Western Reserve Capital Management, LP

Published Research

July 2008 – January 2010

Confidential Materials

2009 Review & 2010 Outlook January 2010

“The Error of Pessimism is born the Size of a Full-Grown Man…”

- James Grant (via Pigou) Dear Partners, A year ago amid the throws of the financial crisis, we referred to the then existing market opportunity as “once in a career.” It was. The transition to new leadership in Washington created a historic valuation opportunity. This was a function of both procrastination and politicizing on several fronts which exaggerated and magnified uncertainty. We will address just two. First, the Congress having delayed taking action to deal with the absurdity of mark-to-market accounting (MTM) until the spring of 2009 escalated the financial crisis (crisis NOT to be confused with recession). The devastation of MTM on the financial industry and the stock market resulted in trillions of dollars of “unintended” loss as an apparent consequence of necessary delay until after an election. TARP was a direct necessity and function of this delay. The legislature finally took-up the matter in a congressional hearing on March 12, 2009. The stock market bottomed on March 9…the day the House Financial Services Committee announced the hearing. Western Reserve senior advisor Bob McTeer, former President of the Federal Reserve Bank of Dallas, provided key expert testimony to the March 12th event. Secondly, TARP rules were highly politicized in early 2009 and resulted in the “stress test” for larger banks, most of whom, were coerced to take TARP. A market panic ensued immediately over concern that TARP was being abused by the new administration as a “back-door” ploy to nationalize the U.S. financial system. The independent Federal Reserve Board stepped-in and defended it’s “turf” under the Bank Holding Company Act of 1956. The Fed completed the “stress test” and today bank TARP is a smashing success. Other, non bank uses of TARP well… not so much. Financial markets stabilized and now slowly and steadily are convalescing. The architect of TARP has rightfully been named TIME’s Person-of-the-Year, but the psychological damage to the market and the economy (including record cash hoarding economy wide) has left wide open the window of opportunity still. Investment flows into domestic equities remain deficient at best and U.S. financial services stocks remain

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widely under owned and heavily shorted despite their fundamentals recovering strongly and their valuations remaining compelling. Western Reserve Master Fund (“Fund”) since inception has produced over 20% annualized alpha when compared with any financial services index and has produced profits both long and short. We believe the Fund’s best years lie ahead. The opportunity of a career remains clear and present. For a comprehensive performance summary…See – appendix at the end of this letter. The approach which has dominated our stock selection in 2009 and continues as we enter 2010 incorporates using both strict regulatory analyses (CAMEL e.g.) in assessing which financial firms to invest in as well as good ole fashioned deep value investing. We believe market participants will shift from the liquidity and capital worries that plagued much of 2009 towards earnings power and profit recovery discounting in 2010 and beyond… Our own fundamental research has identified for some time now a consistent escalation in underlying profit power (cash flow) across the financial services sector, while erosion remains far more endemic in more widely owned sectors of the market including manufacturing, commodities and durables. So, high quality U.S. finance and services stocks remain the cheapest stocks found anywhere in the world. There are outstanding opportunities both long and short for fundamentally driven investors as price disparity relative to valuations and fundamentals remain very wide across disparate industries. Financial Crisis Update Miss-priced credit, particularly in the areas of housing and private equity/leveraged loans (LBO’s), fostered our current state of economic malaise. However, it was poorly designed new credit accounting (MTM) and the irrational application therein which created the actual “financial crisis” and with it the multi-decade buying opportunity that we opined was developing over the past year. To the surprise of most investors, the intentionally concentrated home price index – the Case-Schiller 20 City Composite – declined only a modest 3% in 2009. The base-case of the Federal Reserve’s “stress test” called for a 14% decline and the adverse case a 25% decline by comparison. Thus, the current environment is not nearly as bad as the worst-case scenario which was discounted into financial stocks at their lows. Therefore, it is no surprise that financial services stocks have led the rally since the March 2009 lows. The current breather that financial stocks are taking stems mostly from the second wave of TARP repayments and the renewed attacks from the current administration (“banker’s tax” e.g.). This just provides yet another buying opportunity. Credit, on balance, is unquestionably outperforming the once awful assumptions, in large part, because expectations were artificially grim due to MTM. To the Fed’s credit, they told investors that the assumptions in the “stress test” were set too high purposely and few believed them. So, investors should not be shocked at the faster-than-anticipated recovery in credit costs and earnings for banks. If the White House has noticed the

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“obscene” profits recovery at banks, then why haven’t more investors? We find that curious to say the least.

Losses on Bank-held Securitized Loans were Artificial High

-$20bn

$0bn

$20bn

$40bn

$60bn

$80bn

$100bn

Oct

-96

Sep-

97

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98

Jul-9

9

Jun-

00

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-01

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US

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s U

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sses

Source: Federal Reserve, Goldman Sachs Research. It appears (to us) that few have recognized that the stock market bottomed at the precise moment when the Congress announced hearings into the impact of MTM early last spring. Western Reserve started calling for MTM reform in 2007. As the chart above suggests, the accounting magnified fear (liquidity) much more so than predicted credit (cash flow). So - Yes Virginia, the accountants were wrong. The dramatic decline in unrealized securities losses essentially makes our long-standing point about MTM. It was ill-advised legislation which was materially inaccurate due to its being highly pro-cyclical. This essentially caused the financial crisis and thus necessitated TARP! The table below starts in early 2007 as MTM becomes “effective” and shows an updated progression of the trend in asset value recovery at U.S. banks. We predict values could again be positive by the end of 2010.

Quarterly Progression in Unrealized Securities Losses at Banks

Qtr Unreal Sec Losses QoQ ∆1Q07 -$5 31% 2Q07 -$16 213% 3Q07 -$14 -13% 4Q07 -$10 -25% 1Q08 -$17 64% 2Q08 -$31 86% 3Q08 -$45 44% 4Q08 -$77 73% 1Q09 -$63 -18% 2Q09 -$48 -25% 3Q09 -$26 -45% 4Q09E -$12 -53% 4Q10E +$11 -92%

Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods Research; Western Reserve MTM was inaccurate. The Federal Reserve understood this and Bernanke called for “mark-to-maturity” (the far more accurate accounting alternative) and he used the Fed’s

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emergency lending authorities to quell the panic. (Think – cooler heads at the Fed prevailed over CYA CPA’s and “CDO Cowboys” speculating). What really happened last year? MTM caused most to start carrying golf sized umbrellas in 2009 – the kind that covers you, your bag, the golf cart and half the cart path. Naturally, the problem with umbrellas is that it’s hard to see around them when you’re hunkered down underneath. Consequently, too few saw any signs of recovery on the horizon…many still don’t. Goodbye TARP, We Hardly Knew You With all due respect to Massachusetts, the biggest story since our last report has to be the last of the larger banks exiting TARP in December – Bank of America, Wells Fargo and Citigroup. Strangely enough, the market met the news with a thud as the “perceived” overhang of stock translated into a “buyer’s strike” which left the financials vulnerable to a sharp pull-back. The current “war on banks” offered-up by the administration in response to Massachusetts has obliged such vulnerability. The current pull-back is identical in scope to the TARP repayment overhangs of last May-June. Consequently, this likely is the best entry point into financials since the late spring’s “stress test” release and first bevy of TARP repayments. The accompanying valuation table illustrates how some of the nation’s larger banks stack up on a price-to-adjusted book basis and on a pre-tax, pre-provision basis (P/E power) as of the latest reported data (per share basis). Think of pre-tax, pre-provision or “PTPP” as EBITDA where the D&A are not a permanent expense (loan loss provisions fall back by 90% in economic recovery periods). Large US financials are the cheapest stocks in the world, especially on a risk-to-reward basis. They trade hands at just 77% of adjusted book value (to include excess loss reserves) and about 3x free cash flow (to exclude excess loan loss provisions).

Valuations Remain Absurd!

Price

Book Value

Adj. Book1

PTPP2

Price/ Book

Price/ Adj. BV

Price/ PTPP

JP Morgan $41 $41 $50 $12 100% 82% 3.3x Wells Fargo 26 24 29 7 107 88 3.5 Citigroup 3 7 8 2 53 44 2.2 PNC 52 63 73 15 83 72 3.5 Bank of Amer. 15 27 31 6 57 50 2.8 Capital One 40 57 62 16 71 65 2.6 US Bank 22 13 17 5 171 135 4.7

Average 92% 77% 3.2x 1

Stated book plus loan loss reserve drawn down to 1% of loans w/ excess taxed at 40% income tax rate and 2010 EPS. 2 Pre-tax, pre-provision at normalized annualized provision rate.

Bank accounting seems to bewilder many a pundit that we hear blasting the sector and valuations suggest that apathetic investors remain conspicuously in the dark. Once a bank has recognized its bad loans and “reserves” (expenses) for them, they immediately return

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to profitability. They begin to “cash flow” their losses on a continuum again, thus maintaining their reserve (no more non cash reserve building eating into reported profit). At that point in the cycle, the reserve itself is no longer a “real” expense, but de facto retained earnings or “capital”. It is, after-all, “parked” in “reserve” as a contra asset instead of held in the bank’s capital account, a mere accounting convenience during a crisis. Over the past decade, changes to GAAP require that this reserve must be drawn back down so the IRS can claim its rightful piece of the bank’s actual profits. We are at this point in the credit cycle already. We saw our first “reserve releases” from Capital One and JP Morgan as the fourth quarter earnings season is now underway. 2009’s “reserve build” mantra is quickly advancing into a “reserve release” chorus line in 2010 and at a much faster pace than investors have yet to recognize.

Citigroup is Over-Reserved Now!

2.00%

2.50%

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3.50%

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6.00%

6.50%

7.00%

1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09

Loan Loss ReserveNet Charge-offs

Western Reserve outlined and forecast this recovery process early in 2009 and witnessed it’s progression in Q2 and Q3 of the past year. The chart below is a repeat from mid 2009 and outlines the major succession of events.

1. Reductionof Loan Loss

Reserves

Record Levelsof Capital

and Liquidity

5. TransitionalIncrease in

Net Interest MarginSpreads

2. Release ofExcess Loss Provisions

Into Earnings

3. Transaction-related

Earnings as “Money Flows”

Return

1. Reductionof Loan Loss

Reserves

Record Levelsof Capital

and Liquidity

5. TransitionalIncrease in

Net Interest MarginSpreads

2. Release ofExcess Loss Provisions

Into Earnings

3. Transaction-related

Earnings as “Money Flows”

Return

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Large bank reserve builds have peaked and regional banks are inching closer. Therefore, their book values now MUST be adjusted to include the contra asset account more commonly known as the “loan loss reserve” as real capital again (tax adjusted of course). This is the analysis that we have outlined in our arguably non-consensus, but forward looking adjusted book value and PTPP summation. TARP was the “walk-off” home run that we predicted Western Reserve wrote about TARP in September 2008 and predicted it would work to stave-off a depression and that the taxpayer would make a profit (see our letter – Paulson Plan Response, September 2008). People thought we were “Cuckoo for Cocoa Puffs” and subsequently went out and resumed shelling bank stocks in sheer panic. That was of course until MTM was dealt with directly in early 2009 as opposed to indirectly via TARP.

TARP was primarily used to sop-up troubled banks by providing cheap acquisition capital for the strongest banks like JP Morgan, Wells Fargo, PNC and US Bancorp e.g., to save the taxpayer from Washington Mutual, Wachovia, and National City et al. TARP also was utilized to provide financial systems cushion in strong services providers like Bank of New York Mellon, Northern Trust et al to bolster confidence. As a result, TARP served its purpose and was returned to the taxpayer and with a good profit. The public reaction is another story. Any bank receiving TARP, regardless of purpose or repayment, is made to be a villain by populist rant? A rather asinine response one might quarrel… however, we do enjoy the cheap stock valuations. The Fund still has a sizeable weight long banks that are benefiting from sweetheart deals to buy troubled banks. As we wrote in July 2009 – Wells Fargo’s deal for Wachovia is “perhaps the most accretive acquisition in the history of U.S. banking”. As fund managers still early in a recovery in both the economy and financial stocks, it is likely poor form to extol our analysis of TARP, the “stress test” or to take the apparent minority position that Chairman Bernanke is the hero of the crisis per se. TARP and Chairman Bernanke curiously remain “hot buttons” for many populists on and off of Wall Street. And financial stocks remain in most investor’s “doghouse”. Something that shrewd investors are destined to enjoy.

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We thought the Partners might appreciate the perspective of one of the Fund’s senior advisors – Bob McTeer on the matter. The following is a musing from Bob’s National Institute for Policy Analysis (NCPA) blogsite. If you don’t already follow Bob on CNBC or read his blog, we would highly recommend it. He is among the sharpest central banking minds our nation offers and a very “thoughtful” (non partisan) economist.

TARP Thoughts

Dec 17th, 2009 11:24:59 AM By Bob McTeer

A couple of people have mentioned to me that the TARP repayments are all over the news and suggested that I write about it. My response has been that I didn’t know how to avoid saying I told you so. I’ve written and said often that TARP would produce a profit for taxpayers, or only a small loss. However, I could always feel eyes rolling.

While I never bought the idea that TARP purchases of preferred stock was only from banks ALREADY in good condition, I do think it was limited to banks that WOULD BE expected to be in good condition AFTER the purchase. In many cases the government investment was conditional on the raising private capital as well.

For the rest of President McTeer’s comments on the end of TARP see his blogsite home - http://bobmcteer.com/

Inflation - Fed’s Balance Sheet Misconstrued, Needlessly Feared Investor concern about the monetary base is grossly overblown as McTeer and Western Reserve have consistently outlined (see – A Conversation with Bob McTeer, August 2009). Very few have come to this realization. As Bob reminds us, it’s the velocity of money that matters and not the size. We don’t see velocity being a serious problem anytime soon. This buys both the Fed and the economy time to recover naturally and pragmatically. And an environment of a steady unwind by the Fed will be a backdrop which is enormously beneficial to financial firms’ earnings. It is commonly overlooked that about half the Fed’s balance sheet is made-up of voluntary excess member bank reserves. This cash is “parked” there by banks unwilling to lend yet and de facto by the weak demand for loans. This is hardly inflationary. The remainder is in long-term assets and offsetting liabilities necessary for the Fed’s “unusual and exigent” initiatives during the crisis as required by law (see – Federal Reserve Act, Section 13-3). These measures are not monies in circulation and thus cannot be inflationary.

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“Inflation Protected” Treasury Strips Yield Just 1.32%

Source: U.S. Treasury Department; Baseline

Source: Seeking Alpha

We are quite confident that the recent weakness in the dollar was NOT caused by inflation-fanning monetary policy as the velocity of money remains anemic. Case in point, the most recently issued ten-year Treasury inflation protected bonds or “TIPs” yield just 1.32% e.g. signaling that long-term inflation expectations are negligible and that the more likely risk is deflation. The legions of new-aged “gold bugs’ should be

9

reminded that their leading indicator (the price of gold) of future events now finds itself sold via infomercials running 24/7 like the endless Viagra commercials. This smacks more of a speculative bubble than an inflation hedge. As we recall, many “hedged” inflation with $150 a barrel oil too. It predicated deflation. Needless to say, we are bearish on commodities. No, the dollar weakness is not the specter of inflation. Once again, this results from speculators chasing non-dollar denominated assets outside the United States in places like Brazil, India and China. The word for this is “disintermediation” and not “inflation”. Like other bubbles, this too will unwind and we gather could be painful for some. Fragile China Doll What speculators are chasing in China is what we like to call “authoritarian staged economics.” Fund managers keep misreading this as organic growth. It’s a ruse. We see it as nothing more than an inevitable pile of bad debt. In fact, Beijing, which controls its banks, recently extended terms on many very large credits an additional ten years. This is something that U.S. banks cannot currently do legally and have not done since the 1980’s. The Japanese still employ this denial practice and we all know how that turned out. What we don’t know is how long the Chinese can sustain this loan stimulus binge before real-end market demand returns from the west. We doubt they will make it and a substantial correction may be inevitable.

China's Loan Stimulus PlanPile of Bad Debt Coming?

0%

5%

10%

15%

20%

25%

30%

3Q98 3Q99 3Q00 3Q01 3Q02 3Q03 3Q04 3Q05 3Q06 3Q07 3Q08 3Q09

Real GDPLoan Growth

Source: BofA Merrill Lynch, CEIC and Western Reserve compilation To power its supposedly miraculous economy, Chinese state-controlled banks shelled out more loans in 2009 than the entire country’s GDP ($3-4 trillion USD per the leverage

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inherent in the Renminbi). In terms of a credit bubble, this would make Americans blush. Chinese banks already are running-up against capital constraints in support of such heady loan growth and this should concern investors about how sustainable a trend this really can be. China has great long-term promise, but at present it’s ‘window dressing’ it’s economy purely on credit overdrive. This excess credit has caused a stockpile of raw materials (largely commodities), which has driven-up prices but has no end-market demand. Many fund managers in the west are chasing these trends believing them to be sustainable and therefore have drained the domestic equity markets to fund this “performance chase”. We see a sharp reversal brewing which will benefit domestic markets, the U.S. dollar and especially local financial stocks. The winds are ripe for this reversal as it is supported firmly by the fundamentals. Many fund managers are not positioned for this correctly. We suspect emerging markets like Dubai and Greece are just an appetizer; and this at a time when more domestic investors are allocating their capital abroad than at any other time in history. Consequently, we are finding many short ideas amid “back-door’ China plays. The near ubiquitous confidence in China by western portfolio managers has resulted in the gross over allocation to industrials and commodities in most portfolios. Meanwhile, excessive pessimism in the U.S. economy and especially in our financial system has created material under allocation to the U.S. financial sector. So, strictly speaking, the odds fantastically favor U.S. financial stocks. Fundamentally, our financial system is in repair mode while China’s system is fragile, bloated and has yet to deal with their credit excesses. Strangely, a strong domestic bank can be had for less than 1x book value while its Chinese counterpart trades at 5x book value. A lay-up in our view… Credit Quality - State of the Recovery in Our Financial System Although some significant “clean-up” work remains, our financial industry has stared into the abyss (with some serious help from non cash-based loss recognition accounting) and has survived. Actually, the recovery has been text book. As we noted in our research late in 2008, liquidity must be restored first and it was. Then capital replenished and it has. Now asset quality is back to “manageable” and has continued to improve. And finally, earnings restoration will follow. And it is here… Credit migration trends tell the story now… Residential Real Estate The result of a study of residential mortgages (by origination year or “vintage”) by the Federal Reserve Bank of Atlanta delineates the current setting. Put simply, we are past the peak in the residential mortgage crisis although very few investors would believe us.

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Residential Mortgages Are Behind the System

Source: Federal Reserve Bank of Atlanta

How to interpret this chart: People who bought homes in 2002 experienced much better price gains than those who bought in 2005. At the same time, the credit worthiness of borrowers declined between 2002 and 2005 due to the federal government’s “affordable housing” mandates. These mandates legitimized and subsidized weak underwriting on sub prime e.g. via Fannie Mae and Freddie Mac despite the steady warnings and higher rate targets from the Federal Reserve. The Fed began raising rates in early 2004 and accelerated the process through early 2007.

The blue dotted line shows what would have happened if people who bought homes in 2002 actually experienced 2005 price changes. If foreclosure levels were high, then that would imply that declining standards were the main driver, but that's not what one observes. Quite the opposite actually happened. 2002 underwriting standards were still quite strong. So, the only “updraft” in the analysis came from potential home price changes and those were minimal. So, this “easy money” theory that “economic populists” charge with the cause of the mortgage crisis has no empirical foundation. The Fed had nothing to do with high foreclosure rates. Conversely, the dotted red line shows what would have happened if the better credit quality borrowers from 2002 had actually bought homes in 2005. The fact that foreclosures are much lower in this scenario suggests that while home price changes are a factor, it is overwhelmingly poor lending standards that cause foreclosure risks to “go rogue”.

This should end the debate on the whether the Fed’s perceived “easy money” versus mortgage industry lust (led by the Government Sponsored Enterprises) caused the

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mortgage bubble. The lesson is obvious – don’t make bad loans and then blame it on monetary policy. Blame it on bad loans and unintended consequences of ill-conceived government subsidies.

