First Quarter 2009 Review April 6, 2009

“Radical chic invariably favors radicals who seem exotic and romantic…”

- Tom Wolfe

Dear Partners, Western Reserve Master Fund, LP (the “Fund”) closed out a roller-coaster first quarter down approximately 13% versus our closest comparables – S&P financial related indexes down an average 34%. Stocks were first driven essentially by fear and uncertainty over the new concentration of power in Washington and then by ‘shock and awe’ over the hurried magnitude of radical legislative and fiscal policy ambition. Once the ‘shock’ was discounted, stocks stabilized near the end the quarter off deep depression-era values. Investors remain numb, though not comfortably so… From the inflection point in the election last October to the recent lows, stocks and the economy posted their largest and swiftest decline since the late eighteen-fifties or at the eve of the Civil War. They were led down by the horror of rabid and unfounded bank nationalization fear. More than two-thirds of the declines in both stocks and jobs lost in this downturn have occurred since October, when polls all but insured an imbalance of power in the offing. We believe this frightened both investors and business owners alike. It’s at this point the economy simply “fell off a cliff” as Warren Buffett recently surmised. Never before in our lives has politics influenced investing so dramatically and we all have been reluctantly pulled-into the body politic. Wall Street, it would seem, has temporarily moved due south by approximately 204 miles. The good news is that the displacement of the market as measured either by a short train ride or a far more immodest journey into panic, spells opportunity. A record $10 trillion of M2 (cash and equivalents) now sits on the sidelines and much is parked atop the balance sheets of the nation’s banks. Our banking system is much maligned these days amid rampant populism. It has spawned the previously unthinkable such as neo-terrorist groups like “Bank Bosses are Criminals”.

All the same, our financials presently sit on their largest store of liquidity in history. Money is made whence capital flows and our financial system has hoarded much of our country’s capital. Conversely, investment demand for gold now represents nearly 60% of all global mine production (a record) and the percentage of it physically delivered is at levels last seen in 1982 or the onset of the greatest bull stock market of all-time. Make no mistake. This is the worst and most sudden swan dive in the economy in our lifetime and we hardly are bullish for a swift recovery. However, we do believe the discounts in equities are prodigious. And the resilience of our uniquely self-reliant denizens and business stewards can and will work around Washington until “gridlock” returns. “Radical chic” will wear out its favor and majority prudence will restore confidence; as a result the economy and stock market will begin to rise again over a protracted period. This is the time of our lives as investors. The “Chaotic” Case for Financial Stocks Western Reserve has written extensively the past few years about the inherent flaws in mark-to-market accounting (MTM), and its “negative feedback loop” effect on banking and our economy. Not to mention, the underlying problems for accountants who have misapplied “fair value” to the new, unregulated and highly speculative credit default swaps (CDS). For a long time, trees falling in a forest were more than just metaphor. Now, we hear even retroactive recoveries are potentially in the offing from badly needed revision to MTM. It’s promising we now see these tightly correlated issues aired out on television and on Capitol Hill on a daily basis by a growing legion of fervent agreement and more constructive disagreement. The restructuring of MTM is inevitable now and so is the strict regulation of CDS to require offsetting assets and/or material equity investment. It’s actually the CDS issue that makes MTM so flawed as the lack of asset or equity backing caused inefficient price discovery. In combination, their restructuring likely has set a floor on financial stocks in our view and the healing can begin…

“I just don’t get that we should treat credit default swaps as like the Delphic Oracle of any kind. It’s the most easily manipulated and broadly manipulated market that there is.”

- Jeff Immelt, CEO of General Electric We didn’t get it either Jeff. We pulled our GE short off too soon as a matter of fact. Arguably, we were too early on these issues and found ourselves too far out in front (noting two former Fed Chairmen below, we were in good company). We pulled our financial shorts off prematurely as a result. We mistook chaos as mere misinformation that would correct itself in feasible time and totally missed the Congressional flip-flop on TARP. We didn’t expect rational beings to take so long figuring out MTM and CDS. And we frankly were blindsided by the class warfare targeting of the banking industry.

Paul Volcker on Mark to Market Accounting

Former Fed Chairman, Paul Volcker, Chairman of the Group of Thirty, Consultative Group on International Economic and Monetary Affairs, Inc., just released a study with recommendations on financial reform.

