loans, LIBOR (London InterBank Offered Rate or short-term bank-to-bank lending)). TARP provides $700 billion of government funding for the purchase of troubled assets (primarily mortgage securities, but with authority to go where needed) from American financial institutions (and beyond financial institutions, if needed) in order to re-liquefy markets for these securities along with the balance sheets of our financial institutions, freeing them to resume lending.

Liquidity Versus Solvency
The published intent of the legislation is to provide liquidity to markets and financial institutions’ balance sheets. Not directly addressed is the issue of solvency of the institutions who own the securities. The legislation provides the government wide latitude in determining the prices for which assets will be purchased. Because the markets have seized up, TARP’s assumption is that market prices are well below both original issue values and current intrinsic values. If government purchases are made at market prices, liquidity is created, but solvency of financial institutions is threatened. To avoid this insolvency, we expect government purchases will be made at higher prices—how much higher will determine whether or not this program becomes a bailout at the expense of taxpayers.

Recession!
You may be surprised to hear that, based on the definition of two consecutive quarters of negative real GDP growth, the nation has NOT been in recession (See chart: U.S. Real GDP). Economic consensus, with which we agree, is that the nation is now entering recession caused by the contraction in credit and illustrated by the contraction in employment (See chart: U.S. Payroll Employment).

Source: ISI Group Data is assumed to be reliable.

Source: ISI Group Data is assumed to be reliable.

We believe there are three kinds of recession: 1) An inventory recession requiring one or two quarters to flush excess inventory from supply chains; 2) A plant and equipment recession where too much manufacturing capacity has been built requiring six months to a year to fill; and 3) A credit recession which steals the ability to finance our way out of recession and can be more painful. This appears to be the situation today (See chart: U.S. Asset-Backed Commercial Paper). That is why the government has stepped in with TARP to become the lender of last resort (See chart: Total Assets Held at the Fed).

Source: ISI Group Data is assumed to be reliable.

Source: ISI Group Data is assumed to be reliable.

Tools for dealing with credit recessions include bankruptcy, which writes off debt that cannot be serviced by income, and expanding money supply, which attempts to lower the cost of servicing debt by making money available and cheap. We expect both tools to be broadly used in this difficult period. These tools have opposing consequences: Bankruptcy creates deflation, expanded money supply creates inflation. The purpose of TARP is to alter the balance away from bankruptcy and deflation toward easy money and inflation. It is too early to see which will prevail.

Investment Outlook
Failure of iconic financial institutions creates unease in any investor. But consider these facts:

• Merrill Lynch was aggressively overleveraged at 2.2% equityto- assets when forced into the hands of Bank of America. In comparison, financially responsible individuals do not buy a home with 2.2% down payments.
• Lehman Brothers’ commercial paper and other creditsensitive short-term funding exceeded their net worth at their last balance sheet date. By comparison, financially responsible individuals do not promise to pay in excess of their net worth on 30-days notice.
• American International Group made credit default swap (CDS) bets that required them to come up with nearly half their net worth if markets turned against them. By comparison, financially responsible individuals do not bet their net worth on a roll of the dice.
• Countrywide Financial’s entire net worth was represented by mortgage servicing right intangibles. By comparison, financially responsible individuals do not go to a bank listing among their assets what they expect to earn over the next 15 years.

These revered institutions failed because they were not soundly financed. They are not representative of the financial picture of sound businesses. The job of distinguishing between a good business with sound financing and the above examples is called fundamental investment analysis. At Kayne Anderson Rudnick, we pride ourselves on our internal fundamental research process. We believe safety is important and it is best pursued through quality—high-quality fixed-income and equity securities. Despite the current financial and economic stresses, there are opportunities in high-quality equities, which are selling at historically attractive valuations compared to equities overall (See chart: Quality is Historically Cheap). Kayne Anderson Rudnick’s “Quality at a Reasonable Price” investment philosophy is well suited for this environment.

Source: Standard & Poor’s Quality Trends, April 2, 2007. Note: High quality is defined as all stocks with an S&P stock ranking of A+, A, and A-. Low quality is defined as all stocks with an S&P stock ranking of B+ and below. Past performance is no guarantee of future results.

Portfolio Asset Allocation
Please review your asset allocation with your Kayne Anderson Rudnick advisor. This is also a good season to review your tax planning. We continue to recommend a conservative asset allocation that maintains a balance between stocks, bonds, and alternative investments that fits your unique income requirements, risk tolerance, and time horizon.

For those of you with interest in a more detailed analysis of the current credit and economic dislocations, we invite you to ask your Kayne Anderson Rudnick representative for copies of our in-depth white papers titled Credit Crunch and Tapped Out? The State of the U.S. Consumer.

Firm News Effective
October 1, 2008, Phoenix Investment Partners, Ltd., Kayne Anderson Rudnick’s parent company, became known as Virtus Investment Partners, Inc. in anticipation of the company’s spin-off from The Phoenix Companies. There have been no changes to the management of Kayne Anderson Rudnick as a firm or to its investment process as a result of this change. If you held the Phoenix mutual funds in your investment portfolio, you will see a change in the name of the funds to Virtus mutual funds. This is simply a name change and it does not affect the management of the funds in any way.

We thank you for your continued confidence and we invite you to contact us with any questions or comments.