On its ten-year anniversary, it is worth looking back at the root causes of the 2008 Financial Crisis, particularly since similar risks continue to simmer below the surface of our present-day financial system. Here’s how to identify and steer clear of those risks.
Here’s how to identify and steer clear of those risks
The main lesson to be drawn from the 2008 Financial Crisis is still the same: smart investors prioritise simple and liquid investments in their portfolios. Investors sometimes lose sight of investment risks in their quest for a high return. These risks can originate from underlying investments, from systemic risks in financial markets, or even from the legal form of the investment product. In short, stocks and bonds are less risky, simpler and more liquid than funds, which in turn are more liquid and less complex than structured products.
Flashback to 2008
The financial crisis began with the collapse of a number of funds run by Bear Stearns in July 2007. These were all funds that had invested in collateralized debt obligations or CDOs — risky subprime loans that had been broken down into smaller cash-flow generating assets and repackaged as low-risk bonds. Investors, blinded by the complexity of the investment product, bought these bonds en masse. The US crisis took on a global scale after Lehman Brothers crashed into bankruptcy on 14 September 2008, dragging many other banks in the US and Europe into the fray.
Lehman Brothers was not an isolated case. Other banks had been in trouble in the past. The UK’s Northern Rock, for instance, had faced a bank run precisely a year earlier. If the 2008 Crisis made one thing painfully clear, it is that it was possible to sell high-risk investments as defensive products with a low-risk profile. This was because the structured investment products being sold had become so complex that few people — not even financial regulators — understood where their risks lay. The fact that these CDOs found their way into the portfolios of European private and institutional investors is proof of this matter. Looking back, it is hard to understand how all this could have happened. But have the structural deficiencies in our financial system been corrected?
Keeping it simple
How can investors ensure that they are not buying overly complex or repackaged financial products with underlying but hidden risks? One strategy is to opt for the simplest products on the market. If you do invest in other financial products, be sure that you understand how they are structured and that you are aware of the potential risks associated with these product types.
Stocks and bonds
Stocks and bonds are the simplest products on the stock market. Their risk level depends on the issuing company or government and the general market risks. They are typically liquid products that can easily be discarded when there is a market shift.
Investors should, however, structure their portfolio so it is sufficiently diversified.
Diversification can easily be built into an investor’s portfolio without buying into funds.
Funds are not only less liquid than stocks and bonds; they also contain certain additional risks connected to the fund itself. When you invest in a fund, you are not only exposed to market risks and the risks associated with the issuing company, but also to all the risks associated with the investment fund itself. Many funds were forced to suspend investors’ withdrawals during the financial crisis, causing investors to be locked into to the funds for months. On the other hand, funds can also be forced to sell shares due to withdrawals, causing the remaining fund investors to incur losses. In these cases, pursing a buy and hold strategy and letting the storm pass could instead be the wiser course of action.
Using a fund structure as an intermediary between investors and the issuing company’s assets moreover increases the risk of negligence, misconduct and possibly even fraud. Any misconduct can be covered up for years when markets are up, but usually bubbles to the surface during downturns.
Another factor to consider is the fund’s responsibility to recover investors’ money when things go awry. Unfortunately, many funds, in particular those of the passive index type, focus on their day-to-day business rather than spending time on potential claims. In doing so, they leave money on the table that could have been distributed to investors.Exercising considered caution when selecting investments and paying attention to how the funds are structured and managed is thus key.
Index trackers or ETFs have exponentially grown in recent years because of their low cost. They are relatively new products that have ascended in popularity since the Financial Crisis. This means we have no idea how these funds will respond to any future crises.
Investors should always know where they are putting their money.
Important questions to ask before buying an ETF include: How is the tracker structured? Does the ETF invest in real assets or does it only invest in derivatives, which carry an additional risk? What are the tracker’s exit rules?
Always carefully read the product’s prospectus, ask yourself what could go wrong and consider the different fallout scenarios for structured products. Risk factors for structured products include:
- Credit risk: this is largely due to risks associated with the underlying bonds.
- Capital risks: it may be impossible to recover capital or to recoup it fully. When Lehman Brothers declared bankruptcy, their capital guarantee expired, causing investors with structured bonds from Lehman to forever lose their money.
- Liquidity risk: it can be difficult or impossible to trade structured products. When they can be traded, it is often at an excessively high bid-ask spread.
- Interest rate risk: rising interest rates have a negative impact on the underlying bonds.
It is difficult to say how a future financial crisis could influence the value of structured products. With the 2008 Financial Crisis serving as a stark warning/ serving as precedent, structured products should generally be avoided by non-professional investors.
Investors often give little thought to a fund’s domicile- and it is no coincidence that funds are often established in financial centres such as Luxemburg and Ireland. These countries do not offer investors optimal protection. Similarly, it can be difficult and costly for investors to enforce their rights in the offshore locales where some products are domiciled, even when they have a strong claim to their money. Indeed when something truly goes wrong, it can still prove difficult to recover losses from investments that appear safe and seem to offer good investor protection on paper. This holds true even for EU-compliant ICBE funds, established for instance in Luxembourg or Ireland.
The elephant in the room
Western governments bought off the credit crisis with debt, but the structural flaws in the system have been left intact or were insufficiently repaired. Credit is everywhere when money is cheap, but the debt our financial system has built up will one day inevitably lead to great losses, especially in times of rising interest rates. This means investors should be extra wary of financial products with high fixed interest rates, especially in the current market climate. Funds that invest in high-return fixed income products can carry particular risks.
Written on October 8, 2018 by
Executive Board member & Managing Partner of Deminor Recovery Services. Responsible as managing partner for day-to-day management of Deminor Recovery Services.
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