Recommendation #12 on Fair Value Accounting reads as follows:

a. Fair value accounting principles and standards should be reevaluated with a view to developing more realistic guidelines for dealing with less liquid instruments and distressed markets.

b. The tension between the business purpose served by regulated financial institutions that intermediate credit and liquidity risk and the interests of investors and creditors should be resolved by development of principles-based standards that better reflect the business models of these institutions . . . ."

Alan Greenspan on Mark to Market Accounting

On November 1, 1990, Federal Reserve Chairman, Alan Greenspan, in a 4-page letter to Richard Breeden, Chairman of the Securities and Exchange Commission, said, in part:

"The Board believes that market value accounting raises a substantial number of significant issues that need to be resolved before considering the implementation of such an approach in whole or in part for banking organizations.

Accounting methodology should be developed to measure the results of a particular business purpose or strategy; it is not an end in itself. For an institution whose business purpose is to trade marketable financial assets on an intra-day basis, for example, closing daily market values would measure the success or failure of that particular business purpose. An end of the day balance sheet, marked to market, is clearly the appropriate accounting procedure in the example.

Generally, the business strategy of commercial banks, on the other hand, is to employ their credit insights on specific borrowers to acquire a diversified portfolio of essentially illiquid assets held to term. The success or failure of such a strategy is not measured by evaluating such loans on the basis of a price that indicates value in the context of immediate delivery. Clearly, one aspect of value in an exchange is the period of delivery. But the appropriate price for most bank loans and off-balance sheet commitments-is the original acquisition price adjusted for the expectation of performance at maturity. It is only when that price differs from the book value of the asset that an adjustment is appropriate. A reserve for loan losses is such an adjustment. To mark such an asset to a market price intended to reflect the value of a loan were it liquidated immediately is interesting, but not a relevant measure of the success of commercial banking."

The good news is that we have made no fundamental mistakes (have had to take no permanent losses long) and prices just got better and better, thus lowering our average cost and increasing the upside. Chaos brings with it both short term and long term opportunities. There was a great opportunity chasing a “short all the financials” bubble. We looked at MTM and CDS, saw the flawed pricing, and didn’t draw the fundamental case to chase the short trade far enough. The “populism” that erupted into the bank nationalization panic during the quarter was a wild card (read: blind luck). This financial crisis is different in one significant way than the one we witnessed as banking regulators in the early nineties. In the S&L Crisis, the accounting lagged the poor underwriting decisions of many banks and it had to be altered after-the-fact. The current crisis also involves some ridiculously poor underwriting by some lenders, but it was isolated to certain types of mortgages and in the absence of MTM and lax CDS regulation, we believe it would have begun and ended there. In this crisis, MTM and CDS were the agents of spreading credit concerns to unnecessary levels and across uncorrelated asset classes. This go ‘round, we are forced to unwind perhaps well intended but hastily crafted and deeply flawed accounting after-the-fact. The investment opportunity is the same however…gloomily under valued financial stocks, which should lead the recovery. Opining about the financial crisis which concluded in the early 1990’s, value investor David Dreman writes in Contrarian Investment Strategies, “A full-fledged panic in financial stocks began during the Gulf Crisis, in August of 1990. Banks, S&L's, insurance companies and other financial stocks, already down sharply because of real estate problems, went into a free fall. Fears were now voiced about the viability of the banking system itself, and doubts were expressed as to whether it could withstand the shock of trillion-dollar losses in real estate. From the beginning of the year to the end of September of 1990, money center and regional banks dropped 50%. Some financial stocks fell by as much as 80% from their previous highs."

“Crisis investing opens the door to large profits. But you had better don your general’s hat and flak jacket. To make this killing you have to charge ‘into the valley of death’ while overreaction is roaring and thundering all around you.”

