Learning from Investment Bank Mistakes

“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.” – Larry Swedroe

What can investors learn from the mistakes of investment banks, such as Lehman Brothers and Bear Stearns? That question is what Larry Swedroe addresses in his article: Anatomy of a Crisis: Lessons Learned From the Credit Crunch.  Swedroe believes that one should not judge a strategy “solely on the outcome.” Nevertheless he identifies the “major strategic errors” investment banks made.

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).

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 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.

Lessons Investors Should Learn

1. Investment banks and active managers (including hedge funds) cannot protect investors from bear markets. All crystal balls are cloudy … 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? …
2. Never take more risk than you 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 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.

How Wall Street Became a Giant Hedge Fund

 “Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” – Warren Buffett (2003).

Some people are placing the blame for our current financial crisis squarely on the shoulders of greedy Wall Street financiers. They have a valid point. At least part of the problem can be attributed to greed. How and why greed undid some of the great financial institutions is best told by a Wall Street insider.

“Andy Kessler is a former hedge fund manager turned author who writes on technology and markets.”

His article, The Demise of a Giant Hedge Fund - The old Wall Street is dead. Long live the new Wall Street, appeared in the October 13, 2008 The Weekly Standard.

Wall Street is really just a compensation scheme. Firms generate sales, and employees get half the money. Yes, half. The rest, after expenses goes to shareholders. Sweet deal.

By 2002, Wall Street firms, despite being flush with huge balance sheets of capital to generate returns with, were no longer making money in their bread and butter business of stock and bond trading, investment banking, and money management. The one group making money were these weird guys with math Ph.D.s creating exotic securities, derivatives, pieces of paper backed by pools of assets, maybe airplane leases, or home mortgages. The neat thing about derivatives is that no one but the person who created them knows what they’re worth, so you can sell them at huge markups. Woo-hoo. Mammoth departments were created all over Wall Street to securitize everything that moved. With the Fed forcing low interest rates in 2002-2004, the higher the yield the better.

Subprime home mortgages, because of higher risk (ooh, don’t say that word), had high yields and moved to the top of the list. When not enough of these loans could be bought from banks, firms like Bear Stearns and Lehman set up entire loan-origination subsidiaries, and in true Wall Street style were aggressive and rose to the top of the market-share tables. If you want to know why Wall Street CEOs made so much, it wasn’t from trading your 1,000 shares of Apple stock.

Still, those profits weren’t enough. Their customers were making great money buying Wall Street’s derivatives. But why should banks and pension funds and hedge funds have all the fun? What a perfect use for all that capital on their huge balance sheets and cheap financing from low interest rates. Wall Street, en masse, started buying all these high yielding derivatives for their own account. They ate their own dog food, if you will.

…all of a sudden, Wall Street is no longer a business of traders or stock brokers or investment bankers, it’s a giant hedge fund. And they have no idea what they are doing. None. I ran a hedge fund for a lot of years and learned rather quickly that if a trade was too good, if everyone was doing the same trade, then I should absolutely turn around and run for the hills. But no one on Wall Street did. The spreadsheets flashed green. Risk was a four-letter word best not said in polite company.

Wall Streeters became hedge fund cowboys and loved the spoils, until a tiny little downturn in housing sent everyone rushing to get out of the pool at the same time. Deleveraging a balance sheet leveraged at 30 to 1 is not easy or pretty when everyone is doing it along with you. And this is not the customer panic-selling and paying fees to Wall Street, it’s Wall Street doing the selling, pushing prices into the irrational range and turning companies belly up overnight.

Is this the end of Wall Street? More like the start of a new one. At the end of the day, Wall Street is not about the names on the door, it’s about the people inside. There were great people at Lehman and Enron, Bear Stearns and AIG. Those who have a nose for making money will join other firms, or hedge funds, or start their own shop. Still, I’m pretty sure that half of those employed on Wall Street in 2007 will be doing something else by January.

And the new Wall Street? There’s only one direction. It’s back to basics. Not quite back to the old white shoes-blue blood partnerships of the past but certainly that business model. With a lot less capital, sit on the edge of the stock market and provide access to capital for the next set of great companies. Take ‘em public, bank ‘em, and grow with ‘em. It may not be as exciting as the last few years, but it beats getting dumped in the East River.

My Conclusion

In the end, greed was a big factor, but so was a complete failure to manage risk, properly. Top management at some investment banks, supposedly intelligent people, essentially bet their whole company on a strategy that amounted to putting too many eggs in one basket. They ending up owning “exotic securities, derivatives, pieces of paper backed by pools of assets.” They did not understand these securities any better than the people they sold them to.

And because there was no transparency or regulation, the investment bankers could take on as much risk as they wanted to. So they used way too much leverage. They simply took more risk than they had the ability to take. These bets were very profitable, until things went the wrong way. And, because they used such a large amount of borrowed money, there was just no margin for error.

And when many on Wall Street tried to “deleverage” at the same time, i.e. they all tried to sell at once, there was no one on the other side of the trade. There were not enough buyers, so there was no liquidity, just when it was most needed.

See the quote at the top of this post.

To be continued …