In 2009, we have seen home price declines moderate to low single digits per the Case-Shiller Indexes. This is materially below the Fed’s “stress test” metrics as mentioned previously. The residential mortgage crisis has peaked with the worst vintage of any magnitude being 2005. This vintage is seeing foreclosure hazard steadily decline while better underwritten older vintages are at less risk to home price erosion. We actually look to invest in some of the very best mortgage underwriters taking market share, namely Wells Fargo and Bank of America.

Mortgage “Reset” Risks are Abating Quickly

For investors, the forward looking observation here is that all vintages of residential mortgage credit have seen peak foreclosure incidence and we are now in recovery. It will be a long recovery and we will not see another “housing boom” for some time…maybe decades. But, residential real estate no longer poses systemic risk to the broad financial system. Although some “reset” risks remain in 2010, they drop-off in 2011 and beyond. They also are higher quality mortgages and mortgage rates (for refinancing) remain low, which are material mitigating factors.

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As one can quickly discern (table below), residential mortgages are materially out performing the “adverse” scenarios presented by the Fed’s “stress test”. So far, realized losses on residential mortgages are running at 1/3 what banks have “reserved” for already. Reserve releases are inevitable. This is one reason why Citigroup has recently paid-off its insurance coverage of their large mortgage-backed securities portfolio. The upside is clearly evident.

Credit Quality is Materially Outperforming the “Stress Test”

19 Largest Banks “Stress Tested” by the Federal Reserve

YTD09 Charge-Offs

Times 24 Months

Fed’s 24 Month “Adverse” Stress

Commercial Industrial 1.9% 3.7% 8% Commercial Real Estate 0.6% 1.2% 10% Construction 4.2% 8.4% 18% Residential Mortgage 1.2% 2.4% 8% Home Equity 3.1% 6.2% 16% Credit Card 9.1% 18.2% 20%

Source: Federal Reserve and Western Reserve compilations

Commercial Real Estate

Financials, especially banks, continue to be the most shorted stocks by hedge funds and speculators. Commercial real estate (CRE) is their target. They are taking too broad a stroke and they simply are wrong.

Commercial Real Estate: A Tale of Two Types of Nomenclature

19 Western Reserve Capital Management, LP © 2009Confidential

Why Financials present the greatest risk-reward opportunity

Credit Costs Have Peaked:Commercial Real Estate Over Billed as the “Next Shoe”

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-1.0%

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

Construction loans

CRE loans

Source: Federal Deposit Insurance Corporation

Net

Cha

rge-

Offs

, US

Ban

ks (a

nnua

lized

)

1991 - 2009

Source: Federal Deposit Insurance Corporation

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The accompanying chart (previous page) from the FDIC clearly details that “commercial real estate” problems remain largely a residential problem resulting from excessive construction and land development credit. This is not traditional CRE. It is without controversy that traditional CRE is deteriorating amid the weak economy; however this pales in comparison to what we saw as bank regulators during the S&L Crisis. Nevertheless, the Fed’s “stress test” assumed an S&L Crisis-like outcome for traditional CRE and this has forced banks to over reserve for this often referenced “second shoe to drop”. JP Morgan already has had to “release” reserves for traditional CRE due to “stress test” aberrant assumptions.

Banks which made a habit of loading their balance sheets with construction and land development credits are another story altogether. They either are gone, absorbed by stronger banks that averted the excess or remain penny stocks. They now are a mute point to the current state of affairs in the financial system…an ugly, yet meaningless data point now for public stock investors. The remaining depositories which are failing are all very small and non public. These will be paid for with ease via higher FDIC insurance premiums over the near term. The crisis effectively is over.

Current Bank Failures are Immaterial Institutions

Bank Name City State CERT # Closing Date Columbia River Bank The Dalles OR 22469 January 22, 2010Evergreen Bank Seattle WA 20501 January 22, 2010Charter Bank Santa Fe NM 32498 January 22, 2010Bank of Leeton Leeton MO 8265 January 22, 2010Premier American Bank Miami FL 57147 January 22, 2010Barnes Banking Company Kaysville UT 1252 January 15, 2010St. Stephen State Bank St. Stephen MN 17522 January 15, 2010Town Community Bank & Trust Antioch IL 34705 January 15, 2010Horizon Bank Bellingham WA 22977 January 8, 2010First Federal Bank of California, F.S.B. Santa Monica CA 28536 December 18, 2009Imperial Capital Bank La Jolla CA 26348 December 18, 2009Independent Bankers' Bank Springfield IL 26820 December 18, 2009New South Federal Savings Bank Irondale AL 32276 December 18, 2009Citizens State Bank New Baltimore MI 1006 December 18, 2009

Source: Federal Deposit Insurance Corporation

In reviewing the banking regulators’ mid year Shared National Credit Review (sometimes referred to as the “SNIC Review”), most construction and land development loans were concentrated in savings banks (thrifts) and smaller regional banks. The ‘leveraged loans’ component in all this (many backed by commercial real estate) were held by non banks (largely hedge funds, private equity firms, bond funds, and insurers).

What happened in the 1980’s was not called the “Savings & Loan Crisis” without reason. It was a result of very poor underwriting standards and lax regulating of smaller federal and state government depositories, almost all outside the Federal Reserve System.

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It appears to have been overlooked by many that these types of poorly regulated institutions again are a problem and were NOT allowed to participate in TARP.

Bank examiners we have spoken with in late 2009 have made it abundantly clear that their focus in recent exams has been on commercial real estate. One district Fed Banking Supervision & Regulation head told us that he was “pleasantly surprised” at the underwriting quality of his district member bank’s CRE. This was post the completion of their swat team-like exams.

Traditional CRE is the last leg of this credit crisis. This brand of exposure is far more prevalent in regional banks than in money center institutions. And as illustrated below, traditional CRE lacks the speculative risk that we witnessed in construction and land development. This is nowhere close to the excesses of the S&L Crisis. Our analysis concludes that this is a very manageable issue for the banking industry and will serve merely to delay earnings recovery for some regional banks relative to their larger peers.

Traditional CRE Losses Tracking Better than Expected

0.0%

0.1%

0.2%

0.3%

0.4%

0.5%

0.6%

0.7%

0.8%

0.9%

2006 2007 2008 2009E 2010E 2011E 2012E 2013E 2014E 2015E

GS CRE estimates (old)

CRE loans (US banks)

Source: Goldman Sachs & Co.

For this cycle, traditional commercial mortgages will be a drag on smaller bank earnings recovery relative to larger banks. Thus, we have positioned the Fund accordingly. We remain overweight large, diversified bank holding companies although we had started to build positions in some recovering regional banks late in 2009. KeyCorp (KEY), Huntington (HBAN) and BB&T (BBT) are among those analyzed carefully and chosen for the Fund.

The Fed’s stress test used very high commercial real estate loss assumptions in assessing capital adequacy. The 2009 losses across all insured depositories on traditional commercial real estate loans were running 1.2% or approximately 1/8th of the “stress test”

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formula for adverse outcome through the third quarter. And we actually see delinquency abatement in the early reports of fourth quarter results at banks.

(For a quick refresher on the Fed’s Supervisory Capital Assessment Program “SCAP” test which is more commonly known as the “stress test”… See the detailed discussion in our Credit Update letter dated July, 2009.)

We believe there is a great opportunity in regional bank stocks in 2010. The valuations of these banks are being maliciously maligned via the misperceptions over commercial real estate. In particular, we believe Wells Fargo (WFC), US Bancorp (USB), and PNC Financial (PNC) are well positioned for value expansion.

Credit Cards

No other form of credit more closely mirrors unemployment trends (initially in recession) than unsecured consumer lines of credit, yet it is an imperfect relationship. The one area where SCAP has been very accurate is in unemployment which is now hovering around 10%. And no other form of credit (save commercial real estate) befuddled bank stock shorts in 2009 as much as credit cards. Hum?

Solely using the unemployment rate as a barometer of credit card losses misses the flexibility that banks have to change terms and adjust their underwriting in near real-time based on changing economic and employment conditions. This is why some of our favorite credit card-related holdings such as Capital One (COF), American Express (AXP) and Alliance Data (ADS) as well as several money center banks (which have large credit card portfolios) are seeing their credit costs abate faster than anticipated and start to detach from the singular unemployment variable. Put simply, their underwriting has adjusted to credit conditions. Amazingly, investors have not recognized this yet.

Trends in Credit Card Migration show Credit Improvement

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The accompanying charts from Discover (Card) and American Express illustrate that credit migration trends have definitively turned despite the stubbornly poor job environment. Credit card issuers have adjusted accordingly and losses (NCO’s) are falling now on both a dollar and percentage basis. And early stage delinquency rates are now rolling over.

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This data below charts American Express’ delinquency and net charge-offs adjusted for seasonality. This indicates that the improving migration trend is even stronger than the absolute seasonally unadjusted migration that most investors identify. So, 2010 will be a strong year for earnings recovery in credit card portfolios and banks with high exposure to credit cards. The Fund is very well positioned in this credit class.

Four areas we would note from the current credit migration trends in credit card data…

1. We are in the seasonally high period for NCO’s (typically they begin to fall in February as tax refunds come-in) however they already are falling sequentially.

2. Excess spreads remain at 8% to 10% making credit cards uber profitable despite high unemployment and this is befuddling the perma-bears.

3. Early-stage delinquency is a more accurate leading indicator of NCO’s. These continue to stabilize (flatten) despite being in the high season; this indicates card issuers have already sufficiently adjusted for the current environment and will be even more profitable in 2010 than analysts expect. Capital One’s huge fourth quarter blow-out profits are only the beginning.

4. Payment rates (the % of balances paid-off each month by consumers) remain elevated proving that the consumer is well behaved. They are not the spendthrifts often portrayed by many pundits, intellectuals and academics. When consumers feel more confident in their employer, they will begin to spend again. Overall credit card loan balances declined over 20% in 2009, so there is plenty of “dry powder” in consumer credit for an eventual economic recovery.

19

Overall Bank Credit Trends have Turned Positive Overall, credit migration continues to improve across most credit categories and on balance have begun to DECLINE (see table below). Thus, the recent pull-back in the financials appears to be the best entry point since the depths of despair last March.

Nonperforming Loan (NPL) Formation Credit Migration Indicates a Peak has Arrived ($Billions)

Q2 2008 Q3 2008 Q4 2008

Q1 2009 Q2 2009

NPA1 Formation

10,869 26,295

23,254

33,385 32,154

Past Due2 Formation

3,490 26,183 74,881

16,812 <8,388>

TDR3 Formation

19,509 <7,179> 5,233

8,009 9,480

Net Charge-offs

16,774 19,247 27,931

30,577 39,168

Total

50,541 64,547 131,299

88,783 72,414

1 Nonperforming assets includes past due >90 days plus foreclosed property under FAS 114 2 Delinquent loans 30 to 90 days 3 Troubled debt restructurings under FAS 114 Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods

[remainder of page intentionally left blank]

20

Industry-Wide Credit has Turned!

Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods

Source: Federal Financial Institutions Examination Council, Keefe, Bruyette & Woods

Aggregate NPL Formation $M

-$20,000

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

$140,000

Q208 Q308 Q408 Q109 Q209

NCO'sTDRPast DueNPA

Aggregate NPL Formation (Excluding NCO's) $M

-$20,000

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

Q208 Q308 Q408 Q109 Q209

TDRPast DueNPA

21

CAMEL analysis of the quarter - KeyCorp (KEY) Observers of our method of picking financial stocks are used to our regulatory approach or ‘safety and soundness.’ As discussed earlier, bank accounting is far simpler than most realize. Once a bank has recognized its bad loans and reserves for them, the bank immediately returns to profitability and eventually retained earnings increases, driving up capital ratios and book value. KeyCorp was not “there” last summer in our analysis. However, we now believe they are very close and thus became a recent addition to the Fund’s long positions late in 2009. Liquid assets have tripled in the past year and KEY has made NO overt underwriting blunders in the downturn (unlike cross town rival National City now part of PNC). KEY’s rising NPL’s are due to the recession (actuarial) and thus pose zero risk to permanent impairment to the franchise (CAMEL analysis expanded below). As one veteran regional bank analyst said recently of KEY – “The loan loss provision, which is currently running 4.5%, is expected to decline to 1% as we enter 2011.” This means KEY is currently trading at about 5x 2011 EPS power. Extraordinary value! CAMEL Capital Adequacy

• Tangible equity 11% high among regional peers • Tangible common 8% solid • T1 RBC 13% high • Tot RBC 17% extraordinary • Primary capital 21% off the charts • Prime cap/NPL’s 538% silly; reserve release/stock buy-back coming

Asset Quality

• NPA’s 3.0% below peer average • NPL’s 3.9% below peer average • Noncurrent loan migration decelerated materially @ 3.0% in 2Q and 3.2% in 3Q • 90 day past dues dropped to 0.6% in 3Q from 0.8% 2Q; migration signaling peak • LLR/NPL 101% suggests reserve build has peaked

Management • Low risk management, but not to be confused with Wells, JP Morgan or US Bank • We think they should sell this bank in the next up cycle to a stronger management

team and get a better ROE out of this quality franchise

Earnings • KEY has never met its potential due to mediocre management (see above) • However, the balance sheet is under loaned and EPS power is $1+ in 2011

(Street way too low at 27c) • ROA should get back to 1.4% or $3 in EPS (regardless of management team)

Liquidity

• Net liquid assets make-up 66% of the stock’s market cap…enough said

22

CAMEL – 1 3 2 3 1 Overall 2 This is a franchise in stable condition which is under managed for potential. The 3 for asset quality could be a 2 in short order and it is unlikely that it would decline… The 2 for management is our opinion that this management team, while solid, is not getting enough out of this quality franchise. The 3 for earnings will be a 2 in no time as the reserve build has peaked. For example, we would suggest selling the bank to US Bancorp in the next up cycle (this may be likely). The valuation is materially below intrinsic value with both credit cost abatement as a driver in 2010 and take-over premium potential in the future. 2x book = $20. Stock is under $6. KEY is a BUY!

The chart above is a repeat with updated data. As we had forecast, the closing of the gap between (PTPP) and pre-tax GAAP was inevitable and will continue. We believe this gap will become increasingly more evident in reported or “GAAP earnings” in 2010 and bank valuations will rise steadily. Financial stock valuations are NOT reflecting just how wide of a disparity still remains. Opportunity of a career!

Regards,

Michael P. Durante Managing Partner

$0

$50

$100

$150

$200

$250

Pre-Tax, Pre-ProvisionPre-Tax GAAP

Bank Earnings “Power” v. GAAP

Mark-to-Market Accounting Overstatement of Losses

Source: Rochdale Research; Western Reserve

23

Appendix – Historical Fund Performance

Performance vs. the Financial IndexPerformance vs. the Financial Index

-80.00%-60.00%

-40.00%-20.00%

0.00%20.00%40.00%

60.00%80.00%

100.00%120.00%

2004 2005 2006 2007 2008 2009 CumulativeRtn Since

Incep.

CumulativeAlpha

Perc

enta

ge

Western Reserve Gross Western Reserve Net Financial Composite Index

Western Reserve Gross Western Reserve Net Financial Composite Index

2004 27.10% 19.90% 12.04%2005 -3.87% -4.20% -4.76%2006 20.30% 14.70% 4.52%2007 -14.70% -12.80% -32.45%2008 -9.49% -9.13% -45.38%2009 27.66% 21.71% -10.25%

Cumulative Rtn Since Incep. 44.84% 29.86% -63.06%Cumulative Alpha 107.90%

The chart above reflects cumulative performance data for each year illustrated. Financial Services Composite consists of equally weighted long-only Financial Indexes. Components include BKX, SPFN and KRE.

Performance Since InceptionPerformance Since Inception

SMID Cap Services Composite consists of equally weighted long-only SMID Cap Growth Mutual Funds and Indexes. Components include WAAEX, WBSNX, BANK, DPSVS, IWM, SPFN and FINAN. Financial Services Composite consists of equally weighted long-only Financial Indexes. Components include BANK, IWM and SPFN.

Since inception, our average annual Alpha is 20.55% per year.

Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross)

-80%

-70%

-60%

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

Dec

-03

Apr-

04

Aug-

04

Dec

-04

Apr-

05

Aug-

05

Dec

-05

Apr-

06

Aug-

06

Dec

-06

Apr-

07

Aug-

07

Dec

-07

Apr-

08

Aug-

08

Dec

-08

Apr-

09

Aug-

09

Dec

-09

Western Reserve Gross

Western Reserve Net (Class A)

SMID Cap Services Composite

Financial Services Composite

Specious Bank Proposals from the White House

January 22, 2010

“Desperation is sometimes as powerful an inspirer as genius.”

-Benjamin Disraeli Dear Partners, We are busy putting the final touches on our 2009 wrap-up report to Partners and have been distracted this week by the antics out of Washington. The 2009 Review Report will be published next week. Meanwhile, this week should have been a great week for our fund. Our financials all reported great earnings recovery trends and many on Wall Street started to finally agree with us that credit costs have peaked (credit has turned). The cherry atop the earnings sundae should have been the out-of-touch progressive agenda in Washington taking a body blow in Massachusetts with the election of a fiscal conservative who disfavors unfair government taxing of bankers that have repaid TARP e.g. Instead, the markets are reeling and the country’s premiere financial firm’s are seeing their share prices distorted by a panic-stricken “buyer’s strike” following the suspicious timing of the specious new bank reforms from the White House. We all know the President badly needs a victory, but this is his “Hail Mary” pass? We have seen a 17% year-to-date gain in the hedge fund erode by about one-third since the Obama administration’s Malakoff cocktail press conference. First, let’s go over the fundamental facts:

• Bringing parts of Glass-Steagall back would do nothing to prevent future financial crises like the one our country has endured. Rumors are circulating that the President chose to ignore his economics team in favor of his political strategy team on this issue.

• Almost all the firms that blew up in the housing crisis would not have been

averted by Glass-Steagall – they were home builders; mortgage companies;

investment banks; government sponsored enterprises; insurance companies; savings and loans; and mostly small community banks.

• TARP worked “magnificently” as Warren Buffett said two days ago in lauding

Chairman Bernanke.

• The TARP losses that Mr. Obama’s “banker’s tax” is supposed to recover are virtually 100% General Motors, Chrysler and GMAC, none of which are banks and the likelihood of repayment seems quite a stretch.

• Yet, the “banker’s tax” targets JP Morgan, Goldman Sachs, Wells Fargo et al,

which all repaid TARP profitably for the taxpayer. So, the “banker’s tax” is an overt lie. If one wishes to “soft speak’ the term to avert offending anyone, it’s a non sequitur. If this is still too harsh, we apologize profusely and gladly would supply the term - “ruse” if this helps to soften the truth.

• Stranger still is Mr. Obama’s sudden interest and discovery that proprietary

trading, private equity firms and hedge funds caused the housing crisis and must be fixed before Fannie Mae. Very odd conclusion. Prohibiting or limiting these valuable sources of capital would certainly be harmful to the liquidity necessary in our capital markets and this ultimately would damage our economy’s recovery prospects. Long-term, such prohibitions make our most important financial institutions far less competitive on the world stage! Who thinks that this helps anyone?

So, what’s up? Even the most veneer review of the facts suggests none of this makes fundamental sense. Did something happen on the way to the Forum?

• The progressive tax and spend agenda has either been defeated or been minimized at every turn, in large part, due to the fiscal conservative populism that has swept the nation beginning last summer, largely over health care reform.

• The progressive agenda suffered significant losses in both Virginia and New

Jersey in November and it was massacred in Massachusetts this week. • Their agenda is lost – healthcare reform; global warming payola; union (card

check) pay-offs and other nefarious slights-of-hand (and big cash movements we might add). Even the Cornhusker Kick-back is suddenly jeopardized. But wait – what about financial reform?