- David Dreman, Contrarian Investment Strategies, 1998 Dreman continues his analysis of this period by pointing out that many bank stocks fell to substantially below book value, observing the same principles that Western Reserve has written about extensively in our prior quarterly client letters. As Dreman qualifies more articulately than we, in times of crisis, pricing becomes as distorted as public opinion. Negative opinion and negative events cycle back and forth or what Western Reserve has described as a “negative feedback loop,” which dominates market sentiment and overwhelms reason. Dreman observes, “In a crisis or panic, the normal guidelines of value disappear. People no longer examine what a stock is worth; instead they are fixated by prices cascading ever lower. The falling prices are reinforced by expert and peer opinion that things must get worse.” Dreman adds, “Further, the event triggering the crisis is always considered to be something new; nothing in our experience shows us how to cope with the current catastrophe.” Few investors understood this period for what it was. Namely, a historic buying opportunity with a great likelihood for extraordinary returns as hadn’t been seen in a long time. Western Reserve views the current environment in very much the same way. Warren Buffett viewed the market

for financial stocks similarly as Dreman in 1990. The following is a brief (and condensed) excerpt from the Berkshire Hathaway 1990 year-end letter to investors.

“Our purchases of Wells Fargo in 1990 were helped by a chaotic market in bank stocks. The disarray was appropriate: Month-by-month the foolish loan decisions of mismanaged banks were put on public display. As one huge loss after another was unveiled -- often on the heels of managerial assurances that all was well -- investors understandably concluded that no bank's numbers were to be trusted. Aided by their flight from bank stocks, we purchased…Wells Fargo for…less than five times after-tax earnings. A year like that -- which we consider a phenomenon -- does not distress us….fears of a real estate disaster caused the price of Wells Fargo stock to fall almost 50% within a few months. Though we had bought some shares at prices before the fall, we welcomed the decline because it allowed us to pick up many more shares at the new, panic

prices.”

Source: Berkshire Hathaway, 1990 Investor Letter The performance of the NASDAQ Bank Index versus the S&P 500 from November 1990 to April 1998 is illustrated in the chart below. During this period and based on daily price at closing, this broad index of regional banking stocks returned approximately 887% versus a return of approximately 200% in the S&P 500. Dreman and Buffet were dead-on.

0%

100%200%

300%400%

500%600%

700%800%

900%

November 1990 - April 1998

NASDAQ Bank Index

S&P 500

Western Reserve offers additional insight that supports the strong likelihood of a sharp recovery in financial company earnings (and stock prices) in advance and in excess of the broader market over the next several years.

The substantial historical out performance of financials following a credit-induced crisis lies in the fact that financial services firms’ profits recover ahead of most product and industrial companies due to five dynamic “profit accelerators” that are unique to financial services firms’ business models and their accounting not found in other industries.

Loan Loss Provision Expense Loan loss provision expenses are non-cash deductions from capital and currently represent more than 85% of banking profit declines. These loan loss provisions are very pro-cyclical non-cash charges which peak long before the economy begins to recover and often become grossly overstated due to “double upping”. As a result, the banking industry will see profit relief from lower loan loss provisions early in an economic upswing. This is an accounting-related phenomenon. In downturns, banks transfer capital to their loan loss reserve accounts by reducing retained earnings (by making non-cash charges against earnings). This is not a transfer of cash or a “cash flow exercise,” it is a balance sheet transfer from the capital account (retained earnings) into a contra-asset account (loan loss reserve). Therefore, bank earnings are significantly reduced during periods of heightened credit losses because most banks expense their current loan losses without corresponding reductions of their loan loss reserve balances causing the expense to be a “double up”. After loan loss provisions peak, such as at or near the bottom of a recession, banks see their earnings recover suddenly as the loan loss reserve “spigot” gets turned off and reported profits "jump" quickly back in line with underlying cash flows. This gives Wall Street the appearance of a very sudden and rapid acceleration in the earnings power of banks, while a bank contemporaneously is over-reserved for future losses. Release of Excess Loss Provisions

New accounting standards governing bank loan loss reserving practices were implemented following the last recession and exacerbate the over-reserved aspect of the aforementioned “double up”. These new standards require banks to “reverse out” any excess loan loss reserves by “releasing” them back through future earnings periods. This creates a levered boost to earnings power as the economy stabilizes. First, new loan loss provisions are eliminated or get dramatically reduced as discussed in the previous paragraph. Second, the excess reserves are released back through the earnings statement. The result is that bank earnings are grossly under stated during downturns and overstated during up turns. “Double ups” become “double dips”… Our research using CAMEL or regulatory insight is the driver of our research combing over the carnage looking for banks that will have very quick recoveries in credit related expenses. Transaction-related earnings as “money flows” return

The economy now is sitting on a record $10 trillion in cash and cash equivalents (defined as “M2” by the Federal Reserve). Most of this cash is currently custodied within the financial services industry. As the economy begins to stabilize and investors begin to accept more risk by moving out of cash, financial services firms realize early and strong revenue growth acceleration because they are, at their core, transaction processing-oriented businesses that generate fees from moving, loaning, servicing and transacting these cash flows.

