September 2008 Investment Report

Continuing problems in the financial system …

As August ended and September began, investors positively reacted to the news that Hurricane Gustav had inflicted only minimal damage in the Gulf region, creating hope that the decline in oil prices would continue. However, progressively deteriorating conditions in the U.S. and world financial system dominated news headlines as the U.S. government acted to take mortgage giants Fannie Mae and Freddie Mac under conservatorship.

As in the weeks following the U.S. government action regarding investment banking firm Bear Stearns in March, the stock market initially reacted positively. The U.S. government’s action to honor Fannie and Freddie’s debt obligations resolved a significant source of uncertainty. Many believed the worst was over. However, this was false optimism, as another Wall Street investment banking giant, Lehman Brothers, failed. Despite several attempts to rescue Lehman, the Federal Reserve and U.S. Treasury were unwilling to stand behind an acquisition of the firm. As a result, the 150-year-old firm’s bankruptcy filing sent shock waves throughout the financial system.

Investors’ confidence was further eroded when it became apparent that the recent credit-related problems were more widespread than expected. Stock prices fluctuated wildly, and the major U.S. financial institutions continued to morph in response. Bank of America, which declined to acquire Lehman, quickly purchased brokerage firm Merrill Lynch. American International Group (AIG) received an $85 billion loan from the Federal Reserve to help it honor its obligations. Morgan Stanley and Goldman Sachs, two of the largest Wall Street investment banking firms, agreed to become bank holding companies, subjecting themselves to Federal Reserve supervision. Finally, at month end, the largest U.S. banking failure in history occurred when Seattle-based banking giant Washington Mutual was seized by regulators and sold to JPMorgan Chase. Though depositors’ accounts were preserved, shareholders and bondholders in Washington Mutual lost virtually the entire value of their investments. When rumors began circulating about the bank’s ongoing viability, depositors withdrew $16.7 billion in the following 10 days, and the bank was unable to survive.

… despite more government action …

In addition to its efforts to restore confidence in the financial system by selectively dealing with problems at a number of financial institutions, the U.S. government pursued a course of action in September to address the severe credit crisis that has impaired the growth of the U.S. economy. Regulators imposed a 10-day ban that restricted sophisticated investors from borrowing shares of a broad array of financial stocks. These investors typically borrow the shares and sell them with the hope of buying them back in the future at a lower price. With the turmoil in the markets, these types of investors had been criticized for destabilizing the markets by spreading false information about companies in order to further drive down share prices.

Regulators also took action to support money market funds, which experienced large redemptions. Investors began redeeming significant holdings in money market funds when headlines reported that a large fund experienced losses attributable to its holdings in Lehman Brothers securities and were unable to honor its investors’ withdrawal requests at the full value of the deposits.

Finally, the U.S Treasury Department submitted a controversial proposal to Congress calling for $700 billion from the U.S. government to purchase debt and equity securities in order to help restore confidence in the credit markets. Under the plan, banks would be able to sell poorly performing investments and receive new capital that would enable them to begin lending again and forestall a severe economic contraction. Many in the mainstream media branded the proposal as a “Wall Street bailout.” The negative reaction from a broad segment of society resulted in the initial defeat of the proposal, sending major stock market indices plummeting. The Dow Jones Industrial Average fell an unprecedented 778 points, the biggest one-day point drop in the Dow’s history. Major indices recovered more than half the losses the next day as investors became hopeful that a revised plan would eventually be passed by Congress.

… could not overcome weak economic news.

In addition to the turmoil in the financial system, the outlook for the economy continued to weaken in September. The unemployment rate jumped 0.4% to 6.1% in August, while non-farm payrolls declined by 84,000. As employment weakens, fear grows that consumption of goods and services will fall, thus decreasing corporate profits and the overall growth rate of the economy. Indeed, the Commerce Department revised its second-quarter reading of total gross domestic product to 2.8%, down from the initial reading of 3.3%. U.S. manufacturing also weakened in August, reflected in a durable-goods order decline of 4.5%. Finally, the housing industry remains weak, as sales are low, prices are depressed and inventories remain high.