• The White House’s apparent response to the Boston Massacre was to accept

defeat on all other reform. So, all the President’s men (well, some of them) were mustered and the politicos hatched a plan for recovery (Not an economic plan, but a POLITICAL one). This plan MUST “capture Tea Party populism” the President demanded and simultaneously “trap” the fiscal conservatives by pitting

their free market capitalism ideals against the one and only major flaw in the Tea Party movement – Tea Partiers appear to hate big business almost as much as they despise big government.

“Scott Brown is just like me” – Barack Obama

• Voilá! Ignore your economics team and pull the ancient formaldehyde preserved

Paul Volker and his antiquated ‘70’s style Glass-Steagall type reforms off the shelf, dust them off and sell them to the Tea Partiers as a way to “punish” big banks under the auspices that it also can reduce systematic risk in the economy – “Hurrah…we’re back!” Volcker’s plans, while stale, are workable if executed pragmatically, but he’s a mere “prop” in a political gambit. Make no mistake.

The new progressive, anti-bank strategy will backfire and we believe bank stocks will return to leadership stocks very soon…

• The voter post mortem from Massachusetts suggests that two things cost Mr. Obama “Mr. Kennedy’s” seat in the Senate – (i) the administrations’ soft stance on the terrorists and (ii) the excessive spending of his progressive government.

• Distaste for “Wall Street” was NOT the cause of the Boston Massacre anymore

than prop desks caused people to buy too much house or speculators to juggle three condos and foolish people to lend to them.

• While many regular folks across America may not like individuals that make

more money than they do…those folks are smart and they do understand that some jobs just pay more.

• The public wants banks regulated but not dismantled and they do not believe

“Wall Street” is refusing to lend to them either. After-all, they can walk into their local community bank and test this theory out and most have…

• The counter evidence against Mr. Obama’s proposal is powerful and irrefutable

on the merits – large banks have repaid TARP and Detroit has not. Detroit is Mr. Obama’s “baby”. “Wall Street” was the Fed’s problem and ….like the Fed, was a profitable venture for taxpayers! Chairman Bernanke saved us from a Depression. Just ask Warren Buffett.

• The “banker’s tax” is wildly unpopular among the public as most Americans have

a material distaste for unfair taxation. Just ask King George. Scott Brown said he disfavors the “banker’s tax” flat out and he partially campaigned on it. While we have yet to discover exactly who Mr. Brown is, we are quite sure he’s not just like Mr. Obama as the President has asserted. And we certainly don’t think the people see them in the same light either.

• Finally, the current financial reform bills in the House and Senate are very

different, quite convoluted and clearly contradictory on several fronts. For

example, some want to “End the Fed” while others in Congress wish to expand it. Mr. Obama further complicates the matter via his “timely” new round of added proposals this week thus causing further splintering throughout the Congress.

• Yesterday, republicans questioned Obama’s “add-on proposals” and even House

Finance Chairman Barney Frank (D-MA) announced his own reservations on the timing of such proposals and their impact on the economy. He appeared in our estimation to be “chapped” that he wasn’t consulted first. Senate Finance Committee member Dick Shelby (R-AL) said he first would demand hearings on the new proposals if they were to be considered at all. So, financial reform getting through the Congress will be sausage grinding that may make health care reform look legible and the folks at Jimmy Dean wince.

Our conclusion is that this will backfire on Mr. Obama and blow over quickly. A mere excuse to take some chips off the table in a market that has made a good move. One buys this Obama swoon in bank stocks! This is perhaps your last chance at an “Obama discount.” It’s his last salvo. One deals with “populism” by ignoring the proposals that have no fundamental merit as the people eventually will figure out the facts. For example – “we need health care reform because we have an emergency where millions of Americans are not insured”. That didn’t work very well. So, how will “Wall Street must pay (even though they already have paid us back)” work with the populace? It will NOT sell. Buy the big, diversified and well capitalized banks. This may be the last great entry point of the crisis.

Regards,

Michael P. Durante Managing Partner

The Central Problem is NOT the Central Bank December 28, 2009 As a former Federal Reserve staffer; long-time Wall Street banking analyst (Salomon Bros., Prudential); and now hedge fund manager, I was astonished at just how puerile Messrs. Klein and Reisman’s essay was regarding the role our central bank plays in asset bubbles. I find it surprising so many investors are falling prey to such trivial and “populist” arguments. We do indeed reside amid the golden age of naive discourse. Clearly, facts and erstwhile gravitas appear optional both on Wall Street and on Capitol Hill. Objectivity has been lost. The authors claimed to have undertaken “a deeper examination” of the role the central bank plays in asset bubbles. Their assertion that the Fed is the causal effect is blatantly untrue and debased of certainty to even the most casual of observers of markets and the Federal Reserve. The Internet bubble; housing bubble and commodity bubble were not a monetary phenomena as asserted at all. They were speculative excesses by investors. To presume interest rate targets and the size of the monetary base automatically causes people to make poor loans and bad investment decisions is delusional. People’s own blind ambitions cause bubbles. The Fed’s role is to manage the excesses inherent in the human nature of market participants as their actions make their way through the capital markets. The Fed’s role does not include predicting bubbles and then preemptively taking action by talking investors off the ledge before they climb out the window. The Fed’s reluctant role is to manage the bust. To assist in cleaning up our messes in a manner not dissimilar to the way the Rule of Law stays ‘mob justice’. Blaming the Fed is a convenient deflection away from our own avarice. It is, as I said, a puerile argument. The child blaming the parent for not warning us enough as one Texas senator recently opined in casting her vote against the reappointment of Chairman Bernanke. The Internet bubble itself was not even debt related. It was driven by an insatiable equity investment bubble where endless operating losses at scores and scores of dot com companies were funded with evergreen stock issuance. It would seem absurd to assert that the Federal Reserve is to blame for “encouraging” investors to fund this ‘get rich quick’ scheme that was the Internet IPO boom as a function of the Federal Open Market Committee having left the Federal Funds Rate (the rate at which banks charge one another for overnight credit) too low as an alternative to equity capital allocation frivolity. The tech boom ended when investors realized their folly and not a moment beforehand. The Fed, however, was there to ease the fallout. Chairman Greenspan warned of irrational equity valuations several years in advance of the tech bust. Like the authors and our politicians, are we to argue the most salient argument is that the Fed “didn’t warn us enough”? Not credible. The authors were correct, in part. The housing bubble was encouraged by Washington policies – namely “affordable housing” mandates from HUD that were adopted at the insistence of an increasingly entitlement drunk Congress following the elections in 2004 and 2006. The real “money printing” was at Government Sponsored Enterprises (GSE’s) Fannie Mae and Freddie Mac. Their massive buying of sub prime and non conforming mortgages at the behest of Congress coupled with their implicit government guarantee all but legitimized perilous mortgage lending. If what the Congress unleashed was not satiable enough, the balance was accommodated by investor greed.

For its part, the Fed started to increase short term rate targets in early 2004. And for those that minded, they declared all out war on housing formation in August 2005 at the Fed’s annual summer meeting in Jackson Hole. Again, most investors took no heed to the Fed’s warnings. When mortgage rates started to rise, mortgage miscreants “hatched” teaser rates and other exotic structures to skirt more conventional underwriting to match abetting Congress accelerating asinine housing subsidies. To their own downfall, the financial institutions that championed the high risk mortgage origination orgy were not bank holding companies, but rather non bank financials outside the purview of the Federal Reserve’s regulatory staff. New Century, Bear Stearns, AIG, Countrywide, Washington Mutual, IndyMac and, of course, the GSE’s all were firms not regulated by the Fed, but rather by the federal government. Perhaps, it’s not surprising that the Congress finds the “Potomac Two-Step” befitting for the Federal Reserve with 2010’s mid term elections looming? The politicians may need a convenient deflection from their own shortcomings as the vast majority of “toxic” mortgages were originated after 2005 and therefore long post Fed applied restraint. Monetary policy, like regulatory oversight reach, has its limitations unfortunately. The commodity surge of the past decade has not resulted in any systemic inflation because it too is a speculative bubble. One borne of excessive non industrial demand or “investment” demand... Luckily, our economy is far less susceptible to such shocks, especially fictional ones, because of the modern monetarist Fed and our dominant services based economy. Sure, the Chinese are partly to blame as their “command and control” economy clearly is out of control and has resulted in unrealistic demand for raw inputs. However, an equally concerning issue is the “debt bomb” that is the commodities futures market, regulated by the Congress. While the cash markets for equity and debt, which are regulated by the Securities and Exchange Commission, have margin requirements of fifty-percent (50%); the derivatives markets, inclusive of commodity futures, require as little as a 5% margin requirement (twenty-to-one leverage). This has resulted in the disproportionate price escalation and volatility of almost all commodities relative fundamental supply and demand much the same way that low down payments and esoteric mortgages distorted housing market outcome. The Federal Reserve plays no role in derivatives regulation and needs to. Blaming the Fed for $150 oil is incongruous. The fact is that the commodity bubble is a function of a lack of prudent regulation by the Commodities Futures Trading Commission, which reports to the Senate Agriculture Committee. More unintended consequences of improvident government... The Federal Reserve is not “juicing the economy” as the authors would have one believe. Their argument is specious at best. It is quite the opposite actually. The Fed has been forced to “plug” holes in our credit markets created by impetuous lending now swinging the delicate pendulum of confidence too far the other way. Such actions have included the use of the Fed’s balance sheet in support dysfunctional securitization markets; ill-advised new accounting regulations imposed by the Congress on the Financial Accounting Standards Board (mark-to-market accounting); and a lack of regulation over derivatives by the CFTC (the AIG mess e.g.). So, the Fed has been busy stepping-up where unintended consequences of government and investors have left the economy more vulnerable that at any other time in the past seventy years. And the central bank has succeeded. The near full repayment of the Troubled Asset Relief Program or “TARP” far faster than anyone could have imagined is testament. Despite a roughly $2 trillion Fed balance sheet, which many a pundit complains about, the velocity of money remains anemic. Money itself isn’t inflationary and cannot cause irrational growth. Half the Fed’s balance sheet is tied-up in offsetting long-term assets and liabilities related to the “holes” that needed to be plugged to avert an out right depression. These “monies”

are not in circulation and thus cannot aid velocity-driven inflation per se. The other half of the Fed’s balance sheet is comprised of the voluntary excess bank reserves held on behalf of member banks and bank holding companies. Despite incredibly low rates of interest on these reserves, banks have been unwilling to put that capital to more productive use at this stage of the recovery. Certainly, a despotic White House and Congress towards the banking industry are playing a role therein. Hoarding cash we are. Afraid of big government, big deficits and big taxes come due. Record liquidity at corporations, banks and individual investors alike are epidemic and THIS is what is stifling the economic recovery. So, the Fed’s “plugs” remain necessary as a bridge over the mob until said pendulum finds its natural balance once again. The Federal Reserve appropriately and comfortably can continue to punish investors for hoarding cash by maintaining low short term rates for a protracted period. The make-up of the Fed’s balance sheet lacks velocity punch and there is little evidence the velocity of money in the private sector is picking-up much steam. The Fed can back out of current undesired capacity within the nation’s monetary base pragmatically as banks slowly begin to lend again, corporations start to invest again and investors regain their nerve once more. For now, that’s not happening. So, stop blaming the Fed. They didn’t choose your investments for you anymore than they chose the folks you voted for. Take responsibility. In contrast, the Fed is all that stood between us and ourselves during the crisis’ worst moments. Regards, Michael Durante

Managing Partner Western Reserve Capital Management

July 30, 2009

One on One with Bob McTeer – How “Tight” is the Fed Really?

Partners, The Western Reserve team was very fortunate to spend an extended lunch recently with Robert McTeer, the former President and Chief Executive Officer of the Federal Reserve Bank of Dallas. The insight shared with us was as ‘tasty’ as the dessert we all enjoyed as an excuse to extend our conversation. We are grateful for his valued time and timely observations. As many already know, Bob is an outspoken former member of the Federal Reserve’s Federal Open Market Committee (FOMC), which de facto sets global monetary policy. Bob currently serves as a Distinguished Fellow for the National Center for Policy Analysis. In addition, to the delight of Aggie aficionados everywhere, he is a recent Chancellor of Texas A&M University (sorry Horns fans). However, we did NOT talk football…as it’s a bit of a sore spot for Aggies in recent years. But, as Bob pointed out, all things are cyclical. An Aggie revival, like an economy, sometimes just sneaks up on a complacent Longhorn! Throughout his career, President McTeer spent thirty-seven years in the Federal Reserve System and is widely acknowledged as among the most experienced, respected and influential central bankers active or inactive the world over. Bob also is a contributor to CNBC, Bloomberg Television and FOX Business….and he also has a tremendous love for country music and cowboy poetry….(For more information and additional analysis, please visit www.bobmcteer.com). Most investors and member of Congress alike seem to be obsessed these days with the extraordinary “power” of the Federal Reserve, the world’s ONLY independent central bank. I joined the Federal Reserve right out of Vanderbilt specifically because of the institution’s unique power to shape global economies. The independence of the Fed differentiates America from all other peers and, in large part, helped create the greatest economy the world has ever known. Americans have an aggregate net worth which is 17x that of any of our peers such as France, Germany, Great Britain and Japan. One of the greatest differences between America and her peers lies in the fact that our central bank operates largely independently of the central or federal government.

President McTeer relayed to us his pointed views on the Fed’s unique powers now being questioned by some in the media. He addressed what most investors and politicians seem to fear most – the Fed’s currently large balance sheet and the prospects for inflation in an economic recovery. President McTeer mentioned a recent presentation he was invited to attend where the speaker showcased a picture of ever rising and unfettered Fed balance sheet growth. The speaker contended that this balance sheet growth by necessity was certain to unleash a wave of vicious inflation. The presenter was absolutely certain that the Fed would be responsible for massive inflation in the imminent future merely by the anecdotal evidence of its balance sheet trend during this financial crisis…clearly an autocorrelation without empirical back-up. Runaway inflation in the offing? Bob doesn’t think so, nor does Western Reserve! As President McTeer described to us, inflation is never inevitable and hardly a result of the size of the Fed’s balance sheet per se. His first point was that the crux of the growth in the Fed’s balance sheet took place over nine months ago and there has been NO further expansion in the Fed’s balance sheet since early December 2008. Secondly, President McTeer made a keen and critical observation that many are overlooking. The composition of the Fed’s balance sheet is not inflationary. Qualifying the nature of the Fed’s balance sheet growth must be considered when determining its potential affect. In fact, much of the significant growth in the Fed’s balance sheet is paired-off by directly offsetting assets and liabilities (mainly loans to troubled financial firms), which are not monies in circulation. Money (assets that support direct liabilities) are not in circulation and thus not inflationary. He warned that one should ignore these offsetting factors when considering the inflationary affect. We believe President McTeer’s comments speak to the point that the aggregate total expansion of the Fed’s balance sheet itself was irrelevant. Only the expansion of true monetary base figures such as bank reserves and cash in circulation or the monetary items on the liability side of the Fed’s balance sheet were to be observed in relation to inflation risks. To this end, he quickly alerted us to the fact that the monetary base itself has not grown at all in several quarters now. And much of the monetary base is easily attributable NOT to the Fed’s actions to bolster troubled institutions last year (as assumed by mere balance sheet size observers), but rather to commercial banks “hoarding” excess reserves (cash) at the Fed as a shelter against the storm that gripped our financial system. Western Reserve made this specific observation in our own musings as bottom-up financial firm analysts in 2008. We echoed this analysis in nearly every correspondence over the past year. The accompanying table below is now a three-peat from our own research letters. The following data indicates just how LIQUID the largest US banks had become by the fourth quarter of 2008. President McTeer’s observation is correct. It agrees with our own fundamental research (driven from bottom-up analysis) when compared to President McTeer’s macro observation about the state of the Fed’s balance sheet.

Large Bank Liquidity is Astonishingly High

Company

Market Value

Cash & Equivalents

Short TermDebt

Net Liquidity

% Market Value

JP Morgan

$131 bil

$489 bil

$33 bil

$456 bil

348%

Wells Fargo $108 bil $200 bil $72 bil $128 bil 119% US Bancorp $31 bil $46 bil $26 bil $20 bil 65% Bank of America $103 bil $435 bil $186 bil $249 bil 241% PNC $17 bil $75 bil -0- $75 bil 1,071% Capital One $10 bil $40 bil -0- $40 bil 400% Average

374%

1Q09 “Call Reports” courtesy of the Federal Deposit Insurance Corporation President McTeer’s observation that much of the dramatic rise in the monetary base was not attributable to the Federal Reserve is evident on member bank balance sheets. As he wrote recently – “(member) banks voluntary holding excess reserves at the Fed….because given the stress and uncertainty facing the banks, banks don’t necessarily regard them as excess.” We would concur. The data table above references for analysis a small sample of large banks. On average, they hold a massive 374% of cash and equivalents (M2) relative to their market value and ALL are materially net liquid on both a short term and long term offsetting liability basis. In every way, these companies no longer resemble banks. They are deploying no leverage. How can that be inflationary? If anything, the return to normalcy for lenders will be protracted at best and “normal” leverage is not inflationary. The inflation hawks likely are simply wrong or premature alarmists to phrase that delicately. The Great Depression It was unlikely that we would have a lively discussion with Bob without the mistakes of the Great Depression coming-up. Western Reserve has opined for some time that the independent Fed saved the Republic last year as a bureaucracy would never have acted in an unbiased, apolitical and efficient manner to handle the financial crisis. As President McTeer noted, the Federal Reserve of the 1930’s, still partially bound (as we had noted) by direct reports to the President (the Treasurer and Comptroller of the Currency) on the Fed’s board, mistakenly believed the high levels of bank reserves were “excess” and thus the cause of the economic rise and bust. So, the Depression-era Fed made the awful choice to “mop up” (as Bob called it) the member bank reserves by dramatically increasing their reserve requirements (effectively locking-up the cash when the economy needed it most). This of course drained the economy of liquidity and deepened and prolonged the Depression. Bob opined that many of our leading politicians and even the talking heads on financial TV are not familiar with this history and, therefore say “strange and dangerous things about the presence of today’s excess reserves” on the Fed’s balance sheet.

President McTeer indicated his great respect and confidence in Chairman Bernanke and noted that of all people, he was a keen observer of Depression-era mistakes. How “Loose” is Monetary Policy Today? President McTeer discussed with us the inherent nature of the monetary base. As he noted, one cannot just “spend” the monetary base. It’s just a raw material. If left idle, it does very little if anything at all. This is the current state of our economy. We have learned the lessons of the Depression and now sit atop a very high level of liquidity in the system. However, for the monetary base to activate or “spur” spending, it requires velocity. Therefore, the size of the monetary base alone is not inflationary at all. President McTeer noted that the recent measures of the monetary base are very tepid after last year’s spurt as banks moved to hoard cash….currently, it is growing at a pace not consistent with inflation risk. As a result, the Fed’s monetary policy is actually a lot “tighter” today than widely accepted and inflation far less a risk. And while the Fed’s balance sheet indeed is large by historical standards at present, the composition “augers well” for Chairman Bernanke to ease back and shrink it as an economic recovery begins. Given the combination of expected low velocity of money and the composition of the Fed’s balance sheet, President McTeer foresees a solid, yet protracted economic recovery not likely to be accompanied by much inflation. He does not subscribe to the calls from academia for the Fed to shrink its balance sheet immediately. To illustrate, Western Reserve has noted record credit card pay-offs in master trust data from Citigroup to JP Morgan to Bank of America to Capital One. All of these credit card issuers are seeing record consumer pay-offs. In addition, the savings rate is at or near an all-time high as well. So, President McTeer is accurate in stating that now is not the time to shrink the Fed as the velocity of money is weak. McTeer’s conclusion was simple – “I don’t think a sharp increase in inflation is in the cards”. Report Card on Bernanke and Paulson TARP worked! Bernanke and Paulson stepped up and did it right. That was the short version of President McTeer’s comments on the subject. We agree. We have a nice spot picked out on the National Mall in Washington for their monuments. In addition, McTeer agreed with our long-standing call that the toxic asset repurchase program auction strategy known as the “PPIP” is an ‘empty gesture’ owing to the colossal inaccuracy of mark-to-market accounting (“MTM accounting”). Now that the banks have excess liquidity and have written down assets well below their intrinsic value, they have no incentive to sell them at auction. In fact, the opposite is likely to occur and already underway. Banks will hold these under priced assets (primarily mortgages) and as MTM accounting now makes its exit; the intrinsic value of these assets will start to be realized and capital levels at banks will rise even beyond their current “stress tested” excessive record levels.