Financial services firm revenues accelerate first in a recovery as money starts to “move around” again. This is true both of monies moving back into debt and equity capital

markets and out of money markets, as well as retail-oriented transactions driven by the acceleration of credit and debit card purchases. Merchant (investment) banks and custodial focused banks tend to move first followed by more traditional commercial banks. Slope of Yield Curve

Like the Greenspan Fed in the early nineties, it’s highly likely the Bernanke Fed will leave short term interest rate targets low for a protracted period of time to help the banking industry “earn” it’s way through higher credit costs. This proved very instrumental in aiding the recovery of banks in the after-math of the S&L Crisis. The effect is to allow bank net interest margins (lending spreads) widen and stay wide for an extended period. Record levels of capital and liquidity

As financial firms have cash and capital hoarded per usual in this credit crisis, the industry is sitting on the largest store of capital and liquidity in history. As a whole, banks have three times the relative level of capital today than they had during the depths of the S&L Crisis. The average bank now carries regulatory capital above 12%, or almost three times the minimum level required to meet standards for being considered “well capitalized.” Any retroactive recoveries from MTM amendments will only further boost capital levels. We do not expect any surprises from the current “stress tests” on-going; as “impairment accounting” which governs 80% or more of bank held assets is timely and effective and our CAMEL approach to analyzing banks is in step with the regulators.

While non-performing loan levels are still rising and we expect them to continue for some time, they remain well below those experienced during other credit crises such as during the period from 1988 through 1992, and significantly below the level experienced during the Great Depression. Many banks are trading at levels below their net cash-on-hand (excluding core deposit “match funded” loan portfolios), so the extraordinary levels of liquidity and capital are not credited in stock prices. Such remarkable levels of capital and liquidity mean that banks are “under-loaned” and have excess cash and deposits on hand. At the point the potential fiscal economic stimulus and obvious “easy” monetary policy effectively grabs-hold, banks will be extraordinarily well-positioned to lend into an economic recovery. This increased lending activity is expected to result in a steady and early increase in the banks income-producing assets which will bolster their net interest margins and profitability. Traditional banks, especially smaller regional banks, will flourish and their valuations climb sharply. In addition, excess capital and liquidity likely will usher-in another extensive merger boom such as we saw in the latter parts of that near 900% climb in the financials between 1990 and 1998.

According to First Call average analyst estimates for the S&P Financials Index, Percent change year over year in earnings-per-share

1Q09 -37% 2Q09 -40% 3Q09 +264% 4Q09 >+500% 2010 >+350%

Source: First Call (These are First Call and Western Reserve estimates)

By comparison, the average earnings progression for the S&P 500 excluding Financials is far less attractive coming out of this downturn as a result of the aforementioned “profit accelerators”.

1Q09 -36% 2Q09 -32% 3Q09 -27% 4Q09 -17% 2010 +2%

Source: First Call (These are First Call and Western Reserve estimates) Conclusion - Financial firm earnings “snap-back” will attract investors on a relative basis into the coming recovery, propelling their shares faster and higher than the overall stock market.

The ‘shock and awe’ of the liberal agenda no longer is a surprise to anyone, so the economy is showing some modicum of stabilization. However, its a stabilization at very depressed levels and recovery will be slow, arduous and lumpy. This is one reason why equities will start to outperform other asset classes and already may have begun. We have record cash on the sidelines in the economy. It eventually has to move off the fence. The economy will be an L-shaped recovery, but stocks will lead and have a U-shaped recovery as a public stock can move ahead of fundamentals whereas a building or land or private equity cannot. Keep in mind that public equities, particularly financials, already trade below private market value as folks have had to see them marked monthly in their account statements, prompting them to sell public stock emotionally. They see their stocks down and sell and live in denial of their private holdings liquidation values. The opposite is true at troughs.

Regards,

Michael P. Durante Managing Partner