Ten years after the weekend that brought the global financial system to its knees, the most important lessons lie not in what has changed (very little that is not cosmetic), but in what hasn’t changed. The main causes of the last financial crisis, self-delusion and irrational exuberance, will likely be the cause of the next one as well. The same economic conditions and policies which drove Satoshi Nakamoto to write the Bitcoin whitepaper and mine the first Bitcoin genesis block still prevail.
The bankruptcy of Lehman Brothers in the pre-dawn darkness of September 15, 2008, one of the world’s most storied banks and also one of the oldest, wasn’t the first nor was it even the worst event out of the Great Financial Crisis, but it had the most repercussions because it was out of the realm of contemplation of the financial world. Surely a bank of Lehman’s stature and history couldn’t go bankrupt. And when it did, the shockwave that was unleashed was the typical sum of all fears, “If even Lehman could go under, what more lesser banks?” There was no line in the sand. All bets were off and everything that had been assumed to be true was suddenly upended.
Yet the same certainties which the financial world had taken for granted for decades were built on no more than sand. American home ownership must rise in the long run — that was the promise of America. When our ancestors came to this land, it was to free themselves of the tyranny of the landed gentry as well as the opportunity to be free of a perpetual landless serfdom. That unshakeable belief helped to fuel the easy-credit home-buying frenzy of the first decade of the 21st century — a belief that property prices would and indeed could, only keep rising. To quote a German proverb,
“Bäume wachsen nicht in den Himmel.”
or, “Trees do not grow to the sky.” Just as trees haven’t become space elevators, property prices can’t rise indefinitely. Yet big and allegedly sophisticated institutional investors — including Lehman — bought into this faith-based rally, betting on all kinds of questionable instruments, from subprime loans to exotic credit derivatives, underwritten by complex loan securities hidden under a maze of mutual obligations. To make matters worse, Lehman, also took out leverage to make these bets and while they were far from the only bank to do so, they were leveraged as much as 33 to 1 at one stage — that’s 33 dollars of debt for every 1 dollar of assets. So it should come as no surprise when the music finally stopped. As for the home ownership rate, it plunged, wiping out four decades of increase and even today is not even close to pre-crisis levels with no signs of abating. Young people today are more than ever likely to rent than to own. If home ownership was the dream of America, that dream today seems more remote than ever.
Yet if delusional optimism led to widespread financial hurt, it’s now ironically, delusion pessimism that’s preventing many Americans from healing. Today, Americans are less likely to own stocks than even before the dotcom meltdown of the turn of the millennium, according to a Gallup research study. Americans are terrified of anything even remotely associated with finance and that has led to incongruous behavior. A recent survey by Betterment (a financial advisory firm) found, incredibly that 48% of Americans think that the stock market hasn’t gone up in the past decade, including 18% who think that it’s actually gone down. This is despite the Commander-in-Chief regularly reminding the American people how much the stock market has soared (presumably under his leadership). In other words, almost half of American adults, believe the exact opposite of what would take them a 5-second online search to verify — stocks are up an eye-watering 140% since the collapse of Lehman Brothers. They’re like the overweight person who won’t get their blood pressure measured. The very thought of a health check-up frightens them to death — where ignorance, really is bliss — which would be unfortunate.
If you had invested in Bitcoin in say early 2012, it wouldn’t surprise anyone that you’d continue to think that Bitcoin is the best investment ever. Sitting on thousands of percent in returns, your portfolio performance would be unbeatable. But had you say, invested in Bitcoin last December when it was near its peak, you’d be forgiven for taking the view that cryptocurrencies were nothing more than a scam. Today, there are countless investors who were burned in the cryptocurrency and ICO (initial coin offering) fever of late and early this year who now swear off cryptocurrencies and aren’t even willing to look at them again. Yet is such an approach rational or emotional? We like the things that we’re good at — but when it comes to investing — luck or randomness plays a role beyond that which we give it credit for. Just because you invested early into cryptocurrencies doesn’t necessarily make you any more learned than someone who invested late — it may be that you were just lucky. Yet the failure to consider any inherent value in cryptocurrencies and ICOs would be like the person who won’t open up a letter from the IRS — fear has gripped that person beyond all rational considerations and assessments because they got burned before. Over the past decade, millions of Americans have also stayed out of the financial markets, because they got burned either in the dotcom bubble or the housing bubble — but had they just stepped back into the fray again, they would have not only been made whole, they’d still be 40% in the money.
Such self-destructive behavior, even today, reminds us of what we relearned during the Great Financial Crisis — that humans don’t behave rationally. The efficient market hypothesis is inherently flawed. Too many on Wall Street trusted these efficient market models which assume that people behave rationally and in ways which will maximize their utility. Such assumptions fed robotic algorithms based on the machinations of classical economics and churned out risk models which predicted that something like the Great Financial Crisis would only happen once in every thousand years or so. Former Fed chairman Alan Greenspan, himself a hyper-rational libertarian for over four decades confessed before a congressional committee that he was “shocked” that his model of the “critical functioning structure that defines how the world works” had failed. But he wasn’t alone. Too often, we project our own personalities, our own rationality of the external environment, regardless of whether or not our observed world is a reflection of our inner world, we project it to be and come up with mental models that reflect those beliefs. The most damaging irrationality from the Great Financial Crisis was the persistent but flawed belief that fundamental rules of valuation (a person with no income can’t reasonably be expected to pay off their debts, no matter how many Powerball tickets they buy) no longer applied — that this time really was different.
And while no one can say for certain what will trigger the next financial crisis — the list of candidates is long, from trade wars to sectarianism — it would be reasonable to assume that they will be built on the same kind of mistakes as the last one. We can’t count on employers, banks, insurers or regulators to protect us, but we can shield ourselves and our portfolios because we already know how to spot trouble:
- The companies that will yield significant returns (or alpha) tomorrow, will look nothing like the companies of today. Think GE, IBM and HP, versus Facebook, Amazon and Google. Keep abreast of the latest technologies, such as AI (artificial intelligence) as well as blockchain (hype or underrated?) and read widely. Remember that certain publications will have a vested interest in maintaining the status quo, especially when it comes to the financial world. Who advertises on these publications?
- Listen to the rational fringe — thinkers with strong records who are contradicting the mainstream view. Remember, a crisis occurs when the last pessimist becomes an optimist. During the last financial crisis, these contrarians included Jeremy Grantham, Robert Shiller and Nouriel Roubini — they were right once, but that doesn’t mean they’ll be right again. The world has changed and Roubini is a well known doubter of cryptocurrencies and blockchain technology. So look to alternative sources, like Reddit.
- Don’t try to predict the future — we can’t. Instead, consider probabilistic scenarios and plan accordingly for each one. For instance, what if Bitcoin really soars to $250,000, would a small $6,500 allocation in Bitcoin change my life today? Not likely. But would it change my life down the line? Possibly and in a big way. Don’t fret that most of your plans will be for situations that won’t pan out — that’s the whole point. Even venture capitalists don’t expect more than one out of ten of their companies to succeed — but that one company is enough to make their portfolios for decades to come. It’s better to be prepared for events that don’t happen than to be caught flatfooted for those that do.
If nothing else, the Great Financial Crisis reminded us that even in an allegedly worldwide financial crisis, not everyone suffers equally. Hedge fund managers such as John Paulson made billions betting against the subprime mortgage market. Similarly, if and when cryptocurrencies surge again, there will be some who will also profit greatly — not a bad idea to be counted among them.