This September marked the 10-year anniversary of the collapse of Lehman Brothers, which was regarded as the focal point of the global financial crisis (GFC). Lehman Brothers, which had survived the Great Depression, world wars, long-term capital management and the Russian debt default, could not deal with the high degree of leverage and large portfolio of sub-prime mortgage securities on its balance sheet and went bankrupt.
Here we share a few of our key lessons from the near collapse of the global financial system from a fixed income perspective.
During times of stress liquidity can evaporate quickly. Having a proper understanding of the liquidity of the assets in the portfolio partially alleviates the problem. Regular assessment and stress testing of the liquidity of different assets in the portfolio will indicate how liquid and how long the portfolio would take to be sold to return cash to investors.
It's essential to carefully consider the underlying liquidity of assets held in any investment product - higher returns often come at the expense of embedded illiquidity risk.
The Dangers of Complex Products
During the global financial crisis, hundreds of billions of dollars' worth of triple-A-rated mortgage-backed securities were abruptly downgraded from triple-A to "junk" within two years of the issue of the original rating. Moody's admitted that they didn't have a good model on which to estimate correlations between mortgage-backed securities (MBS).
The lesson here is to not invest in anything you don't understand and don't rely on third party institutions (such as the rating agencies) to do your thinking for you. The search for yield is enticing during periods of exuberance and new and untested financial products are typically created during this period. These new products typically have little data and a short time series to undergo rigorous testing through market cycles.
To test model predictions against actual outcomes requires data. Unfortunately, for many types of collateralised products, data availability was limited across instruments and did not extend over long periods. Consequently, there was little information about the accuracy and robustness of models over different parts of the credit cycle.
To assess the credit risk of structures, it is necessary to consider other risk dimensions, such as market liquidity and valuation of collateral. These factors were overlooked, though they affect credit-worthiness.
In a market cycle, leverage starts to increase after the bust before it peaks again near the top. During a market crisis, when combined with tighter margins and complex products, small losses become amplified due to the large leverage inherent in the system. It is also not safe to assume a maturing loan can be rolled over and even if they could, the refinancing costs are usually a lot higher.
The lesson here is to be mindful of leverage in all its forms.
Importance of True Diversification
When market conditions are at extremely tight levels, the need to protect returns requires a need to hedge portfolios. Fixed income can be a source of hedge and diversification, while currently not yielding equity like returns, is a necessary allocation during specific time periods when you have drawdowns in the higher risk spectrum and require a less correlated asset class.
Conservative positioning entering a crisis is crucial - it helps investors to maintain a long-term orientation, think clearly and focus on new opportunities while others are distracted or even forced to sell.
Portfolio hedges must be in place before a crisis hits. Investors cannot reliably or affordably increase or enact hedges while a crisis is occurring.
During the worst periods of the GFC, fixed interest and cash outperformed all other asset classes. With equity markets at historically overstretched valuation metrics, a decade into a bull market and the continual underweight towards fixed income, we question whether portfolios in Australia are diversified enough if we see a major market correction.
Having lived through the GFC, at Daintree Capital we have worked hard to incorporate all these lessons learned into our investment processes. That doesn't mean it will always be smooth sailing through the next financial storm, but we've done what we can to reduce the risk of the ship taking on water and sinking.