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The Protection of Fools

04 Oct 2008 12:20TraderF

In recent months the lessons of history are being learnt over and over again. It seems that everybody from Governments, Institutions and Investors have behaved in a complete vacuum. We hear rhetoric about this must not happen again and yet it always reoccurs. The price will be paid by those who seem unable to learn from history.

Does the name S&L mean anything to you, what about Drexel’s? In 1980 Ronald Reagan had to bail out all the “Savings and Loans” banks in the US when they got into trouble from property related lending. Then there was Drexel Burnham Lambert, they invented the “Junk Bond” and sold billions of dollars worth of them to investors until they also when bust is 1989.

In both of these financial storms the commentators pronounced that the sky was about to fall and we where all doomed. Does this sound familiar? Today we have the “Credit Crunch” which is simply a combination of the Savings and Loans and Drexel’s. Junk loans backed by property. Those who packaged and sold these high risk financial products deserve to go bust. This applies to everyone from Blue Chip and Bridgecorp to Lehman’s on Wall Street. Bankers must get a clear message that if they sell high risk financial products and they go wrong, it is them that must pay with the firm and their job. A financial system will always push the risk limit if its activities are underwritten by the Reserve Bank’s printing press. Bailouts are bad and only setup the financial system for a bigger problem when the cycle comes around a few years later.

It is a fundamental truth that in every transaction “The seller knows more than the buyer”. This goes some way to excusing the investors; however they also need to learn to assess risk from a position of knowledge. They need to understand the pricing of risk premium. Risk premium is the difference between the risk free investment and the investment being offered. The chain of risk goes in this order; Government debt, prime registered bank, large investment bank, finance company. Each step along the way the risk premium must be higher, so if a bank is paying 6% then a finance company should be paying 12%+ and the amount that is invested with the finance company should only be one tenth of the amount with the bank.

Hard as it might seem investors need to be taught a lesson and cannot pass all blame to the financial institutions. They believed slick sales talk about “being backed by property” and prestigious names on high rise towers. They should not be bailed out for their foolish behaviour. Simple facts like having your money with five property backed finance companies does not lower your risk. Investors need to learn to recognise the larger cycles and understand that to “buy in gloom and sell in boom” is the best strategy. By the time boom investments are making the 6:00pm news they are finished. Investors must up-skill themselves and learn that all reward contains risk and that risk must be managed.

Government must also shoulder some of the blame. It is their role to ensure that risk is taken in the right places. When a financial institution is selling a product that offloads all the risk to the investor they must be required to disclose the true risks involved. I have long been a critic of financial institutions creating off balance sheet products that pass all the risk to the investors. Government agencies need to take a hard look at this area. To his credit Dr Bollard has resisted bailouts of the finance sector despite the risks to the economy as a whole.

The truth is that blame for the current situation must be shared around Government, the Institutions and the Investors. Each failed in the duty of care to regulate, the creation of high risk products and the ability to assess risk. It is easy to exaggerate the affect of this downturn; it is not a crisis, it not the worst thing to happen but it does require lessons to be learnt by all.

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