Vectors of Credit
John Mauldin's Outside the Box

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The credit markets are in turmoil. This week I have asked Michael Lewitt of Harch Capital in Florida to tell us what is going on from his perspective. Michael has been watching the credit markets from the inside for a long time. So, this week we have a sort of insider's Outside the Box.

Michael is one smart guy with a deep understanding of the markets, especially the credit markets, and how they work. I really look forward each month to getting Michael's insights. The firm manages domestic and offshore debt and equity hedge funds and separate accounts. This may get more technical for some readers, but keep reading, as you can get a sense of what we are really facing.

John Mauldin
Editor, Outside the Box

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Vectors of Credit

by Michael Lewitt
September 1, 2007

" satellite comms., encrypted e-mail, the longs and lats for the transshipment point...all that? It's all cool. But I need a vector, not a location. 'Cause ships move. That's why they call them ships. Ship stops? It's trying to be an apartment building. At sea that attracts attention. That's bad..."

Ricardo Tubbs in Michael Mann's 2006 film Miami Vice

Readers might ask why we begin this newsletter with Detective Tubbs' instructions to the drug dealer Jose Yero concerning the kind of surveillance equipment he requires for their upcoming cocaine shipment. Before answering that question, we should note that while Tubbs is distracting Senor Yero, his partner Sonny Crockett is leading Isabella, the beautiful Chinese drug trafficker (who we later learn banks in Geneva) to his racing boat to speed her across the Straits of Florida to Havana in search of the best mojitos in the Caribbean (as Moby sings the hypnotic ballad 'One of these Mornings' in the background).

In Michael Mann's world, the drug trade has gone truly global, so it is hardly surprising that his undercover cop's description of ships and vectors also describes the modern world of finance. Investors need to understand that corporate credits are ships, not apartment buildings. Corporations are constantly moving and changing, and must be measured by the calculus of credit analysis, which is as much an art as science. It requires a broad knowledge and experience of the world and markets to understand how a company is going to react in different business cycles. It is all too easy too confuse what is occurring with relatively static subprime mortgages with the vital, breathing, ever-changing world of corporate credit.

But just as Mr. Mann's film was a retelling of the great 1980s television series, with faster boats and greater nihilism, today's market's disruptions are a rerun of earlier market panics, driven at a faster speed by new technology and disengaged computer-driven models. But in the end, risk is risk, leverage is leverage, and miscalculation of risk is still miscalculation of risk. All market panics create opportunities for investors that retain a deep appreciation for original principles of value.

The State of the Corporate Credit Markets

High Yield Bonds: One of the more curious aspects of July and early August's market turbulence was the fact that the high yield bond market barely blinked. For all of the sound and fury about the coming end of the world of credit as we know it, high yield corporate bond spreads barely pierced the 400 basis point level. Those of our readers with lives outside the arcana of the financial bond markets should understand that this barely qualifies as a storm in a water glass. Normalized spreads on these bonds have been above 500 basis points on a historical basis, and true crisis periods have seen spreads exceed the 1000 basis point level. On an overall basis, corporate bond spreads are nowhere near a level that would suggest that corporations are experiencing, or about to experience, severe stress.

Nonetheless, there are pockets of the market that are feeling the effects of the housing slowdown and that are likely to experience an increase in defaults. One measure of this stress is the increase in the number of bonds trading at distressed levels. Merrill Lynch's Distressed Index, shown in the graph below, measures the number of bonds trading at a spread of greater than 1000 basis points over Treasuries. This index jumped to 3.8 percent in August (i.e. 3.8 percent of the issuers in the index traded at this spread level), although the percentage of such distressed bonds remains far below previous periods of concern.