Market Reaction

Amidst turmoil in the financial system and economic weakness, major indices zigzagged throughout September. Investors showed little conviction in the market upswings, preferring to sell and avoid additional losses. With the volatility, the S&P 500 declined 8.9%, the technology-focused Nasdaq dropped 11.6% and the Dow fell 5.8% in September. The reaction was even more severe in international markets, as a broad index of international stocks declined 15.0%.

As investors sought safety from the turmoil in stocks, safe U.S. Treasury bond prices initially increased in value. However, in anticipation of the approval of the $700 billion relief plan, investors became concerned about the additional debt that would be incurred by the U.S. government to fund the plan. Accordingly, longer-term Treasury prices declined, and the 10-year Treasury yield ended the month at 3.8%, unchanged from August month end. The broad Lehman U.S. Universal Index, which measures the performance of U.S. government as well as corporate and other types of debt with credit risk, declined 1.9% due to the continued deterioration of investors’ confidence in the credit markets.

Combined with the significant adverse performance of the U.S. and world stock markets in September, the major indices have experienced meaningful losses. The S&P 500 is down 19.3%, the Nasdaq has declined 20.6% and the Dow has lost 16.6%. International markets have also been severely impacted, as a global index excluding U.S. stocks fell by 29.9%.

Investment Fund Review

Inflation Protection Fund

• The Inflation Protection fund underperformed its benchmark in September, primarily due to the fund’s 10% allocation to commodities. Commodities, such as oil, continued to retreat in September as a global economic slowdown is expected to reduce demand. The Dow Jones AIG Commodity Index, a widely accepted measure of commodity prices, declined 11.5% in the month.
• For the quarter, the fund trailed its benchmark, primarily due to its allocation to investments other than U.S. Treasury inflation-protected securities. Investors preferred the safety of U.S. government bonds. As discussed earlier, the price of oil and other commodities declined. Also, the fund’s exposure to foreign bonds impaired performance as the U.S. dollar strengthened.
• For the year, the fund has underperformed its benchmark, due the same factors that contributed to its underperformance for the quarter.

• The Domestic Bond Fund slightly underperformed its benchmark, due to the fund’s somewhat higher-than-benchmark exposure to corporate credit, high yield and debt from developing companies. These market sectors suffered as a result of the continuing deterioration of credit conditions in the U.S. and around the world.
• For the quarter, the fund slightly trailed its benchmark, again due to its exposure to corporate credit and high yield.
• For the year, the fund remains well ahead of its benchmark, reflecting the one-time adjustment to the pricing methodology for valuing the fund’s holding of positive social purpose investments.

• The Domestic Stock Fund outperformed its benchmark in September, primarily due to the fund’s allocation to private real estate and private equity, which have not yet experienced declines similar to those of its public equity holdings.
• For the quarter, the fund remains ahead of its benchmark, again supported by its investments in private real estate and private equity.
• For the year, the Domestic Stock Fund has lost considerable value but remains meaningfully ahead of its benchmark, due to the fund’s allocation to private equity and private real estate and its greater-than-benchmark allocation to small and mid-sized companies, which have performed better than large companies.

• The International Stock Fund declined significantly in September, but it outperformed its benchmark. The outperformance is attributable to most of the fund’s managers outperforming their respective benchmarks, but partially offset by the fund’s higher-than-index allocation to stocks from developing countries, which performed worse than the overall benchmark.
• For the quarter, the fund has declined but remains ahead of its benchmark, due to the same factors that contributed to its outperformance for the month discussed above.
• For the year, the fund has meaningfully declined. But again, the fund’s slight excess performance is a result of the same factors referenced for the month and quarter.

• For the month, the fund is ahead of its benchmark, due to better-than-benchmark returns by the Domestic Stock Fund and the International Stock Fund.
• For the quarter, the fund is ahead of its benchmark, again due to better-than-benchmark performance by the two stock funds.
• For the year, the fund is meaningfully outperforming its benchmark, due to the strong benchmark-relative performance of the Domestic Stock Fund, the Domestic Bond Fund and the International Stock Fund, and partially offset by the underperformance of the Inflation Protection Fund.