Previous Economic Environment (prior to the crash)

Sell in May and Go Away

Halloween indicator¹

Banks lead us into recession and banks lead us out

Healthy economies and bull markets

• The world’s major economies seemed healthy going into 1987, as the recovery from the 1981–82 recession continued into its fifth year. The first nine months of 1987 the stock market was up more than 30%, reaching unprecedented heights. That was after two consecutive years of gains exceeding 20%

• Low interest rates and unusually infrequent rates of default among borrowers boost profits at financial services companies

Easy money

• The 1982-1987 bull market had been fuelled by hostile takeovers, leveraged buyouts and merger mania. Companies were scrambling to raise capital to buy each other out

• By 2007, the housing and bond bubbles were created by cutting interest rates aggressively to 1% and flooding the markets with liquidity

Risk mispriced — preservation of capital is given almost zero consideration

• The spread between U.S. corporate high yield debt and 5 year U.S. treasuries was 270 basis points a year ago. Currently, it is 778. At its widest, in November 2002, it was 1,094 basis points (source: Citigroup). Also, the spread between U.S. corporate high yield debt and U.S. investment grade bonds was 187 basis points a year ago. Currently, it is 549. At its widest, in November 2002, it was 845 basis points (source: Citigroup) (Francis Chou, Chou Fund's 2007 annual shareholder letter)

• In terms of investment ideas in derivatives, we believe that CDS are selling at prices that are compelling. At recent prices, they offer the cheapest form of insurance against market disruptions. In CDS, one party sells credit protection and the other party buys credit protection. Put another way, one party is selling insurance and the counter-party is buying insurance against the default of the third party's debt. The Chou Funds would be interested in buying this type of insurance…. To give you some sense of perspective, in October 2002, the 5 year CDS of General Electric Company was quoted at an annual price of 110 basis points. Recently, it was quoted at an annual price of 8 basis points. To make money in CDS, you don't need a default of the third party's debt. If there is any hiccup in the economy, the CDS price will rise from these low levels. The negative aspect is that, like insurance, the premium paid for the protection erodes over time and may expire worthless (Francis Chou], Chou Fund's 2007 annual shareholder letter)

The USD$ declined as worries about U.S. record budget and trade deficits abounded

• Interest rates were raising globally

• In the first half of 1987, the U.S. dollar experienced a steep decline in value relative to other world currencies. This made U.S. goods and services less expensive and resulted in increased exports, which provided U.S. companies with a strong outlook on earnings and the stock market took off

• In 2007, the Fed reduced the interest rate, which produced a strong and sharp devaluation of the USD$. The Euro was particularly strong. The CAD$ moved from 0.97 to 1.09 in about 2 or 3 weeks, but it moved back quickly to 1.01: it was $1.09 for only a couple of days

History is filled with denial transactions issued at bigger and bigger discounts through deteriorating credit cycles. And one need only go back through the early part of the credit cycle of 1987-1991 to see capital raised by ultimately failed banks

Previous Financial Crashes

There were severe credit crunches in 1987, 1997 and 2007. There probably will be another between 2011 and 2017

1987

• It was an initial drop on February 27^th, 1987, but the market's decline has been orderly and prices (while volatile) have stabilized somewhat

• A number of 1987 participants perceived a resemblance between their era and 1929, and sold stocks based on the analogy they had drawn (Lope Markets). In 2007, the media sometimes compared 2007 with 1987 during the year

• It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the 1987 crash

1997

• The stock market peaked at the beginning of the year

2007

• It was an initial drop of about 15-20% on February, 2007, started in Asia markets. Some people saw a buying opportunity which produced new top by July

The cycle of 2007 started at the next Monday of the US Thanksgiving in 2002. I remember that bottom very well because it told me that it was time to move to Canada, which I did in March 2003