This jump in the number of distressed bond issuers was confirmed by Standard & Poor's, which calculates a similar distress ratio that popped to 2.7 percent in August from 0.9 percent in July 2007. Like Merrill Lynch, S&P also defines "distressed" credits as those that trade at 1000 basis points above Treasury spreads, although the two indices measure different cohorts of bonds. Speculative grade bond spreads increased by 104 basis points in August to 427 basis points, according to the rating agency. Not surprisingly, the industries with the highest distress ratios are consumer products (8.6 percent), retail/restaurants (7.9 percent), finance companies (4.4 percent) and transportation (4.2 percent), closely followed by chemicals and packaging (4.0 percent) and automotive (2.5 percent). HCM would point out that consumer products and retail/restaurants are vulnerable because of their exposure to consumer spending, which investors believe will be negatively impacted by the housing slowdown; finance companies are being pummeled by the subprime meltdown and widening credit spreads; the transportation industry has seen a lot of leveraged buyout activity and is exposed to high energy prices; chemicals and packaging has been a hotbed of leveraged buyout activity; and the automobile industry remains under pressure because of its flawed business structure.

The following chart from S&P shows those industries whose bonds are trading at a significant spread premium to the market (suggesting that they are perceived as much riskier than the market). Defaults are most likely to increase in the near-term in these industries.

HCM would caution, however, that the 148 companies on S&P's distress list still represent a very small percentage of more than 5000 outstanding high yield bond issuers. Overall, the high yield bond market trades at spreads that are well below historical norms, and well below what HCM would consider fair value. The recent difficulties experienced by the credit markets are certain to render credit more expensive and less abundant, which will further increase the number of companies joining those on the distressed list. In other words, we have a long way to go before we hit the bottom of a credit cycle whose downward spiral is just beginning. HCM expects credit to be withdrawn from all markets as a result of recent turbulence, including the corporate credit markets. The U.S. economy has been fueled by debt. Less borrowing will result in lower economic growth, which will in turn lead to higher defaults in industries related to housing and autos and other consumer goods. A spread of 427 basis points is, in HCM's view, inadequate compensation for the risks involved in owning unsecured subordinated debt in view of the higher risk profile posed by the economic scenario we appear to be facing.

The chances of a recession, or at least a meaningful slowdown in economic growth, will increase as credit leaves the system. For this reason, defaults are likely to increase in the next two years, particularly among smaller and medium-sized triple-C and weak-single-B rated companies. Large companies bearing these low ratings as a result of leveraged buyouts, which HCM tends to regards as "fallen angels by design," will be less at risk since they retain many of the characteristics of investment grade credits: significant market shares; access to multiple sources of credit; global businesses; etc.

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Leveraged Loans: Ironically, corporate bank loans, which rank senior to high yield bonds in the capital structures of leveraged companies and enjoy significantly higher recoveries in the event of default, have performed worse than their lower ranked brethren in the recent turbulence. In many individual cases, the bonds of a particular issuer are trading at a higher dollar price than the more senior ranked bank loans of the same company! There are also second lien loans trading at higher prices than first lien loans in some rare instances. There is an explanation for this anomalous pricing behavior, but HCM would still point to these irrational relationships as definitive proof that the markets are being dominated by investors who wouldn't know the difference between a bond and a loan if their lives depended on it.

Bonds are trading better than loans because the primary buyers of loans, Collateralized Loan Obligations (CLOs), have been (temporarily?) taken out of the game by subprime contagion. Over the past couple of years, buyers of CLO liabilities came to believe, for reasons best explained by themselves (because HCM can offer no reasonable explanation), that there was no difference between deals backed by corporate bank loans (CLOs) and deals backed by subprime mortgages (CMOs) as long as the securities they were buying were "rated" as investment grade by Moody's or Standard & Poor's. In other words, they fell into the trap of confusing ships with apartment buildings, and tracking locations instead of vectors. They are now buried in losses resulting from the discovery that these CMOs were either ships constructed with leaky hulls or apartment buildings built on cracked foundations. Either way, they don't own what they thought they were purchasing. Unfortunately, some investors built their portfolios out of a combination of CLOs and CMOs and haven't been able to outrun the losses on the mortgage side. As a result, they are experiencing margin calls from their lenders and/or redemption requests from their unhappy investors, leading them to stop making investments altogether.

