Industry Update - Hovde Capital Advisors LLC

HMarch 2006volume XIX I issue IIIndustry UpdateThe U.S. Economy Walks the Tightrope:A Good Trick So Far… But It's a Long Way Down if We SlipLike an acrobat on a highwire, the U.S. economy performed a delicate and surprising balancing act in 2005.Despite a series of Federal Reserve interest-rate tightenings (now totaling 14 consecutive rate increasessince June 2004), a spike in oil prices, the devastation of Hurricane Katrina, rising consumer debt, andwidening trade and fiscal deficits, the economy performed better than we and many others expected. GDP growthtotaled a respectable 3.5% in 2005 and key inflation metrics remained under control.How was this daring feat accomplished? Clearly, a solid employment market played a substantial role. The U.S.economy created jobs at an average pace of approximately 200,000 per month in 2005 (with the notableexceptions of the Hurricane-affected months of September and October). The unemployment rate fell to 4.9% inDecember from 5.4% in the year-earlier period, and declined further to 4.7% in January, one of the lowest ratesof joblessness in our nation's history. The federal government responded to the Hurricane Katrina and Ritatragedies by providing more than $70 billion in emergency spending and tax breaks, injecting stimulus into theeconomy of the Gulf Coast and a nation facing disruptions to its energy supply and transportation network.Perhaps even more important, the U.S. banking system and global capital markets played critical roles insupporting the U.S. economy in 2005. Banks and thrifts continued to extend loans at a healthy pace andmaintained relatively loose underwriting standards, spurred by interest rates still low by historical measures anda healthy credit environment. Further, the capital markets were also highly active—setting a record in combinedequity and debt issuance—providing further liquidity. Finally, central banks in China, Russia and other emergingmarkets, flush with cash from trade surpluses and (in some cases) riches from oil and other scarce commodities,recycled their excess capital back to the U.S. in the form of hundreds of billions of dollars in Treasury bonds andother dollar-denominated assets. All of these factors kept the U.S. economy and global capital markets awash inliquidity in 2005.The purchases by foreign central banks kept the dollar strong and helped ensure that goods from their countriesremained attractive to U.S. consumers. Active foreign buying of U.S. assets also had the powerful side effect ofkeeping U.S. long-term interest rates low even as the Federal Reserve continued to lift short-term rates. In whatoutgoing Federal Reserve Chairman Alan Greenspan has famously called a “conundrum,” the 10-year U.S. Treasuryyield has remained in a relatively narrow range of 4.0%-4.6% throughout the Federal Reserve's tightening cycle,even as short-term rates have increased to 4.5% from 1.0%. In essence, what stimulus and liquidity the FederalReserve has taken away from the U.S. economy over the past 18 months, Wall Street, the U.S. banking system andglobal capital markets have given back.Despite these positive developments, the economic imbalances we have described for several years—anoverleveraged consumer and a negative personal savings rate, an economy dependent on home-equity extractionand ever-increasing housing prices, and the persistent budget, trade and current accounts deficits—persisted and,in most cases, got worse in 2005. With costs of the wars in Iraq and Afghanistan continuing to rise, the federalWashington202.775.8109Chicago847.991.6622Los Angeles310.535.9200Palm Beach561.279.7199

government will continue to be limited in its ability to“prime the pump” through further tax cuts or spendingdirectly targeted to spur economic growth. Moreover,the United States remains dependent on foreign capitalflows to finance its current accounts deficits, meaningthe U.S., in a number of important respects, has lostcontrol of its own financial destiny. Reports havecirculated for months that some foreign central banks(most notably China) are considering diversifying someof their holdings away from U.S. dollar-denominatedassets, in part, due to their over concentration in U.S.Treasuries. While we do not foresee diversification ona large scale by China or other central banks away fromdollar-denominated assets in the near term, it isdisconcerting to note that, if this were to occur, itwould have a major negative impact on long-terminterest rates and the U.S. economy overall.The U.S. banking system, under increasing pressurefrom regulators to rein in risky forms of mortgagelending, has recently started to tighten underwritingstandards for new loans—a trend we expect tocontinue into 2006—likely contributing to the recentslowdown in housing. The U.S. yield curve, which hasflattened throughout the Fed's tightening cycle, fullyinverted in February 2006, with the two-year Treasuryyielding as much as 10 basis points more than the 10-year and about 15 basis points more than the 30-yearTreasury as of early March before reverting to a flatcurve in the middle of the month. An inverted curvehistorically has been a precursor to a recession, asbond investors concerned about weakening economicgrowth buy long-dated fixed income securities inanticipation of future Fed rate reductions.In sum, while the U.S. economy's highwire act has beenimpressive so far, the path going forward is no easierto navigate. And a slip-up—in the form of a burstingof the U.S. housing