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A reflection on the collapse of Lehman Brothers

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By Capital Partners Lifestyle

We have just passed the anniversary of the scariest day of my financial career – the collapse of Lehman Brothers.  While the Global Financial Crisis (GFC) was well underway, it was the Lehman Brothers Collapse that shifted us from a garden variety downturn, to a truly momentous event that threatened the financial system itself.

In the lead up to 16 September 2008, we had already seen the collapse and then bail out of the venerable Bear Stearns, an institution in the US that survived the Great Depression and went on to become a household name.  Its failure was ultimately a case study in greed.

Bear Stearns was one of the largest investment banks in the world, but as the subprime mortgage crisis worsened Bear Stearns’ hedge fund business began to unwind.

Investors, hearing about the substantial losses, withdrew their funds.

To meet redemptions, assets needed to be sold and prices fell with such speed that their portfolio of mortgage backed securities was rendered worthless almost immediately.

By March it was clear that Bear Stearns could not meet its liabilities, resulting in the Federal Reserve loaning JP Morgan Chase $30 Billion to purchase what remained of Bear Stearns.

Bear Stearns’ demise started a panic on Wall Street.

Investors quickly worked out that all investment banks were likely brimming with the same bad investments that had bought down Bear Stearns, but no-one knew exactly where to look.

This caused a share market sell off and a liquidity crisis where banks began refusing to lend to one another.  Without the Federal Reserve’s intervention, the failure of Bear Stearns could likely have caused other over-leveraged banks like Citigroup, Goldman Sachs and Lehman to collapse.

While all this was going on in the US, the S&P/ASX 200 index had fallen by 15.4 per cent in the three months to the end of March 2008.

At March 31 the following year, the index was down 43.5 per cent and yet there was worse to come.

Back in 2003, Warren Buffett had labelled derivatives as “financial weapons of mass destruction”, and his assessment turned out to be very insightful.  Derivatives come in many forms but essentially, they are contracts based on the price movements of underlying assets.

Derivatives were used to leverage exposure to different asset classes, and they were used heavily in the lead up to the GFC to ‘bet’ on the bundled mortgage bonds known as CDOs.

These are the investments that eventually imploded.  Portfolios of bad and doubtful home mortgages had been bundled up and sold to banks as secure investments, in some cases with a AAA credit rating.

Finally, after months of government bailouts and asset purchase programs, then Treasury Secretary Hank Paulson announced that there could be no further bailouts for Wall Street. The government simply couldn’t take on all of the risk of the financial markets.

In a last ditch attempt the US tried to broker a rescue for Lehman Brothers whose book of mortgage assets was collapsing, but on September 15th, with no rescuer in sight, the unthinkable happened – Lehman Brothers collapsed in an event not seen since the great depression.

The result was an exodus from financial markets and banks.

On September 17th, US investors withdrew $144Bn from money market accounts.  This compares with a normal week of $7Bn.

At this time, I recall receiving phone calls from clients and family members concerned for the security of their bank.  As I look back, these really were days without precedent – certainly in my lifetime.

Once again, the US stock market collapsed when on September 29th Congress rejected the bailout bill designed to guarantee bank deposits and give depositors the confidence they needed to keep their money in the banks.

In Australia, the S&P/ASX 200 index hit its high point on 31 October 2007 reaching 6,828 points and in the two years that followed the market was still down 27 per cent.

As I reflect over these ten years, I think we all need to be thankful that the US Congress ultimately passed the guarantee measures to stabilise the banking system, and we are no doubt fortunate that Ben Bernanke was Chairman of the Federal Reserve.  His steely resolve really did save the day.

Any reflection of this period demands some thought about what we can learn from the crisis.

While any historical assessment is with the benefit of hindsight, there are insights we can gain from this period.  These are my Top Five:

1: Avoid Leverage for Greed’s Sake

There’s no doubt that leverage (borrowing) is a great tool to help create wealth, however we need to be judicious in its use.  In the unwinding of the GFC those institutions and individuals who felt the most harm, were those who were over-indebted and found themselves holding assets with severely reduced values, and a lender still wanting their money back.

Using debt as part of a carefully crafted financial plan makes sense – for housing and for appropriately geared real estate investment.  But debt used for speculative activity can and likely will, magnify losses in a downturn.

2: Have a Cash Reserve

When a severe market event occurs, don’t get caught without a cash reserve.  There’s no doubt that a downturn of the scale of the GFC left many people exposed and unable to meet their liabilities.  This is when a cash reserve is essential as it provides breathing space to make smart, informed decisions.

3: Take a Diversified Approach

It may sound boring, but a diversified approach will beat a concentrated approach in a downturn.  Having assets spread over different  asset classes means that the collapse of one asset class can be cushioned by the other asset classes.  During the GFC our asset class portfolios certainly felt the brunt of the market, however the recovery they enjoyed meant that investors remained on track to achieve their goals.

4: Maintain Discipline

If you have a speculative portfolio the next time the markets suffer a considerable fall, you may well be justified in panicking.  However, if your portfolio has been built using fiduciary principles, you should be completely prepared for whatever the market throws at you.

Maintaining investment discipline means that even through the worst of the GFC a properly structured portfolio was able to weather the storm, maintain retirement income and recover fully in the ensuing years.

5: Don’t be Surprised when Markets are Volatile.

We spend many hours of conversation with clients explaining how and why their portfolio has been structured in a certain way.  This knowledge is empowering because while it can’t eliminate market volatility, it helps prepare us for the reality of markets when the volatility comes along.

I like to think of a portfolio like a car.  It has an engine and it has tyres and springs.

The engine (share market exposure) needs to be big enough to drive the portfolio returns needed to fund the financial plan; and when the car hits a very rough piece of road (volatile market), the tyres and springs (defensive asset exposure) need to cushion the ride so that the passengers aren’t too shaken up.  The last thing we want is passengers leaping from the car!

While these periods of volatility can be very confronting, well constructed portfolios stand the test of time.

Post Script

As I look back on the last ten years I reflect on whether our institutions have learned the valuable lessons such a financial shock offer.  The Royal Commission into Financial Services and Superannuation in its interim report suggested that the key driver of the problem has been greed.

“Banks searched for their ‘share of wallet’. From the executive suite to the front line, staff were measured and rewarded by reference to profit and sales.”

In this kind of environment, individual investors need to ensure that their interests are represented by a fiduciary adviser, and in my next article I will discuss the concept of an Investment Fiduciary further.

Capital Partners is the FPA Professional Practice of the Year and the IFA Boutique Advice Firm of the Year. We are committed to the upholding the highest fiduciary standards, ensuring that the people who team up with us will live richer, happier lives.

The information provided on this site is of a general nature only and may not be relevant to your particular circumstances. The circumstances of each investor are different and you should seek advice from a financial planner who can consider if these strategies and products are right for you.

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