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Why Smart Investors Were Burned in the Crisis

Jason Stipp

Jason Stipp: I'm Jason Stipp with Morningstar. In September 2008 Lehman Brothers collapsed in a shudder and a shockwave across the financial world. And investors, now that we have seemed to have stepped back from the abyss, may be wondering how has the landscape changed going forward?

Here with me to talk about some of those details is Matt Warren. He is Morningstar's associate director of equity research for banks and financials. Thanks so much for joining me, Matt.

Matthew Warren: Good to be here.

Stipp: So as we look back one year later on Lehman Brothers, the government did let it fail, which wasn't the case for some of the other investment banks. In hindsight do you think that the government would act differently today? Was it a mistake to let Lehman go under?

Warren: I think it was a critical mistake, and part of the reason why we had two back-to-back negative 6% GDP quarters. In fact, if they had let another institution fail in that ensuing week, it would have come close to guaranteeing that we faced disaster.

And there are multiple reasons for that. Part of the reason is that there is no resolution system in place for an institution like Lehman. So you couldn't have an orderly wind-down. What you have instead is a pure panic, where the people that lent to that firm and the counterparties and customers to that firm were left scrambling to try and limit the damage essentially and replace the business they were doing with Lehman.

Lenders took a huge hit. And why lend to a financial firm at 5-6% when you can get 100% loss, or 90+% loss on those monies? I think that proved to be the message that people took home from Lehman.

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Stipp: Looking back on it, what do you think it was that was missed on some of these companies? Why were some really great investors tricked into thinking that they were undervalued when really they were at critical risk?

Warren: That is a good question because it was interesting to watch happen. In retrospect you can see all kinds of layers of risks that were involved. You had a bubble on housing prices, a bubble in commercial real estate prices. You had way-too-complicated instruments running around the system and poor regulation incentive, so just a whole layer of items.

But the one that stuck out to me in advance was the housing bubble and that the ramifications of that, when it burst, were going to be enormous. And I think people that got it wrong were looking at the playbook from the last couple of decades.

Whenever there was banking troubles you would go in and buy cheaply, at low price/book and make two and three times coming out the other side. And that was a tried-and-true playbook, and it didn't work when the magnitude and duration were what they were in this cycle. And that is where people really got burned.

Stipp: For the investment banks that remain, how has their profit picture potentially changed? And also, are they going to end up taking the same risks that they have been taking before, or do we see a different picture for the amount of risk that they can take in the future, which may impact their business in some way?

Warren: The I-banks is a bigger wild card and harder to predict. You had a sidelining of a lot of capacity around the events of Lehman Brothers, so Lehman and Bear Stearns became part of a larger company. There is a lot of rationalization of capacity there. You saw some European players, UBS in particular, that was sidelined by their problems and by the regulatory response to those problems.

And then what you had is the profit on just plain-vanilla trading blew up in a good way for these I banks. So you had Goldman Sachs making over $6 billion in revenue a quarter trading. And so what you got is really outsize returns on less-risky business, and it helped repair any large bank that had an I-banking arm. It helped them through the current troubles.

From here, what we are expecting is, and you are already seeing evidence of this, those outsize returns on low-risk business, obviously that is going to bring more capital and more people back into the business.

So you are seeing people like Morgan Stanley deploy more capital back into the business. UBS is working on their plan to get more capital and people back into the business. So we expect those returns to come down. They are not necessarily going to be as commoditized as they were during the bubble phase, but we do expect those returns to shrink from here.

And then looking further out, that is where you can picture the I-banks getting back into risky businesses, once we are further along into an upturn. That is what they always do; I expect they will do it again. We will just have to watch how that develops.

Stipp: And once those easy profits are plucked the need to stretch a little bit more for those extra profits is what starts to heat the waters up a little bit again.

Warren: That has been the history in I-banking and you get blowups and failures in nearly every cycle.

Stipp: Thanks so much for joining me with your insights today, Matt. I really appreciate it.

Warren: Sure thing.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.