Wall Street on 15 September 2008. Major US investment bank Lehman
Brothers had just announced its collapse with about US$ 613
billion (about ¥60 trillion yen) of debt. Also known as the
"Lehman shock" in Japan, it was one of the biggest bankruptcies in
history and left lasting scars on the world economy.
Just 10 years on though and the US economy has quickly recovered from the financial crisis. Its stock market has continued to rise, receiving help in 2018 in the form of a corporate tax cut. The S＆P/Case-Shiller Home Price Indices have also surpassed its level before the Global Financial Crisis.
This crisis joins the ranks of other major economic crises; Black Monday in October 1987 and the Asian Financial Crisis in 1997. With the Global Financial Crisis in 2008, it seems that approximately one crisis hits every 10 years.
Viewing this as a 10-year cycle, there have been predictions that another massive financial crisis may hit soon. There are three lessons to be learnt from the last crisis to make sure investors are better prepared for the next one.
First off, it is never easy to predict what happens next but if
you can spot a bubble forming then you are halfway there.
Before the Global Financial Crisis struck, there were people who made a massive profit from accurately predicting it.
Such people are “backwards” investors, as described by Michael Lewis in his New York Times bestseller, “The Big Short: Inside the Doomsday Machine”. Michael Burry, one of the main characters, closely monitored many different indicators while taking note of rising house prices in the US. He was thus firmly convinced that the phenomenon was a bubble economy.
Burry was manager of a hedge-fund called Scion Capital. He used to be a doctor, and his own investment blog propelled him into investment world.
Burry is a value investor. What he does is just to carefully read information that is available to anyone, like the 10-K Wizard, and find undervalued stocks to invest.
In those days, the market for subprime loans was overheated. Loans were issued to people who did not have the means to repay. These loans were also called "Ninja loans", with “Ninja” referring to the recipients of such loans who had No Income, No Job, and no Assets.
Investment banks on Wall Street were making a big profit selling financial derivatives that bundled products such as these subprime mortgage loans. Even if each loan was suspect, it was believed that the risk could be dispersed through bundling many such products. That is why financial ratings companies actually gave high ratings for these derivatives.
Looking back at this unusual situation, it is clear that the market would definitely collapse. It wasn’t a matter of if but when. So if you can short the market, then you will definitely make a profit. There are three lessons to be learnt from the last crisis to make sure investors are better prepared when the next one hits.
He took a “short” position at that time. It’s different from the
usual way value investors work in which they take “long” positions
in the belief that the price will rise. Basically going “short” is
betting that a financial investment’s price will fall.
What he found was a financial product: Credit Default Swaps (CDS). Simply put, this is a derivative product that pays out insurance money should a subprime loan default. He shorted the housing market by buying this form of insurance and betting on the collapse of the market.
For this “CDS”, all his fund needed to do was pay a marginal premium every year, and if loans defaulted, they would be fully compensated. The rewards clearly outweighed the risk.
The collapse of the US housing market was so obvious to him that all he had to do was patiently wait for the bubble to fully inflate over the years before the returns would flood in after it burst. So simple!
He found a financial product which offered asymmetric risk and reward, and that brought him huge success.
He bet on the big deal, but there was one problem: no one knew the
“when” in terms of the timing of the crisis. It was pretty obvious
that it would happen eventually but it was still hard to predict
Burry was not a retail investor but a fund manager, which meant he had responsibility and accountability for his clients. This created friction between him and his clients.
He believed that investors must hold on to their original convictions. In light of the fact that insurance premiums need to be paid in exchange for this CDS coverage, this point is particularly important. The dilemma here is that even if the market seems certain to collapse, no one knows when it will actually happen.
In the boom years leading up to 2008, an insurance premium fee would be incurred but the exact timing of the collapse could obviously never be predicted. Even when 2008 came around, when a substantial portion of subprime loans had started to default, the ratings companies did not downgrade their high valuations of these bonds.
Moreover, pressure for funds may also come from other fronts. As Burry experienced, different parties asked for a return of funds; the customers of the fund, and the shareholders. These payouts are a drawdown on assets. In such hard times, it can be isolating to hold on to your initial convictions.
But eventually, as predicted by these “backtraders” and proven right by subsequent events the housing market did indeed collapse and the American economy was plunged into a downturn.
Burry finally made an astronomical amount of money from the deal. If he compromised on his convictions with clients or shareholders, his massive success would never have happened.
When will the next crisis hit?
Finally, investors need to be forward looking and constantly
watching out for signs of the next crisis. Complacency in the boom
times in the lead-up to the 2007/2008 crisis saw many investors
adopt the attitude that the “party won’t ever stop”. They were
Chuck Prince, CEO of Citigroup, told that ”As long as the music is playing, you've got to get up and dance” which was periodically used to encapsulate Wall Street’s greed at the time.
Ten years since the last crisis and many companies are now booming. In particular, some technology companies from the GAFA group of Google (NASDAQ: GOOGL), Apple (NASDAQ: AAPL), Facebook (NASDAQ: FB) and Amazon (NASDAQ: AMZN) have already exceeded one trillion dollars in market value.
Meanwhile in Japan, the Nikkei average fell to around 7,000 points after the Global Financial Crisis. Since then, in the Abenomics market environment, the Nikkei’s average exceeded 20,000 in 2017.
Are we still dancing? Or will another crisis strike soon? We might be able to predict it if only we learn from the insights and observations of investors 10 years ago.
Source: Michael Lewis “The Big Short: Inside the Doomsday Machine” (2010)
by Michihiro Soma, Japanese Editor @ FIGS
21 Sept 2018
(Please note that all views expressed in this article are solely my own and do not represent the opinions of FIGS or its related companies)
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