bubble, withdrawal of foreigncapital from dollar-denominated assets, an economicslowdown, a spike-up in long-term interest rates, or acombination of these factors—could be extremelycostly to the U.S. economy.As we have done for the past five years, in this annualIndustry Update we will expand on these themes as weconsider our outlook for the U.S. economy. We willaddress the consumer, real estate, corporate andcapital markets sectors as well as the role of thefederal government in influencing the overall economy.ConsumerAs we have highlighted in our annual Industry Updatesfor the past couple of years, the U.S. consumer remainsour single biggest area of concern and, we believe, thegreatest source of potential risk for the economy.Some conventional metrics of the health of theconsumer, including consumer confidence surveys andretail sales, appear solid, and credit quality metrics atU.S. banks and thrifts remain at pristine levels.However, beneath these positive indicators, theconsumer's balance sheet continues to deteriorate.U.S. household debt payments now stand at an all-timehigh of 13.8% of disposable income, a figure that hasrisen steadily since 2002 even as the economy hasemerged from recession (see next page). With interestrates continuing to rise (Fed rate increases typicallytake nine to 12 months to fully impact the economy),the cost of financing the consumer's short-term and,eventually, long-term debt will continue to rise into2007.Finally, the U.S. consumer has benefited substantially inrecent years from the dramatic appreciation ofresidential real estate in the form of cash-out homerefinancings. Should home prices decline or merelylevel off, the consumer's balance sheet will certainlytake a turn for the worse. Shortly before his tenure asFed Chairman ended, Alan Greenspan co-authored astudy on mortgage debt and its impact on consumerspending—only the second study he co-authored in his18 years on the job. The study found that borrowingagainst home equity added $600 billion to U.S.consumer spending in 2004 alone, equivalent to 7% oftotal after-tax personal income. Early estimates arethat home-equity extraction increased further to some$700 billion (with some estimates as high as $900billion) in 2005, a stunning figure given that interestrates were increasing throughout the year (see chartbelow).$204Home Equity Extraction ($B)$262$398A recent survey by the Federal Reserve on the health ofthe U.S. consumer further illustrates the perilous stateof many mainstream Americans. The survey found that$439$5992000 2001 2002 2003 2004 2005Sources: Federal Reserve Board (2000-2004) andISI Research (2004-2005, estimate)$7002Industry Update

eal (inflation-adjusted) family income growth has beennearly flat in recent years, with median incomes rising1.6% before taxes from 2001 to 2004, the lowest rate ofgrowth since the early 1990s. Median real family networth increased a similar amount over this period—1.5%. However, as we have discussed earlier and inother Industry Updates, the 2001 to 2004 periodfeatured tremendous levels of appreciation of homeprices. Therefore, why did household net worth notrise faster than income growth? While the decline inequity values in the post-bubble period played a role,the increase in debt was a far more substantial factor,increasing household liabilities at a pace almost asrapid as the increase in asset values. Not surprisingly,those at the bottom end of the income spectrum wereaffected most by this trend, while the wealthy haveseen their incomes grow more substantially. “Familiesdevoted more of their incomes to servicing their debts,despite a general decline in interest rates,” the Fedsurvey notes. “Also, the fraction of families with largerequired debt service payments relative to theirincomes rose … and the fraction of families that hadHousehold Debt Payments as % of Disposable Income14.013.513.012.512.011.511.010.510.0Sep-82Sep-83Sep-84Sep-85Sep-86Sep-87Source: Federal ReserveHousehold Debt-Service RatioSep-88Sep-89Sep-90Sep-91Sep-92Sep-93Sep-94Sep-95Sep-96Sep-97Sep-98Sep-99Sep-00Sep-01Sep-02Sep-03Sep-04Sep-05payments that were late sixty days or more … rosesubstantially. These increases affected mainly thebottom 80% of the income distribution.”In prior periods of economic weakness, which aretypically accompanied by lower interest rates,consumers have restrained spending to save money,and shore up their balance sheets by reducing debtand associated interest expenses. However, in themost recent recession, the consumer utilized low ratesand easily available credit to fuel even higherspending. This trend continued as the economy beganto recover and the Fed began to raise rates. As aresult, household balance sheets have taken onconsiderably more debt, and personal savings as apercentage of disposable income has continued itssteady decline over the last 20 years and has nowturned negative (see below). The negative savings rateleaves consumers with less of a cushion to soften theblow should economic conditions deteriorate orborrowing costs continue to rise.% Percentage11109876543210-1-2-3-4Nov-86Oct-87Sep-88Aug-89Jul-90Jun-91Personal Savings RateMay-92Apr-93Mar-94Source: Bureau of Economic AnalysisFeb-95Clearly, continued job and income growth wouldprovide consumers with greater income to finance newspending while continuing to finance their debt. Thecurrent pace of roughly 200,000 new jobs per month iscomfortably above the 150,000 level economistsestimate is required to accommodate those enteringthe work force (see below). However, continuedoutsourcing of low-skilled, and, increasingly, highskilledlabor is a key risk to job growth going forward.In addition, the housing boom has been a majorcontributor to employment growth in recent years, notjust in construction but also real-estate brokerage,mortgage finance and other housing-related400350300250J a n - 04F e b - 04M a r - 04A p r - 04M a y - 04J u n - 04J u l - 04A u g - 04S e p - 04O c t - 04N o v - 04D e c - 04J a n - 05F e b - 05M a r - 05A p r - 05M a y - 05J u n - 05J u l - 05A u g - 05S e p - 05O c t - 05N o v- 05D e c -05J a n -200150100500Change in Total Nonfarm Payrolls, SA (000’s)Source: Bureau of Labor StatisticsJan-96Dec-96Nov-97Oct-98Sep-99Aug-00Jul-01Jun-02May-03Apr-04Mar-0506Industry Update 3

