Lessons from the financial crisis

Excerpted from WSJ: “We Need Better-Capitalized Institutions”, Sept. 17, 2008

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That which does not kill us makes us stronger. Nietzsche may not have been aware of credit default swaps and subprime mortgages when he formulated that worldview, but so it will be with the current crisis. Like the 12 steps of recovery, the financial system is now purging itself of years of excess. How sad that it should have to come at such enormous human and institutional cost.

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Important Lessons

First, these losses were foremost a consequence of poor investment decisions. These decisions, driven by a virulent new strain of irrational exuberance, caused theoretically highly sophisticated firms to put hundreds of billions of dollars of poorly conceived and inadequately collateralized securities onto their balance sheets.

In a sense, that’s no different than other bouts of investing euphoria that ended badly, like the dot-com bubble. So for investors, this episode is an important reminder to stay true to conviction rooted in dispassionate analysis and avoid being swept along with the hype, even when it seems painful to watch others making money that you’re not.

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Second, risk management was equally poor. These financial institutions are (or were) in many ways giant hedge funds, except that they used far more leverage than almost any hedge fund (and made worse investments).

Stunningly, even with all the warning signs, the most fragile institutions shirked from sufficiently tough medicine — taking in ample new capital, selling off divisions, even merging their firms — that might have preserved value for their shareholders.

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Third, the systemic failure extended far beyond government oversight. Apart from experienced and highly paid in-house management, these institutions were each watched over by a flotilla of outside auditors, credit and equity analysts, and rating agencies. Virtually none of them accurately gauged the dangers.

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The market is loudly signaling that it wants larger, better-capitalized financial institutions. Even the vaunted Goldman Sachs and the venerable Morgan Stanley may prove too small to remain independent.

For those which emerge, both management and oversight will need to be far tighter. That will be reinforced by a dramatically changed business model.

Instead of highly leveraged banks providing a commodity — money — at razor thin margins, we will have less leveraged institutions providing a scarce resource — money — at more profitable pricing.

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Full article:

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