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Quarter Ended 30 September 2007 Financial markets were extremely volatile over Quarter 3. The volatility emanated from the credit markets where sub-prime lending and the sub-standard lending practices became evident. Bear Stearns, the US investment bank, announced substantial cuts in the value of two of its hedge funds. This was the catalyst for a retrenchment in liquidity in the credit markets. Sub-prime mortgage lending in the States was often made to individuals who had little capacity to repay the loan. These sub-prime loans were subsequently re-packaged and sold to bond market investors in the form of CDO’s (Credit Debt Obligations). The unfortunate aspect from a market perspective was the lack of transparency associated with the ultimate holder of these CDO’s. Suspected holders of CDO’s included banks, insurance companies and hedge funds. This lack of transparency made banks reluctant to lend to each other and caused an exceptional spike in short-term rates. It was within this environment that Northern Rock and the general banking sector struggled, as can be seen below over Quarter 3:- Bank of Ireland down 13%, AIB down 16%, HBOS down 7%, Anglo down 13% and RBS down 17% Global monetary authorities have differed in their approach to the credit crises. Post weak retail sales and employment data, the US Fed cut interest rates by ½%, indicating to the market their concerns with growth and their belief that inflation had become a secondary issue. The Fed’s concern is that the credit crises moves from Wall Street firms on to main street, in other words that the US consumer becoming ever more aware of negative headlines and falling house prices may be reluctant to spend in future months. The Fed has enacted substantial interest rate cuts in previous financial crises such as 1998 and 2001 and what was previously known as the “Greenspan Put” may now be re-named as the “Bernanke Put”. In essence, what this means is that US monetary authorities, at the first sign of de-stabilisation in the financial markets because of the creation of an asset bubble, (in this case the credit markets), will come to the rescue via interest rate policy. The Bank of England took a different route. Mervyn King, the Head of the Bank of England suggested that the issue of the credit crises was a reflection of too much risk being undertaken by financial market participants. What King feared was the creation of moral hazard that greater risk would be taken in the future with market participants, safe in the knowledge that monetary authorities would be available to bail out the difficulties created. Unfortunately for King and because of the business model of Northern Rock, media images of disgruntled customers queuing outside Northern Rock branches created negative images of the UK financial sector. The ECB took a different approach to both the Fed and the Bank of England. They offered the opportunity to any financial institution in need of funds unlimited borrowing. Unlike the Bank of England, this borrowing could be done on a secretive basis. However, the official ECB rate remains at 4% and because of sub-prime issues and the rapid depreciation of the US dollar against the Euro, rates are unlikely to be increased in the near future. The Irish equity market was one of the most severely hit as a result of the credit crisis. In real terms, few Irish equities have any material exposure to sub-prime. As an example, Bank of Ireland declared an indirect exposure of €10m. The fall in the Irish market can be better explained by a dramatic change in sentiment from overseas fund managers. There has always been a perception by overseas fund managers that Irish GDP growth is focused primarily around the residential property market. Undoubtedly, growth will slow in 2008 but possibly not to the extent expected by overseas fund managers. The ISEQ, as an index, suffers from the technical issue of over-weighting of its top five stocks – AIB, Anglo, Bank of Ireland, CRH and Ryanair combine to represent 63% of the index, hence, and has happened in this quarter, should the financial sector suffer, the headline figures for ISEQ falls tend to make for negative dramatic reading. It is Appian’s viewpoint that monetary authorities will have a very difficult job in minimising the slowdown in growth in an environment of increased inflation pressures. Oil, over the quarter, hit $80 a barrel and many soft commodities reached record levels. The subsequent effect of increased food prices and higher utility bills will eventually influence consumer spending habits and wage/salary demands from their employers. Thus monetary authorities may have to increase interest rates at the first sign of stability in the credit markets. In the forthcoming months, we expect at Appian to see increased volatility as investment banks and hedge funds drip feed the market with negative write-downs. As always, Appian will await with patience before investing in any security. Depending on the level of pessimism, it may provide Appian an ideal buying opportunity. Pat Kilduff
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