Conclusion—How to Avoid the Hot Potato

When I look across the global equity and credit market landscape, I am appalled at what has been allowed to find its way onto the balance sheets of institutions and what is masquerading as AAA rated.

The municipal bond insurers had a great business model until they became greedy and started insuring CDO’s backed by suspect collateral and investing in CDO’s and CDO squares (CDO’s invested into yet more CDO’s - leverage piled on top of leverage on top of leverage).

Firms like this, as painful as it seems, should be allowed to and will most likely, fail. Others like Wilbur Ross, Warren Buffett and other well capitalized, prudent investors will be there to pick up the slack. This is free market activity at its best.

Investment banks and even some regional banks will likely fail unless the Fed wants to endlessly provide liquidity and take all the hot potatoes onto their balance sheet. I shiver when I think of the implications for the dollar if the Fed goes the route of providing endless liquidity.

As I have said since 2000, I believe we're in a secular bear market in equities. The credit unwind likely began in 2005, but will probably unwind much faster than the equity market due to the extraordinary leverage in the system -- remember that the credit cefault swap market is at least ten times the size of the underlying cash market that  it trades on.

While cautious, we do not anticipate taking credit risk from the long side until we are properly compensated to do so. This could be years from now -- but this is OK -- as we are able to participate in lower risk instruments at similar yields.

As for equities, in our long only portfolios, we will be long (like we are now from last Monday’s lows) for short to intermediate term trades as sentiment reaches pessimistic extremes. We will stick to high quality, liquid Exchange Traded Funds, or ETFs, like those based on the Dow Jones Industrial Average.

In our hedged accounts and Harbor Pilot Fund, we will continue to focus on the big picture first, always maintain defined risk and lean short credit risk as market conditions warrant.

It's not fun to watch this correction in risk materialize, but I don't believe we're near the end of the cycle. The CDOs that everyone now owns  -- from the Fed down to local credit unions -- are just derivatives of the subprime loan itself.

Simply put, if the loan does not perform, neither will the asset that is derived from the loan.

We are also paying attention for other fields of hot potatoes. These products include those derived from credit card debt, Alt-A loans, automobile and motorcycle loans and the like. We will always remain opportunistic but lean towards caution.

Our primary goal is always to protect the wealth that clients have entrusted to us to manage and will opportunistically participate when risk is properly compensated by potential reward.