MarketFox Investment Commentary – Investment Innovation Institute

MarketFox Investment Commentary

My Lessons Learned from the GFC

How can cash lose money?

This week marks the tenth anniversary of the collapse of Lehman Brothers. There’s been no shortage of articles and stories reminiscing about the global financial crisis (GFC). It’s all got me feeling a little bit nostalgic. I thought I’d share two stories and the lessons that I learned working at an investment bank and working as an institutional investor during the GFC.

Capital Guaranteed

In early 2008, I was living in London and working for an investment bank. I was in middle office; the meat-in-the-sandwich between the trading desk and the operations teams.

My job was to value structured equity derivatives and hedge fund-of-fund products. These valuations had to be independent, i.e. traders were not allowed to mark their own positions. At least they weren’t allowed to do it directly. They still influenced the process. Middle-and back-office, were ‘cost centres’. And the front-office never missed an opportunity to remind you who was making the money that paid your wage.

The structured equity products that I valued were sold primarily to continental European insurance companies. The sales teams were organised by country. I was assigned to look after the Italian desk, as I’m fluent in the language. I also did work for other desks. The bank felt like the EU in miniature.

A large number of the bank’s traders were French. As I discovered while working in London, the French academic system greatly esteems mathematical ability. Graduates of the Ecole Polytechnique of the Sorbonne University quickly found their way to London, where they could earn British pounds while paying lower taxes.

The underlying strategies that we used were quite sophisticated. I had some contact with the investment professionals working at the insurance companies. I got the impression that they were reasonably sophisticated and understood what they were buying.

I don’t think that the same could be said for the end users of these products. Italian savers are conservative, with most displaying a strong preference for investing in Italian government bonds. But the yields available on bonds had fallen from mid-double digits in the early 1990s to low single digits in the mid-2000s. This prompted many savers to search elsewhere for higher yields.

At the same time, the Italian government was encouraging savers to roll their government-backed pensions into products offered by insurance companies. This created strong demand for products promising a capital guarantee and returns that were higher than those available on bonds or an indexed pension.

Everyone had an incentive to offer products that were too good to be true. In that sense the investment bank, the insurance company and even the saver were all complicit in taking too much risk.

Here’s how a popular structured equity product worked. The saver invested $100. Approximately $66 was invested in a zero-coupon bond maturing in seven years (i.e. 6 per cent coupon). The remaining $44 was invested in a total return swap or derivative contracts linked to the performance of one or more equity markets.

The zero-coupon bond would pay back its face value ($100) in seven years. In theory, the worst that could happen was that the saver received their original $100 back. But the saver stood to make a lot more if equity markets ended the period higher.

What was the problem? The careful reader would have already spotted it. It was the effective interest rate paid by the zero-coupon bond. It wasn’t possible to receive 6 per cent on 10-year German Bunds. No, to earn 6 per cent you had to buy Glitnir, Kaupthing Bank and Landbanki European medium-term notes (EMTNs).

So, the conservative Italian retiree owned a levered exposure to the stock market (usually European equities) backed by the creditworthiness of an Icelandic bank!

The daily volatility on these notes was phenomenal. And most of it was attributable to the supposedly ‘safe’ EMTN that was providing the capital protection.

We were shocked by the volatility, so we went and checked the valuation models that we were using as we’d inherited them from previous staff. Most models had fixed spread assumptions for the EMTNs hard-coded into them! In other words, the risk of the zero-coupon bonds was assumed to be low and constant when it was anything but.

We immediately started updating the spreads daily. Each day, we had to confer with the trading desk to see where spreads were. No estimate seemed to be conservative enough. No sooner had we updated a model before we had to do it again the next day as spreads widened further.

Italian law required that investors in ‘safe’ products had to be notified in writing if these products lost more than a certain value. Our clients, the insurance companies were pleading with us to check our valuations. They were desperate to avoid having to write these letters as they knew all hell would break loose if they did. In the end they had to, causing a lot of pain and anxiety for the savers relying on them for capital protected income.

The lessons:

  • If it looks too good to be true it usually is.
  • Don’t invest in anything that you don’t understand.
  • Incentives matter.
  • Stability sows the seeds of future instability.
  • Lots of things are ‘assumed’ in large organisations that shouldn’t be. The assumptions get lost as people come and go.

