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March 15, 2007

Recent Market Volatility Caused by Sub-prime Lenders

There has recently been a great deal of volatility in the financial markets, driven largely by current problems at various sub-prime lenders. We would like to take this opportunity to share with you our thoughts on the industry and the markets in general.

We believe the financial markets have overreacted to a concern that we at RiverPoint have recognized for some time. Over the last several years borrowing in general has become too easy for many consumers and in particular for those with a very low credit rating. As the economy has slowed and home prices have declined, it is not surprising that many of these consumers have defaulted on their loans, and as a result, many sub-prime lenders like New Century (the largest sub-prime lender), Freemont General and others have seen their stock prices fall 75% or more in the last few weeks. However, we did not anticipate the market’s reaction to an industry that represents an extremely small segment of the economy. Further, we do not expect the recent problems in sub-prime lending to have a considerable impact on the overall economy. Although certain high-risk individuals may have defaulted on their loans, these loans are generally secured by mortgages on real property and the underlying property still has significant value.

What are Sub-prime Loans?

Sub-prime mortgages refer to those loans made to borrowers with less-than-stellar (sub-prime) credit. With interest rates at historical lows over the past several years, many sub-prime borrowers were able to purchase homes for the first time. Many homebuyers used exotic mortgages with lower rates than those offered on the traditional 30-year loan to purchase even larger homes. As interest rates fell further and home prices continued to rise across the country, new homeowners could refinance their existing loans on more favorable terms based on the increased value of their homes.

This arrangement seemed attractive for potential homebuyers. They were able to afford larger, more expensive homes by means of more relaxed loan terms. Mortgage lenders were booking loans as homebuyers and speculators were drawn to the market by constantly rising prices. As more buyers were drawn to real estate, mortgage lenders were obliged to lend them the funds they needed, often at initial terms that would have seemed out of reach only years before. Easy money allowed prices to rise further and this vicious cycle continued unabated.

Unfortunately, as interest rates rose significantly over the last few years the housing market started to slow. As the market slowed and housing prices corrected,

borrowers who were once able to refinance their way out of unfavorable loan terms now found they had little or no equity left in their homes to bail them out. Unable to afford the payment on their mortgages, these borrowers began to default on their loans. This led to the current problem for mortgage lenders as they found themselves saddled with bad loans. Many of these lenders did not accurately assess their risk in a higher interest rate environment. They had sold most of their loans to major Wall Street banks to be packaged and resold to investors as a diversified fixed income investment. Unfortunately, the terms of the banks’ purchase agreements stated that the Wall Street banks could sell problem loans back to the loan originators if the borrowers defaulted within a certain period of time. As more loans turned sour, Wall Street forced lenders such as New Century to repurchase the defaulted loans. New Century and other sub-prime lenders were caught without the funds to repurchase these loans.

As a result, the stocks of these companies suffered dramatically which eventually carried over to the broader stock market. The high yield fixed income market was also negatively impacted by this event as investors began to flock to quality during this time of uncertainty.

At RiverPoint Capital Management, we have had concerns for the last few years about chasing investments in sub-prime lenders with extremely high dividend yields. As such, we have avoided these stocks and bonds for quite a while and continue to find them unattractive on a risk and return basis. For similar reasons, we also remain concerned about many of the hedge funds that are utilizing a dangerous amount of leverage in an attempt to generate attractive returns for investors.

A distinguishing feature of RiverPoint’s investment strategy is and always has been to place quality first and to not chase the sector or the stock du jour. This strategy has served our clients well over the years and we see no reason to change that strategy in the current environment.

For information about RiverPoint Capital Management or to view our report archive visit us at www.riverpointcm.com.