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August 31, 2007 To the friends and clients of Harvey Investment Company, You’re right. Your Harvey Investment Company quarterly letter has arrived three weeks early. Due to business travel and a vacation, it was this or two weeks later than usual. In light of the extreme financial market turmoil of August, earlier seemed best. Market panics occur most often and with the most virulence when the financial crisis is centered on Wall Street’s major players—the big New York brokers, banks, investment advisors, and now, private equity firms and hedge funds. That is why the attack on the World Trade Center, at the geographic heart of financial markets, was so devastating. Today’s subprime mortgage debacle also touches all the market players, which explains why the S&P 500’s hard won double-digit advance in mid- summer was wiped out in just three weeks. Quite abruptly, investors’ nonchalant attitude toward high risks was shaken to its roots by developments we shall explore later in this note. The result is a tempestuous flight from risky ventures to what are perceived as safer havens. Generally speaking, the change in tone has been favorable for our portfolios relative to the market, and, long-term, we welcome a focus on company fundamentals as opposed to leverage fueled speculation. Nevertheless, it is an ill wind for us as well as others that is blowing through the markets. The financial press has parsed the subprime problem for readers in painstaking detail. With time and hard work it is possible to get a decent understanding of what has occurred. Since the story is already out there, we’d like to focus on an aspect of the crisis that has a more universal utility in understanding the panics of the recent past and future ones that are sure to occur because of it. Year by year, we have been increasingly interested in the movement by investment advisors with enormous sums under management to invest on the basis of the past statistical price behavior of groups of things rather than the prospects of an individual thing. The word ‘thing’ may seem vague, but, as a noun that covers the waterfront, it is appropriate in this context since the statistical groups such advisors may assemble is so broad. It might be a basket of currencies, commodities, stocks, bonds, options, mortgages—you name it. A personal story may help to illustrate the evolution of the individual to group orientation. In 1971, when I was 24, I bought my first house. I had about $14,000 to my name. Since the house cost $26,000, and I didn’t want to be dead broke, I sought a mortgage of $16,000. My parents recommended I go see a person they thought highly of named Harry King at the Colonial Federal Savings and Loan. This kindly man spent quite a while learning about me, my income, and my job prospects. He really cared about the loan he was making—and for good reason. He fully expected Colonial to keep that loan on its books, and he wanted to make sure it could stand on its own two feet. Anyone who has taken out a mortgage lately knows that things have changed. Chances are high that the person who makes your loan will not keep it. It will become one of tens of thousands of mortgages that will be sold to a broker, a bank, or another financial institution to be packaged with, perhaps, several hundred other similar mortgages. The packages may then take on a number of other incarnations in order to be sold to individual and institutional investors. This process is called securitization. The mortgage will pass through many hands, each extracting a bit of fee for its trouble, to its final destination in a mortgage pool owned by someone who cares only for the group’s performance and nothing about any one mortgage. Impersonal though it may be, the packaging of conventional home mortgages ended up being a marvelous invention, stimulating the economy and making housing funds available for many more Americans than would otherwise have been the case. Investors fared just fine in the bonds backed by mortgages of homebuyers with healthy credit histories. The borrowers generally made their principal and interest payments on time, and defaults were relatively rare and occurred in a predictable fashion. There has always been a market as well for borrowers with poor credit histories. Results for investors in this arena have been checkered, however. If meticulous care is taken, lending money to subprime borrowers can be an excellent business since a much higher interest rate may be demanded. But if laxity creeps into the process of evaluating potential borrowers, disaster can develop quickly. The evolving catastrophe in the subprime area today is just the most recent chapter in the history of overeager lenders wooing borrowers with dubious credit histories. What is unfathomable, however, is the scale of the current debacle. It is currently estimated that there are over a trillion dollars of securitized low- grade mortgages. It is also estimated that three quarters of these are adjustable-rate mortgages that will move to substantially higher interest rates over the next eighteen months. Default