Lehman Brothers – 10 years on

Jamie Clark, Phil Milburn, Peter Michaelis, Julian Fosh & Olly Russ

Ten years on from the collapse of Lehman Brothers, Liontrust’s fund managers look back at the defining moment of the Global Financial Crisis (GFC), how it unfolded, and why it still matters. Here, in the first of a three-part series, our investment teams discuss its impact on the banking sector.



Lehman’s collapse on 15 September 2008 was labelled as “high finance’s darkest hour” at the time – how did the banking sector fall so far from grace? 

Jamie Clark, Macro-Thematic team: Hindsight bias is seductive. It performs the subtle trick of making each of us believe that we were wise before the event. The reality, however, is that in September 2008, investors were ignorant of what was unfolding.

 

Bank balance sheets were opaque, risk models were dysfunctional and misinformation was rife. An ugly combination that saw interbank funding dry up and share prices implode.

 

Phil Milburn, Global Fixed Income team: Contrary to popular belief, the GFC was not only caused by US subprime mortgage lending; in fact subprime was merely the epitome of the crisis and a few decades of increased leverage in the financial system, coupled with economic imbalances, was the real cause

 

Peter Michaelis, Sustainable Investment team: In the decade before the crisis hit, too much risky debt had ended up in the wrong places. There was a complex web of deals and transactions which led to the GFC, but we’ve boiled it down to three main issues. Firstly, banks’ opaque accounting. Many were mis-representing risk through bundled loans and blurring of balance sheets between investment, wholesale and retail banking.

 

Secondly, banks fostered a culture prioritising growth. Incentives were based on the number of loans sold, typified by the story of Halifax giving cash to the best salesman or woman and a cabbage to the worst each week. There was no consideration of the appropriateness of the loan featured, and pushing ancillary products such as PPI was encouraged with disastrous results.

 

Finally, inadequate scrutiny. Shareholders in UK banks were complicit or at the very least negligent in allowing these practices to continue. In particular, their backing of deals such as RBS’ catastrophic acquisition of ABN Ambro showed an appalling lack of scrutiny.

How did you approach the banking sector in the immediate aftermath of Lehman’s collapse?

 

Jamie: HSBC was our only bank holding in September 2008. This was promptly shown the door, as the scale of the financial crisis became apparent. Given the “ugly combination” I refer to above, we did the only sensible thing possible: sell and sit on the sidelines.

 

Julian Fosh, Economic Advantage team: We did not hold banks in 2008, and nor do we today, as they do not pass our initial screen for possession of one of the three core Economic Advantage intangible assets – intellectual property (IP), recurring revenues and strong distribution networks – which we believe can confer a sustainable competitive advantage.

Although banks may formerly have had high levels of recurring revenues, their pursuit of higher absolute profits from ‘one-off’ sources, culminating in the securitisation boom, has diluted this to such a degree that they don’t pass this test. And while banks have retail branch networks, they do not necessarily confer competitive advantage, particularly with the advent of internet banking.

 

Irrespective of their intangible assets, banks are not able to meet the second criteria of our investment process: there must be evidence that Economic Advantage assets are generating a financial advantage, in the form of a return on equity that exceeds the cost of equity.

How have banks restructured in the aftermath of the crisis and how has that influenced your approach to the sector?

Jamie: The weakest banks, RBS and Lloyds, were recapitalised by the government in return for equity stakes. Others, HSBC and Barclays, resisted part-nationalisation.

 

Political recriminations have resulted in smaller balance sheets, larger capital resources and a corresponding increase in capital ratios. The 2019 ring-fencing of bank retail operations promises to cement this effect in curbing speculation and shielding depositors.

 

Banks seem safer, but with consequences for returns and valuations. This was a big part of our preference for challenger banks. But with interest rates rising, we expect to see margins and earnings grow and now own HSBC and Lloyds.

 

Peter: Some banks were resilient in the face of the crisis, notably Nationwide and a few Scandinavian banks, two of which are currently held in our equity funds, DNB, Norway’s largest financial services group, and Sweden’s Svenska Handelsbanken. These provided the recipe for successful banking and the remedy for others was simple: rebuild capital, simplify business lines, and change culture.

 

Olly Russ, European Income team: While a few individual banks may still suffer from existential crises, the systemic crisis in the eurozone banking system is now over, and individual bank failures (smaller ones at least) can be effectively insulated from the system as a whole. Both Spain and Italy have recently seen failing banks shuttered by the European Central Bank with no real broader market impact – a far cry from the shockwaves this would have caused in the depths of the eurozone crisis.

 

We are now upbeat on the prospects for banks as they tend to perform well in an environment of rising interest rates and bond yields. Their essential business is acting as a middle man between borrowers and depositors. This means taking a cut of the differential in interest rates offered between those two classes. In very simple terms, at higher levels of rates, there is a larger pie to take a slice of. Savers will also have noticed banks do not seem to pass interest rate rises on with quite the same alacrity with which they increase mortgage rates. Banks themselves also have large cash deposits and bond holdings which attract interest as rates go up.

 

Rates rising for the right reasons – an increasing economic expansion – also tends to mean that banks’ bad debts start to fall rapidly as companies and individuals find it easier to stay cash flow positive.

Peter: Over the course of the past decade, dividends have been cut, complexity has been reduced and hardest of all, banks have adopted a new ethos, prioritising service and relationships with customers ahead of sales targets. They have also recognised their sense of purpose, with Lloyds “Helping Britain Prosper” and RBS prioritising “Strength and Sustainability”.

We continue to prefer traditional retail names over investment banks as we see much clearer benefits to society from the former, provided they are well managed. History has taught us that banks able to deliver strong returns without excess leverage are likely to outperform through the cycle and given our investment horizon of three to five years, this suits us perfectly.

Next week: What was the policy response to Lehman’s collapse, and how does that still affect us today?



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Friday, August 31, 2018, 9:00 AM