usinesses. Research firm ISI Group recently estimatedthat 30% of all jobs created since the end of therecession in 2002 have been housing-related. Shouldhousing activity continue to slow, job growth couldslow, as well.In sum, we believe consumer spending will probablycontinue to hold up in the near term. However, afterleading the economy out of recession and serving asthe engine for economic growth in recent years, theconsumer is now a weak link dependent on thecontinued health of the corporate and housing sectors.The key issues to watch are the pace of job growth aswell as the rate at which housing activity and homeprice appreciation slows. Of all the key drivers of theeconomy, the consumer is perhaps walking thenarrowest tightrope, given the backdrop of rising ratesflowing through the economy and housing activityslowing, and will be a critical factor to watch in comingquarters.Real EstateAs we have said on many occasions in prior IndustryUpdates, real estate values float on a sea of finance.The cost and availability of that financing are theprimary factors in determining the price of real estate.Given the dynamics we referred to in our introduction,long-term interest rates remained surprisingly low in2005, keeping real-estate financing rates attractive.Similarly, U.S. financial institutions ensured that realestatefinancing remained incredibly easy to obtain in2005, despite increasing pressure from regulators totighten underwriting standards that intensified late inthe year.Residential Real EstateThe rise in short-term rates, coupled with a focus bythe financial and general media on whether thehousing boom had run its course, impacted homeappreciation and sales activity in late 2005. Annualizedexisting home sales in January were down 2.8% fromDecember and down 5.2% from a year ago (seasonallyadjusted), according to the National Association ofRealtors (NAR). Similarly, the price of the median U.S.home was $211,000 in January, up 11.6% from a yearearlier but flat versus the prior month and down 4.1%from the record high of $220,000 reached in August2005, according to the NAR.The tougher sales environment is having an impact onthe rising inventories of unsold homes, which arehitting multi-year highs in some hot housing markets.Nationwide, the inventory of unsold homes in Januarywas up 36% from a year earlier, according to theCommerce Department. Despite the recent pricedeclines, housing affordability metrics remain stretched.The price of an existing home in the U.S. nowrepresents 3.6x the median family income, according tothe NAR, just below the all-time record of 3.8x in August2005 and up from 2.8x just five years ago.We will not spend considerable time discussing ourviews on the housing sector here given that we recentlypublished a two-part series on this issue (for furtherdetails, see our Housing Industry Updates fromSeptember and November 2005). Suffice it to say,housing is slowing from the breakneck pace of the pastfour years, a period in which the sector was the mostimportant stimulant to the U.S. economy. We expecthome price appreciation to level off, and constructionand sales activity to decline throughout 2006.Further slowing of the housing market will come to actas a drag on the economy in the year ahead. However,we think the big impact of rising interest rates willcome from the re-pricing of substantial volumes ofadjustable-rate mortgages in 2006 and 2007.According to a recent analysis by Deutsche Bank, anestimated $300 billion of mortgages will convert toadjustable-rate from fixed-rate status in 2006, up from$80 billion in 2005. Over $1 trillion, or 12% of allmortgage debt, will adjust in 2007. Given that theseloans are priced on spreads over short-term interestrates, which have increased by 3.50% since June 2004,homeowners' debt payments will rise substantially asthe mortgages re-price.The combination of flat to declining housing prices andrising mortgage debt payments could have asubstantial negative impact on the economy. Despitethe increases in home values in recent years, owners'equity as a percentage of household real estateremains stubbornly near the record all-time low of 55%in 2003, down from 70% in the mid-1980s and morethan 85% in the 1940s (see next page). As home priceshave appreciated, consumers have used their housesas collateral for new home improvements, debtrepayment, and general consumer spending throughmortgage refinancing. Refinancing volumes stillaccount for about 40% of total mortgage originations,and cash-out refinancing volumes representapproximately 80% of total refinancing activity. Whatmakes this such a troubling trend and shows howstrained and reliant the consumer has become onhome equity extractions, is that 50% of current cashoutrefinancings are not economically sensible for thehomeowner because he or she is swapping into ahigher interest rate than the original mortgage. Inaddition, a myriad of new products from banks andmortgage lenders introduced in recent years, including4Industry Update