Hopefully, those investors who avoided the siren song of CMOs or who still have money to invest will avoid the completely illogical conclusion that CLOs are as risk-laden as CMOs and recognize that they now offer one of the best investment opportunities of the decade. Unless loans begin to default at unprecedented rates (in excess of those seen in 2001-2002, the worst credit market since the Great Depression marred by the Telecom and Internet Bubbles), CLOs constructed in the current market at today's loan prices in the hands of a savvy manager should produce attractive returns not only for the equity but for the other liability holders who can now demand spreads that have been unavailable for years. Senior secured corporate credit risk, properly selected by an experienced manager, remains a low-risk proposition even in a recession. This is particularly the case when it is trading at a discount of 4-8 percent below par, as so many loans currently are as a result of technical rather than fundamental credit factors.1

We were recently sent an article written by bearish investor Doug Kass entitled "The Black Swan of Credit" on the topic of leveraged loans to which we feel compelled to respond. In the article, Mr. Kass tried to argue that if the leveraged loan index could tank a further 20 to 25 percent by drawing an analogy between the LCDX North America index of loan credit default swaps and the S&P 500. Mr. Kass is a very smart guy, and HCM enjoys reading his opinions, which are always colorful, generally well-informed, and, well, opinionated. But in this case, we must take issue with Mr. Kass's argument. Mr. Kass is correct to point out that were a flight from risk to occur, all asset classes would sell off (something the quants seem to overlook time and time again). But having been active in the leveraged loan market since its inception, and being intimately familiar with hundreds of individual loans as well as with the history and evolution of the Collateralized Loan Market, the LCDX and the leveraged finance markets (both secured and unsecured), HCM would respectfully suggest that Mr. Kass's argument would be better aimed at the unsecured corporate credit market, which shares many of the same risk attributes of the equity market, and not the leveraged loan market. Unsecured, subordinated high yield bonds are often nothing more than "equities in disguise" and as such could be expected to suffer equity-type losses. Senior secured bank loans (not second lien loans) are senior obligations that retain a senior claim on the assets of the borrower. Even covenant-lite loans are, for the most part, issued by large companies ("fallen angels by design") that have the characteristics of investment grade companies and therefore are much higher in quality than equities or subordinated debt. Accordingly, trying to call attention to the possibility of a massive equity sell-down triggering an equally gruesome collapse in the loan market may make good reading for those who want to believe the world is ending, but is far less useful an exercise than pointing out the likelihood that an equity market collapse would likely trigger a drop in high yield bond prices. When you've been a bear as long as Mr. Kass has, maybe everything starts to look like honey.

It is true, as Mr. Kass points out, that the leveraged loan market experienced its worst performance in history in July (the Credit Suisse Leveraged Loan Index returned -3.3 percent). But there are both technical and fundamental reasons why that performance is unlikely to be repeated, and why loans currently present a buying opportunity, not a reason to panic and run for the hills. Loans traded down sharply in July as a result of the fact that loan prices are unduly influenced by the newly introduced LCDX index. This index was used by dealers in July and early August to hedge the $300 billion or so forward calendar of LBO deals to which they have committed their balance sheets. By selling short the LCDX index, they were also attempting to hedge potential losses on CLO warehouses. This created a self-reinforcing selling pressure that dropped the index to the low 90's, leading loan prices (especially on low-spread and covenant-lite loans) down into the low 90's. The index has recovered to the 95-96 level, but loan prices are lagging in their recovery as buyers remain in command of the market as they await the huge fall calendar of LBO deals. Bonds and loans continue to enjoy a default-free environment (Fedders finally bit the dust after stumbling around like a drunk in a bar for the past few years) and really have no fundamental reason to trade down until defaults pick up. Moody's recent prediction that defaults will increase to 3.5 percent by July 2008 and 4.5 percent by July 2009 should give bond investors some reason to demand more spread than 400 basis points, but the cash bond market is a moribund place while most of the activity in corporate bond credits has migrated to the credit default market. Until the market sees some visibility on defaults, HCM doubts spreads are going to widen much further on an overall basis.

The Fall Financing Line-Up

After Labor Day, the markets will be facing an unprecedented pile-up of financings that are scheduled to come to market before the end of the year. In addition to the chart below, potential mega-deals include The Blackstone Group's purchase of Alliance Data ($7.9 billion),

the buyout of Canadian telecommunications giant BCE Inc. by a consortium of private equity players and the Ontario Teachers' Pension Plan ($48.8 billion), the possible going private transaction of Cablevision Systems led by the Dolan family ($13.9 billion), and the renegotiated buyout of Home Depot's wholesale supply unit ($8.3 billion). Obviously, not all of these transactions will be completed, potentially weighing down the balance sheets of the banks and investment banks that were lured into firm underwriting commitments earlier in the year.

