The 2008 Financial Crisis – Will we EVER learn? – A Six Minute Strategist Guide Part 6

This is the final part of my six part – Six Minute Strategist Guide to the 2008 Financial Crisis.  Today I will review some of the lessons we might learn from the Crisis.

Lessons

I am sure that there are many more books to be written on the financial crisis but here are a few points, which I believe, are worth bearing in mind.

1. Don’t Lose sight of the underlying Investment

If you can’t measure or value it – don’t buy it.  Much of the hyperbole in the market was driven by greed on the part of all market participants to make as much money as possible while the going was good.  In so doing they ended up creating and investing in financial instruments, which they neither understood, and in many cases which were beyond comprehension.  The lesson of this is not to lose sight of the underlying investment.

2. Models – Garbage In = Garbage Out

Models and assumptions are only that and not an alternative for real world assets and experience.  Everyone in the market came to believe in their ability to model these financial instruments and relied on these models to make enormous financial bets on the market, in the end with disastrous consequences.

3. The Future Role of Finance in the Economy

There is a significant question to be asked about the role of banking and finance in the economy.  I believe that the industry lost its sense of purpose and became deluded with the tools of financial alchemy, which seemed to offer unlimited profits and bonuses.  Had many of these brokerage houses been partnerships rather than public companies, the partners capital would have been at risk and I believe there would have been much closer scrutiny of the risks being taken and kept on the books.  Financial institutions have a critical role in the economy that does not include casino management.

4. Are Financial Markets self Correcting?

The evidence of the Financial Crisis would seem to suggest not.  My concern with this part of the discussion is that one theory – Free Market Economics – is embraced and the others discredited.  When a crash occurs, the Keynesians all come rushing out to discredit Hayek and claim the supremacy of their collection of theories.  The result is that one is continually preparing to fight the war that has just been lost.  I would favour common sense over dogma.

5. The Role of Government and Regulation

Governments cannot be excused their part in the Financial Crisis.  Ultimately the bear the responsibility for managing the economies and create regulatory bodies to delegate that work to.  I found the complete absence of responsibility on behalf of either regulators or Governments astounding.  It seems that the credit is to be taken and the blame apportioned (to someone else).  Clearly all this happened on someone’s watch and they need to learn and benefit from it.  The evidence today suggests that this is yet to happen.

6. Complexity and Systemic Risk

The historic assumption was that the complexity of the market reduced the systemic risk by spreading it more widely.  If everyone has a little piece of the risk that is better than a few organisations holding large amounts of risk.  The converse proved to be true.  Little attention was paid to the growing interdependence of the global financial markets.  When Lehman was allowed to fail, this was done on the grounds that the market needed to understand that Governments would not stand behind Wall Street and bail it out – something regarded as akin to socialism in the US.  None of those involved in the situation anticipated the catastrophic market impact this had, the destruction of confidence and ultimately value.  The question is no longer about “too big to fail” but establishing the lower limit of this equation – how small is too big?

I hope you enjoyed this very brief review of an extraordinarily complex series of events.  I hope this helps you to put some kind of structure around your understanding of the crisis and would be very interested to hear if you agree with me or not.  There is no monopoly on wisdom!

I have reposted the Appendix with Wikipedia references as well as some good follow up books you might like to read and which I found helpful and interesting to my understanding of events.

Appendix – Further Reading

Wikipedia: See entries regarding:

  1. I.         Subprime Mortgage Crisis – http://en.wikipedia.org/wiki/Subprime_mortgage_crisis –
  2. Subprime crisis background information –http://en.wikipedia.org/wiki/Subprime_crisis_background_information
  3. The Financial Services Authority –http://en.wikipedia.org/wiki/Financial_Services_Authority
  4. Credit Rating Agencies – http://en.wikipedia.org/wiki/Credit_rating_agency
  5. FICO Scores – http://en.wikipedia.org/wiki/FICO_score#FICO_score_and_others
  6. Fannie Mae – http://en.wikipedia.org/wiki/Fannie_Mae
  7. Freddie Mac – http://en.wikipedia.org/wiki/Freddie_Mac
  8. Sub Prime Lending – http://en.wikipedia.org/wiki/Subprime_lending
  9. Credit Derivative – http://en.wikipedia.org/wiki/Credit_derivative
  10. Credit Default Swaps – http://en.wikipedia.org/wiki/Credit_default_swap
  11. AIG Financial Products – http://en.wikipedia.org/wiki/AIG_Financial_Products
  12. Shadow Banking System – http://en.wikipedia.org/wiki/Shadow_banking_system
  13. Housing Bubble Formation -http://en.wikipedia.org/wiki/File:Lending_%26_Borrowing_Decisions_-_10_19_08.png
  14. Sub Prime Crisis Diagram –http://en.wikipedia.org/wiki/File:Subprime_Crisis_Diagram_-_X1.png
  15. Black Scholes Model – http://en.wikipedia.org/wiki/Black–Scholes

Gillian Tett – Fool’s Gold, How Unrestrained greed corrupted a dream, shattered global markets and unleashed a catastrophe, 2009

Michael Lewis, The Big Short, Inside the Doomsday Machine, 2010

Andrew Ross Sorkin, Too Big to Fail, Inside the Battle to Save Wall Street, 2010

Hank Paulson, On the Brink, Inside the Race to stop the Collapse of the Global Financial System, 2010

If you enjoyed this or wish to comment please do so on the Blog.  I would be delighted to discuss this or other Corporate Strategy issues with you – you can contact me at jbdcolley [at]aol[dot]com.  My full contact details can be found on my About page here.

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