interest-only and negative amortization loans, haveincreased dramatically in popularity. These loans allowconsumers to delay some or all principal payments ontheir mortgages, but in some ways hide the risks ofincreased payments later in the mortgage's term.90%85%80%75%70%65%60%55%50%Owners’ Equity as % of Household Real Estate194519491953195719611965196919731977198119851989Source: Federal Reserve Flow of Funds Accounts199319972001In conclusion, rather than using rising home prices asa means to reduce leverage, the U.S. consumer hasused this windfall as a seemingly never-ending sourceof income, thereby increasing risk to themselves andthe economy overall. The question is, now that thereare clear signs that housing activity and home-priceappreciation are slowing, how will current and potentialhomeowners react in 2006? While home priceappreciation is likely to continue to flatten out, andhousing activity to continue to fall off this year, we donot expect a meaningful decline in housing values andsales activity until 2007, driven by the massive wave ofadjustable-rate mortgages that will re-price.Commercial Real EstateOur outlook for commercial real estate is moreconstructive than our forecast for residential housing,though the dynamic of rising rates is negative for bothsectors. Similar to the slowdown in residential housingprices, commercial property prices took a breather inlate 2005. Starting in 2003 and continuing through thefirst nine months of 2005, overall commercial propertyprices increased even though vacancy rates nationwidewere near historically high levels. Obviously, the onlyway values can go up when the revenues from aproperty are going down is due to low financing rates.Commercial vacancy rates declined last year, as manycompanies resumed expansion and new hiring after alonger-than-expected period of belt tightening duringand after the recession. Overall U.S. commercialsuburban vacancy rates stand at 14.6%, down from17.4% a year earlier, though some markets still have2005vacancy rates greater than 20%, according to realestatebroker C.B. Richard Ellis (see below).U.S. Suburban Commercial Vacancy Rates (%)Source: CB Richard Ellis1 D e t r o i t 22 . 42 C i n c i n n a t i 20 . 93 C o l u m b u s 20 . 94 D a l l a s / F o r t W o r t h 20 . 85 A t l a n t a 20 . 76 C h a r l o t t e 20 . 67 C h i c a g o 18 . 08 P h i l a d e l p h i a 17 . 49 S a n F r a n c i s c o 17 . 310 C l e v e l a n d 17 . 311 B o s t o n 17 . 212 K a n s a s C ity 17 . 213 D e n v e r 16 . 914 I n d i a n a p o l i s 16 . 715 H o u s t o n 15 . 116 M i d J e r s e y 15 . 017 U n i t e d S t a t e s 14 . 618 O r l a n d o 14 . 219 J a c k s o n v i l l e 14 . 120 B a l t i m o r e 14 . 0Perhaps the most striking aspect of the currentcommercial real estate market is the decline incapitalization (or “cap”) rates—essentially, the earningsyield on a property—to historic lows of 3%-4%.Massive new allocations to commercial real estate byU.S. pension funds, foundations and endowments, aswell as interest by foreign investors, have provided theinvestment capital to drive this decline in capital rates.Further, what has also allowed capital rates to reachthese levels is that the banking industry and WallStreet, through the securitization market, have beenwilling to lend to buyers at these capital rates.We forecast that commercial vacancy rates will continueto decline in 2006. However, we also believe thatproperty values will likely be flat to slightly down. Ourreasoning is that even with the benefit of this flood ofinvestment capital in improving vacancy rates, thesefactors should be largely offset by rising interestpayments, given that financing costs are typically thelargest expense for commercial properties. In addition,the expansion in capital available to commercial realestate borrowers, helped by the low ratios ofdelinquencies and charge-offs real estate lenders haveenjoyed, could slow as bank regulators' concerns overthe high concentration of real estate exposure causethe industry to examine its commercial real estatelending allocations more closely.Industry Update 5

In conclusion, the era of “easy” commercial real estatelending is over, and lending profitably and sensibly tothe sector will be tougher going forward. Therefore,while we expect commercial real estate to continue toperform at a reasonably healthy level, we also expectprice appreciation to continue to moderate. We arealso concerned that the risk premiums implied bycurrent commercial real estate capitalization rates areextremely low, leaving the market vulnerable to a repricingshock.CorporateIn contrast to our pessimistic view on the outlook forthe consumer and housing sectors, we see thecorporate environment as a bright spot for the U.S.economy. Corporate America made substantial effortsto improve both its internal operations and balancesheets after the Internet bubble burst in 2000.Accounting and corporate governance scandals at manycompanies, most notably Enron and WorldCom, led tolosses of thousands of jobs and billions of dollarswhile heightening investor suspicion of corporatemanagement. Sarbanes-Oxley and other reforms havetightened regulations on corporate executives andmade financial reporting more transparent.At the same time, in the wake of the recession of 2001and 2002, many companies