The recent wrangling over Home Depot's sale of its wholesale supply unit is only the first skirmish between private equity firms and those who have been so generous with them over the past few years. The interplay between the banks and the private equity firms are living proof of the Wall Street maxim, "if you want a friend, get a dog." The banks are now telling the private equity firms to cut the prices they are paying for companies or they won't finance their deals; just two months ago, the private equity firms were telling the banks how much they were going to lend them, how much they would charge, and how much equity they would have to invest in the deal for the right to do so. How the worm turns! HCM believes it was Bill Gross who pointed out that the private equity firms are now going to have to share the "vig" that they've been skimming from their deals with the lenders, which bodes well for lenders but poorly for buyout firms and for sellers of companies who, like Home Depot, are going to realize significantly lower sales prices. This also bodes poorly for the stock market to the extent that stock prices continue to be sustained by hopes that companies will continue to fetch high prices in auctions fueled by private equity firms overpaying for companies based on the availability of cheap financing.

HCM would like to think that the banks will not merely dump these loans in the market at large losses unless they are experiencing overall credit problems that have not yet been publicly disclosed. All of these buyout loans will be paying interest and performing for the foreseeable future and will have senior claims on the assets of the borrowers. There are a couple of transactions that are so highly leveraged that the private equity firms and banks are going to end up going to the mat to come up with terms that make sense for themselves and the marketplace. But for the most part, the most prudent course of action would be to leak these deals out over the next year or two as the market can absorb them. Having said that, however, HCM expects these deals to be rushed to market at the first sign they can be moved off these banks' balance sheets at the smallest possible loss. This is, after all, Wall Street, where patience and greed are terminally in inverse supply.

Private Equity and Hedge Fund Returns and Fees

Many market observers pointed to The Blackstone Group's IPO as the top of the private equity cycle. For the foreseeable future, life is going to be difficult for the private equity shops who exploited the availability of easy money in the credit markets. Of course, "difficult" is a relative term in this context, since private equity firms have attained wealth and status that invited a correction. "Aggravating" is probably a better term, since these power brokers are going to be engaged in difficult negotiations with their lenders and their investment banks. In the end, however, they will emerge largely unscathed as a result of the fact that they have largely structured their world in a "heads we win, tails you lose" kind of way.

A recent article in argued that the new world for LBOs could reduce projected private equity returns by more than 50 percent, as shown in the following chart:

Private equity enthusiasts will certainly dispute these figures, but the point remains that higher financing costs are going to squeeze private equity returns significantly. The returns to the private equity firms themselves are much higher, of course, since the chart does not take into account the generous fees they charge to their investors. It should also be noted that academic studies have shown that private equity returns, on a liquidity-adjusted and leverage-adjusted basis, are generally far less exceptional than they appear at first blush. If they are further adjusted for inflation and normal market returns, they are even less impressive. The same can be said about the returns of the majority of hedge funds.

Moreover, the unspoken truth about the private equity and hedge fund businesses is that they serve the managers much better than they serve the clients. It's hardly an accident that more private equity and hedge fund managers keep showing up on the list of the Forbes 400. This was less of an issue in the early days of the business, when investors in these vehicles were largely wealthy individuals and institutions. But as the business attracts money from non-profit institutions, this issue is going to gain an increasing amount of political attention. We are already seeing this occur with respect to the issue of the taxation of private equity carried interests. Jeremy Grantham made a similar point in his most recent quarterly letter when he criticized the payment scheme that rewards private equity managers for returns that are attributable to normal market increases. The same argument applies to hedge fund managers, who used to have to earn a return above a hurdle rate before receiving performance fees in order to avoid rewarding them for returns attributable to inflation and a rising market. Private equity and hedge fund managers, at least early in their careers, earn their fortunes primarily through their fees and the skim they earn off their investors' capital. Only after they have accumulated capital and become substantial investors in their own funds do they really share some of the same risks as their investors. But their fee structures still place them in a much more advantageous position than those whose money they manage. Neither private equity managers nor hedge fund managers are required to hand back fees if later investments go sour and their investors end up giving back all of their earlier gains.2

