In Part 2 on my series about value investing during the 2007 – 2009 Credit Crisis and market crash, I discussed some of the macro-issues that created an environment foreign to almost any value investor since the Great Depression of the late 1920’s and 1930s. Some of topics I covered were major trends leading up to the 2007 – 2009 Great Recession, how assets and liabilities were poorly structured nor aligned to reduce risk, and how innovation continues to put enormous strain on our major companies’ balance sheets and the greater economy.
In Part 3 of this series, I wanted to use a specific case (Washington Mutual, which was one of the country’s largest savings and loans institutions) to demonstrate the interconnected nature of compounding risk building up to the market crash in 2008. I will point out that many value investors approached this like any other fundamental market crisis - when in fact - what we faced was a fundamental financial structural crisis. This was not a misallocation of capital caused by market hysteria such as the 18th century South Seas venture or the 1990’s technology bubble. Rather, this was a crisis in scope and scale that we hadn’t seen since the Great Depression and would require an equally innovative and fast-acting group of leaders to prevent a far greater calamity than we actually saw in the darkest of days in 2007 - 2008. The Great Recession was caused by a fundamental failure in our financial model - where risk was seemingly whisked away by the wand of loose regulations and even looser credit rating agencies morals. It was compounded by building a system where bets on this risk were leveraged to the extent that no private company could afford to pay them off. It was - in fact - only sovereign governments that had the strength to step in and avoid a complete collapse of the world’s financial markets.
As I’ve stated previously, I want to make clear this series of articles isn’t making a judgment about any particular value investor or value-based investment company. Most of those mentioned were doing the best they could in an almost surreal business environment. They were seeing behavior by shareholders, management and regulators that was completely foreign to their experience and fundamental values. Some were attempting to make sense of balance sheets that seemingly had a new land mine explode on a daily basis. Others were dealing with a system – in this case the debt and credit markets - based on unwitting (and sometimes quite witting!) fraud. A system that was supposedly based on hundreds of billions of dollars in rock-solid real estate debt that was in reality based on fool’s gold.
A Small Thermonuclear Financial Device: Washington Mutual
If one were to roll back the calendar and pick a date and a company that symbolized the strength – and ultimately the tragic weakness – of these markets, it would be year-end 2007 and the company would be Washington Mutual. Washington Mutual was considered one of the best run and most conservative savings and loan bank in the United States. By the end of 2007, WaMu had more than 43,000 employees, 2,200 branch offices in 15 states, and $188.3 billion in deposits. Its biggest customers were individuals and small businesses. On the cover of its 2007 annual report, management wrote,
“What does the future hold for our company? This report is dedicated to providing perspective on the past year and sharing our confidence in WaMu’s long-term future”.
It went on to describe that roughly 60 percent of its business came from retail banking and 20 percent came from credit cards. They then noted that only 14 percent of its business came from home loans. What they didn’t say - and simply couldn’t understand - was that this seemingly insignificant 14% of their business was enough to destroy the bank and send it into bankruptcy. By the end of 2008, WaMu had become the largest failed bank in U.S. history. Washington Mutual was the largest canary in a very large coal mine.
The reasons for Wamu’s failure are far beyond my ability to fully discuss in 3 pages, but I will quickly sketch the issues and then discuss why traditional value investors had no investment “antibodies” to identify the disease and avoid its infection of their business.
WaMu’s home loan business was part of a greater web of leveraged debt and debt products that overwhelmed the credit markets. While only 14% of their business, WaMu made great profits by writing mortgages (many times writing mortgages that far exceeded the equity in the house) and then selling these into the secondary mortgage markets and removing them off their balance sheet. This model worked great based on two fundamental market conditions. First, home prices would continue to rise thereby creating steady demand for new mortgages as well as assure loans would not fall into “non-performing” or default status.
Second, the secondary mortgage market – made up of Fannie Mae, Freddie Mac, and other private companies – would continue to purchase these loans that originated at WaMu but were bundled up and sold in the secondary market as mortgage backed securities. As long as these two market conditions continued, then the Board was correct in looking forward to a bright future.
Unfortunately, a series of events (which I will label 1A, 1B, etc.) took that 14% of the business and turned it into a small thermonuclear financial device. As these events unfolded, it became increasingly clear that most of them were interconnected in such a way that – like a ball of twine – it had to all be unwound at once – or not unwound at all. The latter was clearly not an option. That linkage took what seemed to be one small problem (“It’s only 14% of our business. How bad can it be?”) and - in its own Frankenstein moment - created a monster no one really understood until it was too late.
