“As a general rule of thumb, the more complexity that exists in a Wall Street creation, the faster and farther investors should run.” – David Swensen, CIO, Yale University
With the eight-year anniversary of the collapse of global financial services firm Lehman Bros. coming up next week, perhaps it’s a good time to take a sober look at the realities of investing. What does it tell us when such a respected financial institution, after more than a century and a half, shuts its doors?
In his book, “The Big Short,” Michael Lewis offers an accessible education on what investment banks like Lehman Bros. were doing to drive the housing bubble toward bursting, which would in turn contribute to the greatest worldwide financial crisis since the Great Depression.
1. Investment banks were increasingly betting on housing, heightening the demand for mortgages. Subprime mortgages – those written for borrowers with FICO scores below 650 – of increasing risk for default were being packaged up into mortgage-backed bonds.Bond brokers would buy up thousands of these mortgages to go into each instrument.
2. This heightened demand induced mortgage originators to make riskier loans to increase supply. Moody’s and Standard & Poor’s were giving these mortgage-backed bonds higher ratings than, in hindsight, we know they were worth. There was little understanding or acknowledgment that the loans inside them were increasingly not only subprime, but adjustable rate mortgages (ARMs) whose “introductory rate” would expire after two years, triggering widespread defaults.
3. The growing number of risky mortgages overwhelmed formerly stable asset pools. Subprime mortgage-backed bonds were increasingly packaged into collateralized debt obligations (CDOs), which used to be backed by a variety of debt obligations (such as credit card payments and other types of loans). Now they became contaminated with housing debt on the brink of default, exposing CDO investors to risk that they probably weren’t aware of. These products were so complex, and their contents so shrouded in fine print, that many brokers didn’t even know what they were selling.
All the Rotten Eggs in One Basket
This was the narrow-minded strategy that led to the downfall of Lehman Bros. The percentage of revenue the investment bank generated from housing increased dramatically in the years leading up to 2007, when those loans started to go bad. By the third quarter of 2008, both investors and creditors had lost confidence in the firm’s ability to contain its losses. On Sept. 15, 2008, the 158-year-old company filed for Chapter 11 bankruptcy with nearly $640 billion in assets. It was the largest filing in U. S. history.
The Moral of the Story
Baupost Group founder Seth Klarman once said, “The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions.”
Greed, that human capacity for losing sight of our values in pursuit of short-term gain, and ignorance, our knack for missing the forest for the trees, will always lead to errors in judgment that will trigger the need for correction in our financial system. What is propped up as valuable over time reveals itself to be worth far less, and those who depended on the fiction will suffer the consequences of facts.
The question is not if there will be another recession. The question is: What is your plan of action for when the market recognizes some error and pulls back?
Planning is Power
Even big banks like Lehman Bros., with all its institutional knowledge and resources, can fall into the gambler’s delusion that, because something has always worked one way (like historical growth in the housing market), it will continue.
Don’t follow suit!
When your investment decisions are value-driven over the long term, and when your eyes are open to the risks you’re taking, then you’re acting more prudently than one of the most respected financial institutions of the last two centuries.
Those who lose everything in a storm are often those who assumed it would never come. Those who weather the storm acknowledge the risk before it hits, have a plan and stick to it when the storm arrives. Do you have a written investment plan? If not, the time to create one is now.
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2016, The BAM ALLIANCE