Somewhere along the line, "one and twenty" or "two and twenty" (and there are more egregious structures out there as well) became a kind of birthright for managers able to convince investors to ignore the fact that a significant amount of the so-called "outperformance" or "alpha" they are paying for is attributable to a rising market or inflation. Forgive our lack of surprise when many of the managers charging these exorbitant fees distinguished themselves by losing large sums of money in the recent market meltdown and then blamed everybody but themselves for their difficulties.

The markets are nervous because they can't figure out where the risks lie. There is leverage overflowing the financial system both inside and outside the subprime mortgage world, but nobody can figure out where it all went. Risk, it seems, is everywhere and nowhere, and that is what has the markets spooked. Financial Times columnist Tony Jackson made the point very well in a column on August 27, 2007 when he said that "[t]he originators of risk – hedge funds, private equity, investment and commercial banks – are not in the business of holding [risk]. That job falls to investors who are prepared for the long haul."3 One thing is for sure – private equity and hedge fund managers spend a great deal of time managing their own career and compensation risks. Sometimes one has to wonder if they devote as much time to worrying about the risks that really ought to matter, like those to their investors and the financial system at large.

The Conundrum of the Central Banks

In a recent interview in welling@weeden, Mark Faber makes the compelling argument that "if Mexico hadn't been bailed out in '94, the resulting crisis in emerging economies would have been nowhere as severe as it then became in '97. Because the excesses were allowed to expand between '94 and '97 as those monetary policies continued." This is the dilemma facing the Federal Reserve today as it approaches the September 17th Open Market Committee Meeting, where it is widely expected to reduce the Federal Funds rate by 50 basis points. A bailout of the credit markets is a two-edged sword: it prevents a systemic collapse, but it rescues a lot of participants who contributed to the problem in the first place and should not be permitted to repeat their errors. From HCM's standpoint, merely bailing out the markets – particularly the subprime mortgage market - through monetary policy maneuvers would be a colossal public policy error, although a complete solution really lies outside of the mandate of the central bank. A real solution to the subprime mortgage problem requires a combination of monetary policy action and legislative reform to remove abusive lending practices from the system. This problem should not be left in the hands of the individual states to handle; a hodge-podge of different state regulations is insufficient to address the problem. Instead, there should be federal mortgage legislation to address the flaws that led to the current subprime meltdown, which was completely foreseeable and therefore completely avoidable. Without such legislative action, the Federal Reserve will be left in a situation where it will merely be lighting the fuse for another series of abuses and a future conflagrations in the credit markets that could make the current one pale in comparison, much like the 1998 near-death experience of the financial markets rendered the 1994 Mexico bailout almost forgettable.

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While it is too soon to determine whether we have seen the worst of market volatility in this crisis, we have certainly been reminded once again of the paramount importance of liquidity. Several commentators, including Henry Kaufman and Mark Faber, have made the important point that the concept of liquidity has undergone a sea change in recent years. While liquidity used to mean cash and cash equivalents, its meaning was expanded to include borrowing power over the past few years. HCM wouldn't bet the farm that this concept is going to change as quickly as some commentators would have us believe. Anybody who believes that hedge funds and investment bankers have stopped thinking about using as much leverage as possible should think again.

The wounded securitization edifice was constructed on the ability to turn illiquid financial instruments into newly tradable and liquid ones. Two of Morgan Stanley's economists, Richard Berner and Joachim point out that this brings both benefits and risks:

"The dispersion of risk resulting from financial innovation across financial markets and institutions is a two-edged sword: It diffuses credit risks across markets and may reduce risk concentration by putting such risks in the hands of those who want and are better equipped to hold them. But the structure in structured subprime and other forms of credit makes it appear that such securities carry less risk than the underlying collateral, encouraging investors to increase leverage. That leverage provided the kindling for a liquidity crisis; deteriorating credit quality and a forced re-intermediation of credit to banks lit the match."4