We already have observed “mark-ups’ on assets subject to MTM accounting year-to-date. More to come… Mark-to-Market Accounting – A “Crusade” If there was one topic that ultimately drove a meeting with President McTeer and Western Reserve, it was the frustration we both felt over MTM accounting. McTeer called his campaign to eradicate the ills of MTM accounting a “crusade”. Western Reserve began writing about the inherent problems with MTM accounting as early as 2007. We are grateful President McTeer championed this cause as most investors and undoubtedly very few Americans have any clue how this arcane accounting brought our country’s financial system to its knees. President McTeer was asked to speak on the matter of MTM accounting before the Congress. You have read our musings on MTM accounting. These are from Bob’s own blogsite….

“During last Thursday's hearings by the Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises on market to market accounting, the most impressive verbal and written testimony for my money was William Isaac's.”

Both President’s McTeer’s assessment, former FDIC Chairman Bill Isaac’s presentation (See chart above) all agree. MTM accounting will end up being wrong by about 10x or 1,000%. The capital “hole” manufactured by the inaccurate loss assessments created the financial panic the country was dragged through from 2007 through March 2009. This crisis (and bear stock market) ended when the House Finance Committee held hearings on MTM accounting in early March of this year. House Finance Committee ranking member Spencer Bachus (R-AL) asked all of his Congressional colleagues to read one of McTeer’s writings regarding MTM accounting

titled “My Mark-to-Market Nightmare.” It may be the one single blog that saved the financial crisis and turned the tide of this awful recession and stock bear market. Here is President McTeer’s commentary in its original form and entirety. The blog rant that turned the tide…

My Mark-to-Market Nightmare

I couldn't sleep at all last night. It started with a dream-nay, a nightmare-that I had taken a three-week vacation in a remote part of the world where cell phone reception was happily non existent. There were zero bars.

It was a good vacation. I came home refreshed, full of vim and vigor, and ready to re-join the rat race. All that changed when my accountant called with bad news. He said I was broke-flat broke. I thought he was kidding.

"How can that be?" I asked. "I have my portfolio of Treasury bills and notes and a few mortgage-backed securities to fall back on if necessary."

"Yes, but you've been gone three weeks, which is an eternity these days. During that time, your Treasuries declined in market value because interest rates increased, and your mortgage-backed securities became illiquid as trading in them virtually stopped. I had to mark them all down to market, which, in the case of the MBSs, was virtually zero. Sorry about that, but that's not the worst of it. Writing down the market value of your securities reduced their value by more than your net worth. So, you're now broke. You've gone from a high-net-worth individual to a no-net-worth individual."

"Wait a minute! I don't have to sell these securities now. I can wait until their prices recover. I can even hold them to maturity if I have to. There's no credit risk. The Treasuries were issued by the federal government, which could print money to pay them off if it had to, and the MBS's were issued by Fannie Mae and Freddie Mac, which are quasi-government. They are obviously too big and important for the government to let them fail."

"I'm afraid a lot happened during your vacation. Fannie and Freddie are government now; they, too, got marked to market and taken over by the government. So did AIG, the huge world-wide insurance company."

"Well, there you are. All my securities are now government securities, and, if necessary, I can hold them all to maturity. There's no need, no rationale, to mark them to market. Besides how low could they go anyway?"

"Your Treasuries are pretty short term, which is in your favor, but a flight into Treasuries still reduced their yield. Your Mortgage-backed securities took the biggest hit. Since the market for them has virtually dried up, I've had to mark them all the way down."

"All the way down?"

"Yes, all the way down."

"Well, I guess I could always sell my house."

"I've already taken the liberty of putting a for-sale sign out front."

"Thanks a lot. I'm glad I have a thoughtful accountant like you. I don't know what I would do without you."

"Thanks. I do my best. I'm actually trying to get appointed to FASB, which is the Financial Accounting Standards Board. That's the outfit that makes up these accounting rules. It would be quite an honor for me. It is the most powerful organization in the country. Even their bosses at the SEC and Treasury are afraid to mess with them."

"Do they have the power to change their rules or modify them a bit to help the country get through this housing crisis?"

"Yes, of course. Or, the SEC could direct them to do it. In its big bailout bill, Congress reaffirmed the SEC's authority to do that in order to remove any doubt. I don't know why they are defying Congress."

"Do you think it will get done eventually?"

"I doubt it. Accountants take pride in their professionalism, and it just wouldn't look right for them to modify an accounting rule just to save the financial sector and the economy."

"Speaking of that, I read on the plane that the Federal Reserve, probably the most conservative institution in America, if not the world, has been pulling out all the stops-taking unprecedented steps-to get the country through this national emergency. And I understand the Treasury has also taken extraordinary, unprecedented steps to save the economy. Am I right?"

"You are right."

"And I believe there is a provision in the Emergency Powers Act, or some such law, that gives the President the right to suspend even the Bill of Rights in a national emergency. Am I right about that too?

"I believe so."

"So the Bill of Rights may be suspended in a national emergency, but not mark to market accounting?"

"It would appear so."

About that time I woke up in a cold sweat and said a little prayer:

"Lord, please don't ever mark me to market, especially on one of my down days."

- Robert D. McTeer, January 12, 2009

In sum, President McTeer is a national treasure and we were very fortunate to sit down with him to discuss meaningful issues of the day. We look forward to our future conversations with President McTeer. In the meantime, please spend some time at www.bobmcteer.com, where you will find similarly unbiased and pointed opinions on other essential issues such as the inner workings of our uniquely independent Federal Reserve System, how great central bankers think, and the banking industry and the economy at large. Thanks again Bob!

Regards,

Michael P. Durante Managing Partner

Credit Update July 28, 2009

‘Reserve Builds’ Peaking; Shift to Earnings Power; Are Shorts Now Just Outright “Gambling”?

Partners, Banks have begun to report second quarter earnings in earnest and there have been no surprises. The media and many investors (highly incited by record short interest – see Chart below) are focusing on the direction of problem loans without qualifying where we are in the normal credit migration cycle. The larger and predominantly untold story being the dramatically improved balance sheets and cash flows that we are seeing industry wide which reflect reserve builds peaking and new problem loan migration decelerating.

Aggregate Short Interest in the S&P 100 Index RECORD Financial Stock Short Interest

In the history of our markets, no one has ever witnessed the level of short interest that is now imbedded in domestic financial stocks. For lack of a better description, it’s a financial engineering powder keg; which very well may be the greatest mechanical lay-up “trade” in investing history. This level of short interest will have to be unwound and the

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result will be skyrocketing financial stocks. This is only a matter of time… actually it’s a time bomb. Short squeezes are unpredictable and violent. We wouldn’t try to “time” it. Miss this one and you will, again for a lack of a professional investment term – “kick” yourself. The stock market rally, which began on March 9, is of great debate. Cyclical, secular? What is not in dispute is the rally’s leadership; the financial sector has led this rally by a wide margin. This has encouraged more and more short selling as a result. So, the consensus is that this is a cyclical bull. Fundamentally, we had been seeing sea-change improvement in financial industry capital and liquidity for more than two quarters now. This quarter, we are seeing definitive improvement in credit migration as well… This coupled with the consensus belief and the fact that we are in a cyclical bull (high short interest) and improving capital, liquidity and now asset quality (at the margin), we believe the more likely outcome is a secular bull. At this stage of an economic recession, one would normally expect problem loans and loan losses to be continuing to cumulate. However, what’s more interesting to us is where the granular data might suggest we are positioned along the credit migration trail. The result so far this quarter is that we see clear indications that the broader industry is well positioned to “absorb” expected losses. Bear in mind, losses are the tail-end of the credit migration trail. As an example, J.P. Morgan Chase & Co. (JPM) is a huge bank which canvasses much of the country and just about every type of loan imaginable (save the “pick-a-payment” lunacy). This provides a good cross study of the credit migration trend and where bank reserves stand.

Western Reserve Capital Management, LP © 2009Confidential

Why Financial Stocks Will Lead the Pending Recovery

JP MorganChase – “Reserve “Build” Peaking

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As the chart above illustrates, management at JPM (considered the best in the industry) has begun to allow their extraordinary high loan loss reserve “coverage ratio” of periodic losses (charge-offs) to begin to drift downward. Why? Simple. They see improving trends in early-stage credit migration at a moment in time when the consensus is focused on late stage migrations (charge-offs) already fully “stress tested” or reserved for. This is why the consensus will be proven wrong. In fact, some market players and pundits have resorted to calling for an all new Great Depression to support their bearish stance which can’t be justified in terms of the fundamentals. Your Fund started covering our financial shorts in January and February in earnest. In retrospect, we were slightly ahead of the March bottom as we saw capital and liquidity solved for ahead of the consensus. Now, we are getting more aggressive with our longs as we see positive credit migration shifts. This quarter has seen most banks reporting improvement or moderation in early-stage problem loans. This confirms our analysis that the industry will never come close to reaching the level of cumulative losses currently imbedded in capital and loss reserves by the Federal Reserve’s “stress test” completed in May. For such “adverse” losses to be reached, early-stage problem loans would need to be surging markedly higher now as opposed to decelerating, moderating and in some cases falling across some loan categories as actually is being reported. Reviewing the data below will assist in illustrating these points. Remember, the Federal Reserve required the nineteen (19) largest banks, encompassing roughly 75% of all US banking assets to “carry” capital and reserves high enough to absorb the test’s “adverse” outcome.

19 Largest banks “Stress Tested” by the Federal Reserve

1Q09 Charge-Offs

Times 24 Months

Fed’s 24 Month “Adverse” Stress

Commercial Industrial 1.9% 3.7% 8% Commercial Real Estate 0.4% 0.8% 10% Construction 3.2% 6.4% 18% Residential Mortgage 1.0% 2.0% 8% Home Equity 2.9% 5.9% 16% Credit Card 8.1% 16.3% 20%

1Source: Federal Reserve, Federal Deposit Insurance Corporation and Western Reserve compilations It doesn’t take long to identify the absurd assumptions of the “stress test” relative to the current reality in credit. In some loan categories like C&I lending e.g., the actual results are running <50% of the “adverse” stressed for. Even highly controversial loan categories such as commercial real estate and residential mortgage are outperforming the most draconian outcome of the”adverse stress test” by several country miles. Commercial real estate is <10% the stressed level; residential <25%. Home equity is <37%. Credit cards are easier to predict because they are very actuarial and correlate to unemployment, yet are running just fine relative the stress test. In fact, the companies

tested with very high credit card exposure – Capital One (COF) and American Express (AXP) - passed the “stress test.” Therefore, the extrapolated actual loss-run rates fall considerably short of what the industry’s regulators have required these institutions carry capital and reserves for. This combined with improving early-stage migrations seen in 2Q09, is why banks are beginning to indicate loan loss reserve builds have peaked or will peak within this calendar year as the chart of JPM indicates. We don’t expect this record bearish position pitted against the nation’s financial stocks to just roll-over one day and admit that this is “over”. We expect a nasty, grinding, blood-letting torturous short cover rally to last for the next several quarters. It should end up similar to the one I witnessed as a young banking analyst just leaving the Federal Reserve’s staff in 1992. That short squeeze annihilated the infamous Feshbach brothers, who liquidated in 1992 as a result. By the way, this occurred long before nonperforming bank loans had peaked. While the Feshbachs were professional short sellers; they merely misread the extent of the banking industry’s woes at the top of the credit migration cycle. Today, we believe much of the current short selling in financial stocks is being done by amateurs (courtesy of retail investor friendly reverse exchange traded mutual funds like the SKF) and grossly over subscribed and highly leveraged (capital structure arbitrage long) less liquid bank preferred. If one looks away from credit, here’s the underlying picture as we referenced in our last research letter.

15 Western Reserve Capital Management, LP © 2009Confidential

Why Financial Stocks Will Lead the Pending Recovery

Bank Profit Recovery Gap is a Record:

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Bank Earnings “Power” v. GAAP

Source: Rochdale Research

Mark-to-Market Accounting Overstatement of Losses

As noted previously, the Federal Reserve’s “stress test” promoted pre-tax, pre-loan loss provision revenue as the first order of “absorption” for credit losses or cash flow (not book value). This caught Wall Street by surprise but not us. This is because loan loss provision expenses are non-cash redirections of equity capital from retained earnings to a contra asset loan loss reserve. Therefore, they are real expenses but are a more accurate reflection of past over statement of earnings power and far less a reflection of current and future earnings power. At this stage of the credit cycle, we are seeing massive reserve builds at banking companies or non-cash loss provision expense which is well in excess of actual periodic losses and this is distorting the reported earnings or “GAAP”. As we said before, pre-tax, pre-provision (PTPP) income is a more accurate gage of where the industry’s cash flow strength stands today. So, it’s time to switch valuation tools to be invested long in the best financials based upon earnings recovery potential relative to current “look through” earnings power. The values are quite compelling. Company

Market Value

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$47 bil

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$5.50

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Wells Fargo $108 bil $37 bil 2.9x $4.00 5.8x US Bancorp $31 bil $8 bil 3.9x $2.80 5.7x Bank of America $103 bil $35 bil 2.9x $3.75 3.0x PNC $17 bil $6 bil 2.8x $5.75 6.3x Capital One $10 bil $5 bil 2.0x $7.00 3.0x Average

2.3x

4.9x

1Pre-Tax, Pre-Provision based on 1Q09 annualized 22011 estimates by Western Reserve Capital Management, LP We also find it odd that we have record short interest against some of the most liquid companies in the marketplace.

Company

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JP Morgan

$131 bil

$489 bil

$33 bil

$456 bil

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Wells Fargo $108 bil $200 bil $72 bil $128 bil 119% US Bancorp $31 bil $46 bil $26 bil $20 bil 65% Bank of America $103 bil $435 bil $186 bil $249 bil 241% PNC $17 bil $75 bil -0- $75 bil 1,071% Capital One $10 bil $40 bil -0- $40 bil 400% Average

374%

1Q09 “Call Reports” courtesy of the Federal Deposit Insurance Corporation

Case-Schiller 20 Market Home Price Index – Through May 2009

 

  The opportunity set between the high mechanical “trade” against the enormous consensus short interest in financials amid improving balance sheets and now stabilizing credit migration across the industry is hard to lay-off in our humble view. The above chart is the Case-Shiller 20 (large) market home price index through May. Home prices are stabilizing now and could indicate the recession is ebbing more quickly than the consensus (or short interest in the financials) believes is possible. In fact, the Case-Shiller 10 and 20 market composite indexes both improved on a month-over-month basis in May. Admittedly the gains were only 0.4% and 0.5%, respectively, but it’s the first positive month since July 2006.

Regards,

Michael P. Durante Managing Partner

Second Quarter Earnings Outlook July 12, 2009

Focus on Pre-Tax, Pre-Provision… Not ‘Reserve Builds’ Partners, Western Reserve Master Fund (the “Fund”) closed the second quarter positive in the low double digits on the year. The fund now has produced nearly 100% of alpha (excess return) since inception relative our financial benchmarks. We are getting a nice price “break” (retrace) in June and July heading into earnings season-based nervousness just as we saw in April. We thought it timely to share our thoughts on where we think second quarter earnings will shake-out for the financials and where they are from a valuation standpoint. There is no argument where the economy is… However, stocks and the economy are never coincident at great deep value points. They are coincident ONLY at overbought conditions.

15 Western Reserve Capital Management, LP © 2009Confidential

Why Financial Stocks Will Lead the Pending Recovery

Bank Profit Recovery Gap is a Record:

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Source: Rochdale Research

Mark-to-Market Accounting Overstatement of Losses

As noted previously, the Federal Reserve’s “stress test” promoted pre-tax, pre-loan loss provision revenue as the first order of “absorption” for credit losses or cash flow (not book value). This caught Wall Street by surprise but not us. This is because loan loss provision expenses are non cash redirections of equity capital from retained earnings to a contra asset loan loss reserve. Therefore, they are real expenses but are a more accurate reflection of past over statement of earnings power and far less a reflection of current and future earnings power. At this stage of the credit cycle, we are seeing massive reserve builds at banking companies or non cash loss provision expense which is well in excess of actual periodic losses and this is distorting the reported earnings or “GAAP”. Therefore, current earnings power should largely be qualified (though not entirely ignored) as a function of the aforementioned. This is especially true in light of the massive equity capital raises at banks at the behest of the Federal Reserve’s stringent ‘stress test’; which the Fed has now verbalized overstates their expectation for credit losses. As we said before, pre-tax, pre-provision (PTPP) income is a clearer gage of where the industry’s cash flow strength stands today. Valuations remain ludicrously cheap on this cash flow-oriented basis as investors are still “hooked” on book value, reserve builds and GAAP. As the chart on page 1 illustrates, never before in history has the financial industry produced so much more cash flow than reported earnings. The recognition and closure of this historic “gap” are the seeds of the recovery in financial stocks that we believe have already begun.

30 Western Reserve Capital Management, LP © 2009Confidential

Pre-Tax Pre-Provision Profits: “Look Thru Earnings”

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Wells Fargo – Consistent Growth

Source: Wells Fargo & Company; 2009 estimated based on actual 1Q09 PTPP annualized.

We keep going back to Warren Buffett’s favorite bank stock –Wells Fargo (WFC) (as it’s also one of our favorites). Buffett refers to PTPP in a far more easy to understand term. He refers to this as “look through” earnings power (a.k.a. cash flow). In the first quarter, Wells posted record “look through” earnings “power” as expressed by PTPP. This was driven by record double-digit organic fee-based revenue growth. The very low dilution related to the purchase of Wachovia is of note. We continue to believe that this was perhaps the most accretive acquisition in the history of U.S. banking. Time will tell of course… JP Morgan (JPM), US Bancorp (USB), Capital One (COF) and PNC Financial (PNC) all closed highly accretive TARP funded acquisitions as well. However, the market has not yet recognized this because investors remain unfocused on CASH FLOW! So, what do we expect to see in the second quarter earnings season? We anticipate more positive surprises than negative… big will trump small

• More loan loss ‘reserve builds’ in excess of periodic losses; however, we believe the level of excess reserve builds has peaked (JP Morgan’s Jamie Dimon concurred on this recently in a meeting) and this will not go unnoticed for highly focused banking observers and astute investors in the sector.

• Investors still remain overly focused on balance sheet capital and not cash flow and

liquidity. How one gets through troubled waters in business is through cash flow and liquidity. This is how the Federal Reserve first ranked ordered banks via capital adequacy in their “stress test”. We believe the recent capital raises; increased liquidity and improving cash flows at banks will dominate the earnings season and will trump periodic credit despite our expectations for continued weakness in the latter.

• Higher non-performing loans, especially in more traditional commercial and industrial

(C&I) and commercial real estate credits. However, the cumulative loss potential on these traditionally more consistently underwritten “garden variety” bank loans will be relatively low and will lead to the lower relative ‘reserve builds’ we are calling for. A subtlety to some perhaps, but not to all. Most banks are in excellent capital and liquidity shape now and most are very good at traditional commercial lending or their “bread and butter”. There is no new “shoe to drop” per se. By contrast, expect to see actuarial-based deterioration in the industry’s underwriting strength wheel-house due to the economy. There was no “bubble” in traditional commercial bank lending.

• The vast majority of residential mortgage, land development and multi-family conversion

“bubble” credit problems have passed through the system now. They are post peak. Let’s stop obsessing about them. The housing collapse is over. It’s collapsed completely now. In fact, recent housing data suggests we are somewhere in the early 1960’s in terms of new supply and prices having begun to stabilize in most parts of the country. We expect no quick recovery. But, we no longer have “Dick Nixon to kick around anymore”.

