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Lessons from the 2008 Financial Crisis from a new angle

Observing the complexity of investment structures
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On the occasion of the ten-year anniversary of the 2008 Financial Crisis, economic experts have extensively dissected the economic causes and consequences of the crash. This piece offers a point of view, which has been a lesser focus of the public debate.

One constant in cases where investors suffered major losses during the Financial Crisis has become apparent. Investors — whether they were private, professional, or institutional — were not sufficiently aware of the risks associated with the products they bought. In 2008, financial products had become so complex that their true risk factors were generally obscure. Introducing complexity is a great way to deceive investors and regulators. Investment products that looked safe on paper were, in reality, highly speculative in nature.

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Ten years later, investors are still trying to recover losses suffered on certain complex financial instruments that they had bought during the so-called ‘good years’ before the crisis. Once confronted with losses, the hidden risks of these investments came to the surface. And only then did the legal structures behind these instruments suddenly become crucial.
Investors asked for instance: “I thought I had bought an index-linked investment, but I have incurred a total loss, how is that possible?” The likely answer was that the investment was a structured product consisting of a bond (loan) and a derivative — when the issuer went bankrupt, investors in these products lost their entire investments, no matter how the underlying index developed.

Complexity and blurry legal structures behind the investment often go hand in hand. They also tend to reinforce each other. Investment structures often make the initial investment more complex and harder to understand. But investment structures also carry additional risks to the exposure incorporated in the underlying investment. When you do not own the asset directly but through an intermediary structure, the value of your investment is not only impacted by the fluctuations of the asset itself, but also by how the investment structure reacts to those fluctuations.
When all is well, nobody pays attention to the complexity of investment structures. But certain questions are too often neglected in bullish markets. These include: Who is the legal owner of the investment? Who carries which risks? Do I have any control rights allowing me to influence the decisions of the persons controlling the investment structure?

What could happen in a worst-case scenario?

After the Dot-com Crisis in 2001–2003, investors had become risk averse. Furthermore, a long period of low inflation and low interest rates followed the crisis. This environment was benign, allowing for the issuance of complex investment products that offered higher yields than government bonds while protecting their holders against the volatility of financial markets — at least on paper. Principal protected notes (PPNs) and collateralized debt obligations (CDOs) became popular amongst private and institutional investors, charities and public authorities during this period.

These structured investment products had become so complex that few people — not even financial regulators — understood where their risks lay. Evidence that this was in fact the case includes the fact that CDOs or Lehman bonds repackaged as index-linked notes found their way into investment portfolios in all corners of the world.

Complex structured investment products typically come to the fore when too much money is in circulation and too few opportunities exist to invest this money. Alternatively, these structures come into fashion when yields on low-risk investments are considered too low to meet obligations towards the beneficiaries of pension schemes, insurance products or other investment schemes.

From this perspective, the world has not really changed much. Interest rates are still remarkably low, investors still remember the losses they suffered in the great Financial Crisis, and there has been a lot of money around. Investors are looking for better returns than those offered by government bonds.

Now that the long rise of equity markets has come to a halt, it might be a good time to scrutinize portfolios and get rid of unnecessary complexity, while bearing in mind that no category of investors was immune to buried risks during the 2008 Financial Crisis.

Keeping it simple

How can investors ensure that they are not buying overly complex or repackaged financial products with underlying but disguised risks? One strategy is to opt for the simplest products on the market. Simplicity is a good thing when markets turn nasty. It is much easier to sell or liquidate a simple investment product than a complex one.
Stocks and bonds are the most straightforward 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. Diversification can be achieved in an investor’s portfolio without having to purchase more complex products.

“You can’t beat the market.” Or can you?

More than ever, it is now commonly accepted that it is very hard to beat the market.

This has created a huge shift from stock picking models to passive investing strategies. An increasing amount of investments are now channeled through large, low-cost investment funds that follow index-tracking strategies such as ETFs.

ETFs provide numerous advantages. They give investors access to all kinds of assets, which they would not otherwise be granted if they had to buy the assets directly. Investors get the benefits of diversification that an index fund holds and can easily buy in and cash out of the ETF thanks to their listing and ample liquidity. Investors can also short sell the shares of an ETF, which allows them to hedge against various risks.

However, ETFs are also investment structures with their own rules and governance.

The assets in which they invest may not always be as liquid as they promise to their own investors. ETFs may also amplify market movements and therefore create further instability in volatile conditions. It cannot be said for certain whether the shares of ETFs would continue to reflect the underlying value of the assets in a deep liquidity crisis. In short, ETFs have not yet been tested in periods of stress, when there is a large degree of volatility and instability and liquidity dries up.

It may well be true that it is hard for individual investors to beat the market. But whether this will also prove accurate in today’s market, which is dominated by large index-tracking funds, particularly when current benign market conditions change, remains to be seen. Investors with cash holdings may one day be able to profit from steeply declining markets caused by the collective activity of index-tracking funds.

The elephant in the room

Governments staved off the credit crisis with debt, but the structural flaws in the system have been left intact or have been repaired poorly. Credit is everywhere when money is cheap, but the debt that our financial system has built up will one day have to be repaid (or written off). Now combine this with complexity and investment structures and you have a dangerous cocktail brewing. A lot of high yield loans have indeed been packaged into portfolios and sold on to investors as structured products or fund investments.

This is probably where the biggest risks in today’s financial markets loom. These will puzzle investors as losses begin to appear once more.

About Deminor Recovery Services Deminor Recovery Services (DRS) is a group of companies that consists of Deminor Recovery Services (Luxembourg) SàRL with registered office at 1 rue Jean-Pierre Brasseur, L-1258 Luxembourg and its subsidiaries in Belgium, France and the USA, and representative offices in Milan, Hong Kong and Montevideo. Our services may vary from country to country depending on local regulations, as set forth in our contracts of services.

Please get in touch to discuss the services we can offer you in your jurisdiction.

 

Erik Bomans

Written on January 9, 2019 by

Erik Bomans

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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