Friday, November 9, 2012

Going Over the Falls: Part 1


Going Over the Falls: Part 1

I’ve just finished reading three more books on the financial crisis:  Sheila Bair’s Taking the Bull by the Horns, Neil Barofsky’s Bailout, and Gretchen Morgenson’s and Joshua      Rosner’s Reckless Endangerment.  The authors are former Chairman of the FDIC, former Inspector General for TARP, and reporters at the New York Times and Bloomberg respectively.  Each of these books fills in a bit more detail about the institutional, regulatory, and political breakdowns that contributed to the financial crisis.  As the books pile up, we learn about more and more bad apples that occupied the credit crisis barrel.  These books cover the expected sources of rot in our financial system: weak regulators, conniving managements, feckless rating agencies, predatory lending practices, and misguided politicians.

We Don't Have A Choice (1997)
However, one giant rotten apple is missing.  Matter of fact, I haven’t seen this bad apple mentioned in any book about the financial crisis, and I’ve read dozens of these accounts.  I am speaking of money managers.  In The Big Short, Michael Lewis details the efforts of a group of contrarian investors who bet against the credit boom.  However, the hedge funds and investors described in Mr. Lewis’s book were a microscopic fraction of the money managers who were analyzing and investing in financial securities as the bubble inflated.  Most of the big players, the firms that manage your money, stayed in the barrel and took your money over the falls during the credit crisis.

The largest firms, such as Fidelity, T. Rowe Price, and Wellington Management to name but three, continued to buy shares in the very companies that would either go bankrupt or require massive bailouts.  Moreover, thousands of hedge funds and other “sophisticated” investors did exactly the same thing.  Amazingly, most of them continued to add to their positions right up until the bitter end.  These firms were populated by portfolio managers and analysts armed with MBAs, designated as Certified Financial Analysts, and showered with the resources needed to dig into companies. The money management industry failed to identify the looming credit crisis until it was too late to do much about it except write plaintive letters to their clients.  Rather than Mr. Lewis’s “Big Short,” I am talking about the “Big Miss.” 

Money managers are required to file a quarterly report with the SEC detailing their stock holdings (a 13F-HR).  I wish I had the resources to do a comprehensive study of these filings in 2007 and 2008 as the credit crisis loomed.  Instead, I took a small sample just to see what a few large money managers were up to.  I selected eight stocks that have been featured in most of the books about the crisis: AIG, Bear Stearns, Bank of America, Citigroup, Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, and Wachovia.  At all the money managers I looked into, it was business as usual.   At best, a firm trimmed its positions in the troubled group of financial stocks, but the remainder of the managers held or even increased their holdings as the crisis heated up.  A firm might take credit for selling its entire position in Lehman, but unfortunately replace it with shares of Bear Stearns.  Most firms were also able to show that their exposure to financial stocks was decreasing on a percentage basis.  However, this was a very weak claim as the reduction was the result of the declining prices of financial stocks.  Most of these firms actually increased the number of shares they owned.  Presumably they thought they were getting bargains as prices fell.

If you are an individual investor who owned FNMA or Bank America, it’s easy to understand why you didn’t see trouble brewing in these companies.  You didn’t have the time or training to dig through the regulatory filings or conduct in-depth research.  Moreover, the quarterly statements from management were filled with soothing reassurances.  Many of you have long given up on owning individual securities, and put your trust in “professional” money management.  You probably figured that a money manager and his analysts had the time, skills, and resources to ferret out trouble before it infected your portfolio.

Why hasn’t anyone written about the “Big Miss?”  I think the answer is pretty straightforward.  It’s not going to sell any books.  The story is boring.  A Pulitzer winning author isn’t going to be able to describe dramatic scenes, or unearth a string of incriminating emails.   Rather, the “Big Miss” would describe people coming to work, sitting in investment meetings, reading a few reports, making several phone calls, putting in a series of trade tickets, and going home.  The book would undoubtedly include a few contentious debates in investment meetings in which some people might curse.  I am sure the author could unearth the transcript of a conference call, where some rogue analyst had harsh words for a bank CEO after a particularly weak earnings report.  However, the book would be about nothing, because money management did nothing.

Tomorrow I’ll write about why money management didn’t do anything and start to explain why the failure of money management was a big deal in the credit crisis.


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