• Consumer loan charge-offs will continue to escalate alongside the substantial rise in

unemployment claims since the beginning of the year. Now, more than 80% of this cycle’s job losses have occurred since last November with most in the past five months. The rise in claims has tapered-off, but job losses are still losses. As a result, heavy

consumer-focused financials will continue to lag in earnings power for now. But, the slowing job loss rates and tighter underwriting now in its second or third year will start to show investors the ability for these banks to plow through the cycle in far better shape than what currently is priced-in. Companies like Capital One (COF) and American Express (AXP) e.g. did pass the Fed’s “stress test” and even have repaid TARP. They are incredibly cheap stocks!

• Analyst expectations have begun to “creep” higher in recent weeks. Could anybody have

imagined Bank of America (BAC) would now be expected to post a profit on a GAAP basis (cash flow definitively will be in the black a.k.a. PTPP)? We “appear” to be down to one “zombie” large bank called Citigroup (C). And we are not sure it’s as much of a “zombie’ as its billing and its current price would suggest. BAC certainly is no zombie. Mortgage banking, investment banking and retail brokerage are soaring there.

• Merchant banks like JP Morgan (JPM), Goldman Sachs (GS), Morgan Stanley

(MS) and BAC will likely see “mark-ups” on under valued securitized assets as credit spreads have narrowed in the second quarter. So,”mark-to-market” accounting now is turning positive and may surprise many investors. We believe the mismatch between intrinsic value and MTM value for many securitized assets are grossly distorted. We expect “mark-ups” on these assets over the next several years as they mature and pay-out. The PPIP buyers will be very disappointed in the lack of “product” for sale in the Treasury Department’s over emphasized “legacy asset” purchase program. No major banks, who hold >80% of such assets, have any interest in selling them. Vulture investors like Wilbur Ross recently opined that the PPIP may only be “1/8th to 1/10th” the original size planned. Forget the PPIP. It’s dead on arrival. Accounting over stated the losses and now banks have no reason to sell. Instead, the accretion will flow to the banks holding these assets to maturity now. Bank stocks de facto are the best distressed debt funds to own.

• PTPP will continue to be very strong at WFC, JPM, BAC and US Bancorp (USB) et al.

Look for the TARP “arranged marriage” winners like JPM, WFC, USB and PNC to post the most significant year-over-year gains in PTPP.

• Smaller banks, which hold fewer assets subject to MTM accounting, will be the quieter

reports since their primary accounting – impairment or FAS 114 – will result in higher reserves and non performing loans. This is due entirely to the economy and not to poor underwriting for the majority of these banks. These banks will benefit from a steep yield curve and higher net interest revenue. Of course, it will be a mixed bag and selecting the highest quality small community banks will be paramount. Those banks most levered to the shape of the yield curve are an opportunity… as we see a prolonged steep yield curve. We like and own several. Our favorite is First Niagara Financial (FNFG), which as it turns out, received all of PNC’s overlap branches in Pittsburgh related to the National City acquisition for virtually nothing. So, FNFG’s PTPP also will soar year-over-year.

Conclusion – Cash flow for the banking industry will RISE year-over-year and this will stand out relative to all other industries, which are suffering significant cash flow declines year-over-year. So, while selectivity remains important; the financial sector will post the best year-over-year cash flow comparisons in our view. Therefore, focus on the larger, multi-line banks with high fee income generation for this quarter and high quality regionals. We are starting to “nibble” into re-caps like Huntington Banks (HBAN) on this pullback as well.

Valuation Update: Prices Remain Absurd; Buffett Buying is Correct Focus on “look through earnings” or cash flow (PTPP)…

We prefer to walk the CAMEL line when evaluating financial companies. We now believe two of the most critical early issues in this crisis – capital and liquidity – have been solved for the vast majority of banks. The “melt-down” period is behind the industry. The independent Federal Reserve did a tremendous job despite the federal government’s missteps and gaffes. Now, we still have a deep recession with deteriorating credit to tackle and this is “managed” like any problem credit cycle once capital and liquidity are restored – cash flow. So, the best way to value financials now is no longer the deep “melt-down” book value (capital) many have clung-to, but rather the cash flow strength underlying individual banks as this will show one how cheap or expensive the stocks really are now.

By our calculations, many banks are ridiculous cheap on cash flow or what Buffett would call “look through” earnings…We chose six banks to illustrate this. 2.3x cash flow and 4.9x recovery EPS is ludicrous. Company

Market Value

PTPP1

MV/PTPP

Recovery EPS2

P/E

JP Morgan

$131 bil

$47 bil

2.8x

$5.50

6.0x

Wells Fargo $108 bil $37 bil 2.9x $4.00 5.8x US Bancorp $31 bil $8 bil 3.9x $2.80 5.7x Bank of America $103 bil $35 bil 2.9x $3.75 3.0x PNC $17 bil $6 bil 2.8x $5.75 6.3x Capital One $10 bil $5 bil 2.0x $7.00 3.0x Average

2.3x

4.9x

1Pre-Tax, Pre-Provision based on 1Q09 annualized 22011 estimates by Western Reserve Capital Management, LP Conclusion – Financials are ridiculously cheap. Below are the same banks on a market cap to net short term liquidity basis. Totally absurd! More net cash than market value?

Company

Market Value

Cash & Equivalents

Short TermDebt

Net Liquidity

% Market Value

JP Morgan

$131 bil

$489 bil

$33 bil

$456 bil

348%

Wells Fargo $108 bil $200 bil $72 bil $128 bil 119% US Bancorp $31 bil $46 bil $26 bil $20 bil 65% Bank of America $103 bil $435 bil $186 bil $249 bil 241% PNC $17 bil $75 bil -0- $75 bil 1,071% Capital One $10 bil $40 bil -0- $40 bil 400% Average

374%

1Q09 “Call Reports” courtesy of the Federal Deposit Insurance Corporation

Also by our calculations, many non bank financials are quite inexpensive as well on cash flow. We chose several irreplaceable franchises to illustrate this. Company

Market Value Ebitda

EV/Ebitda3

Fiserv

$7.0 bil

$1.7 bil

6.2x

Jack Henry $1.6 bil $235 mil 6.9x Alliance Data $2.2 bil $714 mil 4.9x American Express $27 bil $6.9 bil 7.5x MasterCard $21 bil $2.4 bil 8.8x NYSE Euronext $6.3 bil $1.1 bil 7.7x Average

7.0x

32011 estimates by Western Reserve Capital Management, LP

Outstanding Historical Performance and Alpha Generation

amid One of the Worst Periods for Stocks in History

Performance vs. the Financial IndexPerformance vs. the Financial Index

-80.00%

-60.00%

-40.00%

-20.00%

0.00%

20.00%

40.00%

60.00%

80.00%

2004 2005 2006 2007 2008 1st Half2009

CumulativeReturn

CumulativeAlpha

Perc

enta

ge

Western Reserve Gross Western Reserve Net Financial Composite Index

Western Reserve Gross Western Reserve Net Financial Composite Index

2004 27.10% 19.90% 12.04%2005 -3.87% -4.20% -4.76%2006 20.30% 14.70% 4.52%2007 -14.70% -12.80% -32.45%2008 -9.49% -9.13% -45.38%

1st Half 2009 10.91% 8.43% -21.22%Cumulative Return 25.83% 15.60% -67.58%Cumulative Alpha 93.41%

Western ReserveWestern Reserve-- Annual Alpha GenerationAnnual Alpha Generation

"Alpha" measures the value that an investment manager produces. Typically, the return of a comparable benchmark index (such as the S&P Financial Index), is subtracted from the fund manager's performance to calculate "alpha" or the excess return produced by the manager over the reference index. For example, if a fund had an alpha of 10% for a given year, it would have produced a return that was ten percentage points higher than the benchmark index. Source: HedgeCo.net (adapted)

0.00%

10.00%

20.00%

30.00%

40.00%

2004 2005 2006 2007 2008 1st Half 2009 AverageAnnualized

Alpha

Perc

enta

ge

Annual Alpha Generation

Western Reserve Gross Financial Composite Index Annual Alpha Generation

2004 27.10% 12.04% 15.06%2005 -3.87% -4.76% 0.89%2006 20.30% 4.52% 15.78%2007 -14.70% -32.45% 17.75%2008 -9.49% -45.38% 35.89%

1st Half 2009 10.91% -21.22% 32.13%Average Annualized Alpha 21.36%

The two charts above reflect Western Reserve’s gross and net returns versus the financial composite index and Western Reserve’s pure average alpha generation respectively. All data reflects performance since inception January 2004 through the end of June 2009. As illustrated, the fund has produced positive returns in what has been one of the worst periods for stocks in history. On a cumulative basis since inception, the fund has produced nearly a 100% spread between our gross returns and that of our benchmark financial composite index. We have produced double digit alpha generation in the 20% per year range; on both an annualized average and a cumulative total return basis.

[Remainder of this page intentionally left blank]

4 Western Reserve Capital Management, LP © 2009Confidential

A Compelling Empirical Precedent

Financials soar 900% from last banking crisisFinancials soar 900% from last banking crisis

NASDAQ Bank Index vs. S&P 500NASDAQ Bank Index vs. S&P 500

0%

100%200%

300%400%

500%600%

700%800%

900%

November 1990 - April 1998

NASDAQ Bank Index

S&P 500

Source: Thomson Reuters - BASELINE

Annualized1991 1992 1993 1994 1995 1996 1997 1998 Return

59% 58% 29% 2% 48% 33% 57% 5% 36%

83% 29% 31% 0% 51% 31% 26% 11% 33%

71% 44% 30% 1% 50% 32% 42% 8% 35%Source: Thomson Reuters - BASELINE

COMPARISON

NASDAQ Bank Index

S&P Financial Index

Combined Annual Average

For the Calendar Years Ended December 31,HISTORICAL

The data above is the same empirical that we have shared with our investors throughout this crisis. This illustrates the nearly 900% rise in bank stocks between 1990 and 1998. Buy the pull-backs! We are seeing a very favorable pullback on light volume in June and July. Right now is a very good time to be adding capital to high quality financial stocks.

Regards,

Michael P. Durante Managing Partner

Mid Quarter Update May 12, 2009

Post Traumatic “Stress Test” Order Partners, Western Reserve Master Fund (the “Fund”) closed April positive on the year and has since moved up not insignificantly so far in May. The Federal Reserve’s worse case estimate for the roughly seventy percent of banking assets held by the largest nineteen banks seemed to positively surprise most on Wall Street, though not us. We had moved to a very long-bias via covering shorts in February, which initially proved to be a tad early. As former bank regulators, we believed we had an edge in deciphering what Secretary Geithner meant when he first uttered “stress test” and we wrote about it almost immediately. The test itself is nothing new; it’s the long time industry standard CAMEL analysis. The simulation modeling for worst case losses, of course, was the devil in the detail. We were accurate on the capital adequacy component of CAMEL in our high quality financials which we chose to de facto overweight by reducing short coverage against them in February. By no means does this suggest the financial industry has seen peak non performing loans or peak loan loss reserve builds. However, what is behind us is the liquidity crisis (the ‘L” in CAMEL) and the major capital adequacy worries (the “C” in CAMEL). Earnings recovery already has begun and precisely where we had projected – in fee revenue… This being a function of the massive Fed stimulus kicking-in as record M2 (cash) of over $10 trillion has started to move out of neutral. When money starts to “move”, the financials earn transaction fees. This is our early read on a much broader-based recovery. Arguably, we have a lot of wood to chop, particularly since psychology has been so damaged in this cycle. However, as liquidity skyrockets (as we noted since the beginning of the year), the seeds of recovery are sown. Suddenly, the financials (large banks, small banks and even equity REITs) have been raising new equity in the public markets with relative ease. This above all else is a clear sign of a recovery already well under way. Some are raising equity to shore-up liquidity and some to meet “stress test” shortfalls, while others are repaying TARP. This all is very positive…

What’s more important today is to focus on “look through” earnings (recovery) across our universe and making certain that we own those names that are positioned to deliver the most significant and rapid recoveries.

Why Financial Stocks Will Lead the Pending Recovery

5 Dynamic Profit Accelerators:

1. Reductionof Loan Loss

Reserves

4. Record Levelsof Capital

and Liquidity

5. TransitionalIncrease in

Net Interest MarginSpreads

2. Release ofExcess Loss Provisions

Into Earnings

3. Transaction-related

Earnings as “Money Flows”

Return

S&P 500 Earnings Estimates By SectorSource: Thomson Reuters First Call and Standard & Poors, as of April 2, 2009

S&P Weighting

(1)Sector 1Q '09

(Estimate)2Q '09

(Estimate)3Q '09

(Estimate)4Q '09

(Estimate)Full Year '09 (Estimate)

10.90% Financials -37% -40% 264% N/A (2) (3) N/A (2)13.10% Energy -56% -61% -61% -24% -51%18.10% Technology -31% -26% -21% 10% -17%9.60% Industrials -39% -34% -26% -6% -26%15.00% Health Care -3% -1% 1% 3% 1%

8.80% Consumer Discretionary -107% -38% 15% 432% -21%

12.80% Consumer Staples -7% -5% 1% -2% -3%3.20% Materials -80% -63% -59% 253% -54%4.00% Telecommunications -15% -21% -7% 9% -9%4.70% Utilities -7% -7% 3% -2% -1%

Average growth rate (excluding financials) -36% -32% -17% 170% -8%

Notes:(1) Based on market capitalization.

(2) Thomson Reuters First Call does not calculate growth rates from negative base-year earnings. In Q4 2008 the financial sector lost $33.9 billion and for the full-year 2008 it lost $24.5 billion.

(3) Western Reserve estimates Q4 2009 EPS growth over 2008 could reach +500% based on the impact of the dynamic "profit accelerators" discussed in this proposal and combined with the cumulative impact of restatements of prior period securities impairments under the revised FAS 157 rules changes.

Percent Change in Current Year to Past Year EPS

The diagram above illustrates the profit recovery cycle for financials. These profit accelerators (see previous client letters for a detailed discussion) are patently overlooked by the larger market. These features illustrate how financials earn their way out of recessions and result in a dramatic snap back to earnings power. This will result in financials leading the pending recovery in our public equity markets and indeed they have since the market started a recovery off early March lows. Keep in mind, the Federal Reserve’s “stress test” promoted pre-tax, pre-loan loss provision revenue as the first order of “absorption” for credit losses or cash flow (not book value) and this also caught Wall Street by surprise, but not us. This is because loan loss provision expenses are non cash redirections of equity capital from retained earnings to a contra asset loan loss reserve. Therefore, they are real expenses but are a more accurate reflection of past over statement of earnings power and far less a function of current and future earnings power. Pre-tax, pre-provision (PTPP) income is the better gage of where the industry’s profit power stands today. Valuations remain dirt cheap on this cash flow-oriented basis as investors are still “hooked” on book value.

A good example of “look through” earnings power is Wells Fargo (WFC). To illustrate this succinctly, we have borrowed a diagram from Wells’ own slide presentation from their post “stress test” conference call. In the first quarter, Wells posted record earnings “power” as expressed by PTPP, driven by record double-digit organic fee-based revenue growth. It is noteworthy to mention the enormous positive impact on PTPP from the purchase of Wachovia, which was acquired for virtually nothing….perhaps the most accretive acquisition in U.S. banking history? We think so.

30 Western Reserve Capital Management, LP © 2009Confidential

Pre-Tax Pre-Provision Profits: “Look Thru Earnings”

$0

$5

$10

$15

$20

$25

$30

$35

$40

2003 2004 2005 2006 2007 2008 2009E

Pre-Tax Pre-Provision Profits

Wells Fargo – Consistent Growth

Source: Wells Fargo & Company; 2009 estimated based on actual 1Q09 PTPP annualized.

Wells was asked by the Fed to raise roughly $14 billion to “cover” the Wachovia asset bulk as part of the “stress test.” We believe the equity raise is <7% dilutive to existing share count while the cash flow accretion from Wachovia is near 100%. A home run acquisition! JP Morgan (JPM), US Bancorp (USB), Capital One (COF) and PNC Financial (PNC) all did highly accretive TARP funded acquisitions as well, which the market has yet recognized because investors remained focused on arbitrary valuation yardsticks like book value instead of cash flow… For example, Wells still trades at an incredibly attractive 3.5x current PTPP earnings power despite its recent strong move up. And Wells is not alone in such a low valuation based upon cash flow. Both USB and JPM e.g. trade at just 4.5x PTPP. Under valuation in the financial sector remains a real pandemic. So too is the next problem – over capitalization.

We believe the “stress test” was an unintended communication gaffe by the new Treasury Secretary, who was strictly attempting to add “gravitas” to his coming out speech, knowing banks already go through a rigorous stress testing by regulators annually. Once “stress test” fever took hold of the market (perception), the Federal Reserve was in an awkward position as the sole regulator of bank holding companies to create a “public CAMEL” rating procedure to ease market worries about the so-called “stress test.” In our view, the actual test employed will result in the over capitalization of the financial industry and usher-in a profitability panic (ROE) by late 2010. Our own stress testing on several well-known banks suggests that their next hurdle will be overcoming very low ROEs (return on equity ratios). This stands in contrast to stock market perception that continues to discount under capitalization. So, in contrast to the consensus, we expect to see record stock buy-backs and a binge of acquisition activity to begin at some point in the next 12 to 18 months. This, in turn, will move the sector from overly bearish valuations based on faulty “book value of convenience” madness towards cash flow discounting. We anticipate the group will be in a long uptrend for the next several years on both earnings recovery and multiple expansion off of very low “look through” earnings power multiples at present. Identical to what we witnessed coming off of the S&L Crisis (See Chart below).

4 Western Reserve Capital Management, LP © 2009Confidential

A Compelling Empirical Precedent

Financials soar 900% from last banking crisisFinancials soar 900% from last banking crisis

NASDAQ Bank Index vs. S&P 500NASDAQ Bank Index vs. S&P 500

0%

100%200%

300%400%

500%600%

700%800%

900%

November 1990 - April 1998

NASDAQ Bank Index

S&P 500

Source: Thomson Reuters - BASELINE

Annualized1991 1992 1993 1994 1995 1996 1997 1998 Return

59% 58% 29% 2% 48% 33% 57% 5% 36%

83% 29% 31% 0% 51% 31% 26% 11% 33%

71% 44% 30% 1% 50% 32% 42% 8% 35%Source: Thomson Reuters - BASELINE

COMPARISON

NASDAQ Bank Index

S&P Financial Index

Combined Annual Average

For the Calendar Years Ended December 31,HISTORICAL

The data on the previous page is the empirical behind the nearly 900% rise in bank stocks between 1990 and 1998. We have referenced this in our letters over the past several months as financial stocks plummeted. Buy the pull-backs! Of note however, our analysis of the 1990-1998 period suggests that the opportunity for pull-backs of more than 10% are likely to be quick, rare and shortly lived. Why? Naturally, because we all seem to want them now. The recent “bounce” in the financials has garnered much press. However, the typical financial stock index still will rise almost 300% from here just to get back to under valued circa October 2007 when faulty mark-to-market accounting placed a stranglehold on the sector. Alpha in excess of that will come from choosing those that are gaining market share in the current shake-out. A few have been mentioned in this letter.

