In all aspects of life, we hope to learn something because the definition of insanity is to the same thing over and over expecting a different result. If we actually learn something perhaps we can do it better next time. In the world of investing, the best investors have also lost money, no one is perfect, but the more you learn the less you will fail. However somewhere along the line, you will likely made a significant win and then you invest with more money. On the stock market all companies start the day with the same advantages – quarterly and annual reports are made available to the investing public. Many stories are told, some of them are better than others but storytelling is the key to attract multiple numbers of people to buy the stock. If an investor looks back over the years, they will likely same losing money helped me understand the functioning of the markets and over time I learn and prospered. For a new investing, while not encouraging anyone to lose money, if you lost money and learned something important, then it may be worth losing money. If you lost a lot a money it might be a crisis.

In a book called Firefighting – The Financial Crisis and its Lessons written by Ben S Bernanke, Timothy F Geithner and Henry S Paulson published by Penguin Books, NY, 2019. The book offers lessons from a crisis. The 3 authors were the lead news daily in 2008 through 2010 as the financial industry went through losses, destabilization, recession and recovery. The 3 people had to come up with a variety of tools to fight the fires and to allow for recovery. In all industries including finance, regulations are there for the last crisis not the current one. If the crisis is worse this time, the regulations are less effective because all industry change from the last crisis. Finance is always a little different because much of finance is about confidence. Banks lend money, they have to have a level of confidence the counterparty will repay. When the confidence falls, investors run will their money to something safer. When money goes to something safer, it effects regulatory levels.

Not surprisingly, the 3 authors noted the system is more complex than ever and when they tried to do something, they quickly realized the tools in the toolbox were not sufficient for the job and needed to persuade politicians to give them better tools.

In the financial world, too much debt is the biggest problem. The debt is tied to leverage and leverage is the double edge – leverage can increase both positive returns and negative losses.

The basic vulnerability of the financial system stems from the fact that banks provide 2 important economic functions that occasionally come into conflict. The banks allow people to place their money that provides safety and higher interest rates than leaving your money in your mattress; then they use the money to provide loans to finance riskier investments in homes, cars and businesses. In other words, they borrow short-term and lend long-term a process known as maturity transformation. The problem is even if a solvent bank, with assets more valuable than its liabilities, can collapse if those assets are too illiquid to cover its creditors’ immediate demands for cash.

The US has tried to reduce this risk regulation that limit the risks banks are allowed to take, coupled with government-provided insurance for depositors that reduces their incentive to run if their banks seem unstable.

Every financial institution can function without confidence, and confidence is evanescent. It can go at any time, for rational or irrational reasons. When it goes, it usually goes quickly, and it is hard to get back.

The 3 authors are remembering how the system where it was: with the benefit of hindsight. it is clear that the government failed to rein in the excesses that would help spark the crisis. For example, that the government let major financial institutions take on too much risky leverage without insisting that they retain enough capital, the flip side of leverage; the more an institution relies on borrowing, the lower its capital levels, and the greater its exposure to shocks. Capital is the shock absorber that can help an institution withstand losses, retain confidence, and remain solvent during a crisis. At the time, banks were easily exceeding their legally mandated capital requirements, and regulators did not think they could demand that they raise more.

It would later become clear that the backward-looking capital regime for banks, designed to protect against the kinds of losses created by relatively mild recent recessions, was not conservative enough. Regulators allowed banks to count too much poor-quality capital toward their required ratios, rather than insisting on loss-absorbing common equity. And supervisors failed to recognize how much leverage banks had hidden in complex derivatives and off-balance vehicles, which made them look better capitalized than they actually were. And most bankers were overconfident as their clients about risks in the housing market.

And the most damaging problem with America’s capital rules was not that they were too weak, but they were too weak and applied too narrowly. The institutions with the most reckless mortgage-related investments and the least stable funding bases also had the thinnest capital buffers, but they were operating largely outside the reach of the regulatory system.

The 3 of us learned, that reform is extremely tough to achieve without a crisis to make the case for it. Fannie Mae and Freddie Mac owned or guaranteed half of the residential mortgages in the US. We believed they were seriously undercapitalized and under-regulated. Market participants assumed the government that chartered them would rescue them if they ever got into trouble, so the companies felt safe piling up leverage. (there is a line in the movie – The Big Short – the Brad Pitt character says to a hedge fund client trying to short the market, if you right then everyone in the US will be losing money on their residential real estate, the US will be in a recession, do not be too happy). Just about everyone in the US was on the other side of the equation including regulators.

Linking to dividend paying stocks, the reason to initially buy the stocks is for defensive purposes, the companies have been through many economic cycles and continue to make profits. The fact they continue to make profits allows them to trade at higher multiples or the stock prices tend to increase overtime. We all have an expectation of some sort of balance in the economy tills it is not there, but we never are positive what sector will be affected. Once the sector is affected, we realize the economy is very interconnected and what we believe are regulations to protect everyone are not as strong as we hope. Dividend stocks prices will fall, but they tend to bounce back faster as the economy does recover and along the way dividends are still being paid.

There are more questions than answers, till the next time – to raising questions.