Cash Enhanced

It was mid-2008 and my UK visa was about to expire. I wasn’t ready to come back to Australia, so I explored the idea of working in Ireland. Ireland was, at the time, the custodian of Europe. The attractions to investment banks and hedge funds were obvious. Everyone spoke English, it was part of the EU, Ireland shared same time zone as London and the tax rate was a lot lower. There was a shortage of people with finance and investment experience. The Irish government had a special class of visa for migrants with the right kind of skills and experience.

Fortunately for me, I decided to come back to Australia. Things were starting to get serious with a special someone back home and I didn’t relish the idea of a long-distance relationship. Anyway, not only did I dodge a bullet by not going to Ireland, I ended up with a wife, a son and now a baby on the way.  It was definitely the right decision in more ways than one!

Anyway, back to the story. I found a job working as an investment analyst with a superannuation fund. I joined the fund in August 2008. The fund managed a little over AUD $5 billion at the time. The cash member investment choice option was roughly 5 per cent or AUD $200-$300 million.

Markets were falling and members were scared. The cash option was growing each week as members switched out of the fund’s other investment options and into cash. Then Lehman Brothers went bankrupt and the cash option posted negative returns for two weeks in September.

If there is one asset that is supposed to have zero correlation to risky assets, it’s cash.  And yet now even cash couldn’t be relied upon in a crisis! This shouldn’t happen.

Panicked members were calling up to ask what happened. The directors were demanding answers. Everyone was in shock. How can cash lose money?

The simple answer was that the investment option was largely invested in ‘cash enhanced’ investments. Our fund was not alone in doing this, most funds were invested in similar products. The extra return came from introducing credit risk into the fund.

The credit securities included supposedly highly-rated asset backed and mortgage securities. These securities were quickly marked down amid the chaos of the GFC, triggering losses in what was supposed to be the safest of asset classes.

Australian mortgage-backed securities were nowhere near as risky as their US counterparts. There were relatively few subprime loans and asset-backing levels were much higher. But nobody cared. The mood was ‘shoot first and ask questions later’.

How did it come to this? Stability breeds instability. When times are good, it’s tempting for a fund to try and eke out a little extra return by adding some credit risk. After all, the probability of loss is extremely low. Soon competing funds notice the higher returns on cash options. Naturally, they also start using cash enhanced products. You know the rest.

In good times, it’s easy to forget that extremely low probability events happen far more often than we expect.

We’d identified the problem but we were now faced with a dilemma. The cash option was full of securities that didn’t belong there. The cash option was carrying investment risks that were totally inconsistent with our members expectations. And yet, selling the credit securities would have crystallised the losses on fairly sound securities that were trading at unfairly depressed prices.

We figured out an innovative solution that gave our members the stability that they expected from a cash option while avoiding the need to become a forced seller. Necessity truly is the mother of invention. The one positive of a crisis such as the GFC (if there even is such a thing) is that it’s a tremendous opportunity for a young person like me to learn a lot in a very short space of time. You simply had no other choice.

In the meantime, money was flooding into the cash investment option. By March 2009, it had reached almost AUD $1 billion, up from AUD $200-$300 million only seven months before. Over the same period, the value of the fund’s assets had fallen in value by over AUD $1 billion. The cash option was now somewhere between 20-25 per cent of fund assets!

March 2009 saw the biggest monthly inflow into the cash option. Our members had timed the bottom perfectly!

It was sad to see so many members switch in panic and crystallise their losses. But the worst was yet to come. The stock market began to rally. But they just sat in cash. It rallied further. Still nothing.

Eventually, as they rally continued members started to switch out of cash. We notice a peculiar pattern as they switched. Members that were in the High Growth option switched back into Balanced option. Likewise, members previously in Balanced option switched back into Moderate option. The same was true for members formerly in the Moderate option, who switched back into the Conservative option.

These members had finally noticed the rally, but they just couldn’t bring themselves to go back into the products that they were happily invested in only a few months before. The trauma of the GFC had shifted their risk appetite downwards. Perhaps these members changed options again in the future, I don’t know. If not, the downward shift in their risk appetite has probably cost them much, much more than they lost during the worst of the crisis.

The lessons:

  • Defensive assets should be kept pure. They don’t need to be ‘enhanced’. After all, that’s what the rest of the portfolio is for.
  • Member have the right to expect that an investment option ‘does what it says on the tin’.
  • Crises, while stressful, can be learning opportunities.
  • Without a plan our emotions will get the better of us.
  • Letting a traumatic experience permanently alter our perceptions of risk can be very costly in the long run.


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