2010 Spring Review May 28, 2010

Extraordinary Popular Delusions & the Madness of Crowds

- Charles Mackay circa 1841

Western Reserve Master Fund (the Fund) rose 22.3% gross and 18.2% net in the first quarter of 2010 compared with the S&P 500’s 5.5% advance and our closer comparables – our passive services industry composite up 11.36% and our financial services composite up 14.3%. As of the end of April, the fund has delivered YTD a cumulative gross return of 40.1%.

(A year by year performance summary since inception is found at the end of this letter)

Extraordinary Popular Delusions & the Madness of Crowds is a book written about popular folly by the renowned Scottish writer and journalist Charles Mackay. The text was first published in 1841 and it chronicles abstract responses by humans under either intense despair and/or intense euphoria. The subjects of Mackay's debunking include economic bubbles, alchemy, crusades, witch-hunts, prophecies and fortune-telling, as well as trivial subjects such as the shape of hair or beards of the day. Purportedly, these factors influenced politics and even religion “in the day” (apparently any day in any century for that matter from our vantage point). The current President of The Federal Reserve Bank of Dallas’ Richard Fisher lauded the text as a modern day reminder of all things empirically unpredictable, erstwhile inexplicable and politically expedient by men of sound judgment and good intentions (and others neither too sound nor good). So, thanks Dick. We copied you here.

What the US (and global) economy and especially our financial system have endured over the past few years would make a very good chapter addition to Mackay’s ageless text. The growing legions of books that we have examined about the ‘Financial Crisis’ are devoid of both conclusive fact and clever cognizance alike. None come anywhere close to Mackay’s brilliance. We have posed the challenge of updating Mackay’s master work to Western Reserve senior advisor and former President of the Dallas Federal Reserve Bank, Bob McTeer, albeit, Bob’s “My Mark-To-Market Nightmare” is conclusive enough to us.

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The administration’s “witch hunt” of acute timeliness con Goldman Sachs alone has a Mackay-like feel to it. So, we are to believe The US Senate has uncovered that for every buyer of a security that there must also be a seller present? And an intermediary brings the parties together sometimes and becomes the counterparty or “market maker” in the absence of two parties too? Brilliant!

JP Morgan’s venerable CEO Jamie Dimon once referred to the current administration’s endless attacks against bankers as a “scarlet letter.” We find this reminiscent of Mackay’s musings about the acts of an irrational mob. Unfortunately Mackay is not with us today to take advantage of the extravagant price dislocations provided by this particular mob’s madness. Considering Mackay’s thesis, it is not surprising that few modern investors have yet to take advantage of the current lunacy.

While many have argued that markets again are fully priced, we argue, at least from the bottom up, that many equities remain in a highly delusional price dislocation funk. Take Wells Fargo (WFC) below. Should one of the best managed and most profitable banks see its shares traded as though it was a high yield bond? We think not. But, here it is being treated as such.

And as noted, the Fund started to “reach back” to smaller regional bank stocks as early as the fourth quarter of 2009. The risk reward pendulum already has begun to favor a more balanced approach to encompass stocks of all market capitalizations within the services space. Consequently, the Fund has added numerous smaller capitalization regional bank stocks.

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Jim Grant’s “Error of Pessimism is born the Size of a Full-Grown Man…” has yet to expire despite the Fund’s long positions being a bit more expensive than the absurd valuations of a few months ago and the once in a lifetime opportunity approximately a year ago. However, do not despair! We are nowhere near a full earnings power and price recovery yet in services stocks, especially in financials. This will be a multiple year opportunity as we often have sighted and the pull-back in May is yet another “gift”.

We hear many of the talking heads on the financial shows talking about how expensive financials have become and that there’s no upside left… This is good news as it creates obligatory “corrections.” Here are some stats that may alter your view if you have previously subscribed to the “TV talking heads” way of thinking:

• At recent peak, the S&P Financials Index traded at 2x book value and about 12x earnings (so not terribly “rich”)

• Today, the Index is a tad below 1x book and 6x-7x 2011 earnings (which doesn’t

reflect a full economic recovery) • The Index FELL 84% or the worst drubbing of any major index in world history

(even Internet stock indexes faired far better, but they didn’t have the “madness” of mark-to-market accounting)

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• 3/4 of that 84% fall in the Index came after the November 2008 election (The 2008 election was an exigent and unusual event it seems)

