The 2008 Global Financial Crisis; Was it caused by some Dick [Fuld]?!

In 2008 the world saw its largest economic depression since world war II, with an estimated figure of $700bn lost from the three largest stock exchanges.

So who is to blame?

After watching the “Love of money: the bank that bust the world” documentary, there is a clear message that suggests the sole perpetrator of the crisis of 2008 are the banks, and in particular the Lehman Brothers. It is remarkable that Lehman went from being a bank with assets of $639bn to an insolvent wreck. It did not require much to make Lehman go up in smoke. At the end of its last financial year, it was so highly leveraged that its assets had only to fall in value by 3.6 per cent for the bank to be wiped out (Ft.com, 2016).

The management team led by Dick Fuld ignored the fundamental economic concept that you do not finance long-term investments with short-term money, and this is what led to their downfall. They had a leverage ratio of 44:1, and so when the housing bubble eventually collapsed, they were in a position of insolvency as they didn’t have enough cash to pay their debts as they fell.

 

Lehman brothers share price 2004- 2009 graph

 

 

 

 

 

 

 

 

 

 

It is evident from the historical share price graph that Lehman brother’s strategy was initially shareholder value creation but when the housing market collapsed in 2007 their strategy became value destroying for the shareholder.

Although a lot of blame was directed towards the Lehman Brother’s, there were also a number of other factors which played a role in the global financial crisis. The turner review, a report compiled by the FSA, criticises the regulatory approaches that were in place at the time of the crisis. These approaches were created based upon intellectual assumptions, mainly being the theory of efficient and rational markets. Below is a brief summary of their 4 key criticisms of the theory of stock market pricing:

• Market Efficiency doesn’t imply market rationality
• Individual rationality doesn’t ensure collective rationality
• Individual behaviour  is not entirely rational
• Empirical evidence illustrates large scale herd effects and market overshoots

 

Financial Times,. (2016). ‘Lehman Brothers: A crisis of value’ by Oonagh McDonald - FT.com. Retrieved 19 February 2016, from http://www.ft.com/cms/s/0/d6099910-b3c2-11e5-b147-e5e5bba42e51.html?ftcamp=engage/capi/widget/client/openft/b2b#axzz40dQ6XZ4m

Portfolio Theory - Is it wise to place all of your eggs in one basket?!

Portfolio theory has been the topic of debate for a number of years. First developed by Markowitz in 1952, the idea that investors can reduce risk by diversification and holding a portfolio of investments has been challenged by many investors; most notably Warren Buffett.

A prime example of Portfolio Theory being applied is in the pharmaceutical industry, which attract the question why has there been such a surge in mergers and acquisitions, with totals of $221 billion in the first half of 2015? (Fortune, 2015).

 The giants in the pharmaceutical industry, such as Teva, Mylan and Pfizer, are diversifying their risk by buying smaller research focused companies. This is a much cheaper strategy and is far more suited to their high growth business model as they don’t have to invest years into researching and developing new drugs. These companies believe that acquisitions are the only way to keep their revenues growing as fast as investors expect. The complexity of today’s breakthrough medicines mean that it is often cheaper for a company to acquire the next blockbuster drug than to develop it in-house.  

The pharmaceutical industry is an example of the application of portfolio theory being a success, as it is easy for a firm to just purchase a company to acquire new patents which can then be used to mass produce new drugs. When used in other contexts, for example as an investment technique, it is not always as efficient. It relies on past information to make future returns, which cannot give you an advantage as this information is and has already been available to the market. This is the fundamentals of the efficient market hypothesis.