An old military saying has become popular on Wall Street: "Amateurs study the plan. Professionals study the assumptions."
It's too bad that nostrum wasn't in fashion a few years ago, when it seemed as if nothing could go wrong in the go-go economy. An epic housing boom fueled by low interest rates was turning ordinary Joes into real estate magnates, and everybody wanted in. Home equity materialized out of nowhere, helping everyday Americans buy fancy vacations and luxury cars. When Henry Paulson was nominated to be treasury secretary in 2006 and came to Washington for confirmation hearings, nobody even brought up the topic of subprime loans or a housing bust. What, us worry?
We know what happened, of course. Investors seeking the highest possible returns badly underestimated the risks of exotic securities linked to doomed mortgages. Things that couldn't possibly go wrong went very wrong. Financial geniuses on Wall Street ran computer models showing what would happen if their own risky bets went sour—but not if everybody else's did, too, at the same time. And then, the unthinkable: the collapse of Wall Street titans like Bear Stearns and Lehman Brothers (LEH) and an earthquake in the financial system.
Behind all of those meltdowns were bad—sometimes awful—assumptions. Here are some of the most egregious:
Real estate values always rise over time. That was true for most of the last century—until they rose too much in too little time in the middle of this decade. We know now that housing values nationwide peaked in 2006 and have been falling ever since. So far, prices are off about 20 percent from the peak, with probably a further decline of 10 or 15 percent ahead. Assuming that home values would keep going up was a catastrophic miscalculation—for Citigroup (C), Merrill Lynch (MER), Fannie Mae (FNM), and millions of homeowners who now can't afford a huge asset that's falling in value.
Lesson: Never bank on outsized gains that haven't materialized yet.
[See why the feds rescue banks, not homeowners.]
The mighty consumer will keep spending. Remember when economists kept marveling at the willingness of Americans to get out their wallets, no matter what their debt load or job prospects? Well, the economists aren't so impressed anymore. During the second half of 2008, retail sales, for example, fell nearly 8 percent, the steepest decline on record. The good news is that consumers are paying off debt and saving more, but for an economy in which consumer spending accounts for two thirds of gross domestic product, the pullback signals a dramatic realignment that will be painful for an overspent nation.
Lesson: You can't spend your way to greatness.
A buyer will always emerge. But at what price? All those bidding wars over homes in 2005 and 2006 were driven by the belief that somebody else would pay even more for the house in a couple of years. But when home values started to fall, buyers evaporated, because nobody wants to buy a big asset that could be worth less the day after you close the deal.
It wasn't just homes: Lehman Brothers CEO Richard Fuld was convinced a last-minute buyer would emerge for his troubled company—right up to the moment Lehman declared bankruptcy. Bear Stearns and AIG foundered because suddenly there were no buyers, at any price, for vast amounts of troubled securities that had been as good as cash a year earlier. General Motors (GM) has been trying to sell its Hummer division for the better part of the year, but it turns out nobody wants to pay real money for a division that represents the conspicuous consumption of a bygone era.
Lesson: An asset is worth only what somebody else is willing to pay for it—not what you think it should be worth.
[See why a bankruptcy boom is coming.]
Banks will be careful with their money. Ha! Once upon a time, bankers were conservative investors whose first responsibility was to make sure they didn't lose their principal. That led people like former Federal Reserve Chairman Alan Greenspan to assume that the mere risk of losing money was plenty of incentive for banks to make smart, careful investments.
Greenspan was wrong. Here's what he said in October: "Those of us who have looked to the self-interest of lending institutions to protect shareholders' equity...are in a state of shocked disbelief." So are bank shareholders: The S&P 500 index is down about 40 percent for the year, but the financial sector is down about 60 percent.
Lesson: Never underestimate people's ability to screw up.
[Read four myths about free markets.]
Don't worry, the smartest guys in the world are working on the problem. A disproportionate number of the world's geniuses work on Wall Street—which might be one reason that the problems they cause are so colossal. Let's revisit Greenspan, who also pointed out that, "in recent decades, a vast risk management and pricing system has evolved, combining the best insights of mathematicians and finance experts." So, what happened? Back to Greenspan:
The whole intellectual edifice collapsed in the summer of last year because the data inputted into the risk management models generally covered only the past two decades, a period of euphoria.
Oh. Garbage in, garbage out. Guess the experts didn't think of that.
Lesson: Arrogance lowers IQ. By a lot.
Technology is the solution. One reason there was so much overconfidence on Wall Street is a vast electronic network that allows millions of global trades to take place every day. That allows traders to spread risk far and wide, and gamble even more money—because, theoretically, there's less chance they'll lose it.
Except there was a bug in the system. Here's how IBM CEO Sam Palmisano described it this fall: "The financial institutions knew how to spread risk. But they couldn't track the risk. Capacity and speed made it more difficult to control once it began." Superfast computers may have provided some investors an advantage, in other words, but it turns out they also jeopardized the overall system.
Lesson: Never let technology supersede the basics.
The feds will fix things. Funny how all those free marketeers on Wall Street suddenly want Big Brother to save their skin. And while government intervention has clearly prevented a total seizure of the financial system, we've also seen the limitations of government action. Loans to consumers and small businesses are hard to get, for example, even for people with good credit. And $7.5 trillion of government aid, in various forms, still hasn't been enough to prevent a painful recession.
Lesson: Plan for a rainy day, and pack your own umbrella.
[See why the bailout tally so far is twice the entire government budget.]
There's plenty of liquidity. This was the mantra among big investors in the middle of this decade, when vast sums of global money were available for investing in practically anything. But back then, investors were sure they'd get their principal back, usually with a handsome return. When Lehman Brothers collapsed and AIG nearly went under, investor confidence went into reverse and money became scarce—for investors and ordinary consumers alike.
Lesson: Take advantage of credit. But don't become dependent on it.
[See why AIG gets billions, while GM gets scorn.]
Things will bounce back. Sure they will, eventually. But timing is everything. As financial firms like Citigroup, Washington Mutual (WM), Bear Stearns, and others started announcing losses in 2007, famed money manager Bill Miller of Legg Mason (LM), for instance, decided it was time to rapidly accumulate their shares: The bad news would surely pass, and when the shares rebounded, his fund would earn a healthy payout. That strategy had worked countless time before, but this time, Miller guessed wrong. His fund, famous for beating the stock market, ended up performing 20 percent worse than the markets over the past year.
Lesson: Ask what will happen if you're wrong and events don't unfold the way you're sure they will.
[See how the smart money turned dumb in 2008.]
It can't happen to us. If the "it" is another crushing depression, then yeah, it probably won't happen. But the current recession will be harsh and it will erase the beliefs that business cycles are a thing of the past and that modern progress has overcome human nature. In much the way that we look back at the Great Depression with bemusement, citizens of the future will look back on us as greedy and foolish.
Lesson: There's always a chance you'll look stupid tomorrow.
Disclosure: no positions.