August 2007 Crisis in the
Investment Markets

The U.S. and world stock markets have experienced nearly a 10% decline the past few weeks, after peaking in July. In addition to stocks, the value of virtually every other type of investment has declined except for bonds issued by the U.S. government. Even some supposedly safe money market funds have reported losses or have taken action to prevent customer withdrawals because of the current conditions in the financial markets. Investors generally, and participants in the General Board’s funds specifically, are concerned and want to know what has caused the current market crisis and when they can once again see gains in their personal investment accounts.

It all began with the bursting of the technology bubble…

The origin of the current crisis in the world financial markets can be traced back to the bursting of the Internet and technology stock bubble beginning in March 2000 and ending in December 2002. The Federal Reserve (Fed) is the agency that controls the U.S. money supply and directly influences short-term interest rates that banks pay to borrow money. The Fed, under the leadership of its former chairman, Alan Greenspan, began an aggressive campaign to stimulate the economy by lowering interest rates to historic lows in an attempt to offset the adverse economic consequences of the bursting of the tech bubble. As a result, low interest rate money was plentiful, and borrowing to take advantage of these low rates increased dramatically.

The bursting of the tech bubble also caused a significant change in the expectations of large institutional investors about future returns on their investments. In the 1990s, many investors believed that their stock investments would continue to produce double-digit returns into the foreseeable future. The 2000-2002 period changed all that. Institutional investors became less optimistic and the widely held view shifted—investors would be lucky to attain mid-single-digit returns on their stock portfolios.

Then, low interest rates resulted in a housing bubble…

The bursting of the tech bubble and its impact on investors caused a noticeable change in the investment practices of some large institutional investors. In order to attain higher expected returns on their investments, large investors began using complicated investment strategies to direct significant amounts of their capital. The expected gains from many of these strategies could be magnified by using low-interest, borrowed funds available as a result of the Fed’s attempt to stimulate the economy.

One of these complicated investment strategies involved home loan mortgages. Most homeowners are unaware that the majority of home mortgages are pooled with similar types of mortgages and sold to other investors in the form of publicly traded securities. These popular securities are designed to meet varying investor needs and are often very complex. One particular class of investors, collectively known as hedge funds, professed to have significant expertise in using complicated strategies involving the use of home loan mortgage securities. The administration of these strategies involves assumptions and sophisticated techniques to carefully control the risk of losses. Often, these hedge funds simultaneously borrow large numbers of low-interest funds in an attempt to increase their expected returns. (Note: The General Board does periodically engage in hedging strategies but has no investments in strategies that borrow funds to buy home loan mortgages.)

Initially, hedge funds that applied strategies that invested in home loan securities earned excellent returns on investors’ capital. These strategies grew in popularity, so that there soon was an insatiable demand for mortgage loans. Unfortunately, unethical and unsound lending practices on the part of mortgage companies were an outcome of this increased demand for mortgage loans. Some mortgage lending companies made loans with little or no proof that the borrowers could afford the homes they bought. Not surprisingly, many home buyers simply did not have the means to make the monthly payments on their mortgage loans.

As the lending situation worsened, some unscrupulous lending companies convinced home buyers that they could stay out of trouble by refinancing their mortgage as home values continued to climb. Home owners did not understand the consequences that would occur if housing prices stopped rising or if interest rates began to rise. Eventually, market conditions changed—interest rates rose and housing prices declined. Many borrowers were unable to afford the resulting higher monthly payments and defaulted on their mortgage agreements.

A “crisis” resulting from bad mortgage loans spread to other investments…

Once home owners began defaulting on mortgages, investors behind these complex strategies realized that their investment risk assumptions were wrong, and they began losing money. Their losses were magnified because they used borrowed funds that were combined with investors’ capital.

Two principal outcomes have resulted: First, the banks that provided low-interest money to investors (such as hedge funds) began demanding that these investors return borrowed funds because of underlying losses. Second, many investors executing complex strategies began analyzing the risk assumptions for other investments they held—if they did not properly assess the risk of home mortgage securities, perhaps they also made a mistake in assessing the risk of other investments. The result of these two outcomes has been widespread, indiscriminate sale of investments not considered to be completely safe from loss (i.e., U.S. government securities).

General Board funds feel the impact…

The impact of the current market crisis (which history may refer to as the “bursting of the credit bubble”) has been felt primarily in the stock market. Consequently, the General Board has seen a drop in the value of its stock holdings. Some investors, such as mutual fund investors, are nervous about losses they have sustained and have withdrawn large amounts of money from stock mutual funds. This has forced the mutual fund companies to sell at lower prices. Other investors fear economic consequences resulting from the current crisis and believe that banks and other lenders will become more risk averse, significantly reducing the number of loans they make. They reason that if companies and individuals cannot borrow money to buy homes, expand businesses or make investments, the economy will suffer.

Some of the General Board’s bond investments have also declined in value. In particular, the value of the General Board’s positive social purpose investments (such as affordable housing loans) has declined despite no change in the quality of the loans. The General Board also has meaningful investments in bonds from developing countries, which have historically added significant value to participant accounts. Bonds in this category have also experienced a significant decline in value despite no change in the fundamental conditions of the local economies. As of the date of this report, all of the General Board’s funds have produced positive returns for the year, although several of the funds have declined considerably from their mid-July peaks.

General Board fund management considerations

The General Board administers its investment program with a disciplined long-term investment philosophy and, at this time, does not believe any change in investment strategy is warranted. From time to time, the financial markets present unique opportunities to selectively add value, and we will take advantage of these opportunities as they arise. History has shown that periods similar to the current crisis will continue to be experienced over time. Participants can rest assured that the General Board will continue to administer the funds supporting participant account balances with the same prudent investment practices that we have held over the years.

General Board long-term investment strategy

The General Board simply does not know nor does it try to predict how future events will unfold. We will continue to monitor the financial markets and our investments, and we will issue periodic reports if conditions materially change. We realize that for some, the negative market fluctuations of the past several weeks are a source of stress and anxiety. We are sensitive to participant concerns regarding losses in their account balances, but overall, we believe that the U.S. and world economies are strong and that markets will be resilient. We also believe that adhering to a long-term investment philosophy is the right strategy.