History always provides a guiding light to a better future the trick is to follow the light!

What caused the GFC? What are the lessons from the GFC for both Lenders and Fund Managers?

In a nutshell, a US housing price surge in the very early part of the 21st century saw unsophisticated, uncreditworthy, low income “sub-prime” borrowers’ binge on US real estate with investors globally developing “bubble blindness” with all logic flying out the window.

As it does take “two to tango,” investors kept buying these poor-quality mortgages dressed up as “AAA” rated investments. When the bubble burst, markets tanked, people panicked, and emotions took over. And as we have seen, fear drives extreme and unpredictable behaviour.

One of the truest saying ever coined is “Those who do not learn from history are doomed to repeat it”. There are many examples of this, including the outbreak of World War II less than 25 years after the conclusion of World War I. Another example, albeit with a longer time gap is the Global Financial Crisis (GFC), 78 years after the Great Depression. Whilst on the subject of history’s lessons, let’s hope that future generations learn how to proactively protect the world’s population from another COVID pandemic.

In this article, we will discuss the causes of the GFC in 2008, and then, the resulting lessons still to be learned by some Lenders; (institutions such as banks, finance companies and credit providers who arrange loan funds to individuals and companies). On the flip side, we will discuss Fund Managers (property, mortgage, equity, infrastructure, cash, futures, and the like) who are charged with investing, protecting and growing their clients hard-earned money.

For the sake of stating the obvious, you can’t repair something unless you can identify what has gone wrong and then work out what needs fixing and how to do it. Just like when a relationship breaks down and at least one of the parties say they don’t understand why the breakdown occurred, then it becomes very difficult, if not impossible, to repair something when there is no defined cause.

Interestingly, when something goes wrong, humans need a scapegoat. I know that it is perverse, but we feel better when we blame someone else for our woes. Finger-pointing takes the focus off our own behaviour and turns the heat on the “real” culprits. Plus, it feels good to play the innocent victim and exclaim: ‘It’s not my fault!’

The good news is there’s plenty of blame to go around when it comes to the GFC, both personal and corporate. The responsibility for the COVID like a contagion that was caused does not reside with any one individual or group. No one faux pas can claim a monopoly on the causes of the GFC which were greed and debt run amuck and the creation of synthetic securities and common human stupidity. Interestingly, there were many in the populace and media who demonized everyone and anyone after the GFC.

Greed

Chief among the villains was the fat cat US lending CEOs who pocketed huge pay packets while presiding over almost non-existent lending rules. Others blame well paid US regulators for turning a blind eye to an unsustainable domestic mortgage market. Not to be forgotten were the highly paid financial whiz-kids who invented the newfangled securities that turned toxic. Last, but not least, was the global – fee sucking – sales forces led by Lehman Brothers who sold the junk bonds to unsuspecting and blindly trustworthy investors around the world, who financially underpinned the “sub-prime” machine.

In Australia, billions of dollars were lost by church groups, local councils, benevolent institutions, charities and the like, and yes, those who should have known better – local fund managers.

Fast forward 10 years in Australia to 2018 and the Banking Royal Commission and we were reaping the rewards of what we had sown over that past decade. Dubious and risky lending practices created a Devil’s kitchen where institutions have gorged on a diet of toxic loans. The global financial system is still trying to digest a poisonous broth of sub-prime mortgages and is now starting to swallow a rising number of personal bankruptcies caused by credit card debt. No wonder the system is choking!

But what about citizens? Do we need to temper our righteous indignation in the knowledge that, as a society, we have become greedy credit junkies?

Debt

For many years, I watched with dismay as personal “wealth” was increasingly born of leverage. It seemed as if virtually everyone wanted to “super-size” their debt. That’s why borrowers are not blameless spectators to the GFC. Many consumers who have binged on debt are still suffering a self-inflicted hangover.

Over 30 per cent of borrowers elected to borrow on an “interest-only basis” which means they could borrow more money and not pay off any of the core debt so that, in theory, they could increase their wealth faster with this increased leverage. Good in theory-bad in practice!

It’s not hard to argue, that we were and still are, living beyond our means. For many, unsustainable expenditure has become the drug of choice.

