Stanford Brown TW3 – Lessons From Lehman

Market Wrap

Global markets shrugged off fears of an escalating trade war this week, with the S&P 500 closing at an all-time high last night. Despite China announcing new duties on $60b USD of American goods, markets rose as many investors were relieved that the new tariffs were not as large as previously feared. Investor sentiment was helped further by reports that weekly jobless claims had fallen to their lowest level in almost 50 years, which gives the Federal Reserve further scope to raise rates when its committee meets next week.

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The change in investor sentiment comes at a time when a Gallup poll shows that consumer sentiment towards the economy is at an all-time high. American Economist Hyman Minsky believed that stability breeds instability, since stability induces risk-taking behaviour. Despite increasing volatility and headwinds, the market is behaving as if the good times will keep on rolling. While we have taken risk off the table, many are still all in. In the words of US poet T.S Eliot “in my beginning is my end”.

Finance 101 – The GFC

Last Saturday marked 10 years since the collapse of the investment bank Lehman Brothers, the largest bankruptcy in US history. The sudden demise of the world’s fourth largest investment bank triggered a full-scale panic in global markets, with many believing that the world as we knew it was ending. But how did we get there?

The Global Financial Crisis (GFC) had its roots in the US residential property market. Low interest rates and loosened regulations to promote home ownership created a white hot property market in the US, and everyone (even those who couldn’t afford a mortgage) wanted a piece of the action. Banks didn’t want to have too many mortgages on their books, so they hired investment banks to sell their mortgages to investors by creating new products called mortgage-backed securities, which combined thousands of mortgages into an investable asset. These new products sold like hot cakes, with investors paying top dollar for a high yielding investment that was “as safe as houses”.

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This is where things begin to go awry. Banks needed to underwrite more mortgages to create more mortgage-backed securities, and since they were going to get the new mortgages off their books ASAP, the banks no longer cared whether the mortgage applicant was able to pay off their mortgage. Banks started to loan money to anyone, even those with no income, no job and no assets (known as NINJA loans). The rating agencies hired to grade the risk of the mortgage-backed securities all rated them as safe as government bonds, since they would lose the bank’s business if their report was anything but glowing. Pension funds, retail investors, foreign banks and everyone in between loaded up on mortgage-backed securities, assuming that they were investing in an asset that was as good as risk-free. The entire world had essentially bet the house that US home prices would keep on rising forever, and the regulators were asleep at the wheel.

Then the music stopped. Interest rates began to rise and tens of thousands of homeowners began to default on their mortgages. The value of the mortgages underlying the mortgage-backed securities plummeted in value, and now the biggest institutions in the world were facing losses in the hundreds of billions. The sudden collapse of investments deemed to be as safe as government bonds caused hysteria in financial markets, with banks no longer lending out money in fear that they might not be paid back. This credit crunch ground the global economy to a halt, and Lehman Brothers, a bank with $639b USD in assets, had to file for bankruptcy because it couldn’t borrow money to fund day to day operations.

So what lessons are there to learn from the GFC?

Lehman 10 Years On – Lessons for Investors

Our favourite Lehman article, from the plethora released this week, was from legendary value investor Seth Klarman. Here are a few of the 20 insights he gleaned:

  • Things that have never happened before are bound to occur with some regularity. You must always be prepared for the unexpected, including sudden, sharp downward swings in markets and the economy. Whatever adverse scenario you can contemplate, reality can be far worse.
  • Nowhere does it say that investors should strive to make every last dollar of potential profit; consideration of risk must never take a backseat to return. Conservative positioning entering a crisis is crucial: it enables one to maintain long-term oriented, clear thinking, and to focus on new opportunities while others are distracted or even forced to sell.
  • Risk is not inherent in an investment; it is always relative to the price paid. Uncertainty is not the same as risk. Indeed, when great uncertainty – such as in the fall of 2008 – drives securities prices to especially low levels, they often become less risky investments.
  • Do not trust financial market risk models. Reality is always too complex to be accurately modelled. Attention to risk must be a 24/7/365 obsession, with people – not computers – assessing and reassessing the risk environment in real time. Despite the predilection of some analysts to model the financial markets using sophisticated mathematics, the markets are governed by behavioural science, not physical science.
  • Financial innovation can be highly dangerous, though almost no one will tell you this. New financial products are typically created for sunny days and are almost never stress-tested for stormy weather.

