Healey: The housing market will be the tipping point. Laird mentioned the marginal buyers. The homeownership rate is, 70% of the households in America own a home now. Traditionally that has been in the low 60s, say 65%. That last 5% is kind of dragged in by financial firms that go out of their way to get these subprime borrowers into houses that they basically could not afford, and now when the piper comes to be paid that 200-basis-point uptick in their ARM rate, it will be interesting.
The bigger issue, and this is directly from Janet Yellen, who is president of San Francisco Fed, is what she terms as housing as a piggy bank. It is not just these marginal buyers, it's people that actually own their homes that have seen this tremendous price appreciation. Like Laird out in California-I'm from Greenwich Connecticut and if you looked at today's paper, we were in the top ten there as well, the median price I think was $1.4 million. That has probably doubled if not tripled over the last four years.
     A lot of people are looking at this $1.4 million, and they look at their house as a big part of their retirement package. They believe they will be able to take the equity out of that house, trade down, and take that and go live off of the income. Now, with the savings rate negative, what have people been doing? It is similar to what happened with the Nasdaq bubble. The stock market was saving for them, so they can go out and spend it until there's a crash.
    Now look at the housing market. Similar things, if you look at the charts at how high prices have gotten and the amount of equity that people so called have in their house. If we get a 15%  to 20% drop in home prices, that paper profit that they thought they had, in some cases $200,000 or $300,000, is money that they are not going to have available, in their minds, to spend in retirement. So they will have to save the old-fashioned way. I think that could happen.
    On the recession, Jay mentioned it, the stock market, a good predictor in the past, says no way is there a recession. My biggest point on this is we don't know when it is going to be, but I will guarantee you that this recession, if and when it happens, will be nothing like 1991, where we didn't even know it happened. It will be severe, I think, because you haven't had a true recession dating back to 1991. I think you have to hedge for that, and Dan mentioned extending your duration. My point is when it does happen it is, unfortunately, I think it is going to be ugly.

Fuss: This is what makes markets, Bill. I agree with you and I don't. The part where we agree, you just have to, when you get in this environment, if you get caught by reinvestment risk, you have had it. So, if there is even a one in 20 chance you are going to extend, because once interest rates go down there is nothing you can do. If they go up that is good news. because you reinvest at a higher rate. The argument for a softer economy, but not a recession, is that you get these geographically dispersed rolling adjustments, slow business in Detroit, lousy home prices in Greenwich, California and a boom in the mountain states. With regard to the Fed, I might add that the Fed under Bernanke is not politically strong yet.

Simonoff: Let's look at the positive side. Jay, where do you see opportunities in the bond market?

Chitnis: Laird mentioned that risk premiums in the bond market are extremely low. We think that the areas where the spreads over Treasuries are narrow, where the problems could be, are areas like junk bonds and emerging markets. You aren't getting paid for the risk. So by default, Treasurys are looking pretty good as a residual of everything else looking not so good. The worst in the housing market may be over. One of the things we hang of our hats on is contrarian sentiment, and sentiment in the housing market is so poor we think relative value there may be pretty good as a result of all the bearish sentiment.
    One thing we are very bearish on is TIPS, by reason of our deflationary outlook. TIPS have performed very poorly for the last year, particularly in the last few months, so we think it may be time to dip your toes back in the TIPS market as a hedge against our deflationary bias. The mortgage marketing in a placid interest rate environment is interesting, so we've dipped our toes back in there. But if you believe in a deflationary environment over the next few years as we do, there is substantial prepayment and reinvestment risk out there.

Landmann: Good points, but we couldn't disagree more about the homebuilders. Many are concentrated in areas like Florida and California, and we think you have just seen the tip of the iceberg. Some homebuilders will take 12 to 18 months just to clear out excess inventory. What do I like? We agree about TIPS, there are pockets in the mortgage markets that offer nice spreads with good credit protection so you can add them for absolute return. Corporate bond spreads are tight, and we think emerging market bonds will be one of the worst-performing sectors over the next three to five years.

Healey: The pockets of pain will come first from housing-related investments. In the subprime  area, people just don't know what they're buying. A lot of these new structures haven't been tested. They will be. In the commercial real estate sector, we think you can't have a residential recession without having spillover into the commercial area.
For opportunities, I agree with panelists on TIPS though I think it's really a relative value and not an absolute value play. We do like munis, and one of the reasons is that we think this is as low as tax rates are going to be. Depending on what happens in November and definitely on what happens in 2008, there will be a new regime that tries to raise taxes. Demographics suggest that taxes will have to be raised. In emerging markets, we believe in the China story, we believe in global growth, so we think there are pockets of opportunities. Lastly, we think cash is not a bad place to park some funds for preservation of capital. You can get 5.25% in some of the short-duration funds. Given all the uncertainty, with ten-year Treasuries at 4.5% or 4.6% and the Dow about to set a new all-time high, sitting in cash at 5% isn't a bad alternative.

Fuss: I agree with the thoughts on munis and TIPS. I think TIPS are cheap based on our outlook, but they keep getting cheaper. As for emerging markets, we have a somewhat different view. Some emerging markets are stronger than others. But in Asia we like to split the currency from the creditor because the spreads of the local currencies are so narrow you don't make any money.

Simonoff: Jay, many of you have been able to realize some significant capital gains in bonds. Do you think the bond market over the next five years will be as conducive to that style of investing as the last few decades have been?

Chitnis: I would guess everyone here would agree on that point, because the bond markets are not efficient. So you have this oscillation between fear and greed and the opportunity exists in taking advantage of that oscillation, not in buying and holding. Yield is really a somewhat meaningless economic variable, although investors do have a demand for income. So you shouldn't let the income component wag the total return investing dog.

Landmann: Fixed-income markets are pretty inefficient and emotionally driven. I got a laugh recently when one of my colleagues suggested that this business does risk management much better today, so that explains why the recent  collapse of a few hedge funds with big positions in commodities caused so little damage. We actually think risk management is done as poorly today as it ever was, and you have all these hedge funds pushing the limits to get the 10% or 12% returns their investors are demanding. But these markets aren't volatile enough to earn those kinds of returns, so the heyday investors are expecting isn't going to come. The heyday is really protecting your capital and waiting for the deflationary cycle that Jay is talking about to come, when people panic and throw away very good investments. That's what you want to position yourself for.