THIRD QUARTER 2007 – RETROSPECTIVE AND PROSPECTIVE

“Next to knowing when to seize an opportunity, the most important thing in life is to know when to forgo an advantage.” — Disraeli

Cheap credit and high yields. It all seemed too good to be true; and it was! Today the holders of Asset Backed Commercial Paper (ABCP) are wishing that that they had been a little less greedy and forgone that extra margin of yield.

The Third Quarter of 2007 has been turbulent, plummeting on the threat of any crisis, rallying on the slightest pretext of good news. Takeover activity continues, although at a reduced rate. A few names of note included Hilton Hotels, Coles, Alcan, Altadis, EMI, Dow Jones, Imperial Chemical Industries, Tribune, Gateway Computers and Stelco. However, fragility in the underlying economy has begun to pervade market sentiment.

Headlines highlighting concerns in “sub-prime mortgages” and “collateralized debt obligations” (CDO’s) as well as ABCP are indicative of growing faults that have been building in a period of easy credit. Central banks have been quick to cut rates in order to stave off panic and rumoured imminent corporate failures. What has led to this state of affairs?

Inexpensive money and rising home prices have enabled consumers to borrow and lever the equity in their home while at the same time wages have been constrained. Lenders, sensing easy conditions allowed their borrowing practices to become lax, extending loans to borrowers, many of whom may not have qualified previously, for up to 100% of the presumed value of those homes. Investment bankers, detecting easy pickings, bundled these mortgages with better credits into tranches that mathematically predicted little chance of a major default assuming also that the market for these instruments remained liquid. Operating companies securitized credit card and other receivables that the investment banks were only too happy to package and sell. Hedge funds, leveraged on cheap debt, bought and sold these packages of securitized obligations and created classes of derivatives to exchange the default risks of differing obligations. Institutional and individual investors, hungry for yield, were only too happy to buy these instruments, evidently with little due diligence, given the promise of higher returns. It worked for a while, and then the party stopped.

Over-extended consumers in the US began to hit the wall and some of the “sub-prime” mortgages went into default. As the repercussions filtered through the financial system, the players began to question the viability and credit worthiness of a lot of this paper. As buyers for these instruments began to dry up, the housing market started to sputter. Many mortgages that were placed several years ago at artificially low rates are coming up for renewal at rates the home-owners cannot afford.

Today, the inventory of unsold homes in the US is at an eighteen year high while the default rates on both sub-prime and conventional mortgages are spiking. Countrywide Financial, America’s biggest mortgage lender faces the threat of bankruptcy. Two large hedge funds, managed by Bear Stearns, collapsed due to problems in the credit derivative market.

The markets are entering a classic credit contraction and the effects are global. In the UK, a run on Northern Rock, a large mortgage lender, forced the Bank of England to act. In Canada, the large banks are attempting to form a consortium to honour their ABCP, much to the chagrin of other institutions. During the period of easy money and low interest rates, the premium paid for riskier loans all but disappeared. Now those premiums are returning and the financial markets are being forced to adjust to new conditions.

In this adjustment period, we will see opportunity! During periods of extreme volatility, stocks prices tend to over-react on the upside and the downside. We are monitoring many situations and we will take advantage during this period to selectively upgrade portfolio positions in firms with more pristine balance sheets (less levered to debt), better margins (more profitable) and superior operations.

FIXED INCOME NOTES – THIRD QUARTER 2007

Concerns regarding credit risk and the mispricing of risk premiums came to the fore with a vengeance during August and set the tone for fixed income markets for the remainder of the quarter.

The declining U.S. housing market and some of the ill considered mortgage lending practices resulted in the wholesale avoidance of investments associated with sub-prime mortgages by investors.

In Canada, these events precipitated the almost unheard of spectacle of the money market, one of the most liquid sectors of fixed income markets, grinding to a virtual halt. Credit concerns regarding the quality of Asset Backed Commercial Paper issues (securities backed by pools of assets such as car, credit card or equipment loans) made investors flee to the safety of Treasury bills and other government securities.

Concentrated efforts by central banks helped avert an outright market meltdown. In Canada, the issue of ABCPs will ultimately be resolved, especially as the underlying assets in most cases are likely solid. At the same time, sub-prime mortgage loans in the U.S. and the uncertainty of their impact on banks and investors, can hardly be underestimated. Originally, asset backed securities were supposed to transfer and diffuse the concentration of credit risk. Unfortunately, through their opacity they had in fact called into question all asset backed securities, whatever their individual merits might be.

The impact of these events resulted in the Bank of Canada foregoing its expected rate increase, despite the solid performance of the economy and low unemployment rate. In the U.S., the Federal Reserve cut the Fed Funds rate by a half of one percent in an attempt to both reassure markets and to forestall a possible slide into recession. While these actions have been well received, the ultimate outcome of the housing crisis and its impact on markets is as yet unclear.

Let me assure you that none of your funds had been invested in the above noted Asset Backed Commercial Paper or sub-prime mortgage categories. We continue to be mainly invested in Federal, Provincial and Municipal government issues in addition to which we hold securities of major Canadian chartered banks.

The total return performance of the bond market for the quarter, as measured by the PC Bond Universe Bond Index (formerly Scotia Capital Universe Bond Index), was 1.7%. Yields on a representative ten year Government of Canada bond decreased over the course of the quarter to yield 4.34%. At the same time, largely as a result of a flight to quality, rates on provincial and corporate bonds increased when measured against similar Government issues.

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