For client accounts, we remain void of credit risk after having been short credit risk in the Harbor Pilot Fund - short side bets that were removed during the Bear Stearns debacle on March 14th and 20th.

We continue to favor Fannie Mae (FNM), Freddie Mac (FRE) and Ginnie Mae mortgage pools at yields approaching 300 basis points over Treasuries, the widest on record - another sign of stress in the financial system. We also own, for the intermediate term, a modest position in FNM and FRE preferred shares with ‘tax equivalent’ yields approaching 11.5%.

While I don’t know if the credit crisis will ever make its way to Fannie and Freddie common and preferred equity, it's possible I suppose, so we'll have our eyes on the exit door if these securities rally in the near term, as I suspect they might.

The Fed is Not Federal

I want to make one important point: The Federal Reserve Bank is not Federal.

There are some that believe the Fed was secretly created by a bunch of prominent businessmen on a trip to Jekyll Island, Georgia, in 1910.  To be honest, I have no way of knowing if this is fact or fiction - it's most likely a combination thereof. At any rate, the book The Creature from Jekyll Island is a great read and I will leave it up to you after reading it which story is correct.

From the Fed’s website, below is a description of the current ownership of the Fed.

The Federal Reserve System is not "owned" by anyone and is not a private, profit-making institution. Instead, it is an independent entity within the government, having both public purposes and private aspects.

As the nation's central bank, the Federal Reserve derives its authority from the U.S. Congress. It is considered an independent central bank because its decisions do not have to be ratified by the President or anyone else in the executive or legislative branch of government, it does not receive funding appropriated by Congress, and the terms of the members of the Board of Governors span multiple presidential and congressional terms. However, the Federal Reserve is subject to oversight by Congress, which periodically reviews its activities and can alter its responsibilities by statute. Also, the Federal Reserve must work within the framework of the overall objectives of economic and financial policy established by the government. Therefore, the Federal Reserve can be more accurately described as "independent within the government.

The twelve regional Federal Reserve Banks, which were established by Congress as the operating arms of the nation's central banking system, are organized much like private corporations--possibly leading to some confusion about "ownership." For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

Since the Fed has clearly changed its focus from controlling inflation to keeping asset prices afloat, we must ask ourselves why they've changed their tune, what's the impact on the Fed’s balance sheet, and what are the implications for equity and credit markets in the near and longer term.

First, let’s look at what actions the Fed has taken since August 2007.

• Reduce the Federal Funds rate from 5.25% from 2.25%.
  
• $100 billion in monthly Term Auction Facility (TAF).
  
• $100 billion in 28 day repurchase agreements.
  
• $200 billion in Term Securities Lending Facility (TSLF).
  
• $36 billion in foreign currency swap arrangements.
  
• Inter-meeting 75 basis point cut on January 22nd, 2008.
  
• $30 billion guarantee to JP Morgan to buy Bear Stearns.
  
• 25 basis point emergency discount rate cut on a Sunday night, March 16th, 2008.
  
• Allow Primary Dealers to go to the discount window, not just commercial banks.
  
• Allow Agency, non-Agency and ‘other’ issues to be accepted at the discount window.
  

The list goes on and on. The European Central Bank has undertaken other measures like a $500 billion injection to stabilize the Libor rate a few months back and pledging ‘whatever it takes.’

In spite of all these measures, the Treasury market is either dysfunctional or spelling further problems down the road for credit. Or could it be sniffing out an upcoming bout of deflation?

I believe in the longer term, credit markets will worsen much more, even though we profitably removed our short credit risk bet into last Monday’s abyss. We also went from highly under-invested in equities to a more neutral view as investor sentiment had gotten extremely bearish and a bounce is possible -- possibly a sizable bounce -- but still in the context of a secular bear market in equities and credit.