Monday, September 16, 2013

The Financial Crisis: Lessons to Remember

September, 2008 was very strange time. Markets froze and stayed frozen for some time. Trust was replaced by fear. People began to contemplate the unthinkable. I even began to check the ATMs to make sure they still dispensed cash. Fortunately, the free fall stopped-although the pain continues for many. Five years later I have compiled a list of lessons I leaned from that time. They are as follows:

1)     The big banks have gotten bigger and are just as accident prone as they were before the crisis.

2)     Debt spreads and availability can change dramatically. For example, high yield bond spreads jumped from pre-crisis 250BP over comparable treasuries, to 2000BP during the crisis.

3)     Equity risk premiums are also very volatile.

4)     Diversification is no shield against systematic risk. In a crisis all correlations go to one.

5)     Do not forget about counter party risk. Just like a pancake there two sides to every transaction.

6)     The only perfect hedge is in a Japanese garden.

7)     Recovery from a debt deflation crisis takes long time-7+ years on average. See Reinhart and Rogoff.

8)     An investment grade rating is not just for sissies. It is key to maintaining capital market access during troubled times.

9)     Asset pricing shifts from fundamental to technical factors during a crisis.

10)  There are limits to arbitrage. Value and price can diverge and remain that way for a long time. Keynes was right-markets can remain irrational longer than investors can remain solvent.

11)  Liquidity risk, the poor man’s alpha, becomes deadly during a crisis. The price for liquidity spikes during a crisis.

12)  Liquidity means cash, not access to cash. Cash liquidity should be viewed as insurance, not a low return asset. Liquidity preference is a behavior toward risk. Keynes was right again.

13)  Beware of academics and consultants preaching “leverage your firm to the hilt” during the good times. Financial distress costs are more difficult to quantify than interest tax shield benefits. Nonetheless, they are every bit as real.

14)  Debt means you have to be right. Debt without liquidity means you have to be right every day.

15)  Be humble-we know less about markets than we think. Do not confuse risk or luck for skill.

16)  Risk is not a number. It is an exposure that is not always reflected in history. Absence of evidence is not evidence of absence.

17)  More money has been lost betting against market efficiency than has been made.

18)  Financing windows can shut without notice. The capital when you can-not when you must.

19)  Beware of bridge financing becoming bridges to nowhere.

20)  As Robert Marks noted-the relationship between price and value is the key to investment success.
These lessons seem to un-learned and relearned over time. Perhaps, James Grant was right when he said all knowledge in markets is cyclical. Do not despair as this presents buying opportunities for disciplined, liquid and well capitalized buyers - sounds like Buffett doesn’t it?


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