Investors and lenders convinced themselves that financial alchemy would turn illiquid securities into liquid securities in all market conditions. But leverage and liquidity require two participants. A borrower needs a lender, and a buyer needs a seller. Otherwise each is just a ship at sea. Liquidity is a human phenomenon, a psychological phenomenon. Investors made the mistake of believing that financial technology had repealed the laws of human nature. But, as Bill Gross wisely pointed out in his September Investment Commentary, "Noothing within the current marketplace allows for the hedging of liquidity risk and that is the problem at the moment."5 This point is so obvious that it can be overlooked. Wall Street spends so much of its intellectual and financial resources trying to figure out how to hedge every kind of risk it can imagine. But the one kind of risk that repeatedly brings down markets and the biggest and boldest players in those markets is liquidity risk. The only true hedge against liquidity risk would be to cut out man's greed gland. You can't hedge human nature.

Michael E. Lewitt

1 In the interest of full disclosure, Hegemony Capital Management, LLC is a CLO manager and is talking its book here, but it should also be noted that we are investors in the equity tranches of CLOs and believe that the different rated and unrated tranches of CLOs represent unusually good value at the current time. Neither the previous sentence nor the paragraph above nor anything else in this newsletter should be understood in any manner to be a solicitation or offer of securities, and please see the Disclosure Appendix at the end of this newsletter for full disclosures as required by law.

2 The issue extends to those who lend money to hedge funds and private equity firms as well. If your institution has been a lender to a hedge fund or a private equity firm, you have been bestowing gifts that have the individuals running these funds pinching themselves at your generosity. The goal of private equity managers over the past few years has been to reduce their equity commitments in deals as quickly as possible by taking out dividends at the earliest possible moment. This is why subordinated debt has become such a bad bet in today's market and would remain a bad bet even if the spreads were much wider since subordinated debt holders bear all the equity risk without receiving any of the equity upside.

3 Financial Times, August 27, 2007, p. 17, Tony Jackson on Monday, "Rate cut calls miss the point after profound market change."

4 Richard Berner and Joachim Fels, Morgan Stanley, Global Economics, "After the Shock: Risks for the Global Economy and Markets," August 20, 2007.

5 Bill Gross, Investment Outlook, PIMCO, September 2007.

Disclosure Appendix:
This publication does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. This report contains general information only, does not take account of the specific circumstances of any recipient and should not be relied upon as authoritative or taken in substitution for the exercise of judgment by any recipient. Each recipient should consider the appropriateness of any investment decision having regard to his or her own circumstances, the full range of information available and appropriate professional advice. Hegemony Capital Management, LLC recommends that recipients independently evaluate particular investments and strategies, and encourage them to seek a financial adviser's advice. Under no circumstances should this publication be construed as a solicitation to buy or sell any security or to participate in any trading or investment strategy, nor should this publication or any part of it form the basis of, or be relied on in connection with, any contract or commitment whatsoever. The value of and income from investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies, geopolitical or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. The information and opinions in this report constitute judgment as of the date of this report, have been compiled and arrived at from sources believed to be reliable and in good faith (but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness) and are subject to change without notice. Hegemony Capital Management, LLC and/or its employees, including the author, may have an interest in the companies or securities mentioned herein. Neither Hegemony Capital Management, LLC nor its employees, including the author, accepts any liability whatsoever for any loss or damage arising from any use of this report or its contents. All data and information and opinions expressed herein are subject to change without notice.


Your keeping an eye on the markets while on vacation analyst (I can't help myself ),
John F. Mauldin


John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC and InvestorsInsight Publishing, Inc. (InvestorsInsight) may or may not have investments in any funds, programs or companies cited above.


Communications from InvestorsInsight are intended solely for informational purposes. Statements made by various authors, advertisers, sponsors and other contributors do not necessarily reflect the opinions of InvestorsInsight, and should not be construed as an endorsement by InvestorsInsight, either expressed or implied. InvestorsInsight is not responsible for typographic errors or other inaccuracies in the content. We believe the information contained herein to be accurate and reliable. However, errors may occasionally occur. Therefore, all information and materials are provided "AS IS" without any warranty of any kind. Past results are not indicative of future results.

Posted 09-03-2007 11:50 AM by John Mauldin