From the Investment Desk

Market Update

The credit markets continued their improvement during the third quarter. The leading indicator of improvement in the credit markets continues to be the steady decline in LIBOR rates. Perhaps the most telling illustration is the spread between 1-month and 3-month LIBOR. The spread is currently less than 4 basis points, although it began the year at 100 basis points. The 3-month LIBOR rate now stands at .28%, a drop of an additional 31 basis points from its June 30 level. This rapid decline followed the European Central Bank's (ECB) actions in late June, when it put the equivalent of $600 billion into the European banking system by terming out short-term bank funding at a fixed-rate of 1% for one year. The fixed rate euro operation at the end of September continued the pressure on short-term rates through quarter end.

The Fed's September report on Credit and Liquidity programs highlights the continued decrease in utilization of Fed facilities. The AMLF balance ended the quarter at $79 million, the lowest point since the facility's inception and a 99.9% contraction from its peak of $152.1 billion. The Fed's modifications last quarter to the AMLF, requiring money market funds to experience "material outflows" to be eligible (defined as redemptions of 5% in a single day or 10% over 5 business days), strongly contributed to the decline. In addition, the Commercial Paper Funding Facility (CPFF) declined to $38.5 billion from its peak of $350.3 billion in January 2009. The composition of CPFF assets also continued to shift with asset-backed commercial paper (ABCP) comprising 73% of holdings at quarter end, and unsecured financial issuers contributing only 27%. In December 2008, CPFF assets were split 37% ABCP and 61% in unsecured financial issuers. The top 10 issuers represent 70% of the balance. It would appear that most of the top 10 borrowers are ABCP conduits that have had difficulty reaccessing the markets in any size and therefore remain reliant on the CPFF for funding. The Money Market Investor Funding Facility (MMIFF) will expire at the end of October. The MMIFF, the only facility that was eligible for securities lenders, has not been utilized to date. We continue to believe the Fed will allow the AMLF and CPFF to expire in February, allowing the Fed to exit their support.

The Treasury allowed its guaranty program to expire on September 18, as expected. The expiration of the guarantee has not had a material impact on the balances of prime funds as none of the post-September 2008 inflows to prime funds, roughly $273 billion, were covered by the Treasury guarantee. Prior to the expiration, 72% of total assets under management in prime funds were covered by the guarantee.

Market participants continue to be focused on the Fed's statements as an indication of future policy actions. After the September 22-23 meeting of the Federal Reserve Board, the Fed's statement highlighted improved economic and financial market activity, an expectation for continued weakness and a commitment to policies that support economic growth. The Fed continues to see inflation as a minor risk, but is monitoring inflation expectations. A final important part of the statement highlighted the Fed's intention to exit their support of mortgage lending and housing markets, giving the end of the first quarter 2010 as a target for the completion of their purchase of $1.25 trillion agency mortgage-backed securities and up to $200 billion agency debt. The slowing pace of the purchases will allow a smooth transition to occur in these markets.

Chairman Bernanke continues to be cautiously optimistic on the economy and indicated that the U.S. recession is "very likely over". There have been continued signs that this is true. U.S. housing starts rose 1.5%, to a seasonally adjusted rate of 598,000 in August, the highest level in nine months. U.S. retail sales climbed 2.7% in August, and U.S. industrial production rose 0.8% from July levels. Bernanke also suggested the U.S. economy will remain weak for some time. Many economists agree, citing the continued concerns around employment with the U.S. unemployment rate hovering just below 10%.

The floating rate market was quiet during the third quarter. The predominant issuance was government guaranteed product from outside the U.S., as the FDIC decreased Temporary Liquidity Guarantee Program activity. Floating rate deals were issued at tightening credit spreads. Two-year average spreads were 12.8 basis points tighter and three-year average spreads were 8.8 basis points tighter.

Strategies and Outlook

The continued improvement in the economy and the financial markets supported an extension of our investment horizon for the highest-rated credits, with a continued focus of maintaining liquidity through our portfolio structure. After consulting our securities lending clients, the investment desk revisited the maximum 95-day investment horizon we maintained since quarter one, extending the tenure of highly-rated credits, per below. The investment desk continues to seek value within these parameters focusing on the one-month to three-month sector and monitoring liquidity closely. Even with improving markets, our best liquidity is achieved through our maturity structure. We manage portfolio liquidity by maintaining a target level of maturities in the 2-30 day range, as well as total maturities of fewer than 95 days. This strategy ensures adequate liquidity, and supports targeted purchases of our highest-rated credits further out the maturity range. The improvement in credit has allowed investors to expand this maturity profile beyond 95 days. In addition to our current fixed-rate strategy, we remain buyers of floating-rate guaranteed issuance, guaranteed by the FDIC and other sovereign entities.

The investment desk remains cautiously optimistic in our belief that the worst of the credit crisis is behind us. While we have begun to expand our maturity profile we have not changed our strategy. We remain focused on maintaining liquidity and creating an investment product that supports our clients' lending activities and allows flexibility to match their individual risk profiles. We look forward to continued discussions around the risks and rewards of your reinvestment portfolio and its importance to your overall securities lending strategy.