This past week was a week so eventful that happens only once in a generation. The speed and magnitude of events along with the market and mood swings were phenomenal. We started off with the Feds' deciding that Lehman Brothers was not too big to fail. The very next day the Feds decided to take over the insurance giant AIG because of "systemic risk". It continued with two huge money market funds breaking the dollar, something we had not seen in a very long time. Then, mid week we had a swift freezing of the credit markets and the Feds taking the strongest intervention in the markets we have seen since the Great Depression! We finished the week with the markets ending up about where they started the week but, in the meantime, it was the wildest ride I can remember!

I am going to attempt to explain in simple terms what happened, what we are currently going through and what we are doing. In the last newsletter, I mentioned that we are all learning to function with less debt, a process called deleveraging; this process is long and painful. This process is continuing.

What happened?

After the tech stock crash earlier this decade the interest rates were kept too low and too long. Real estate became the next "can not lose" investment as cheap money caused a sharp rise in home values all over the country. Greedy investors with spotty credit history and no documentation loans kept buying houses, mortgage brokers were happy to give the loans to them, and these loans were passed off and repackaged again and again and again by greedy investment bankers to naive investors all over the world who relied on ratings by rating agency employees who were not good enough to get jobs in the same investment banks.

Between 2002 and 2006, household borrowing grew at an average annual rate of 11% and borrowing by institutions grew by 10% annually. The investment banks packaged and repackaged these loans in a ridiculously complex web of "innovative" securities they 'structured" and sold to hedge funds and special entities banks set up called up structured-investment vehicles, or SIVs. To fund their activities, the investment banks led by their multimillion dollar CEOs and hordes of "smart" grossly overpaid employees borrowed heavily.

In 2006 home prices tipped downward and started a painful chain reaction. Eventually many of the borrowers could not pay back their loans and real estate values started going down even more which exacerbated the problem. Heavy losses on mortgages and other investments proved to be way too much to overcome for their thin capital bases and the markets they relied upon for funding dried up.

In many cases these firms doubled down! Lehman Brothers started this year with a balance sheet leveraged 30 to 1! Talk about securitization run amok and a complete inability to understand and face the risks of the investments they made. Out of five Wall Street investment banks, only two, Goldman Sachs and Morgan Stanley, are standing and by the end of the year they may not be around either. Bear Stearns was forced into a sale to JP Morgan, Lehman went bankrupt and Merrill Lynch saw the writing on the wall and sold itself in lightning speed to Bank of America. I say good riddance; these guys were the ones who first put the lipstick on pigs!

Market knows best...NOT!

Henry Paulson, the Treasury Secretary, is a former Goldman Sachs CEO who up to last year argued strongly that there was too much regulation and it was crippling American finance in an intensifying global competitive marketplace. Well, those days are gone. The ferocity of the intervention of his response has been unprecedented. Mr. Paulson and Mr. Bernanke (whose Ph. D. thesis was on the Great Depression by the way) appear determined not to go down in history as the ones in charge of a meltdown.

I never pretend to have a crystal ball so let's hope the medicine they are about to administer are the ones needed to restore confidence and get the proper credit flowing again. But make no mistake about it, the availability of credit will be substantially reduced, there will be more government regulations and all of us will be paying for it in higher taxes for many years to come. The financial landscape has changed dramatically in the last six months. The question is not if but how much tougher the new governmental oversight will be and in what form. Looking back to what has happened this year with all the bailouts sometimes I feel like I am living in France! I just hope they institute effective regulations to reduce incentives of reckless behavior so these CEOs do not rely on more bailouts again in the future when they screw up so spectacularly!

We are likely not out of the woods yet. The complexity of these debt securities (many of which include pieces of other instruments, which in turn include pieces of others, many steps removed from the actual mortgages or consumer loans they are based on) is very high. Getting to the bottom of it and unraveling all these strands and the underlying collateral will be a very difficult task. At least now all this work will be done at one place in the government and all this toxic paper is out of the regular markets. All the bodies will be found eventually; it will take time and it will likely take more than $700 billion, which of course is added to the national debt that it is now allowed to go up to $11.3 trillion!

As the painful process of deleveraging continues we will eventually emerge with sounder financial institutions at some point. The brightest students will no longer aim as their first choice for a job at a Wall Street investment bank or a hedge fund to shuffle paper and trade it. Hopefully these students can engineer some actual products and accomplish some real work! I find it very encouraging that both parties appear committed to speedy passage of legislation to address the crisis. And I am really glad that this is happening with Henry Paulson as Secretary Treasury than his predecessor John Snow who was asleep on the wheel for years.

What to do now?

We do not do drastic and sudden moves based on what is happening in the markets. We continued small selective purchases the first three days of this past week while also taking advantage of the opportunity to book some capital losses to offset eventual capital gains and reduce taxes.

Every client has an asset allocation plan and we stick to it. We stay diversified at all times, keep cutting investment expenses to the bone and rebalance at least twice a year. We do not deal with individual stocks or bonds or bother with options, shorting or "quantitative" techniques. We sell no products and all other forms of compensation other than the fully transparent fees clients pay directly to us is strictly forbidden. Every portfolio is built with downside risk in mind and we pride ourselves in our cherished independence and lack of conflicts of interest that the Wall Street firms were known for.

And we always look ahead many years down the road. Investors with less than five years of investment horizon do not belong in the stock market! If you are losing some sleep during these wild market rides perhaps the stock allocation of your investment portfolio is too high. And it's okay and natural to be afraid. But it's not okay to panic. I always encourage clients not to watch CNBC and not look at their account statements too often. Why? It is totally unproductive and a waste of time really. We are not doing irresponsible market timing moves, we just stick to our plan and keep plugging away making good decisions on things we can control and try not to worry too much about the sometimes terrifying volatility of the markets these days.