Regards,

Michael P. Durante Managing Partner

First Quarter 2009 Review April 6, 2009

“Radical chic invariably favors radicals who seem exotic and romantic…”

- Tom Wolfe

Dear Partners, Western Reserve Master Fund, LP (the “Fund”) closed out a roller-coaster first quarter down approximately 13% versus our closest comparables – S&P financial related indexes down an average 34%. Stocks were first driven essentially by fear and uncertainty over the new concentration of power in Washington and then by ‘shock and awe’ over the hurried magnitude of radical legislative and fiscal policy ambition. Once the ‘shock’ was discounted, stocks stabilized near the end the quarter off deep depression-era values. Investors remain numb, though not comfortably so… From the inflection point in the election last October to the recent lows, stocks and the economy posted their largest and swiftest decline since the late eighteen-fifties or at the eve of the Civil War. They were led down by the horror of rabid and unfounded bank nationalization fear. More than two-thirds of the declines in both stocks and jobs lost in this downturn have occurred since October, when polls all but insured an imbalance of power in the offing. We believe this frightened both investors and business owners alike. It’s at this point the economy simply “fell off a cliff” as Warren Buffett recently surmised. Never before in our lives has politics influenced investing so dramatically and we all have been reluctantly pulled-into the body politic. Wall Street, it would seem, has temporarily moved due south by approximately 204 miles. The good news is that the displacement of the market as measured either by a short train ride or a far more immodest journey into panic, spells opportunity. A record $10 trillion of M2 (cash and equivalents) now sits on the sidelines and much is parked atop the balance sheets of the nation’s banks. Our banking system is much maligned these days amid rampant populism. It has spawned the previously unthinkable such as neo-terrorist groups like “Bank Bosses are Criminals”.

All the same, our financials presently sit on their largest store of liquidity in history. Money is made whence capital flows and our financial system has hoarded much of our country’s capital. Conversely, investment demand for gold now represents nearly 60% of all global mine production (a record) and the percentage of it physically delivered is at levels last seen in 1982 or the onset of the greatest bull stock market of all-time. Make no mistake. This is the worst and most sudden swan dive in the economy in our lifetime and we hardly are bullish for a swift recovery. However, we do believe the discounts in equities are prodigious. And the resilience of our uniquely self-reliant denizens and business stewards can and will work around Washington until “gridlock” returns. “Radical chic” will wear out its favor and majority prudence will restore confidence; as a result the economy and stock market will begin to rise again over a protracted period. This is the time of our lives as investors. The “Chaotic” Case for Financial Stocks Western Reserve has written extensively the past few years about the inherent flaws in mark-to-market accounting (MTM), and its “negative feedback loop” effect on banking and our economy. Not to mention, the underlying problems for accountants who have misapplied “fair value” to the new, unregulated and highly speculative credit default swaps (CDS). For a long time, trees falling in a forest were more than just metaphor. Now, we hear even retroactive recoveries are potentially in the offing from badly needed revision to MTM. It’s promising we now see these tightly correlated issues aired out on television and on Capitol Hill on a daily basis by a growing legion of fervent agreement and more constructive disagreement. The restructuring of MTM is inevitable now and so is the strict regulation of CDS to require offsetting assets and/or material equity investment. It’s actually the CDS issue that makes MTM so flawed as the lack of asset or equity backing caused inefficient price discovery. In combination, their restructuring likely has set a floor on financial stocks in our view and the healing can begin…

“I just don’t get that we should treat credit default swaps as like the Delphic Oracle of any kind. It’s the most easily manipulated and broadly manipulated market that there is.”

- Jeff Immelt, CEO of General Electric We didn’t get it either Jeff. We pulled our GE short off too soon as a matter of fact. Arguably, we were too early on these issues and found ourselves too far out in front (noting two former Fed Chairmen below, we were in good company). We pulled our financial shorts off prematurely as a result. We mistook chaos as mere misinformation that would correct itself in feasible time and totally missed the Congressional flip-flop on TARP. We didn’t expect rational beings to take so long figuring out MTM and CDS. And we frankly were blindsided by the class warfare targeting of the banking industry.

Paul Volcker on Mark to Market Accounting

Former Fed Chairman, Paul Volcker, Chairman of the Group of Thirty, Consultative Group on International Economic and Monetary Affairs, Inc., just released a study with recommendations on financial reform.

Recommendation #12 on Fair Value Accounting reads as follows:

a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.

b. The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards that better reflect the business models of these institutions . . . ."

Alan Greenspan on Mark to Market Accounting

On November 1, 1990, Federal Reserve Chairman, Alan Greenspan, in a 4-page letter to Richard Breeden, Chairman of the Securities and Exchange Commission, said, in part:

"The Board believes that market value accounting raises a substantial number of significant issues that need to be resolved before considering the implementation of such an approach in whole or in part for banking organizations.

Accounting methodology should be developed to measure the results of a particular business purpose or strategy; it is not an end in itself. For an institution whose business purpose is to trade marketable financial assets on an intra-day basis, for example, closing daily market values would measure the success or failure of that particular business purpose. An end of the day balance sheet, marked to market, is clearly the appropriate accounting procedure in the example.

Generally, the business strategy of commercial banks, on the other hand, is to employ their credit insights on specific borrowers to acquire a diversified portfolio of essentially illiquid assets held to term. The success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery. Clearly, one aspect of value in an exchange is the period of delivery. But the appropriate price for most bank loans and off-balance sheet commitments-is the original acquisition price adjusted for the expectation of performance at maturity. It is only when that price differs from the book value of the asset that an adjustment is appropriate. A reserve for loan losses is such an adjustment. To mark such an asset to a market price intended to reflect the value of a loan were it liquidated immediately is interesting, but not a relevant measure of the success of commercial banking."

The good news is that we have made no fundamental mistakes (have had to take no permanent losses long) and prices just got better and better, thus lowering our average cost and increasing the upside. Chaos brings with it both short term and long term opportunities. There was a great opportunity chasing a “short all the financials” bubble. We looked at MTM and CDS, saw the flawed pricing, and didn’t draw the fundamental case to chase the short trade far enough. The “populism” that erupted into the bank nationalization panic during the quarter was a wild card (read: blind luck). This financial crisis is different in one significant way than the one we witnessed as banking regulators in the early nineties. In the S&L Crisis, the accounting lagged the poor underwriting decisions of many banks and it had to be altered after-the-fact. The current crisis also involves some ridiculously poor underwriting by some lenders, but it was isolated to certain types of mortgages and in the absence of MTM and lax CDS regulation, we believe it would have begun and ended there. In this crisis, MTM and CDS were the agents of spreading credit concerns to unnecessary levels and across uncorrelated asset classes. This go ‘round, we are forced to unwind perhaps well intended but hastily crafted and deeply flawed accounting after-the-fact. The investment opportunity is the same however…gloomily under valued financial stocks, which should lead the recovery. Opining about the financial crisis which concluded in the early 1990’s, value investor David Dreman writes in Contrarian Investment Strategies, “A full-fledged panic in financial stocks began during the Gulf Crisis, in August of 1990. Banks, S&L's, insurance companies and other financial stocks, already down sharply because of real estate problems, went into a free fall. Fears were now voiced about the viability of the banking system itself, and doubts were expressed as to whether it could withstand the shock of trillion-dollar losses in real estate. From the beginning of the year to the end of September of 1990, money center and regional banks dropped 50%. Some financial stocks fell by as much as 80% from their previous highs."

“Crisis investing opens the door to large profits. But you had better don your general’s hat and flak jacket. To make this killing you have to charge ‘into the valley of death’ while overreaction is roaring and thundering all around you.”

- David Dreman, Contrarian Investment Strategies, 1998 Dreman continues his analysis of this period by pointing out that many bank stocks fell to substantially below book value, observing the same principles that Western Reserve has written about extensively in our prior quarterly client letters. As Dreman qualifies more articulately than we, in times of crisis, pricing becomes as distorted as public opinion. Negative opinion and negative events cycle back and forth or what Western Reserve has described as a “negative feedback loop,” which dominates market sentiment and overwhelms reason. Dreman observes, “In a crisis or panic, the normal guidelines of value disappear. People no longer examine what a stock is worth; instead they are fixated by prices cascading ever lower. The falling prices are reinforced by expert and peer opinion that things must get worse.” Dreman adds, “Further, the event triggering the crisis is always considered to be something new; nothing in our experience shows us how to cope with the current catastrophe.” Few investors understood this period for what it was. Namely, a historic buying opportunity with a great likelihood for extraordinary returns as hadn’t been seen in a long time. Western Reserve views the current environment in very much the same way. Warren Buffett viewed the market

for financial stocks similarly as Dreman in 1990. The following is a brief (and condensed) excerpt from the Berkshire Hathaway 1990 year-end letter to investors.

“Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month-by-month the foolish loan decisions of mismanaged banks were put on public display. As one huge loss after another was unveiled -- often on the heels of managerial assurances that all was well -- investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased…Wells Fargo for…less than five times after-tax earnings. A year like that -- which we consider a phenomenon -- does not distress us….fears of a real estate disaster caused the price of Wells Fargo stock to fall almost 50% within a few months. Though we had bought some shares at prices before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic

prices.”

Source: Berkshire Hathaway, 1990 Investor Letter The performance of the NASDAQ Bank Index versus the S&P 500 from November 1990 to April 1998 is illustrated in the chart below. During this period and based on daily price at closing, this broad index of regional banking stocks returned approximately 887% versus a return of approximately 200% in the S&P 500. Dreman and Buffet were dead-on.

0%

100%200%

300%400%

500%600%

700%800%

900%

November 1990 - April 1998

NASDAQ Bank Index

S&P 500

Western Reserve offers additional insight that supports the strong likelihood of a sharp recovery in financial company earnings (and stock prices) in advance and in excess of the broader market over the next several years.

The substantial historical out performance of financials following a credit-induced crisis lies in the fact that financial services firms’ profits recover ahead of most product and industrial companies due to five dynamic “profit accelerators” that are unique to financial services firms’ business models and their accounting not found in other industries.

Loan Loss Provision Expense Loan loss provision expenses are non-cash deductions from capital and currently represent more than 85% of banking profit declines. These loan loss provisions are very pro-cyclical non-cash charges which peak long before the economy begins to recover and often become grossly overstated due to “double upping”. As a result, the banking industry will see profit relief from lower loan loss provisions early in an economic upswing. This is an accounting-related phenomenon. In downturns, banks transfer capital to their loan loss reserve accounts by reducing retained earnings (by making non-cash charges against earnings). This is not a transfer of cash or a “cash flow exercise,” it is a balance sheet transfer from the capital account (retained earnings) into a contra-asset account (loan loss reserve). Therefore, bank earnings are significantly reduced during periods of heightened credit losses because most banks expense their current loan losses without corresponding reductions of their loan loss reserve balances causing the expense to be a “double up”. After loan loss provisions peak, such as at or near the bottom of a recession, banks see their earnings recover suddenly as the loan loss reserve “spigot” gets turned off and reported profits "jump" quickly back in line with underlying cash flows. This gives Wall Street the appearance of a very sudden and rapid acceleration in the earnings power of banks, while a bank contemporaneously is over-reserved for future losses. Release of Excess Loss Provisions

New accounting standards governing bank loan loss reserving practices were implemented following the last recession and exacerbate the over-reserved aspect of the aforementioned “double up”. These new standards require banks to “reverse out” any excess loan loss reserves by “releasing” them back through future earnings periods. This creates a levered boost to earnings power as the economy stabilizes. First, new loan loss provisions are eliminated or get dramatically reduced as discussed in the previous paragraph. Second, the excess reserves are released back through the earnings statement. The result is that bank earnings are grossly under stated during downturns and overstated during up turns. “Double ups” become “double dips”… Our research using CAMEL or regulatory insight is the driver of our research combing over the carnage looking for banks that will have very quick recoveries in credit related expenses. Transaction-related earnings as “money flows” return

The economy now is sitting on a record $10 trillion in cash and cash equivalents (defined as “M2” by the Federal Reserve). Most of this cash is currently custodied within the financial services industry. As the economy begins to stabilize and investors begin to accept more risk by moving out of cash, financial services firms realize early and strong revenue growth acceleration because they are, at their core, transaction processing-oriented businesses that generate fees from moving, loaning, servicing and transacting these cash flows.

Financial services firm revenues accelerate first in a recovery as money starts to “move around” again. This is true both of monies moving back into debt and equity capital

markets and out of money markets, as well as retail-oriented transactions driven by the acceleration of credit and debit card purchases. Merchant (investment) banks and custodial focused banks tend to move first followed by more traditional commercial banks. Slope of Yield Curve

Like the Greenspan Fed in the early nineties, it’s highly likely the Bernanke Fed will leave short term interest rate targets low for a protracted period of time to help the banking industry “earn” it’s way through higher credit costs. This proved very instrumental in aiding the recovery of banks in the after-math of the S&L Crisis. The effect is to allow bank net interest margins (lending spreads) widen and stay wide for an extended period. Record levels of capital and liquidity

As financial firms have cash and capital hoarded per usual in this credit crisis, the industry is sitting on the largest store of capital and liquidity in history. As a whole, banks have three times the relative level of capital today than they had during the depths of the S&L Crisis. The average bank now carries regulatory capital above 12%, or almost three times the minimum level required to meet standards for being considered “well capitalized.” Any retroactive recoveries from MTM amendments will only further boost capital levels. We do not expect any surprises from the current “stress tests” on-going; as “impairment accounting” which governs 80% or more of bank held assets is timely and effective and our CAMEL approach to analyzing banks is in step with the regulators.

While non-performing loan levels are still rising and we expect them to continue for some time, they remain well below those experienced during other credit crises such as during the period from 1988 through 1992, and significantly below the level experienced during the Great Depression. Many banks are trading at levels below their net cash-on-hand (excluding core deposit “match funded” loan portfolios), so the extraordinary levels of liquidity and capital are not credited in stock prices. Such remarkable levels of capital and liquidity mean that banks are “under-loaned” and have excess cash and deposits on hand. At the point the potential fiscal economic stimulus and obvious “easy” monetary policy effectively grabs-hold, banks will be extraordinarily well-positioned to lend into an economic recovery. This increased lending activity is expected to result in a steady and early increase in the banks income-producing assets which will bolster their net interest margins and profitability. Traditional banks, especially smaller regional banks, will flourish and their valuations climb sharply. In addition, excess capital and liquidity likely will usher-in another extensive merger boom such as we saw in the latter parts of that near 900% climb in the financials between 1990 and 1998.

According to First Call average analyst estimates for the S&P Financials Index, Percent change year over year in earnings-per-share

1Q09 -37% 2Q09 -40% 3Q09 +264% 4Q09 >+500% 2010 >+350%

Source: First Call (These are First Call and Western Reserve estimates)

By comparison, the average earnings progression for the S&P 500 excluding Financials is far less attractive coming out of this downturn as a result of the aforementioned “profit accelerators”.

1Q09 -36% 2Q09 -32% 3Q09 -27% 4Q09 -17% 2010 +2%

Source: First Call (These are First Call and Western Reserve estimates) Conclusion - Financial firm earnings “snap-back” will attract investors on a relative basis into the coming recovery, propelling their shares faster and higher than the overall stock market.

The ‘shock and awe’ of the liberal agenda no longer is a surprise to anyone, so the economy is showing some modicum of stabilization. However, its a stabilization at very depressed levels and recovery will be slow, arduous and lumpy. This is one reason why equities will start to outperform other asset classes and already may have begun. We have record cash on the sidelines in the economy. It eventually has to move off the fence. The economy will be an L-shaped recovery, but stocks will lead and have a U-shaped recovery as a public stock can move ahead of fundamentals whereas a building or land or private equity cannot. Keep in mind that public equities, particularly financials, already trade below private market value as folks have had to see them marked monthly in their account statements, prompting them to sell public stock emotionally. They see their stocks down and sell and live in denial of their private holdings liquidation values. The opposite is true at troughs.

Regards,

Michael P. Durante Managing Partner

First Quarter 2009 Update February 9, 2009

“Negative Feedback Loop”

Western Reserve Master Fund, LP (the “Fund”) closed out a tumultuous 2008 down a modest 3% for the year. Our closest comparable index is the S&P Financial Index and it fell roughly 60% in 2008. The Fund’s short positions in isolation compounded at over 40% in 2008 and long positions in isolation lost approximately 35%. Overall, the fund dipped slightly down on the year as a function of a very poor showing in the fourth quarter as we expanded our net exposure amid compelling valuations in large, liquid banking stocks. Without exception, the Fund’s exposure is driven purely by valuation relative fundamentals. We believe that the financials have traded well below intrinsic value based upon manic level fear.

Performance Since InceptionPerformance Since Inception

SMID Cap Services Composite consists of equally weighted long-only SMID Cap Growth Mutual Funds and Indexes. Components include WAAEX, WBSNX, BANK, DPSVS, IWM, SPFN and FINAN. Financial Services Composite consists of equally weighted long-only Financial Indexes. Components include BANK, IWM and SPFN.

Since inception, our average Alpha return was 16.18% per year.

Western Reserve Hedged Equity, LP Cumulative Performance Since Inception (Gross)

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We will not devote a great deal of attention in this letter to 2008 as what is most intriguing is the opportunity at hand in the equities markets. This is particularly evident in

the much feared financial sector coupled with what we believe are the most suspect debates in capitalism’s history – mark-to-market accounting (“MTM”) and the systematic “nationalization” of the banking system. The first of which is largely inaccurate and the latter of which is neither necessary nor sane. We believe the mere existence of these debates has had a “purging” effect on the sector and therefore fuel for what we believe will eventually result in dramatic gains. Mark-to-Zero Accounting A refresher on the “Negative Feedback Loop” Paralyzing the Economy Western Reserve has been discussing the inherent flaws in “mark-to-market” (MTM) since 2007 and we remain stunned that this is still debated in 2009. This remains the primary reason why the country has been unable to stabilize itself amid the worst financial crisis in perhaps seven decades. MTM is “theoretical accounting” which is seriously flawed, inaccurate and self-fulfilling. We believe that it must and will be dismantled either directly or indirectly via the Bernanke/Bair Plan. Over recent months, pundits have been willing to debate nationalizing the entire US financial system and thus unwittingly embracing what would be the de facto end of capitalism. Would not a simple review of the accounting for its flaws be a more prudent first move? At least the accounting is finally being debated now as well. When we first started writing about MTM in 2007; not a soul seemed to know what we were talking about. To be completely fair, that fact alone caused us to be prematurely bullish. Nevertheless, it appears we have been in good company. Both the FDIC’s Sheila Bair and the Federal Reserve’s Ben Bernanke have stated publicly that they believe MTM to be inaccurate due to a dysfunctional secondary market and that most of these bonds held by banks and insurers are marked-down well below intrinsic value (discounted cash flow based valuation or “DCF”). The Fed even has stated repeatedly that they are making money on the Bear Stearns assets they purchased last spring using DCF (not MTM). The current “aggregator bank” and loss insurance plans espoused by both Bair and Bernanke favor using DCF analysis to value the “at risk” to MTM assets at banks. What the Bair/Bernanke plan entails is relieving the financial industry of a broken secondary debt market which was in large part caused by MTM and speculation in illiquid credit derivatives. At a minimum, we believe a much harder review and response to the accounting standards that followed Sarbanes-Oxley is necessary before considering such Draconian actions as nationalization. Even the new Obama administration has acknowledged their disinterest in nationalization in favor of the Bair/Bernanke solutions. As a result, we suspect real relief is closer than the market has currently discounted. The reluctance to set aside MTM is due to the concern that it would further undermine confidence. A credibility and confidence concern is understandable, however keeping an illogical accounting standard in place due to a perceived illogical response is in and of itself…illogical. We would recommend suspending MTM and having the FASB turn MTM into a disclosure issue and return us to cash impairment-based accounting. This

would prevent the self-perpetuating capital account destruction which in essence is what the current paralyzed debt market creates. The current accounting system is forcing most financial firms to assume they are being liquidated every day they are open for business. No wonder our system is paralyzed. The banking system finds itself hoarding record cash, capital and liquidity to defend itself against MTM. As a result, the banks starve the rest of the economy of needed credit. This is why we are in a deep recession, perhaps worse than anyone has seen in seven decades. The legislature and accountants are to thank for this colossal blunder.