In event 1A, housing prices declined for the first time since the Great Depression. The loans on WaMu’s balance sheet suddenly needed either a cash infusion or had to be sold into the secondary mortgage market - quickly. In event 1B, the mortgage backed securities market collapsed. WaMu could no longer remove the real estate liabilities from its balance sheet. In the fourth quarter of 2007, it wrote down $1.6 billion in defaulted mortgages. Bank regulators forced WaMu to set aside cash to provide for future losses. As a result, the bank reported a $2 billion net loss for the quarter. Its net loss for the year was $67 billion (the bank only made a profit of $3.6B in 2006 profit). In event 1C, Lehman Brothers declared bankruptcy on September 15, 2008. This led (here’s that linkage again) to a massive run on the bank with depositors withdrawing $16.7 billion or 9% of WaMu's total deposits. By then the Federal Deposit Insurance Corporation (FDIC) said the bank had insufficient funds to conduct day-to-day business and began looking for buyers. For a company that had looked towards such a bright future at the end of 2006, it was bankrupt by end of 2008.
Like Sharks and Chum: The Value Investment Titans
As the problems I just outlined began to develop at WaMu, value investors began to see a classic value investment opportunity in the making. Most classic value investors still saw this as a market crisis, not a fundamental financial system crisis. Here was a company that was predominantly based on consumer deposits (traditionally very sticky assets) which were federally insured by the FDIC. It seemed the real estate problem child of the bank could be walled off (“I mean, it’s only 14%. How bad can it be?”) and then - in classic value investment practice - investors could wait out the panic and watch the bank stock price rebound. It was the classic value investment approach creating a handsome profit for those willing to take the risk.
Let’s take a step back from the Washington Mutual case, and look at the broader crisis as it was developing in 2007 – 2008. Many value investors at this point made major bets on a wide range of financial industry players. These included the largest commercial banks, investment banks, insurers, ratings agencies, even the quasi-government agencies of Fannie Mae and Freddie Mac. For most of those investors, the inner doubts of “did I buy too early?” became “should I have bought at all?”. By mid-summer 2008, many value investors were looking at staggering losses - and in many cases - permanent capital impairment.
In an article published on the Motley Fool website on July 24, 2008 entitled “Value Investing Has Failed”, author Richard Gibbons said the following:
“One of the biggest losers is Bill Miller, who boasted a 15-year winning streak against the S&P 500. In the year ended June 30, Miller's Legg Mason Value Trust (LMVTX) lost more than 30%. He's not the only one. Over that same time period, Bill Nygren's Oakmark Select Fund (OAKLX) was down 30%, while Marty Whitman's Third Avenue Value Fund (TAVZX) fell behind the market, losing 18.9%. In each of these cases, the causes vary. Miller seems to have been completely oblivious to the possibility of a housing bust. He owned Countrywide Financial, Freddie Mac, Citigroup (C), Pulte Homes (PHM), Centex, and even Bear Stearns. In fact, it's hard finding a stock that got clobbered that Miller didn't own. In contrast, Bill Nygren was mainly hit by Washington Mutual (JPM). Back in 2004 the stock made up 16% of his fund's assets; it's still a top-10 holding. Whitman's returns have been hurt by his investment in Florida real estate company St. Joe (JOE) as well as his bets on financial insurer Ambac.”
Amazingly, it never occurred to the writer (and many value investors up until this point), that a common theme ran through all of those stocks Mr. Gibbons was writing about. It’s quite a list. Countrywide, Citigroup, Pulte Homes, St. Joes, Ambac, and yes, our old friend Washington Mutual. With 20/20 hindsight, it’s obvious to see that these companies were all part of that interrelated ball of
twine - the real estate credit and financing ball - that was at that moment nearly bringing down the entire world financial markets. It’s oddly prescient that Mr. Gibbon’s only take away from the poor returns of these value investment titans was that value investing had failed. His article captured the same tunnel vision he was blaming on his value investment leaders.
As we look back at the Great Recession and the 2007 – 2009 market crash, it’s easy to think that value investing had become outdated and simply didn’t work anymore. But I think that’s similar to looking at advances in automobiles - larger engines, more gadgets, better safety features, and so forth - seeing increasing deaths in younger drivers and saying the brakes no longer work. The actual increase in deaths is a complex problem and some factors - like texting - have nothing to do with cars at all. Value investors got complacent in how they thought about risk. It wasn’t any fundamental flaw in their strategy, it was simply bad execution in the process. Here are some major issues that presented a problem and in some case still need to find a better solution.