Synthetic Securities

The online Merriam-Webster Dictionary defines alchemy as “a science that was used in the Middle Ages with the goal of changing ordinary metals into gold”. Medieval alchemists believed they could transform something common (molten lead) into something precious (pure gold). Viewed through a financial lens, alchemy is about converting a lower value item into a higher value item.

But care must be exercised since attempting to turn “trash into treasure” caused the Global Financial Crisis (GFC). The Alchemists of Wall Street transmuted toxic subprime mortgages into junk mortgage-backed securities and sold them as gilt-edged, AAA-rated bonds. Put another way, investment “lead” was dressed up as “fool’s gold” triggering the worst financial crisis since the Great Depression.

Stupidity

There are a number of reasons why economists missed the warning signs of the impending GFC crisis, but chief among them, in my view, is that neoclassical economic theory is unable to account for flawed human psychology.

Put simply, economists have unrealistic expectations of rational behaviour and when money is involved, and the lure of big return is on offer, many humans develop a condition called stupidity!

What are the lessons out of the GFC?

Patience – Not greed

Last year, I planted a new hedge in my front yard. No matter how much I water, fertilise or even sing to it, I know the hedge will grow at a pace largely determined by nature, not by me. While the systems in nature can’t be rushed, we humans think we know better when it comes to the systems we build and how quickly we should get rich.

The dangers of short-term thinking were very evident in the global financial crisis. The manic pursuit of quick profits from borrowers and investors alike, drove the speculative housing bubble in the US. Borrowers, lenders, investors and fund managers, saw US real estate as a get-rich-quick scheme. How wrong they were!

Patience along with persistence and determination will see you prevail with much lower risk.

Take on good debt – Not bad debt

I think as a society we need to take a long hard look at ourselves. Collectively, we need to take ownership of our actions. We need to understand that debt is not risk-free. We need to save more and encourage habits of thrift among our children.

Remember that “Rome was not built in a day” and neither will your wealth. They say, “gamble with your head and not over it.” The same applies to any borrowings including credit cards.

Deal in products developed with a “KISS” Modus Operandi – Not synthetic securities

I know it’s easy to be wise in hindsight, but greater risk assessment should have been undertaken before sub-prime loans – and in Australia – 100 per cent loans and low doc loans were put on the financial investment menu.

If you look at a loan product whether as an investor or fund manager and it doesn’t pass the KISS test, then walk away.

KISS is – Keep It Simple Stupid!

Act sensibly – Not stupidly

a) If it seems too good to be true it probably is.
b) Risk/Reward – Ask yourself how much risk you are willing to take before you lose money.
c) Have a healthy scepticism. Don’t blindly believe everything you are told.
d) Ask lots of questions.
e) Challenge opinions and statements made to you.
f) Ask for independent evidence of matters offered up as “facts.”
g) If you can’t understand it, don’t buy it.
h) Above all else – Get financial advice from a totally independent qualified advisor.

Lessons for everyone out of the GFC

Lenders need to go back to school and re-learn their trade and borrowers should modify their behaviour and live within their means. A refresher course right now in good lending principles for both lenders and borrowers at a “101” level is just what the doctor ordered.

Less spicy loans and a return to bread-and-butter lending standards and simple loan product guidelines will provide investors and fund managers with a clear matrix of lending risks, which if understood and heeded, will provide a boost to everyone’s fiscal health.

Specific lessons for Lenders

Like with so many things in life, when things fail, go back to basics and start again. For Lenders the cornerstone of good responsible lending is the 5C’s, which are Character, Capacity, Cash Flow, Competency and Collateral.

Addressing the 5C’s of good commercial lending in more detail.

i. Character

Only deal with individuals, including directors, who are of first-class character. Make sure they have clean credit rating reports and that they have previously honoured all their financial and contractual obligations. As well, character checks are always helpful.

ii. Capacity

Examine the borrower’s balance sheet to determine the strength of the business to which you are lending. A healthy net assets position is always favourable. Next, interrogate the Profit and Loss statements over at least the last two years. Not only can you see if the business is profitable, but you can analyse trends in sales and costs. A healthy balance sheet and a profitable business usually equal a good borrower.

iii. Cash flow

A balance sheet and P&L statements are historical snapshots in time of a company’s performance and so we need future-looking cash flow projections for the business over at least the next 12 months to ensure that the business is still sustainable and profitable.

iv. Competency

In an ever-changing and fast-moving world, lenders need to ensure that borrowers have a continuing competency to manage and grow their business in the face of financial, technological and other competitive challenges.