cut expenses, reduceddebt, outsourced non-core functions, and avoided largeacquisitions and other strategic moves. As a result,cash and liquid investments as a percentage of totalassets at U.S. non-financial companies increased to arecord high of 4.6% in the third quarter of 2005, upfrom 4.0% in 2000, according to ISI Group. Similarly,Goldman Sachs estimates that total cash among theS&P 500 companies now stands at $2.1 trillion, doublethe level in 1997. This buildup in liquidity has occurredeven as companies have been more aggressive onacquisitions in recent quarters.The U.S. manufacturing sector, in many ways,exemplifies the progress the corporate sector has madeas the economy has emerged from recession intorecovery. Many commodity-based industries, includingsteel, cement, and coal, have capitalized on hugedemand from rapidly expanding emerging marketsaround the globe. Similarly, industrial production andcapacity utilization have rebounded from lows reachedin 2001 and 2002. The Fed's Industrial ProductionIndex—a measure of physical output of factories, minesand utilities, of which manufacturing represents 85%—is now at an all-time high, ahead of the prior peakreached in 2000. In addition, capacity utilization,according to the Federal Reserve, has increasedsteadily from a low of 74% in mid-2003 and is now inline with the historical average of about 80% (seebelow).1151059585756555Mar-86Jan-8786%85%84%83%82%81%80%79%78%77%76%75%74%73%Mar-86Industrial Production (SA)Nov-87Sep-88Jul-89May-90Mar-91Jan-92Nov-92Sep-93Jul-94May-95Mar-96Jan-97Nov-97Sep-98Jul-99May-00Mar-01Jan-02Nov-02Sep-03Jul-04May-05Feb-87Jan-88Dec-88Nov-89Oct-90Sep-91Aug-92Source: Federal Reserve BoardCapacity UtilizationJul-93Jun-94May-95U.S. corporations have used globalization to theiradvantage: selling their products in new markets, usingcheap overseas labor when appropriate, and takingadvantage of low long-term interest rates to improvetheir debt profile. However, globalization has alsomade many corporations more dislocated from theirhome market. The American corporation is losing itsconnection to the American economy and the Americanworker. Skilled workers, at least for now, are safe fromthe globalization of the labor market. However,unskilled laborers will continue to face greaterchallenges—and, right or wrong, will be a lower priorityfor employers more concerned with global competitivepressures, legacy costs, and delivering shareholdervalue. The continuing layoffs in old-line sectors of theU.S. economy, such as autos and airlines, illustrate thisdilemma, as firms like General Motors have been forcedto reduce current headcount substantially, even as theyApr-96Mar-97Feb-98Jan-99Dec-99Nov-00Oct-01Sep-02Aug-03Jul-04Jun-056Industry Update

spend billions to support the pension and healthcareneeds of thousands of retired workers.With the consumer balance sheet running close toempty, the corporate sector will need to take the leadin sustaining economic growth in 2006 and beyond.However, there are two dynamics at play here that areimportant to consider. First, consumer spendingaccounts for approximately two-thirds of GDP andultimately supports much of the corporate sector.Thus, the overall economy could be hurt if consumerspending falters, even if corporations take up some ofthe slack. Second, a greater portion of corporateprofits are being generated from financial services—notjust banks, thrifts, brokers and the like, but companiessuch as General Electric, GM, and Ford that nowgenerate considerable profits from their financialservices units. Financial services now generateapproximately 30% of earnings for the S&P 500, thehighest level on record. As we have discussed before,earnings of financial services are closely linked to thehealth of the U.S. consumer and the level of interestrates, so a decline in consumer spending and creditwould have significant consequences in the corporateworld. Finally, while corporate balance sheets appearstrong on a reported basis, when one takes intoaccount the massive unfunded pension liabilities ofmany U.S. corporations, corporate liquidity no longerappears nearly as healthy, particularly in old-lineindustries, such as automobiles and airlines.The key question going forward is whether or notcorporations use their excess liquidity to expand, hirenew workers, and make capital investments tocontinue to stimulate economic growth. If they do, thiswill bode well for the consumer and the economyoverall. On the other hand, should corporations preferto invest overseas, move more U.S. jobs abroad, buildcash reserves, accelerate share-repurchase programs,or boost dividends, it would benefit shareholders atthe expense of workers, who, as we addressed in theConsumer section above, are overextended and highlyindebted. In sum, the two sectors are intertwined, anda substantial downturn in consumer spending wouldclearly have a negative impact on the corporate sector.Capital MarketsThe capital markets and the banking system are, in asense, the gas stations for the economy. Throughequity and debt underwritings, the capital marketsprovide cash that companies need to expand and grow.Suffice it to say, Wall Street's gas station was pumpingaway in 2005, with underwriting volumes more robustthan many had expected. Total corporate U.S.underwriting activity (debt and equity) was a record$3.15 trillion, up 10% from 2004. From traditionalasset managers looking to boost performance in aflattish year for U.S. equity markets, to hedge fundsputting inflows to work, to corporations looking