rates on mortgages are currently rising rapidly, calling into question the value of the cash flows directly supporting billions of dollars of bonds or serving as collateral for other types of mortgage backed obligations. This condition is the nexus of the crisis affecting today’s financial markets. We think that the transition of investors’ emphasis to the statistical behavior of pools of similar investments instead of the analysis of a single investment has always had the potential to wreak havoc in the markets chosen for such activity. Today’s focus is subprime mortgages. Why does it happen? When in doubt, blame the nerds. Mathematicians have long been fascinated with the movement of market prices, especially fast ones moving like the stocks. Some forty years ago some influential academics began looking at markets as problems in probability in which a scientific statistical look at past market behavior would yield data that could reveal what the future was likely to look like. Armed with such data, models were constructed with groups of stocks or bonds or whatever that, in theory, would yield predictable, superior returns. Numerical exactitude and the brilliance of the creators lent an air of certainty to the models. The real world implementation of investment programs based on mathematics has produced often satisfying and, occasionally, extraordinary success. Wall Street now regularly employs math and engineering PhDs to concoct and refine trading models. To work, models must reflect the real world accurately. Billions of dollars each day are invested based on the expectation that they do. Significant deviations from expectation can spell trouble—big trouble, given the money involved. The trillion dollar question is how so many, often highly sophisticated, investors all over the world could be enticed to invest in such dubious loans. Loans were often well in excess of the property backing them. There were loans where the borrower could simply increase his debt if money was too tight to make the monthly payment. Loans were made that started at an artificially low rate, then ballooned in a couple of years. Perhaps most alarming, loans were advanced with no research at all into the borrower’s ability to pay. How did investors get sucked in? The models made them do it. They were desperate for yield, and the models made it seem ok. As a bit of historical perspective, in the aftermath of the bursting of the internet bubble and 9/11, the Greenspan Fed lowered the short term interest rates to 1% driving down interest rates for high quality debt across all maturities. Investors were starving for more yield. They were ready to believe. They only needed a vehicle. Wall Street, ever brilliant and industrious, conjured up supply to meet the demand. It always does. The product was low-grade debt dressed up for market with fancy, new models. The nature of the financial engineering which made the subprime mortgage-backed securities appealing is complex. Essentially pools of mortgages, after being sliced once, were again diced on the basis of risk, so investors could choose the slice of the pie that met their needs. The new slices were supported by mathematical models predicting delinquency and failure rates for the pool and for each slice. The big rating services, Moody’s and S&P, blessed the various slices with their ratings, and investors, prepared to believe anything, readily accepted them. The problem is that the models are not working which should come as no surprise. There is no precedent for such a volume of so poorly conceived loans. It may all seem like one lollapalooza of a scam, but, since everyone seems a victim, it is hard to say who scammed whom. Where the fallout from this sorry episode will lead is unknowable. Secretary of Treasury Paulson is right when he says there is no quick fix. There is no place to go for the customary bailout because the problem is not centered anywhere in particular. It seems certain that a consumer spending slowdown lies ahead. The economy depends very much on consumer confidence so recession can’t be ruled out. Our best guess is that the financial pain from this reckless affair will gradually dissipate over several years. From an investment point of view, we take comfort in the high quality companies in which we own stakes, as well as the cash and high grade bonds we hold on your behalf. By the way, I checked with my friend Joe King to make sure my references to his father, Harry King, were accurate. He told me his father made only three bad loans in is life. I called another friend who was an executive in the industry during much of Harry’s career to see if that could possibly be true. He said he didn’t doubt it. Sincerely, Samuel C. Harvey In compliance with Rule 204-3 of the Securities and Exchange Commission, we are pleased to offer you upon request and without charge a copy of Part II of our Form ADV. This disclosure document contains information about the business practices and procedures of Harvey Investment Company, LLC. Please call us at (502) 339- 8270, if you would like a copy.
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