The illustration above comes from the venerable Bank of New York Mellon (BoNY) which is long noted for being conservative in their projections. BoNY estimates that MTM is inaccurate by $1 billion or roughly 1/3 of the bank’s annual earnings last year. BoNY is NOT experiencing cash flow impairment on these securities and their own discounted cash flow analysis (the long-time standard in business finance) suggests MTM is off by more than 80%. The reason for this is the lack of liquidity. Of late, there is no liquidity in the secondary market for credit. But when has price ever been an accurate assessment of value? This is especially true in a panic. MTM has become a liquidity discount and NOT a credit repayment discount. As we have explained, MTM makes matters far worse than reality. The accounting itself amplifies BOTH boom and bust cycles by overstating asset prices in booms and under stating prices in busts. Bonds are not traded and are not intended to be traded, like shares of common stock. MTM takes into account “observable input” in the market to then assess the spot value of bonds. Consequently, these “marks” aren’t even based upon

actual trading in the securities, but rather trading in highly levered speculative derivatives (bets) used by investors to gamble on the direction of value. The high leverage involved exacerbates the synthetic or “theoretical” price movements in the underlying bonds and increases the amplitude of the boom or bust. Historically, bank balance sheets are made-up mostly of loans (whole loans) and bonds (pools of partial loans). MTM only affects the latter – bonds (also a flaw). And by our careful observation, banks are carrying so much cash and equivalents (highly liquid securities) now that some have as much cash and equivalents as they do any other type of asset on their balance sheets. For example, banks like Citigroup, Bank of America, JP Morgan, Wells Fargo, US Bancorp, Capital One and PNC et al have multiples of cash relative to their own market capitalization values now. And most have loan to deposit ratios below 100%. This means they are hoarding cash to avert MTM and this is starving our economy of needed liquidity. Conclusion…MTM is smothering America! The Congress asked the Financial Accounting Standards Board (“FASB”), which oversees accounting standards in our country, to review MTM as part of the Targeted Asset Repurchase Program (“TARP”). FASB has given a relatively weak response but did state that the price of “disorderly” trades is NOT “determinative” when measuring fair value. However, public accounting firms are too fearful to adhere even to the clarification made by the FASB. After the events surrounding Arthur Andersen and Enron, no public accounting firm will take any position that doesn’t apply the absolute worst case scenario possible when assessing value. The FASB needs to go much further in its language to give relief to both the public accounting firms and the banks they serve by eliminating MTM and returning us to the pre-Sarbanes-Oxley “mark-to-maturity” method. An inherent problem with MTM is that it presumes that non-owners of bonds are an efficient market, which they are not. Speculators are not the best arbiters of intrinsic value. This has been recognized by Federal Reserve Chairman Ben Bernanke and FDIC Chairwoman Sheila Bair. They are both proponents of our government buying-in or insuring bonds (that have been subject to MTM accounting) at prices that ignore MTM and better reflect “fair value”. Chairman Bernanke has testified before the Congress on this topic by using the term “mark-to-maturity”. In recognition of the flaws in MTM, the Fed recently insured both Citigroup and Bank of America bonds subject to this flawed accounting. The Fed also bought bonds from Bear Stearns in it’s liquidation at values materially above their MTM “marks.” Recent reports on those assets from its servicer (Blackrock) suggest those bonds continue to materially outperform the mark-downs in terms of cash flow performance. Thus, “mark-to-maturity” is proving far more accurate than MTM. If the two primary banking regulators – Fed and FDIC see flaws in MTM, then why don’t the rest of us? A recent study by the Bank for International Settlements (BIS) on the value of mortgage-backed securities under MTM found loss assumptions to be as much as 60% off relative to realistic cash flow losses. The measure of “MTM” for mortgage-backed securities

now centers on a series of obscure synthetic derivative indices collectively referred to as the ABX indices. As the BIS observed, “the so-called ABX index family has served as a widely followed barometer of the collapsing valuations in the US subprime mortgage market, which has been at the core of observed credit market developments”. The BIS further concluded -“importantly, the combined ABX indices capture only a part of the underlying universe of sub prime mortgages.” Specifically, the BIS found that the ABX indices represented only $31 billion in mortgages out of $1.5 trillion in total subprime mortgages outstanding and roughly $10 trillion in total mortgages outstanding or a mere 2% of subprimes and 0.03% of all mortgages outstanding in the US. This hardly is a statistically significant sample, yet it is this series of obscure indices that has been integral in this credit crisis. Their only legitimacy is that accountants have adopted them to meet the standards of a new accounting standard – MTM as an “observable input.” Astonishingly, it is this statistically insignificant sample size of subprime mortgages upon which the entire US financial system is being indirectly valued. As an example, Citigroup e.g. now has written off more than $50 billion worth of mortgage-related securities based upon MTM. Citi now carries all subprime related mortgage securities at as low as 7c to $1 of original par; Alt-A at 28c; and commercial mortgage related securities at 60c. These carrying values are ludicrous. The 7c figure presumes an absurd outcome where 100% of every mortgage in those portfolios defaults and the loss on the home is 93%. On Alt-A mortgages, the MTM “marks” against Citi’s book value presumes 100% of those mortgages defaults and the loss on the underlying house is 72%. Again, these are absurd outcomes as the BIS study and our own prior research has concluded. There is no question MTM is deeply flawed. The synthetic indices used to meet the new MTM standard also are not cash markets as we have noted in the past. They are derivative markets no different than say – commodity futures. We now all realize that when crude oil reached $147 a barrel last summer (recently as low as $31), that speculators controlled more oil than OPEC. This is due to leverage. Oil speculators can invest in future oil price movements for as little as 5% capital down or lever their bet by 20 fold. This enabled speculators to materially overwhelm natural supply and demand for crude oil and create highly distorted prices. We recognized this distortion and shorted oil and oil related stocks last summer. Currently, there is a similar and obvious distortion in the pricing of derivatives related to speculators gambling on the direction of credit and this is what has led to banks having written down mortgage related securities to preposterous outcomes such as 100% foreclosure rates and 93% home value declines. This is evidence of the flaw in MTM and why we refer to it as… “mark-to-zero”. The accounting itself creates what psychologists would call a “negative feedback loop”. The more the indices fall in value… the more speculators wish to chase the “short.” This results in a spill over into other asset classes like prime mortgages and commercial mortgages out of greed. This is not unlike the effect that crude oil speculation had in pricing up all sorts of other commodities like gold e.g.

Again, this is not unlike the Internet bubble. If you missed Yahoo!, then you chased some other Internet stock and the process became self fulfilling and attracted more enthusiasm in a “positive feedback loop.” This “negative feedback loop” in financial assets and bank stocks can and will be stopped. The upside in banking and financial related stocks is unimaginable now when this becomes clearer to investors. The Fund, while showcasing increased volatility in recent quarters, is in position to take advantage of this incredible upside potential in the financial services sector of the stock market. TARP has turned out to be a “liquidity trap” as the money is not getting out into the economy. The government blames the banks for hoarding cash or opportunistically investing the cash in other banks, when of course it isn’t the banker’s fault. It’s the government’s fault for not fully recognizing and addressing the problems with MTM. We believe the second half of TARP in conjunction with he Bernanke/Bair Plan will untie this knot. The Capital Controversy As MTM has selectively devastated bank capital levels (on mostly non cash write-downs), investors have turned their attention to capital adequacy at banks. This too has become a mania. Few investors are experienced at understanding regulatory bank capital standards; how these standards are applied and how one should evaluate capital strength. Bank examiners have universally used what is referred to as risk-based capital (RBC) analysis when determining a bank's "capital adequacy". In recent years, this standard was agreed upon by all US and American bank regulators under BASEL II and has been used by all US regulators since the last crisis in the late 1980's. RBC is a RAAP (Regulatory Accounting Principles) procedure which assesses the risk of every asset class held by the bank and assigns a minimum capital allocation to each asset class based-upon empirical risk. RBC analysis requires a bank to carry a certain % of capital against each risk weighting accordingly. This is a very thorough and carefully detailed analysis; as opposed to GAAP which is limited in its approach and detail. What is important to note is that “intangible assets” are included and appropriately discounted in the RBC capital ratios while GAAP accounting (which focuses on Tangible Common Equity) deducts these from its capital ratios. So, what is an "intangible asset" at a bank? It's a deposit franchise! Banking industry “intangible assets” are deposits premiums. These deposits are valuable assets because one can turn them into money by investing them in loans and/or bonds. The stickier or more "core" the deposits, the more valuable they are. GAAP accounting is dated on this topic and it reflects items like intellectual property as an intangible. For example, if you paid a

Tier 1 Capital consists of common shareholders’ equity, qualifying preferred stock (including the cumulative preferred stock issued by Group Inc. to the U.S. Department of the Treasury’s (U.S. Treasury) TARP Capital Purchase Program and our junior subordinated debt issued to trusts, less deductions for goodwill, disallowed intangible assets and other items. Source: Federal Reserve

premium for Walt Disney because Mickey Mouse cartoons generate cash flow forever; then any price you pay over book value is considered "intangible.” This doesn't mean Mickey Mouse isn't valuable beyond book value does it? Of course not… It is for this reason that most industries do not use book value to value themselves (they use cash flow) and no other industry discounts "goodwill" as being worthless either. In fact, banking industry goodwill which is considered “intangible” is more tangible than most industrial firm's tangible assets like plant, equipment etc. There is no such thing as “intangible capital.” Only assets can be labeled “intangible” under GAAP. As we have pointed out, GAAP ignores many assets (and in the case of banks – deposit liabilities) that generate cash flow and labels them as “intangible.” Currently, our markets and the pundits that comment on those markets are transfixed on tangible common equity (TCE). Tangible common equity is common equity minus any intangibles or goodwill. Why would TCE be so popular of late? It’s popular for the same reason Internet stocks once traded on eyeballs and page views. This too is a mania. The market seeks out a justification for a trend. This is the new valuation tool that befits the times and sentiment of the market. TCE is the ultimate lowest level of possible valuation for a bank and thus is very popular among a market that only sees financial stocks in decline. This is the “negative feedback loop” that we alluded to earlier. It’s a herd mentality. This is the same herd that was chasing oil and cement and taking everything that the Chinese government says as being factual. All bubbles. Bubbles come with absurd valuation "techniques" and TCE is the current justification for shorting high quality banks and valuing them materially below their economic value. If the Federal Reserve and the Treasury were believers in the validity of valuing banks relative to TCE… then why did they design TARP capital to meet the strongest RBC class of capital? There is a reason banks are measured under RAAP and not GAAP by regulators. The perception of what it means to take TARP was the concern. As a result, the Fed and the Treasury asked superior banks like Wells Fargo and JP Morgan to accept TARP dollars and remove any potential stigma. The current obsession is with whether or not assets are “toxic”….this too is a mania. I would define toxic NOT by an assets’ liquidity, but by that assets’ viability. The media is defining our economy for us and they are fueling this downturn via a series of misconceptions. Boiling It Down Valuations are amazing…banks are flush with capital! Right now our country’s banks have record Tier 1 RBC. This is a point that Western Reserve has been making in futility for months. The banking industry has more capital and liquidity than at any other time in history… We are seeing some of the most manic distortions of valuation in market history. Currently, Exxon’s market cap now exceeds that of the 50 largest banks. We are wondering why Exxon doesn’t immediately tender a stock swap for all fifty of them before folks figure this out. One oil company equals the fifty largest banks? We are in a valuation mania that is no different than the Internet bubble. These are ridiculous times.

As I have written in the past; valuation methods shift with psychology and not economics. The current obsession with tangible common equity as the primary way one values a bank, of course, makes as much sense as valuing an Internet company based on its number of page views. The measure itself says nothing whatsoever about the profitability or risk of the company. Evidently, valuation methods are like fashion…they change with the seasons. As a former Wall Street bank analyst, I’m aghast at the lack of consistency from period to period. Right now, TCE is ultra popular as the consensus base for valuation and this has caused the average bank stock to fall 80% in this bear market. Why? Based on earnings in normal economic climates, a 12x P/E translates into >3x market cap to TCE. So, banks all trade now at low to mid single digit P/E’s on economic recovery earnings power. In the eventual recovery, guess what valuation tool these inexperienced analysts will use to value bank stocks? You guessed it…P/E!

Opportunity in Financial StocksOpportunity in Financial Stocks

Financial Stocks at historic low valuationsFinancial Stocks at historic low valuationsand very low Nonand very low Non--Performing Assets levelsPerforming Assets levels

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The U.S. domestic regional banking index has reached a Great Depression low of 0.5x book value this winter. The chart (See above) graphs the banking sector’s price-to-tangible book ratio (line graph) as well as the non-performing assets (bar graph) in money center banking institutions. This data illustrates that current valuations (price to tangible book ratio) are below the previous level they reached at the trough of the crisis in 1990 (S&L Crisis). However, the fundamental metrics of banking institutions are better today than they were then (as most of the “problem” assets are captured by MTM now as opposed to cash flow or impairment-based accounting). As the chart illustrates, non-performing assets (meaning assets which are not cash flowing) are a fraction of where

they were during the last banking crisis. Today, actual problem loans are approximately one-third or less of the level reached during the 1990 crisis; while capital ratios are approximately three times higher than in 1990. Deep value investors would be wise to take this very seriously. As the valuations illustrated in the price-to-tangible book ratio chart speak volumes, they are only part of the larger picture. What ultimately makes for such a compelling opportunity in financial stocks is the nature of and speed with which their earnings power returns. We look at the current environment in very much the same way Warren Buffett viewed the market in 1990. The following is a brief excerpt from the Berkshire Hathaway 1990 year end investor letter… “Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month by month the foolish loan decisions of mismanaged banks were put on public display. As one huge loss after another was unveiled - often on the heels of managerial assurances that all was well - investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased our 10% interest in Wells Fargo for $290 million, less than five times after-tax earnings, and less than three times pre-tax earnings into an eventual recovery.” Source: Berkshire Hathaway- 1990 Investor Letter The valuations that Buffett recognized and took advantage of in 1990 via purchasing Wells Fargo; are very similar to the opportunities that we are seeing today in JP Morgan (JPM) and Capital One (COF). As former bank regulators, we methodically analyze banks under strict regulatory accounting practices (we ignore GAAP as it is flawed on many levels) and evaluate the safety and soundness of banks based on the classic bank examiner’s CAMEL rating methodology. CAMEL being an acronym for Capital Adequacy, Asset Quality, Management Strength, Earnings Power and Liquidity. Each of these factors are critical in determining which banks are in position to not only survive this onslaught, but also in position to gain tremendous market share in a recovery. CAMEL is best illustrated by example: JP Morgan (JPM) Capital Adequacy

• Tier 1 RBC 11% is >200% of the regulatory minimum for “well capitalized” • Total RBC 15% is off the regulatory chart strong • Total RBC plus Loss Reserve 18% is off the regulatory chart strong • Tangible Common Equity is >250% above the old 1.5% minimum regulatory standard

Asset Quality

• Nonperforming Assets are a low 0.6% of total assets • Nonperforming loans are well below industry average at 1% • Loan loss reserve is 3% or well in excess (> 250%) of nonperforming loans

Management

• Jamie Dimon and team are considered among the best in the industry and the Federal Reserve has referred to JPM as the “second Fed”. Federal Reserve’s #1 “go to” bank. The government chose JPM to aid in the liquidation of Bear Stearns and the take-over or clean-up of Washington Mutual, a huge vote of confidence in management.

Earnings

• JPM’s core cash earnings were quite positive in 4Q excluding excess reserve build • The “look through” earnings power is >$3.50 EPS and we believe WaMu accretion

exceeds $1 EPS • So, JPM is trading at roughly 5x recovery EPS

Liquidity

• Loans-to-Deposits at roughly 70% indicate unheard of liquidity to manage any deposit withdrawals and/or accelerate loan growth as economic conditions improve

• Current assets less current liabilities is an amazing $1 trillion or 10x the stock’s market value and 40x the TARP monies they were asked to take

• Cash and equivalents less total debt is $556 billion or nearly 6x the stock’s market value and 22x the TARP they were asked to take

Conclusion – JPM is an extremely valuable franchise trading at panic level valuations. The balance sheet is extraordinarily liquid, capital levels extremely high and asset quality well contained if not remarkably strong relative the economic environment. The stock is priced at 50% of book value; 5x “look through” earnings power and the bank has no less than 6x net cash to market value. This is the bargain of a lifetime. Capital One Financial (COF) Capital Adequacy

• Tier 1 RBC 14% is almost 300% of the regulatory minimum for “well capitalized” • Total RBC 17% is well off the regulatory chart strong • Total RBC plus Loss Reserve 21% is well off the regulatory chart strong • Tangible Common Equity is >500% above the old 1.5% minimum regulatory standard

Asset Quality

• Nonperforming Assets are a low 0.6% of total assets • Nonperforming loans are well below industry average at 1%

• Loan loss reserve is 4.5% or well in excess (> 450%) of nonperforming loans Management

• Rich Fairbank and team are considered consumer finance stalwarts and were instrumental in forever altering the credit card industry, which now is controlled by an oligopoly of only the strongest underwriters. Their current credit statistics are the lowest in the industry despite these troubled times. The government turned to COF’s management to help them deal with troubled Chevy Chase Bank, a huge vote of confidence from the regulators.

Earnings

• COF’s core cash earnings were positive in 4Q despite a massive excess reserve build • The “look through” earnings power is >$7+ EPS and we believe Chevy Case will be

accretive in the years to come while further shoring-up deposit funding strength • So, COF is trading at roughly 2x recovery EPS

Liquidity

• Loans-to-Deposits at roughly 90% indicate strong liquidity to manage any deposit withdrawals and/or accelerate loan growth as economic conditions improve

• Current assets less current liabilities is $38 billion or 6x the stock’s market value and 10x the TARP monies they were asked to take RE: Chevy Chase

• Cash and equivalents less total debt is $15 billion or 3x the stock’s market value and 5x the TARP they took-down

Conclusion – COF is an irreplaceable consumer credit franchise trading at panic level valuations. The balance sheet is highly liquid, capital levels incredibly high and asset quality far stronger than its peers. The stock is priced at 25% of book value; 2x “look through” earnings power and the bank has no less than 3x net cash to market value. This too is the bargain of a lifetime. As we wrote last year, the financials rallied nearly 900% off the 1990 trough by 1998. I see a 1,000% run over the next decade from these excessively depressed valuations. Downturns like euphoric bubbles always are one part truth and at least two parts hyperbole. Ultimately, the reversion to the mean (the truth) is two-thirds psychological.

Financials soar 900% from last banking crisisFinancials soar 900% from last banking crisis

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This change in psychology often appears at the least expected moment and usually is reflected in stock prices moving well ahead of fundamentals. This is precisely what occurred in financial stocks in 1990. Problem loans hadn’t peaked until 1993 and the Resolution Trust Corporation didn’t close down until mid 1995; yet banking stocks began their rally in October 1990. If investors had waited for the 1993 non-performing loan peak or the closure of the RTC in 1995 to buy bank stocks; the investor would have missed a 200% and 300% return respectively. The “negative feedback loop” paralyzes the vast majority of investors, as a result most buy high and sell low….Not us. We see many correlations between 1990 and the present. The RTC was formed in 1989 much as TARP was enacted in 2008…. And Warren….he has been buying stocks again just as he did in 1990. It looks like he is about 90 days early so far and averaging-in…

Regards,

Michael P. Durante Managing Partner

September 25, 2008

Response to the Treasury or “Paulson” Plan

Partners, The Fund is experiencing a double digit profit in September as of the President’s

speech last night. Extreme volatility is to our favor given our deep discount valuation bias, our focus on quality, and our deep experience in the financial sector which is a key component in our strategy. Like most fund managers, we have been fielding many phone calls over the past two weeks and now that we have some “meat on the bone” behind the combined Treasury and Federal Reserve actions to stem the country’s liquidity crisis; a more formal response relative to the Fund is appropriate.

For over a year, we have been calling for the banking and capital markets

regulators and the Congress to address mark-to-market accounting (“MTM”) inefficiencies. This has now been forced upon them by an eruption and disruption to our credit markets not seen since the Great Depression. We were gratified that even a few congressmen and woman, who clearly don’t have much understanding of MTM, started asking questions about it this week. Finally!