Stanford Brown’s Podcast!

The latest edition of Stanford Brown’s Market Insights is out! This month’s agenda ranges includes the new PM, rumblings in emerging markets and the impact of population growth on portfolios.

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You can find the podcast here and here. If you like it, feel free to leave a 5 star rating!

Insurers Make the Bankers Blush!

The Financial Services Royal Commission has set its sights on the insurance industry over the last fortnight, with some of the misconduct enough to make a banker blush! The proceedings started with Clearview admitting that it may have broken the law more than 300,000 times by using cold calling tactics to sell insurance, whilst perverse compensation arrangements at Freedom Insurance resulted in a man with down syndrome buying several insurance policies after receiving an unsolicited call. Other cases involved an insurer trying to deny the income protection claim of a nurse with an anxiety disorder by hiring a private investigator to follow her, a breast cancer survivor being denied a trauma claim because CommInsure hadn’t updated their definition of radical surgery since 1998, and flood victims having to wait up to four years for their homes to be rebuilt.

The cases heard in the Royal Commission underscore the importance of having a trusted adviser when purchasing insurance and making claims. Policyholders with advisers have much higher success when making claims, and if troubles arise, our clients can rest assured that the resources and networks of Stanford Brown will be leveraged to ensure they receive the best outcome.

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Bad news sells best because good news is no news. While we welcome the reforms in the insurance industry that are taking place in light of these malpractices, the vast majority of our client experiences with their insurance policies have been positive. If you have any reservations regarding your insurance policy, please speak to your adviser.

Bricks & Slaughter

On Sunday evening, Channel 9 aired a segment on its 60 Minutes program entitled ‘Bricks & Slaughter’. The report claimed that the Australian property market could fall up to 40% within the next 12 months, and various commenters on the program made confident statements such as ‘get out while you can’ and ‘it’s going to fall off a cliff’. So, is it time to sell up and rent? Or is this just alarmist nonsense?

Let’s stick to the facts. First, it is true that property prices are lower than a year ago, but only a little. According to Corelogic, a market research company, national house prices are 3% lower and units are down just 1% on a year ago. Second, there is great regional variance as we always see. Sydney and Darwin are struggling, but Hobart is flying (+10%). The program focused exclusively on the Western suburbs of Sydney. And yes, areas that are heavily exposed to interest-only mortgages are exposed. And third, the program warned that the 40% price falls experienced in certain parts of the US during the GFC could be coming to an Aussie suburb near you. Well, that is nonsense. Mainly because the Aussie market is very different to the US property market. The largest difference is the non-recourse nature of the US mortgage market. This enable homeowners to simply walk away from properties whose value had fallen below their purchase price. Try doing that in Sydney and see what CBA does to you! Our advice is to not to panic but to speak with your adviser. Property can go up as well as down.

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CBA Withdraws from SMSF Lending

Staying with the theme of property, CBA announced this week that it will shelve its SuperGear product and no longer be making new loans to finance property purchases held in Self-Managed Super Funds (SMSFs). This move means that from October, none of the four major banks will offer new SMSF loans for residential property, following Westpac’s decision in July to withdraw from the sector. Investors still keen to buy property using their SMSFs must now raise the debt themselves and on-lend the proceeds to their SMSF. If you want to find out more about how this works, please contact your adviser.

Financial Advisers as Justices of the Peace

Financial advisers have been granted a status equal with accountants, lawyers and justices of the peace – they can now witness official documents for clients. This is as a result of being included within the terms of the Statutory Declarations Regulations 2018. If you need documents witnessed, please contact your adviser.

Who am I?

Congratulations to Lawrie and Janet for spotting a Sir Peter Cosgrove in the last instalment of Who Am I!

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But who is this young rooster?

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Pic of The Week – A sign of the Times!

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Video of The Week

Who needs to spend three year studying the history of Europe at Uni? Just watch this short video instead! Fantastic.

Have a great weekend!

Jonathan Hoyle, CEO & Nicholas Stotz, Investment Analyst

Stanford Brown

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