toboost returns on excess cash, the U.S. (and the world)remained awash in liquidity in 2005, helping to drivedemand for new securities issues.Total U.S. equity underwriting in 2005 was $182 billion,10% below last year's pace but well ahead of the levelof about $155 billion in both 2002 and 2003. Inaddition, announced share buybacks rose to a record$440 billion in 2005, according to the SecuritiesIndustry Association, well ahead of the prior year'srecord of $312 billion (which in turn was well ahead ofthe prior record of $219 billion in 2001). Sharebuybacks provide support to stock prices and alsoeffectively create demand for new issues, sincecompany repurchases essentially reduce the supply ofstock in the market. Despite expectations that bondunderwriting volumes would be hurt by rising interestrates, corporate debt underwriting was helped by theincreased diversity of the asset-backed securities (ABS)market and companies' interest in locking in interestrates still low by historical standards. As a result, totaldebt underwriting volume hit a record $2.96 trillion in2005, up 8% from the prior record of $2.73 trillion in2003, according to the Securities Industry Association.Mergers and acquisitions activity continued to reboundfrom trough levels in 2002 and 2003, but remained wellbelow levels reached in the late 1990s and 2000. U.S.announced M&A volume totaled $1,085 billion in 2004,up 28% from 2004, according to Thomson Financial.The 2005 total still lags the $1.5 trillion to $1.7 trillionin M&A volume announced each year from 1998 to2000, a total of more than $5 trillion over the threeyearperiod.Given that the capital markets benefit from corporateactivity, we see healthy corporate balance sheets aspositives for the capital markets outlook in 2006.However, it is always critical to remember that thecapital markets are built on the confidence of investorsand issuers, confidence that is fickle and can changerapidly. One area of concern to us is the substantialincrease in leverage in the financial system in recentyears. As we noted above, many corporations haveused excess capital to repay or refinance debt on theirbalance sheets in recent years. Yet, at the same time,derivatives volumes of all types—from plain-vanilla rateswaps to collateralized debt obligations (CDOs) andcredit derivatives (CDS)—have boomed in recent years.The Bank for International Settlements estimates thatthe over-the-counter derivatives market has grown at aIndustry Update 7

compound annual rate of 30% since 2001, with grossmarket values now totaling $10.7 trillion. Similarly, theincreased size of the mortgage-backed securitiesmarkets means that Wall Street is now more levered tothe housing market than ever before. Driven by theboom in housing activity in recent years, outstandingmortgage-backed securities totaled $5.9 trillion as ofyear-end 2005, up 8% from a year earlier and morethan double the $2.4 trillion outstanding a decadebefore, according to the Bond Market Association.Derivatives and securitization are designed to diversifyrisk among corporations, financial institutions, andinvestors. However, the explosion offinancial innovations has made it harder toknow who ultimately is responsible foraccepting that risk should a crisis occur. Aloss of confidence would have substantialripple effects on these many and variedderivatives contracts that are impossible topredict with certainty because the marketsare so much larger than they were in priorperiods of crisis (the 1987 stock marketcrash, the collapse of Long-Term CapitalManagement in 1998, etc.).As a result, while the capital markets have -350-400remained robust thus far in 2006, we are-450cautious about the heightened degree ofleverage, the declining risk premium formany asset classes (high-yield bonds,emerging-markets debt, etc.) and theincreased importance of hedge funds asholders of high-risk assets, given the potential forquick redemptions. If consumer credit lossesaccelerate, housing values decline precipitously, ageopolitical crisis occurs, or—as frequently occurs in arising rate environment—a financial shock occurs, thedelicate and complex balance of the capital marketscould unwind in an abrupt and unpleasant manner.GovernmentSimilar to the U.S. consumer, the federal government'sbalance sheet has gotten worse, not better, during therecovery, posing a significant obstacle to continuedeconomic growth. With the wars in Iraq andAfghanistan continuing and the reconstruction of theU.S. Gulf Coast Region a new drag on spending, federaldeficits are projected to continue to run at a rate ofgreater than $300 billion for the next six fiscal years,according to the Congressional Budget Office (see chartat right). Most experts acknowledge that the budgetdeficit is actually worse than it appears because ofgovernment accounting conventions that underestimate$ in Billions250200150100500-50-100-150-200-250-30012/30/81the future obligations of entitlement programs, such asSocial Security, Medicare, and Medicaid.Will the forecasts prove too low, or too high? Thatdepends, of course, on Congress and the President.While President Bush has attempted to reducediscretionary spending in his last two budget proposals,Congress pushed back last year and is even more likelyto do so this year, especially with an election loomingin November. At the same time, President Bush hasproved reluctant to use his veto pen, and it is not clearwhether he will be willing to use this power as he lookstoward the end of his second term.Fiscal Year: October - September12/30/8312/30/8512/30/87Annual U.S. Budget Deficit / Surplus12/30/8912/30/9112/30/9312/30/9512/30/97Sources: U.S. Treasury & Congressional Budget Office12/30/9912/30/01One positive note to this debate is that new HouseMajority Leader John Boehner recently won a surpriseelection over interim leader Roy Blount, a candidatemore closely tied to outgoing leader Tom DeLay, in parton Boehner's promises to his fellow Members to crackdown on spending. At the same time, the first of the79 million Baby Boomers turn 60 this year. With anaging population, reform of entitlement programs suchas Social Security, Medicare, and Medicaid remains amajor issue, one that could potentially overwhelm evensubstantial cuts in discretionary spending. PresidentBush made Social Security reform one of the toppriorities of his second term, but the issue haslanguished, and now appears to be off the table for2006.The second major risk of the high federal and tradedeficits is increased dependence on foreign capital.Because the U.S. savings rate is negative, foreigninvestors—particularly central banks—have becomemajor financiers of the U.S. deficit. Foreign countriesare sending us their goods, and we are sending them12/30/0312/30/0512/30/0612/30/08Projected12/30/1012/30/1212/30/148Industry Update

IOUs. Central banks of Asian countries that are majorexporters to the U.S, such as Japan, China, Taiwan, andSouth Korea, have purchased hundreds of billions ofU.S. government bonds and other dollar-denominatedassets. These foreign governments have supported theU.S. dollar in an effort to keep their currenciescompetitive versus the dollar and make their exportsmore attractive to U.S. buyers. As a result, foreignownership of U.S. treasuries increased from 15% in1982 to 43% in mid-2004, according to the FederalReserve (latest data available). This phenomenon wasexacerbated by the further rise in oil prices throughmuch of 2005. Oil-rich countries, such as Russia andthe Gulf countries, took the windfall from their oilexports and plowed the proceeds back into the safetyof U.S. Treasuries, keeping U.S. bond yields lower thanwould typically occur at a time when the FederalReserve is raising rates.This symbiotic relationship has benefited both the U.S.(in the form of expanded borrowing capacity and lowerinterest rates) and its overseas partners (in the form ofcompetitive currencies that help their exporters) in theshort-term. However, in the mid- to long-term, thesestructural imbalances create substantial risks for theglobal financial system. Should foreigners begin toquestion the structural health of the U.S. economy, theFederal Reserve could lose further control over mid- tolong-term interest rates.An increase in U.S. exports could help to increasedemand for the dollar and alleviate the pressures thatcould be caused by a crisis of confidence by foreigninvestors in U.S. financial assets. However, the U.S.has already lost much of its manufacturing capacity tocountries with lower labor costs, resulting in a steadilyincreasing trade deficit. In early February, the U.S.Department of Commerce reported that the trade deficithit a record $725.8 billion in 2005, an 18% increasefrom 2004 and a record 5.8% of U.S. gross domesticproduct (GDP). Growth in the deficit reflects surgingimports, particularly oil and other manufactured goods,in 2005.One of the bigger macroeconomic surprises of 2005was the strength of the U.S. dollar relative to manyforeign currencies. Many market participants werebearish on the dollar, given the structural imbalanceswith the U.S. consumer and federal government wehave discussed above. Two factors combined tocontradict these forecasts.First, the relative yield on U.S. assets increased as theFederal Reserve raised short-term rates at a time whenmost foreign central banks kept rates neutral orlowered rates. Second, the repatriation of billions of1.31.21.110.90.80.7Dec-98Jun-99Source: Bloombergdollars of foreign earnings by U.S. corporations, part ofPresident Bush's plan to stimulate the economy, alsoprovided a boost to the dollar. More than 350companies returned some $290 billion to $325 billionin foreign-sourced profits. In 2006, however, with thetax benefit on repatriation of foreign earnings havingexpired, coupled with the continuing trade deficits andhints that some foreign central banks will diversify their$ in Billions$50$0-$50-$100-$150-$200-$250-$300-$350-$400-$450-$500-$550-$600-$650-$700-$750-$800Dec-67Dec-69USD/Euro Exchange RateNov-99Apr-00Sep-00Mar-01Aug-01Jan-02Jul-02Dec-02May-03Oct-03Mar-04Sep-04Feb-05Jul-05Dec-05Net Export of Goods & Services (SAAR)Dec-71Dec-73Dec-75Dec-77Dec-79Dec-81Source: Bureau of Economic AnalysisDec-83reserves away from U.S. assets, we think the bearishcall on the dollar may belatedly prove to be correct.As in the consumer and real estate sectors, we seesound government policy as key to balancing the U.S.economy. Unfortunately, the federal government'sfinances are in worse shape than at almost any time inour history. We see the record high budget deficit,along with the increasing trade and current accountsdeficits, tying the government's hands shouldeconomic conditions deteriorate. Further, as it pertainsto the trade and current accounts deficits, at someDec-85Dec-87Dec-89Dec-91Dec-93Dec-95Dec-97Dec-99Dec-01Dec-03Dec-05Industry Update 9

