Those who do not study history are doomed to repeat it. Yet time and again, massive missteps are caused by remarkably similar mistakes - and often by people who should have known better.
This was the theme of a two-part webinar recently hosted by Rigardt Jonker, Risk Specialist at Andile Solutions. He brought together two seemingly different - yet highly correlating - examples of how assumptions and underestimating risk led to significant financial mistakes.
Andile Solutions, a pioneering South African modern FinTech solutions provider, created the Axiom webinars, offering access to the in-depth knowledge of its staff and partners. Kicking off the series, Jonker launched into the story of Long Term Capital Management, or LTCM. Now almost forgotten after subsequent financial disasters, LTCM was once the poster child of financial creativity gone amok, leading to massive debts and - at its time - an enormous bailout.
This deep-dive into the LTCM story, which at the time assembled a financial dream team like no other, explored how its traders made enormous returns using risk in a stable market. One strategy was to buy certain undervalued securities and hedge against similar overvalued securities and profiting when their prices converged. It was a brilliant playbook and delivered enormous profits - upwards of 40% after fees. But within a few years, this collapsed when volatility reared its head.
In part two, Jonker turned his attention to the subprime financial crisis of 2007 to 2009. Financial wizards again relied on a stable market to ride risk to high profits. In this event, it was the over-indulgence of extending easy credit, then using collateralized debt obligations (CDOs) to get around securitization limits of their debt pools. They passed the debt along through special vehicles, using the investment ratings agencies’ scores to represent debt pools as less risky than they were. All this made sense while the market was calm and property prices kept rising. But, as we know today, that turned out to be an incredibly costly assumption.
LTCM vs the subprime crash
At face value, LTCM and the subprime crisis do not seem to be similar. Yet Jonker’s presentation highlights several important comparisons.
Both situations worked well as long as the markets were stable. LTCM collapsed because its diversification was really just doing the same things in different markets, much of that at sovereign bond levels. When some of those economies turned south, LTCM went from Wall Street titan to broke in a matter of months - at one stage losing $4.6 billion in 5 weeks.
The subprime crash resulted once debtors started defaulting on home loans. At this stage, the debt sold in the market was so convoluted with different types of CDOs and misrepresentative investment ratings (not to mention the notorious credit swap default bets made by insurers they couldn’t meet) that it all quickly collapsed. Both situations had risk models which relied too heavily on financial data, which only works when markets are calm.
Another common trait is that LTCM, as well as the many financial institutions caught in the subprime collapse, were woefully overleveraged. The differences LTCM focused on were exceedingly small, so it bought securities in bulk to make a worthwhile profit. That often leveraged the fund at ratios such as 1:22. Many of the major banks caught in the 2007 crisis had similar, and often higher, leverage ratios. So, when the piper came calling, they did not have the resources to pay their obligations.
The third common trait is that both situations radically underestimated their risk. Some of this can be ascribed to the arrogance of smart and highly successful people. It ended in tears - literally: some of LTCM’s partners cried as they signed the legal agreements that saved their firms, yet ended their power and wealth. But in early 2007, when some banks started worrying about their exposure to the circulating debt, they still far under-estimated their true exposure. The fallout ended up destroying several revered institutions and required $700 billion in bailouts.
What can we take from these lessons? It is effortless to underestimate risk, especially when you lean too heavily on historical data. It is also not difficult for people who should not make such mistakes to make them - and for others to follow.
Jonker’s presentation offers food for thought and urges us back to the drawing board. The financial world does a lot of good. But volatility and risk should not be underestimated. As the world enters what will be a volatile period to be remembered in history, are we taking in the right lessons and asking ourselves the most salient questions?