Anatomy of a Crisis: Learning from the I-Banks’ Mistakes

It is easy to play “Monday morning quarterback.” However, that would be confusing strategy with outcome, and a strategy cannot be judged solely on the outcome. Instead, it should be judged by what alternatives might have played out. With this concept in mind, it is easy to demonstrate that investment banks such as Lehman Brothers and Bear Stearns appeared to make major strategic errors.

First, they “bet the house” by using too much leverage, meaning the company would go bust if these bets lost. Highly leveraged institutions must be right all the time because even if they are correct in the long term, they may not weather a short-term storm. This is a lesson these institutions should have learned from the 1998 experience of hedge fund Long-Term Capital Management (LTCM). While banks, with stable deposits bases, leverage between 10:1 and 12:1, Lehman and Bear Stearns had leveraged more than 30:1—and that included only balance sheet assets. Their real leverage, including off balance sheet risks, was much higher. In other words, these investment banks had evolved into highly leveraged hedge funds, and experienced a similar fate to LTCM. 

Second, they failed to effectively diversify risks, placing too many eggs in just a few highly correlated baskets (such as residential and commercial real estate).

Third, they forgot that even if assets have low correlation, risky assets have a nasty tendency to turn have their correlations turn high at the wrong time.

Fourth, they treated the unlikely (housing prices falling sharply) as impossible. They also forgot that just because something had not happened does not mean it cannot.

Fifth, they failed to understand that liquidity can be illusory: There when you don’t need it, but “gone with the wind” when you do.

The following are seven lessons investors can learn from this financial crisis.

Lessons Investors Should Learn          

1. Investment banks and active managers (including hedge funds) cannot protect investors from bear markets. All crystal balls are cloudy, which is why Warren Buffett concluded: “The only value of stock forecasters is to make fortune tellers look good.” If their money managers could protect you, why did Lehman Brothers and Bear Stearns go belly up and Merrill Lynch have to run into the arms of Bank of America to prevent the same fate? Investors don’t need to pay investment banks or stock brokers big fees to manage their money. Those fees are only likely to make the managers rich, not investors. In other words, Wall Street’s best skill is designing product that separates capital from its owners.
2. Never take more risk than you they have the ability, willingness or need to take.
3. Diversify broadly, and don’t concentrate labor capital and financial assets in one basket. Many employees of once great companies lost not only their jobs but also much of their financial assets because they made this mistake.
4. For fixed income assets, stick only with government bonds and the highest investment grade bonds. Anything else (such as junk bonds and preferred stocks) can have the risks show up at the wrong time.
5. We live in a world of uncertainty (the odds of events occurring cannot be measured), not a world of risk (the odds can be measured). Thus, stocks are high-risk investments, no matter how long the investment horizon. That is one reason for the large equity risk premium.
6. Treat neither the unlikely as impossible, nor the likely as certain. And, if something has not yet happened doesn’t mean it cannot or will not.
7. Make sure your investment plan incorporates the high likelihood of crises. The only way to avoid them is to not take risk, and thus accept Treasury bill returns. While bear markets are painful, there is no good alternative to buy and hold except to avoid risk. Timing the market is a mug’s game. As Warren Buffett said: “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”And Peter Lynch said: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”As further evidence against the folly of market timing efforts, a study on 100 pension plans that hired the “best managers” around to engage in tactical asset allocation (a fancy term for market timing) found that not one had benefited from the efforts.

The Bottom Line

The key to successful investing is to get the plan right and stick to it. That means acting like the lowly postage stamp that does one thing, but does it well. It sticks to its letter until it reaches its destination. The investors’ job is to stick to their well-developed plan (if they have one) until they reach their destination. And if they don’t have a plan, write one immediately.

Disclaimer: Larry's opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.

Comments

[rcraig:]

Wrong, anyone who has an inkling of basic personal financing knows you need to evaluate your financial plan on a regular basis. Just don't over do it. These clowns obviously were evaluating their financial positions on a daily basis without realizing many of the rapid changes they were watching were being conducted by computer software programs.
Yes, many leaders in the financial world did over done it. In my view as a novice they totally forget or ignored the basic's of economics or were absent from class on the morning the professor gave his lecture on the subject. In short there is no excuse for such mismanagement by such well educated men and women.
Seems to me there will be so many of these men and women who are in violation of federal laws there will be an outrage by the men and women who have lost their jobs because of their mismanagement that no new special prisons will be constructed to house them. If they are not placed in prison more outrage will be ignited. It is coming down to the simple fact that the average working man and woman like myself are tired of being abused by lying executives, board members, and politicians.
It doesn't matter who takes the presidential office at this point in the financial chaos we are witnessing, so long as they do not enforce massive socialist policies by taking more away from the few men and women trying to keep their employees and scrap out a profit.
I don't want to be any part of any government placing limits on how much a man or woman can make but, do believe there should be restrictions on "golden parachutes" for idiots. If the government is going to regulate the process then they should require a certification test for any man or woman submitting to take over any corporation classified as a large cap stock.
I'm sorry, but, every common sense rule you listed was violated by these idiots who have financially raped the world finances even if we are going through a natural historical adjustment.

2008 Oct 19 01:06 PM

[VentureJim:]

I grew up during World War II on a tobacco farm in Virginia. My uncles came home from winning the war and wound up with good jobs in the auto industry in Michigan; the shirt factories and furniture industry in North Carolina.... I remember the beautiful smell of the leather in a 1953 Pontiac Chieftain hardtop driven up by one relative who worked in a shirt factory in Kannapolis...(I was 12)

The United States has had a good run for the last 50 some years... Nothing lasts forever, though, and now all of our wealth generators have moved to foreign countries....

Our only hope for the future are the international companies we've built and the trading infrastructure that we have built with other countries...This may help to cushion the next 100 years of a down-hill slide in U.S. purchasing power... Our best hope is that other countries can "Decouple" from us and then we can invest in those countries and companies that can pick up the slack as they do more business with each other... Until I can find such opportunities, I will keep my 401K in a "cash reserve" fund that is paying 2.5% interest...

2008 Oct 19 07:53 PM