The TSX is only down 50% - great!

I don’t think even today that we truly comprehend the incredible magnitude of what has happened, and what is happening, to the global banking and financial business.
With so much government involvement and government ownership of big banks in both the U.S. and the U.K., we won’t know the full impact of all of this for a decade. The stock market impact has been significant.
- the Standard & Poor’s diversified bank stock index is down 72%
- the financial index is down 76% and
- the insurance composite index is down 72%
The TSX Bank Stock Index is only down 50% - isn’t that wonderful – (we have outperformed).
I am not going to dwell on the causes of this crisis because they have been extensively and well covered in the press.
They include;
- Major public policy failure in the U.S. in the housing area.
- Far too low interest rates and easy credit under Alan Greenspan.
- Failed financial innovation on a massive scale.
- Almost complete regulatory failure in the U.S., U.K. and Europe – it was the age of deregulation.
- Total rating agency failure - - for the tenth time and
- Finally, too much leverage everywhere you look.
You could write a book on each of the above but for business owners, I recommend you pick up a copy of Money Magnet to find out about the new money - private equity.

The old model for Finance is dead

The collapse of this twenty-five year credit bubble made 2008 a year for the history books. I never thought I would see the day when the likes of Citigroup, AIG, Royal Bank of Scotland, UBS and B of A, the biggest names in the banking world, had to be bailed out by their respective governments and partially nationalized – to forestall collapse.
I never thought I would see the likes of Merrill Lynch, Wachovia, Washington Mutual, and Countrywide Mortgage, all huge financial institutions, being forced to sell to forestall bankruptcy. In particular, the five big investment banking firms in New York, which a year ago had total assets of $4.2 trillion, blew themselves out of the water.
- Bear Stearns, with total assets of $350 billion, forced to sell out for a pittance and Lehman, with assets of $700 billion, bankrupt.
- Merrill forced to sell to Bank of America which over-reached itself and is now in trouble.
- Morgan Stanley and Goldman forced to raise equity at distress prices and convert to bank holding companies to get federal aid.
For these five big investment banks, this has been a complete and unmitigated self-inflicted disaster.
As I said in my book, Money Magnet, the old model of investment banking for these five big firms on Wall Street is dead. The new era will have private equity race ahead with its focus on relationships and its manageable size.

Quite a Laundry List - Bubbles

Look at U.S. household debt as a percentage of GDP – a huge rise in just the last ten years.
Look at the incredible decline in the U.S. personal savings rate over the last 20 years.
Look at the acceleration of U.S. housing prices starting in 2000 (existing houses doubled 2000 – 2006).
Globally, from 2002 to 2006 there grew a euphoric feeling that low interest rates, easy credit, vast liquidity and rising house prices would last forever.
It was a classic example of herd mentality, “when everyone is thinking alike, no one is thinking”.
Commodity prices took off, and the private equity and hedge fund industry exploded on cheap money. Borrowing and spending were in vogue and saving was out.
It was obvious the trends on these charts were unsustainable, but where was the tipping point.
A credit bubble is like blowing up a balloon – it gets bigger and bigger and bigger and you never know when it’s going to burst. This bubble could have broken three years ago, or it could have broken two years from now.
But now we know, this bubble broke in the Spring of 07.
(One thing investors should learn about investment bubbles and manias – “it’s much better to leave the party an hour early than two minutes late”.) Every bubble is different, but in many respects every bubble is the same. The difference this time is that we have an all encompassing credit bubble and it’s global. This was a bubble;
1. In housing prices and mortgage debt
2. In consumer debt
3. In new and untested financial products
4. In commodities and
5. A bubble in bank lending, private equity deals and hedge funds

Quite a laundry list.

Twenty-Five Year Credit Bubble

So what sort of mess have we gotten ourselves into this time?
Well, over the past two years we have witnessed the bursting of a twenty-five year credit bubble of monumental proportions.
The epicentre of the bubble, of course, has been in the U.S. sub-prime mortgage market.
Contrary to almost all forecasts, it spread quickly to all sectors of the banking and credit markets and now to the real world economy – main street.
This economic contraction is the first synchronized global downturn since the 1930s.

What is the new risk?

I think that systemic risk in global financial markets has increased quite dramatically.
- What is the long term impact of one to two trillion dollar deficits in the U.S. annually for the next few years?
- Who will purchase all these treasury bonds”?
- Will the Federal Reserve ultimately resort to printing money?
- Will some of these big banks have to be nationalized.
- Do we have now, in effect, a bubble in U.S. treasuries?
- Will all the credit creation lead to major inflation three or four years out?
- Will we have a major crisis in the U.S. dollar over the next year or two?
This is all uncharted water and, no one on the face of the planet knows how it will play out.

Dr. Bernanke explains quantitative easing

Finance deep freeze

We are now in a deep freeze of credit. It is trickling down that it is no longer business as before. There are new rules and it's back to the basics.

So, what does “back to basics” mean for the financial business. To me, it means.
-running a more conservative business across the board
-reining in your growth expectations to more realistic levels.
-reducing leverage
-much less financial innovation and much less financial engineering
-more focus on client business
-more organic growth and fewer grandstanding acquisitions and
-for the world’s biggest financial institutions it means downsizing your business and scraping your plans to rule the world.

