In May 2007, the financial sector replaced the energy sector as the largest component of the U.S. economy. Banks, notably Wachovia, Citigroup, Lehman Brothers, Bear Stearns, Bank of America, JP Morgan, and a few others, began employing “high-grade structured credit strategies” in building the real estate portfolios on the bank’s balance sheets.
What that means is this: A bank like, like New Century Financial, would lend $150,000-$200,000 to borrowers with shaky credit histories in order to purchase a $200,000 home. But New Century Financial didn’t just sit on these mortgages and collect the high interest + principal on the payments from the families that had taken out mortgages. Instead, what they would do is bundle these mortgages together—with the thousands of other low-credit quality mortgages in their portfolio—and sell little slices of them to the banks mentioned above. During ordinary and good economic times, and when property values were rising, these loans proved extremely lucrative as these bundled loans would earn returns of 11%, 12%, or 15% per year.
Bear Stearns and Lehman Brothers loved adding these loans to their balance sheet. The logic, if you could put yourself in the shoes of the people making these deals at the time, was that a double margin of safety existed: even if some subprime borrowers defaulted, the debt had been packaged in such a way that there was perceived safety through diversification as the high interest payments from the remaining families with mortgages would compensate for those that fell behind.
And secondly, it was a mortgage—the debt was tied to property. If you defaulted, the bank could seize the home (which at the time had the medium-term trend of appreciating in value each year) and then sell it for a value within hailing distance of the loan amount. It was believed that the interaction of secured credit plus diversification of subprime borrowers would enable banks to minimize risk while taking on ever-growing sums of low-quality mortgage debt.
In the case of Lehman Brothers, the company’s management team thought it would be supremely clever to (1) engage in commercial real estate at a more aggressive rate than real estate, as it was believed that low-quality businesses would make rental payments better than low-quality family borrowers would make mortgage payments, and (2) the company began using its short-term cash on hand to flip real estate deals.
That second component is an important part of why Lehman Brothers went bankrupt that often gets ignored. The New York Times reported on the morning of Lehman’s bankruptcy on September 15th, 2008 that Lehman carried over $600 billion in toxic debt on its corporate books. That figure sounds ominous, and it certainly was, but that is an incomplete explanation of what happened that drove Lehman under. It was the fact that company depleted its cash on hand and credit lines to put up $22 billion to acquire the Archstone-Smith Trust. What doomed Lehman in September 2008 is that expected payments stopped arriving and the capital tied up its rainy day capital to make the Archstone acquisition.
Why do I mention this on a long-term dividend investing blog? Because it touches on the importance of bank management teams when you deal with financial stocks—it’s not just about P/E ratios and earnings, but you have to pay heightened vigilance when monitoring how those profits are made in a way that you do not have to do for Kellogg, General Mills, Kraft, and Nestle. In my opinion, catching a bank that is depleting its short-term liquidity to goose profits is one of the hardest skill sets to develop as an investor because most data shows up months later and you have to catch the risk in real time as it happens. That’s why I often recommend that financial stocks in a portfolio be limited to U.S. Bancorp, Wells Fargo, Berkshire Hathaway, Visa, T. Rowe Price, and Franklin Resources if you aim to have 20+ year holding periods, and you limit those stocks to around 10% of your overall portfolio so that a subsequent financial crisis will not wipe you out. As a different, but related thought, it is funny how easy investing can become when you eliminate leveraged finance stocks and companies prone to product obsolescence from your list of potential investments completely.