Additionally, lenders should be wary of borrowers who become complacent with the advent of their continuing success being unchallenged by existing players and or new entrants heralding new ways of doing things with new technology and a sharper customer focus. Just ask the Taxi Council’s around Australia if they regret their complacency around Uber’s entry into their monopoly market.

v. Collateral

We take out car insurance so that in the unlikely event of a car accident we can recover under our insurance policy. So too, lender’s need to take out “insurance” if a borrower seriously defaults on a loan and that insurance is in the form of “collateral security” primarily over real estate as well as a General Security Agreement (GSA) over the assets of a business as well as personal guarantees from any individual borrowers or company directors.

Specific lessons for Fund Managers

In Australia, it is not uncommon for the fund manager to also be the lender. Whether that is the case or not, a fund manager must ensure that the lender is following the 5C’s of good commercial lending, as noted earlier. Of even greater importance, an independent fund manager must take the time and effort to get to know the lender well, to make sure that the lender will always act openly and honestly and in the best interest of the fund manager and the fund managers clients.

Over and above all of this, the fund manager must understand each and every specific mortgage that they are recommending to their investors, and they must be very wary of so-called credit enhancements which were used in the sub-prime fiasco to fool many, including luring fund managers into a false sense of security. To use an Australian lending cliché, “If the (lending) deal can’t stand on its own legs (without any enhancements) then you should not do it” – nor should you invest in it!

Importantly, a good fund manager is additionally expected to look beyond the merits of a good commercial mortgage loan transaction and be able to form their own educated view on things that could impact the commercial mortgage market and individual borrowers to the detriment of the fund managers clients who invest in these commercial lending assets.

Accordingly, the fund manager needs to look at things such as;

a) Property market trends, particularly in an overheating market – When do you pull out?
b) Interest rates increases – When do you apply tougher serviceability requirements?
c) Economic trends – What are they telling you about future market conditions?
d) Borrower sector spread and maximum exposure limits – What are they set at?
e) Property type spread – residential, commercial, industrial & retail – What are the percentages?
f) Specialised property – hotels, clubs, motels, bowling alleys, nursing homes and the like – Do you lend on them and if so, what additional conditions (and lower LVR’s) apply?
g) Construction and development loans – What is the demand and what is the trend?
h) Geographic property spread – Don’t have all your eggs in the one area – Have a policy
i) Political implications – New taxes, regulations, restrictions & the like. What do you do?
j) Global implications – Export markets suddenly closing (China?) What do you do?
k) Social trends – Good for some & bad for other borrowers. How do you monitor this?

To my continuing amazement, the US sub-prime fiasco fooled mum and dad investors, churches charities, local councils, sophisticated investors, fund managers and national regulators.

As a practising fund manager at the time of the GFC, I resisted huge pressures from my board to invest $300 million in excess cash that I was holding, into what became known as sub-prime mortgages.

Why? Simply because – for me – it did not pass the KISS test, nor did I buy the credit enhancement story and finally, I stuck to my mantra that “If it appears too good to be true it probably is”.

How sad that this openly deceitful offering was able to fool so many who collectively lost trillions of dollars worldwide and it effectively bankrupted many nations including what colloquially became known as “The PIGS” – Portugal, Italy, Greece and Spain.

Remember, history always provides a guiding light to a better future – the trick is to follow the light!!!

John (JT) Thomas

This article is provided by John (JT)Thomas, a 45-year veteran of the financial services industry and since 1987 a specialist in commercial mortgage funds. Considered by many to be the grandfather of the modern commercial mortgage fund sector, JT helped establish and then manage – for 17 years – what became the largest and most successful commercial mortgage fund in Australia the Howard Mortgage Fund. At Howard’s, JT lent over $7bn in commercial loans to a variety of commercial borrowers for a variety of reasons including construction and development purposes.

JT has been proudly involved with Princeton Mortgages for eight years and sits on both the Princeton Credit Committee and the Princeton Compliance Committee as well as being an advisor to the Princeton Board.