Of course, running a more conservative business, with less leverage, will mean somewhat lower profitability than we have been accustomed to in the past. That’s the price of running a more conservative business but at least, over time, you will be in business.

The Human Capital of Private Equity

- The stock market is down 50 percent.
- Banks are in trouble and have curtailed lending.
- Commentators predict widespread industrial bankruptcies.
- Unemployment is rising fast.
- Interest rates are volatile.
It all sounds familiar. But those headlines aren’t from today. They’re from 1974. Doomsayers foresaw disaster 35 years ago, predicting hundreds of corporate bankruptcies. New York City and State, and utilities like Con Edison, seemed on the brink of collapse. Business publications wrote that major money-center banks would fail and ran articles like, “I’ll Never Own a Stock Again!” Struggling companies got little help from financial institutions, which had problems of their own. Businesses with the highest returns on investment, the most innovation and the fastest growth were starved for capital. The debt of good companies sold for pennies on the dollar.
In 1974, as now, those who once thought they had the answers came to realize their assumptions were flawed. But opportunity emerged from that crisis as people with creative solutions and the skill to implement them stepped forward and developed new ways to access capital. Over the next two years, the markets recovered strongly. That skill in finding new opportunities when things look bleak is part of what economists call human capital.
In financing companies that could grow and create jobs, I always considered management skills as important an asset as numbers on the balance sheet. And it’s never more important than in times of crisis.
While people worldwide have recently suffered some $60 trillion in losses on financial instruments and real estate, that figure is actually dwarfed by the value of the world’s human capital, worth substantially more than $1,000 trillion. With a value like that on our collective potential, a cancer cure would be worth more than $50 trillion in the U.S. and well over $100 trillion globally.
This suggests that investments in medical research may have more value than building new bridges or highways. And it underscores what we already know about education: in the long run, it’s the single best investment in stimulating the world’s economy.
Also - the human capital that private equity brings to a company is the reason their results are superior to the public market investments.

Famous words

You do need to keep your head when those around us are going off their rockers. CNBC had a very telling slideshow of famous last words: Go to show.
My favorite classic line:

"In today's regulatory environment, it's virtually impossible to violate rules...it's impossible for a violation to go undetected, and certainly not for a considerable period of time."
Bernard Madoff, Oct. 27, 2007.

Maybe this could be used in MBA classes?

Triple Whammy - stock market, banking, real estate

Now, the IMF has described this as the largest financial crisis since the Great Depression in 1929.
I think we would all agree.
A reasonable question to ask is why banks and dealers, as well as investors, never learn from previous financial crisis. If you look back over the past 150 years, booms and busts and financial crises occur with depressing regularity – almost like clockwork.
Ton Fell often said, if your country hasn’t had a banking or financial crisis in the past decade, just wait – one will be coming shortly.
There was a major banking crisis in the U.S. in the late 1870s following an incredible railroad boom. The U.S. Federal Reserve was created in 1913 following a series of bank crises and runs on deposits.
And then, of course, we had the stock market crash in 1929 and the Depression. This was followed in 1934 by the establishment of the Federal Deposit Insurance Corporation in the U.S. to protect depositors and the Securities and Exchange Commission to protect investors.
Crises over the last seventy-years have been less severe, although I can tell you they seemed, and were, very serious at the time.
The LDC banking crisis in 1982 – the Canadian Bank Stock Index fell by 42%.
The U.S. Savings & Loan crisis in the late 1980s when 2,000 S & Ls went out of business – U.S. bank shares fell by 45%.
Until now, the all time high water mark for massive market and business excesses in living memory was the breaking of the Japanese bubble in 1989. While this crisis was confined to Japan, it is the second largest economy in the world so it was big.
This was a triple whammy. A stock market bubble, a banking bubble and real estate bubble all wrapped up in one. When the bubble burst many banks and insurance companies were forced to merge, restructure or were bailed out by the government. The Japanese bank stock index topped out just after Christmas 1989 and dropped by 45% in just the first year but eventually declined by 91%.
(I call that a bear market)
It is of interest that, even now, the overall Japanese stock market, as measured by the Nikkei Dow, is 80% below where it was twenty years ago. The Japanese crisis lasted more than a decade and total losses were estimated at about $750 billion.
Finally, in the late 1990s we had the incredible telecom and internet bubble which broke in 2000. We can all remember this - you know, when Nortel had a market cap of over $350 billion.
The late 1990s was a period of wild investor hysteria.
It was a true feeding frenzy with the Nasdaq tripling in less than two years and IPOs doubling and tripling on the first day of trading.
As always, the bubble broke, the Nasdaq Stock Index declined by 77% over the next three years with the bankruptcy of Enron, Worldcom being two of the biggest in American history.
That crisis brought us Sarbanes-Oxley.
When you look back on all these cycles, a central question is “why do we have to go through constantly recurring market and business bubbles.
Kindleberger, the late MIT historian, is well known for his 1978 book “Manias, Panics and Crashes” which traces four centuries of booms and busts.
Cycle after cycle the similarities are striking. It all gets back to;
- over-optimism and herd mentality
- greed in the financial business
- excessive leverage
- borrowing short and lending long
- flawed financial innovation and
- regulatory failure
(usually all wrapped up with a good dollop of fraud and corruption)
Those who don’t learn from the mistakes of history are doomed to repeat them and that’s why we are here again – one more time.