• The Index remains today roughly 60% below the 2007 high, which itself is well

below historic high valuations of >3x book • So, just to get back to 2007, the Index would RISE some 230%; and a repeat of

the post S&L Crisis high valuation would mean a RISE of >350% before growth in earnings and book values

• Fundamentally, the financial sector historically gets larger and more profitable out

of every recession; this crisis leaves the industry atop the largest stores of liquidity; capital and reserves in history

• Clearly, the US economy is not merely to return to 2007 levels and then halt any

further growth • The best financials now have more market share than ever and have more capital

than at any other time in history, so there is no quality “give-up” for alpha • Furthermore, the amount of idle cash sitting on the sidelines of the economy is at

or near record levels >$10 trillion

• This type of industry and economic leverage is what led financials to rise 900% if you bought near the bottom of the S&L Crisis

• People have forgotten that after recovery comes growth and that the leverage is

twofold - the expansion of valuation multiples X expansion of earnings and book values

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We thought we’d spend the remainder of the letter highlighting a few recent and few old research items… all of which remain germane to the Fund’s positioning. Citigroup (C) - Long The Fund made its first investment (ever) in Citigroup (C) in the spring of 2009 at prices as low as $1.50. While C is a liquid, widely-held and followed stock, our research identified some very unique things in this investment which we believe the rest of the investment community was not taking into account. First, Fair Value Accounting (SFAS 157, 133 etc or “MTM”) was proving inaccurate and we believed the capital raised and losses taken on C’s “bad bank” were significantly over done. The result would be material recapture of loss provisions from the “run-off” portfolio and the ability of Citigroup to re-invest the excess capital from TARP not yet converted to common stock into more productive investments over time. This would include stock repurchases and other accretive acquisitions and business realignments elsewhere in the company’s continuing operations or “good bank”.

Losses on Bank-held Securitized Loans were Artificial High

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Source: Federal Reserve, Goldman Sachs Research. The chart above illustrates the inaccuracies of MTM accounting. No other large US financial institution, save perhaps Bank of America (BAC) (which the fund began purchasing at $4.50) was going to benefit more than Citigroup from the accounting applications primary flaw known as an “observable input.” The “inputs” were based on illiquid insurance derivative contracts which proved to be inaccurate when compared to their discounted cash flow.

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 began calling for MTM reform in 2007.) Secondly, as a former Federal Reserve bank regulator, I was assigned to Mellon Bank Corporation (now BK) during the S&L Crisis, when they attempted the “good bank; bad

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bank” strategy also know as the “Grant Street (Pittsburgh) Bank” experiment which was only a partial success. Based on my experience in that endeavor, the bank regulators have learned from the lessons of “Grant Street Bank” and improved upon them in the restructuring of Citigroup. In our view, investors overly focused on the “bad bank” run-off and thus clearly over reserved and capitalized for this while ignoring the highly valuable remaining assets and businesses of Citigroup. As a result, the franchise was selling for well below its break-up value. One such business was the AAdvantage credit card business. As analysts that once focused on monoline credit card firms and credit card transaction processing stocks, we had a unique view of AAdvantage. This is the world’s most profitable credit card program….and a very reasonable multiple of ebitda, shares of C were trading BELOW the intrinsic value of just this one product line of the company. Third, as former regulators, we noticed early stage credit migrations were starting to improve as early as the spring of 2009 which ultimately would take pressure off earnings. While many analysts believed C wouldn’t return to profitability until as early as 2012-2013, we believed 2010 was more likely based on our credit migration analysis. In 1Q10, we were proven correct. The chart below depicts the “good bank” improving credit position since 1Q09… something few other investors took note of given the share price.

Citigroup is Over-Reserved Now!

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Loan Loss ReserveNet Charge-offs

Finally, in both a deteriorating and then improving credit migration environment, we look out into the future at the bank’s “earnings power” as opposed to simply looking at the present. The lowest risk (for an investor) way to get through a credit crisis is to evaluate the bank’s ability to “earn” through the peak of the credit losses. The method we espouse is the use of adjusted pre-tax, pre provision income (cash flow) and adjusted book value (account for excess reserve build). The Federal Reserve used a similar strategy in their SCAP analysis of the largest banks more commonly known as the “stress test”. We believe bank accounting (particularly loss reserve build analysis) confuses most investors and is a key advantage to our approach to the early detection of sea-changes.

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The table below illustrates just how “cheap” large US financial institutions became (especially Citigroup) and why the risk of owning the stock versus the reward started to reverse – the evidence is in their ability to “earn” through problem loans.

Valuations Became 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.