point there will have to be a correction, and thatcorrection could be very painful for the U.S. and worldeconomies. The key questions are: when will thecorrection occur and can it happen slowly? The bestand most hopeful outcome would be if foreigncountries were to reverse their current direction andconsume substantial volumes of U.S. goods. In thiscase, the trade and current accounts deficits couldachieve a soft landing.Outlook for 2006The U.S. economy is like a large battleship: it takes aconsiderable amount of time and resources to changedirection, and it often takes a while to notice whichway it is heading. The U.S. economy appears to becontinuing to plug along in early 2006, with economicgrowth anticipated to be strong in the first quarter,profits for Corporate America continuing to increase ata healthy pace, and long-term rates remaining relativelylow (though the 10-year yield moved up meaningfully inMarch and traded above 4.75% as of mid-March).Many investors appear to be anticipating a“Goldilocks” scenario in which U.S. economic growth issolid but not too strong, and inflation remains benign,allowing the Fed to halt its interest rate tighteningcampaign by mid-2006. Strong January retail sales—sales rose 2.3% on a seasonally adjusted basis fromDecember and 8.8% from a year earlier, helped by giftcardredemptions and unusually warm weather in manyparts of the country—sparked hopes that consumerspending will remain solid.Despite these positive signals, we do not believe ourmetaphorical acrobat has made it to the other side ofthe highwire yet. The effects of last year's interest rateincreases will continue to impact the economy, even ifthe Federal Reserve ends its tightening campaign inmid-2006 (as noted earlier, Fed rate increases take nineto 12 months to be fully realized). The flat or flat toinverted yield curve (see chart at right) will continue toplace pressure on financial and non-financialcompanies alike. Oil prices have remained volatile in2006 and (at prices around $60 per barrel as of earlyMarch) remain near historic highs. GM and Ford, twoof the largest employers in the U.S., face tremendouschallenges and each could face the prospect ofbankruptcy, though probably not in the near term. Ontop of all of this, we continue to exist in a period ofheightened geopolitical risk—the war among religiousfactions in Iraq is intensifying, and now Iran has defiedinternational calls to halt efforts to develop nucleartechnology—in which terrorism and disruptions to theworld's social fabric and economy remain constantthreats. We also hold to our view, cited in previousIndustry Updates, that credit quality will deteriorate,from current near-pristine levels, in late 2006 or in2007, when the volume of adjustable-rate mortgagere-pricing accelerates dramatically. What makes usworry even more about these risks than in times pastis the amount of leverage that has been built into everylevel of the U.S. economy and capital markets. Further,it is rare to find a time at which risk premiums—fromcap rates on commercial real estate, to credit spreadson junk bonds, to volatility measures for U.S. stocks—have been so tight and, in our view, under-priced.21.751.51.2510.750.50.250-0.25-0.5Jul-04Aug-04Sep-04Oct-04Nov-04Source: Bloomberg10-YR Treasury vs. 2-YR Treasury SpreadDec-04Jan-05Feb-05Mar-05Apr-05Apr-05May-05Jun-05Jul-05Aug-05Sep-05Oct-05Nov-05Dec-05Jan-06Feb-06Mar-06All of these issues present significant challenges anduncertainties for the U.S. economy and pose a numberof questions for company executives and investors.Can the housing market slow without taking the U.S.economy down with it? Do high energy prices seepinto core inflation data? Does wage pressure emerge?Does a geopolitical crisis emerge? How serious will theFed, led by new Chairman Ben Bernanke, be inaddressing the structural imbalances we and othershave identified in the U.S. economy in terms of fiscaland current accounts deficits and inflated asset values?Only time will tell, however, we'll be back in 2007 withthe answers to these questions.10 Industry Update

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HFounded in 1987, the Hovde Organization is headquartered in Washington, DC withadditional offices in Chicago, Los Angeles and Palm Beach. Hovde has a uniquefocus on the financial services industry particularly in the areas of InvestmentBanking, Asset Management, Merchant Banking and Securities.FINANCIAL LLCis a leading and nationally recognized investment banking firm specializing in mergers,acquisitions, and strategic and advisory services for community and regional banks, thrifts,insurance companies, mortgage companies, lending companies and other specialty financecompanies. Visit www.hovde.com for transaction history and special industry reports.CAPITAL ADVISORS LLCis a registered investment adviser with the Securities and Exchange Commission and the advisorto the Financial Institution Partners series of hedge funds. Visit www.hovdecapital.com to learnmore about investment opportunities.ACQUISITION LLCis Hovde’s merchant banking/private equity division. This entity manages a private equity fund,Financial Services Partners Fund I LLC, which invests in both privately and publicly heldcompanies, in most cases assuming control positions through equity investments. In addition,it provides strategic and financial advice and capital to privately held or closely held financialinstitutions in order to help finance their growth.SECURITIES LLCworks with banks and thrifts of virtually all asset sizes ($100 million to over $5 billion) tostructure, purchase and pool Trust Preferred Securities and other capital transactions.Washington202.775.8109Chicago847.991.6622Los Angeles310.535.9200Palm Beach561.279.7199