Recency Bias and Saber Tooth Tigers
Much like the early Cro Magnon that learned over tens of thousands of years that following footsteps in the snow led to dinner, we have become genetically programmed to think that if something worked previously, it should keep working. Unfortunately, many Cro Magnon followed saber tooth tiger tracks and were removed from the gene pool before we could receive some of their powerful (albeit, very short-lived) wisdom. Prior to the 2007 – 2009 market crash, purchasing low price-to-book financial stocks had been a relatively successful strategy. Unfortunately, this approach turned out to have very large teeth and paws when combining high leverage and very poor credit quality.
Complexity Is Here to Stay…But So Is Value Investing
Since the onset of the Great Recession I have often heard that value investing is dead. Granted, the returns of many of the value investor gurus haven’t been all that glittery over the past decade (though not a value investing guru, this writer shares the rather pedestrian record with his far more illustrious compatriots). But I think calling in the physician and “pronouncing” is a little bit premature. I don’t think the core concepts of value investing - whether that be low P/E, low P/B, or DCF intrinsic value - are dated at all. What it needs is an injection of youthful vigor in the way we approach gathering and looking at data of a prospective investment. Many value investors dropped the ball when they approached financial statements with a view from the 1980s. What we see today is financial engineering on a biblical scale - something even Noah would have been proud of in his time. As an example, whether we disagree or not, derivatives and all their associated noxious side effects are here to stay. Whether they crop up as credit default swaps or Bermuda options, value investors must understand what impact these type of products will have on their investment holding. Just like the individual who said “who would have thought a housing bust in Albuquerque could bring down Lehman Brothers”, value investors have to see things in a whole different way.
It's Always the Future That Catches You
There was a story about a state trooper conference that was taking place and a speaker was discussing the fact that roughly 70% of speeding tickets were given by officers who were ahead of the driver and not behind. From the back of the room someone could be heard saying “it’s always the future that fucks you up”. Please forgive me (and the trooper) the profanity, but that pretty much described what happened to value investors during the 2007 – 2009 crash. Far too many were fighting the last war and using processes that worked in many previous crashes. If you want to be a consistently successful value investor (and not one of the one-hit wonders who gets one call correct and the next 7 incorrect), then you need to be constantly asking “what future event could undo me?” and then follow that question up with “what form of adaptive thinking do I need to see that event?”. There are many bits of wisdom that convey this thinking - Wayne Gretzky’s “skate to where the puck will be, not where it is” or Mark Twain’s “history doesn’t repeat itself but it often rhymes”. The bottom line is that bubbles are almost always caused by two things – rapid and unsustainable inflation in an asset price and interconnectivity of that asset with other unknown players in the economy. Keep your eyes open and constantly improve your thinking and you might have a chance of avoiding a beating like those value investors in the credit crisis.
This is without a doubt the longest article – both stand alone and as a series – that I’ve ever written. If you’ve made it though all 3 parts then I hope I’ve successfully conveyed what happened in the 2007 -2009 market crash, why traditional value investors did so poorly, and what we can do to avoid such a situation again. Value investing isn’t easy. It isn’t meant to be. It requires two things that go against our very make up. First, we have to be contrarian and content to swim against the tides. It isn’t easy to zig when everyone else is zagging. Particularly when 70-80% of the time you look like a damn fool as you do it and your investment partners see others making money as they lose their own. This is an emotional challenge. This wasn’t really an issue in the credit crisis. The second is being able to take the same data that everyone else has and coming to very different conclusions. This requires an investor to build models that force them to look at things from multiple angles, pokes holes in their most sacred cows, and leads them to some truly startling conclusions (again: who would have thought a housing crash in Albuquerque could bring down Lehman Brothers? Answer: very few). This is a processing problem. This was the failure in 2007 – 2009. Too many value investors were complacent that if they followed A (contrarian thinking) then B (startling conclusions) would necessarily follow. Our great lesson is that the two things are interdependent in their process but independent in their outcomes. It takes enormous energy and focus to make both of them to work for you.
 These are an actual thing. Unfortunately I can’t make out exactly what they do, which means I’m unlikely to use them in my investment process. If someone can figure out how they work, can explain how they work in three sentences or less, and can have a neutral party of one UN ambassador, a Wharton finance professor, and a Tibetan monk agree it’s a functional description, then I will provide that individual with a case of whatever beer they’d like. And that my readers, is about how derivatives work.
 Although there’s no actual evidence Twain said this.