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ECONOMENTS

Edgewood Management LLC
October 3, 2007

“The yen carry trade”—“The sub-prime mortgage meltdown”—“The credit crisis.” These headlines dominated the news and the markets in the 3rd quarter.

At its simplest the carry trade allowed investors to borrow money in yen at very low interest rates (less than 1%) and reinvest the borrowings in US Treasuries or other securities to earn a higher rate of return. When the yen strengthened and Japanese rates climbed, the era of free money came to an end.

The sub-prime mortgage mess stemmed from a sizzling hot housing market that lured many unqualified borrowers to take out loans they could never hope to repay. To make matters worse these borrowers took on adjustable rate mortgages that put them deeper in the hole when the rate reset only to have the value of their homes decrease at the same time. The banks were left holding the bag on foreclosures; investors who purchased the mortgages in collateralized pools (pensions, hedge-funds, investment banks) found the value of their mortgage securities declining. These events spiraled into a credit crunch in July and August as lenders could not lend and borrowers could not borrow, followed by a stock market swoon that for the most part has recovered to “pre- crisis” levels.

There are two camps in terms of where we are in the length and duration of the credit/mortgage fiasco. On the one side economists believe we are in the middle innings while others believe we have not yet finished the national anthem. Two things are certain: first, the markets, like a pendulum, spend less time in the middle than they do at either extreme; sometimes the pace of the pendulum is faster than at other times. This leads to the second point: as noted by the late MIT economist, Rudi Dornbusch, in financial markets things take longer to happen than one would expect but once they happen the events unfold much faster than expected, witness the credit crisis. The worries about sub-prime lending and residential overbuilding had been talked about for 2 years; the unwinding occurred with lightning speed.

The ripple effect was no less amazing: from market neutral hedge fund and quant fund collapses, to mortgage company bailouts to Federal Reserve intervention. The surprise victims of the market correction were the “black box” quantitative hedge funds whose inputs and models strive for a market neutral approach with steady monthly returns. Many of these funds lost more money in 3 days than they had made in 3 years...a few were bailed out and a few collapsed.

We think it important to point out that the valuation of your portfolio is just as attractive as it was at the beginning of this year, despite over 20% appreciation year to date. U.S. equities provided liquidity to fund managers that could not find liquidity anywhere else and your Edgewood managed portfolio felt some of these tremors during the quarter; some fund managers were forced to sell not what they wanted but what they could. When the dust settled we were able to take some advantage of the downturn to purchase great companies at great prices. A clear change of direction took place as the markets sifted through the carnage. Investment management firms with a solid process of fundamental analysis percolated to the top of the performance quadrants while riskier investments saw decreasing money flows. We believe that this trend is not short lived and in fact will be the trend for some time to come.


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