For Citigroup, a reasonable valuation would be to take the recent adjusted PTPP multiple of just 2.2x, tax affect it up to 3.1x and quadruple that to 12x for a reasonable P/E of about $14-$16. This is before including the assumption that at some point the economy will start growing again….and C has one of the best global growth franchises anywhere. Wells Fargo (WFC) - Long

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.

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As mentioned earlier, pre-tax, pre-provision (PTPP) income is a more accurate gage of where the industry’s cash flow strength stands. Valuations remain ludicrously cheap on this cash flow-oriented basis as investors are still “hooked” on book value, reserve builds and GAAP. 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” is inevitable... the seeds of recovery in financial stocks is already underway. We keep going back one of Warren Buffett’s favorite bank stocks –Wells Fargo (WFC) (one of our favorites as well). Buffett refers to PTPP as “look through” earnings power (a.k.a. cash flow). In the first quarter 2009, 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 also of note. We continue to believe this is perhaps the most accretive acquisition in U.S. banking history? Time will tell of course… For WFC, a reasonable valuation would be the recent adjusted PTPP multiple of just 3.5x, tax affect it up to 5.2x and triple that to 15x. This multiple produces about $70-$75 before incorporating any assumptions regarding eventual growth in the economy.

The chart above illustrates the closing of the gap between (PTPP) and pre-tax GAAP which is inevitable and which will continue. We believe this gap will become increasingly more evident in reported or “GAAP earnings” in 2010 and consequently bank valuations will rise steadily. Financial stock valuations are NOT reflecting just how

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Bank Earnings “Power” v. GAAP

Mark-to-Market Accounting Overstatement of Losses

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wide of a disparity still remains. This is why the Fund is over weighted traditional financials at present and expects to be so for some protracted period of time. How to Ride a CAMEL We wrote in early 2009 – 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 but to determine which are in an optimum position to gain tremendous market share in a recovery. CAMEL is best illustrated by example and these are repeats from last summer’s analysis we did on each bank: 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

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• 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

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• 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. Bubble Alert (Short Opportunities)

What speculators are chasing in China is what we like to call “authoritarian staged economics.” Fund managers keep misreading this as organic growth. This is a ruse. We

see this 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 has 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?

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Source: BofA Merrill Lynch, CEIC and Western Reserve compilation

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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 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. Regional Banks – CRE isn’t what it seems – Long Selectively Much of this is a repeat from prior published research as well. 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…

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Credit migration trends tell the story now…

Texas Ratio Deltas (of select regional banks the Fund owns)

4Q09 1Q10 Huntington 60% 45% Marshal & Ilsley 54% 41% KeyCorp 32% 31% Citigroup 50% 31% PNC 51% 34% Wells Fargo 41% 33% US Bank 46% 33% Bank of Amer. 43% 35% Capital One 19% 13% JP Morgan 16% 17%

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.

Residential Mortgages Are Behind the System

Source: Federal Reserve Bank of Atlanta

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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 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.

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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.

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.

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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

Source: Federal Deposit Insurance Corporation

The chart above 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”

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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.

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.

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.

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Traditional CRE Losses Tracking Better than Expected

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); ZIONS Bancorporation (ZION); Marshal & Ilsley and BB&T (BBT) are among those analyzed carefully and chosen for the Fund based on our CAMEL analysis-based insights.

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

We believed there was 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 as well.

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?

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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

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.

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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.

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.

22

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 CAMEL analysis - KeyCorp (KEY) Observers of our method of picking financial stocks are used to our regulatory approach or “safety and soundness.” 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

23

• 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

This is a franchise in stable condition which is under managed for potential. 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.

Regards,

Michael P. Durante Managing Partner

24

Appendix – Historical Fund Performance

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 21.88% per year.

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

-80%

-65%

-50%

-35%

-20%

-5%

10%

25%

40%

55%

70%

85%

100%

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

Apr-

10

Western Reserve Gross

Western Reserve Net (Class A)

SMID Cap Services Composite

Financial Services Composite

Performance vs. the Financial IndexPerformance vs. the Financial Index

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.

-60.00%-40.00%-20.00%

0.00%20.00%40.00%60.00%80.00%

100.00%120.00%140.00%160.00%

2004 2006 2008 Jan-April2010

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 22.95% 17.80% -10.25%

Jan-April 2010 40.08% 32.85% 20.06%Cumulative Rtn Since Incep. 95.40% 66.43% -55.66%

Cumulative Alpha 151.06%