Accounting didn’t get our country in this jam. Some ridiculously lax

underwriting standards in the residential mortgage arena did. However, the “real” credit problems facing our country’s banking and financial system are pale in comparison by many multiples to the exacerbation caused by MTM. Refer to our mid-year client letter from July to review. The average federally insured bank has only 0.7% in seriously troubled bank loans. That is hardly a substantial systemic credit crisis. In fact, it’s about one-third of the last crisis that peaked in 1990 when I was a young bank examiner with the Federal Reserve. MTM makes it appear to be about five times this size. So, let’s bring-in the bean counters…

As the mortgage crisis has passed peak already (not over, just passed its peak), it’s

dispiriting that the crisis now is liquidity and the sole culprit MTM. Many Americans now can’t get a car loan or a small business loan or any type of credit and this, of course, has absolutely nothing to do with sub prime mortgages. The mortgage debacle was and still remains relatively focused and manageable on a “cash” accounting basis save a few institutions that went over the top like Washington Mutual e.g. whose fate is and should be uncertain. But what of the rest of the financial system? MTM has crippled our entire

credit system now and this is what the Treasury Plan (“Plan”) put forward by the now reluctant TV stars Hank Paulson and Ben Bernanke attacks. We might have used the word “addressed”, but we are at war. Warren Buffett called this a “financial Pearl Harbor”. The Plan is an attack. A counter-attack against MTM.

Pundits across Wall Street, TV and popular print media keep referring to the Plan

as a “bail-out”. They are missing this by a country mile. Federal Reserve Chairman Bernanke first questioned MTM as a credible accounting of “fair value” during the Bear Stearns’ asset sale to JP Morgan last spring when he hired bond manager Blackrock to value Bear’s assets. What Bernanke was saying (and few were listening as we were) was that the Fed’s de facto purchase of Bear’s assets was going to be based upon intrinsic value (discounted cash flows) and not GAAP’s MTM. He even mentioned this specifically a few days later in a speech before the Richmond (Va) Economics Club to no “catch-on” by the media.

The Plan is a broader version of the Bear Stearns structured asset purchase. It was

never a “bail-out”. If it was a “bail-out” then who paid up? Bear’s stockholders? JP Morgan? No. The Fed paid “fair value” for assets, if held through the crisis of confidence will pay-out at rates considerably better than the accounting mark-downs implied. It was a discount asset acquisition and we immediately bought shares in JP Morgan that day in your Fund. The market missed the point and we were able to buy more JP Morgan again throughout June and July at even more favorable prices (some below book value) and we thank all those who sold bank stocks ubiquitously in the panic this past summer.

Bernanke used the term “mark-to-maturity” in his prepared speech before the

Senate Banking Committee this week. It appeared by the Q&A that not a single senator seemed to have a clue as to what he was talking about (we may need a new Senate Banking Committee). The Plan is NOT a “bail-out”. It’s the government stepping-up to “make a market”. There is no market on Wall Street because of MTM tortuosity now and what the economy needs is a “market maker”. And market makers (those who step-up with capital in crisis) usually make reams of money if history is a guide.

It’s no surprise to us that more and more financiers agree as we do with Hank

Paulson that the government is very likely to make a ton of money off of Fannie Mae, Freddie Mac, AIG and now the Plan. Does any of that sound like a “bail-out”? Even the President, in his folksy language, made mention in his speech last night that the government now appears to be the only institution which possesses the “patience” to buy mortgage-based assets, which as he put it are severely under valued. MTM is the new “buzzword” suddenly. And only those who are short financial stocks en mass think it’s accurate. Well, there are few academics that think so too, but they invented MTM in a cubicle somewhere far removed from the real world.

A recent Goldman Sachs survey of the largest hedge funds suggests that the only

sector that most funds are net short are financials; and it’s substantial…almost 25% net short. We estimate hedge funds eventually will have to “cover” as much as $1

trillion in financial stock shorts just to get back to neutral on the sector. This is all to our benefit; and imagine if some start to go net long!

Bernanke said it about as plainly as a Fed Chairman could. Most of the nation’s

banks are reporting materially under valued balance sheets. We know all too well what Ben is talking about. We are long several small cap financial names in the Fund that have negative book values under GAAP MTM, yet have experienced no credit deterioration and no cash flow impairment. We’d like an explanation of what “negative book value” means by a rational accountant. MTM robs us all of patience because it distorts values. These longs we mention have as much as 50% of their stock borrowed short by folks that we must presume believe GAAP is accurate.

The Plan is about two things – making a market that has rational pricing

intentions and (as the President said) “patience”. This crisis is self solving if we can inject a little patience.

The Plan, in effect, should rid us of the shackles of MTM and option-like market

“marks” driven by gamblers in the ultra thin ABX, CMBX and CDS markets (which aren’t actually markets as they are pure OTC and unregulated). As stated before, we take no issue in these highly levered “option-like” derivatives. Advanced capitalism should offer many ways to skin a cat with varying degrees of risk-to-reward. However, accounting is not an “art” as one public audit firm recently opined in a white paper regarding FAS 157 et al or MTM. It’s a science. Accountants are awarded degrees that are science degrees…not arts degrees. “Fair value” has never been a spot-in-time empirical. It should never be tied to these highly speculative and most apt to display distortion pricing instruments. They should never have been tied to MTM by the audit community searching desperately for an “observable input” under Level II FAS 157, which is the root cause of the liquidity crisis. A new, unbiased market-maker will now be able to set rational prices (barring a highly unlikely congressional blow-up). Ben Bernanke understands “fair value”. It’s dreadful that he has to show us what it means by force.

In the Fund, we were aggressive buyers of numerous financial stocks in the

desperate days in late June and early July. Without getting into a lot of detail, we were looking for “safety and soundness” factors in our selections relating on both qualitative and opportunistic levels.

One, we required that they have adequate capital and reserves or “primary

capital” well in excess of potential problem assets in order to ride out both the “real” credit crisis (fair market or intrinsic value) and the surreal MTM storm. This didn’t mean we excluded financial firms with obvious credit issues at hand, but they needed to have already aggressively addressed those issues with hefty “haircuts”, new equity capital injections and substantial reserve builds. Others we purchased had no material credit rift whatsoever and were just thrown out with the bathwater.

Two, we required that they have excess liquidity to survive the “bear raid” risk from short sellers, CDS cowboys and the now reactive rating agencies (a day late and several dollars short). These investments could not have short term debt in excess of short term cash and near cash assets or de rigueur a strong “quick ratio” for old schoolers (like us). They had to be fundamentally bullet-proof against the most egregious non fundamental attack on the US financial system ever devised by accountants, lawmakers and speculators en mass. We are at war with 99% of all hedge funds! We had to adapt to their game and best it. The opportunity set was too great not to. The excessive level of short interest was fuel. The valuations were as we stated in July – “Buy-in of a Lifetime”.

Three, they had to have a clear path back to strong profitability and future growth.

And fourth, who benefits from the shake-up? Timely investments in Wells Fargo, JP Morgan and numerous small regional banks come to mind. As of now, the Fund has completed a major move into undervalued small cap banks aggressively over the past two months.

In reference to the third requirement, it is of note that we suspect many investors

don’t understand bank accounting thoroughly. Curiously, business schools teach widget maker or manufacturing firm accounting and not financial firm accounting in their case studies. Given that much of America is driven by services, especially financial services and no longer manufacturing, we have no idea why the B-schools are so far behind the times. This is good for us we suspect.

It is of fact that 93% of federally insured bank profits in the second quarter were

masked by loan loss provisions. A loan loss provision is a non cash accounting entry that merely moves what otherwise would be retained earnings on the balance sheet over into a contra asset account. Provisions are not to be ignored by any stretch, but they are not a representation of earnings power of a bank or finance company as they, in essence, merely restate prior periods of over statement of earnings power. We realize this concept is difficult for many to swallow. However, when the provisions are spiking, one must begin to discount their impact on future earnings. The provision is less of an earnings issue than it is a capital adequacy issue. For example, a bank that we deemed to be taking aggressive action to resolve current credit losses by adequately retaining or acquiring strong primary capital has a clear path to a quick recovery in profitability and growth again. Capital One Financial, which the Fund loaded long in the $30’s in June and July is an example. Cap One is a common short seller target. Historically, Capital One is a widow maker for shorts because those shorts constantly under estimate the snap-back earnings power of the company. Its shares have risen as much as 50% since the summer panic. We paid 50% of book value for Cap One and less than 5x earnings power. The Fund recently unloaded some near $60 when it was added to the no short list and we would like another shot at her lower.

In general, we like what we are seeing in credit and banking. Early-stage

delinquencies are declining; credit migration is improving; foreclosed asset sales are accelerating; provisioning has been aggressive; and liquidity has greatly improved in the

sector through de-leveraging. All that really remains for the majority of financial firm investments is solving the MTM/”bear raid” trade. We have hedged the “bear raid” trade fundamentally through our four-pronged acid test described earlier. Now, we are on to psychology and that’s where we believe the Plan at the margin helps.

When the dust settles, we doubt many financial firms will take the government up

on their not so little distressed asset hedge fund ambitions. All this wrangling in Washington over minutia in the Plan to become a Bill is far less necessary than believed, acted out and grandstanded over. So, do not be surprised if only the few remaining very troubled institutions are likely to participate and they are not important to us anyway. Your Fund is chock full of well capitalized, highly liquid and quick to recover profitability financials. None of them should have the need nor the desire to sell assets to Uncle Sam based upon our careful assessment. None of your holdings have an interest in giving away stock warrants to the vulture firm of Dodd, Pelosi and Frank LLC. Or become a conservatorship…whatever that is. The Plan will get done. The Bill will become law. And it incrementally gets us closer to an end of all of this because it creates a market maker. How much actually trades there is less important.

Many fund managers have aggressively been betting against America the past few

years and with some success. However, “shorting” America is a losing strategy over time and the level of short interest still gambling on the country’s demise is living on borrowed accounting. If one can dodge the “bear raid” trade and take advantage of the insane discounts, the opportunities have never been better.

Regards,

Michael P. Durante Managing Partner

July 25, 2008 “Buy-in” of a Lifetime

In the seventies, oil trader Boone Pickens mused he could buy oil production

cheaper on Wall Street than he could buy oil wells. This is not unlike the amazing “arbitrage” opportunities of any emotionally charged market. Today, one can buy the core of America (mortgages and financial stocks) cheaper on Wall Street than on Main Street. This is a fact. In large part, new accounting rules and massive momentum shorting in housing related and financial firm investments has created a gulf between the write-downs, slam-downs and reality. The ability to buy well managed financials on Wall Street at ridiculous discounts to Main Street exists and, in our estimation, is a once in a lifetime opportunity.

A Flawed Premise

The New York Times, whose writers have struggled in the past to deduce fact from

fiction, gets kudos for breaking their trend and getting it half right in a recent article entitled “Are the Bean Counters to Blame? (Article attached for your review). The article referenced some of the problems with accounting rule FAS 157 (FAS 133 for credit insurance derivatives) and how this rule is amplifying and thus distorting the losses and write-offs in financial assets like residential and commercial mortgages and, therefore, financial stocks. The crux of the issue does not lie in FAS 157 itself. Yes, this accounting treatment is flawed. But it’s the application of this new accounting treatment by the accounting profession that is well off the mark and the crux of the problem.

The FASB (Financial Accounting Services Board) devised rule 157 (and rule 133)

in an effort to prevent future frauds like Enron. They created a new set of accounting standards that require “mark to market” accounting of private placement investments to a liquid secondary market. This “liquid secondary market” does not exist and thus is the inherent flaw in their logic and methodology. Nevertheless, the accounting profession began to explore how companies could “meet” the requirements of 157/133 just as the sub-prime mortgage crisis erupted last year. For lack of a “real” secondary market, auditors imprudently began “marking” financial assets to newly created 2006 credit insurance indexes. These indexes were NOT designed for the accurate and efficient “marking” of cash assets. They were created as an “option” market for speculators who pressed Wall Street firms for ways to “play” the obvious direction of the U.S. housing market. These indexes were designed to perform just like option markets and therefore are highly volatile and intentionally exacerbate the magnitude of underlying cash market

securities through excessive leverage. What all of this amounts to…. is an unintended distortion of credit and loss. This distortion has produced a tsunami of non cash write-downs of perfectly performing credits that are held by very solvent financial firms and within very solvent credit structures such as CDO’s. This is likely to result in tens of billions of dollars of write-ups of performing securities in the future across Wall Street. The application of these new FAS standards against non cash markets overstates the nation’s credit crisis by as much as five fold. This has resulted in financial stock and financial asset valuations that are at eighty-year lows. We think these valuations are absolutely remarkable and yes… a once in a lifetime opportunity.

The Data Distilled

The two most well known of the credit insurance (option) indexes are the ABX-HE (securitized sub prime home equity loans) and the CMBX (commercial mortgage-backed securities). The ABX-HE indexes price-in catastrophic loss assumptions that we believe are an utter and complete exaggeration. Even a firm (which we do not own) as disadvantaged as a Washington Mutual e.g. (due to the types of mortgages and locales) will see cumulative losses of less than one-half to one-third the losses implied by the ABX-HE mark downs. To date, the financial services community (banks, brokers and insurers) have taken approximately $500 billion of write-offs (under FAS 157/133 marked to the ABX-HE) against domestic residential mortgages and related securities. This is 5% of the value of all domestic mortgages ($10 trillion), an impossible outcome. To put 5% into perspective and assuming a dramatically inflated 30% decline in home prices nationwide coupled with an equally pessimistic 10% equity in mortgages foreclosed upon; $500 billion in absolute losses implies that $2.5 trillion of mortgages will go into default. This would equate to one in every four American homes [$500 billion/20% = $2.5 trillion]. There is no conceivable way one in four Americans are about to lose their home in foreclosure. Some pundits even use a $1 trillion dollar write-off figure which would equate to one in two Americans losing their homes.

The actual performance of the ABX-HE collateral versus the option market pricing of the individual series says it all.

Implied Cumulative

Losses per Index Actual to-date

Losses Our Estimate for

Cumulative Losses ABX-HE 06-01 22% 2% 8% ABX-HE 06-02 29% 3% 9% ABX-HE 07-01 41% 1% 10% ABX-HE 07-02 45% 1% 12%

More telling than the statistics above is that over half the original principal

balances of the two 2006 series collateral has paid-off (refinanced) or been charged-off already. So, how can the losses leap to 29% e.g. in the 2006-2 series if we are at only 3% to-date with only 14% in non-accrual and >50% paid-off already? Answer: it can’t. Even if one assumes no abatement in new delinquencies and 100% loss on the 14%

remaining in non-accrual. Eighty percent of the mortgages remaining would have to default in order to reach the losses that the index implies.

(Note: delinquencies are falling-off… see Chart below) Put simply, the speculators driving these dynamics are not doing the math;

they merely have “jumped” on a trade too aggressively and have distorted prices relative to reality i.e. a “bubble”.

Source: Western Reserve; Issuer ‘trust reports’ As the chart above illustrates, the “roll rates” for new early-stage delinquencies

peaked last winter. What fundamentally has taken place in the ABX-HE collateral pools is that the peak delinquencies experienced late last year essentially “flushed” out the speculative players in the housing market. What remains are the lower risk of default owner-occupied borrowers (people who actually live in the home and will fight hard not to lose it). Declining early-stage delinquency, significant pay-downs, pay-offs and refinancings all coupled with speculators getting flushed out spells a peak in mortgage losses and at a level materially below the current mark-downs by several fold.

A significant distortion is also taking place in the commercial mortgage-linked

CMBX index. The two worst post Depression commercial mortgage vintages are 1974 and 1986. Cumulative losses on the 1974 commercial real estate credits were 7% and on the 1986 vintage (the worst that anyone still alive has ever experienced) were 9%. The current CMBX pricing suggests losses on 2005-2006 commercial mortgages to top 15%. This index projection is a complete disconnect from reality. The underlying collateral of the CMBX has non-accruals of LESS than 50bp thus far. To extrapolate a 15% loss from <50bp of non-accruals is not an index that is linked in any way to reality. Massive write-ups are inevitable…

As an example, Citigroup, which the Fund has recently acquired at prices ranging

from $15.30 to $16.20 has taken nearly $30 billion in write-offs, most of which relate to residential mortgages. Citigroup’s whole loan portfolio of sub prime mortgages has to-date 8.5% non-accruals. When these same loans are securitized and held by Citi as

ABX 06-1 Subprime Mortgage Index Loans 31 to 60 Days Delinquent as a Percentage of the Trusts' Start-Of-Month Balance

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“securities” like RMBS and CDO’s of RMBS; they are priced reflecting 20% to 40% losses (per ABX-HE “marks”). This highlights the massive distortion taking place when applying FAS 157 to an “options” market and not to realistic stress-tested discounted cash flows. Citigroup trades well below book value; the significance of which is greatly understated by the accounting distortions of the ABX “marks”. Without a doubt, this distortion of true valuation via these new accounting rules has created an unparreled opportunity in financial stocks. This is especially true in smaller capitalization financials where we have a deep and extensive expertise. Most of our long capital is invested in small cap financials which are experiencing record low valuations, record high short interest and excessive and illegal naked shorting. We suspect this combination of variables has positioned our portfolio very favorably.

SO, HOW DOES TODAY’S CREDIT CRISIS COMPARE WITH THE

ONE I EXPERIENCED AS A REGULATOR ON THE FEDERAL RESERVE’S STAFF IN 1990-1992?

ANSWER: IT’S NOT EVEN CLOSE!

Today, our banking industry’s average non-performing loans plus foreclosed

upon property (OREO) known as nonperforming assets or NPA’s is about 60 basis points or one-fifth where NPA’s stood in 1990. Conversely, today’s risk-weighted capital ratios are at three-times the 1990 level. So, this crisis is more of a liquidity (panic) crisis than a really deep credit crisis. IndyMac Bank which our fund has never owned failed last week. What I found interesting (and Senator Schumer may find expensive in the form of potential lawsuits) is that IndyMac is the first U.S. bank to fail with an NPA ratio less than 50% of capital. To make the FDIC’s watch list, an institution must have an NPA ratio (pre-risk weighted) approaching 100% of capital. IndyMac was taken over by regulators at less than half the FDIC’s “watch list” criteria. According to IndyMac’s primary regulator, it failed without being on the watch list because of the comments made by the NY senator. There are ninety banks on the FDIC’s “watch list” today. When comparing the ninety banks on the watch list for potential failure today to the 500+ banks that were on the same list under the same definition in 1994… one must ask oneself….what the hell are we doing to our financial system in this country? Only 1% of the banks on the FDIC’s watch list in 1994 actually failed.

The Opportunity Where are valuations? The regional banking index reached a post Depression low

of 0.6x book value early last week before a wicked short covering rally ensued. The accompanying chart is the banking sector’s price-to-tangible book ratio. This too suggests valuations are at or below the crisis that troughed in 1990. As previously mentioned, problem loans are one-fifth and capital ratios are three times where they were in 1990. Deep value investors would be wise to take this very seriously.

Price-to-Tangible Book Ratio (Financial Sector)

050

100150200250300350400450500

12/2

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89

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90

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91

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9/19

92

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93

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94

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95

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96

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Source: Stifel Nicolaus

This is the “buy-in” of a lifetime. The nation’s credit issues are NOT this severe. Only narrow slices are severe and the Draconian and ubiquitous misapplication of new accounting standards has caused a baseless distortion of the credit picture of many of the nation’s financial institutions. We have been duped into believing the solvency of our financial system is truly at the brink of destruction when the math gets you nowhere even close. Who is to blame? The bean counters who messed-up the accounting? The speculators who have over shorted (some illegally) the financials? Wall Street which created the ABX/CMBX out of greed? The political opportunists in Washington? WHO CARES? I don’t…It’s a gift!

The fund is flat year-to-date as of this writing and we continue to buy into

weakness amid the greatest panic in American financial stock history. The financials rallied over 800% off the 1990 trough by 1998. I see a 1,000% run over the next decade off these lows. The heightened level of short interest alone that we see in financial stocks is a powder keg for a rocket ship ride north like we have never seen before. Investors should care less who caused it or why. They also should care less about near term price volatility. They should simply want to get involved in this sector. The rewards are ten times the risk… and that risk can be mitigated easily by avoiding the financials truly at risk to a liquidity panic.

Regards,

Michael P. Durante Managing Partner