Lessons from the Credit Crisis

During September, the Dow Jones Industrial Average (Dow) has dropped nearly 10%.  This compares with drops in the NASDAQ of 16%, the S&P Small cap index of 9% and the Wilshire 5000 of 14%.  While prices were dropping, the government became linked with the capital markets.  Over the past year, we have seen Treasury and Federal Reserve (Fed) attempt to influence behavior.  All of these actions were done at the edge of acceptable policy and were meant to unclog the capital markets while allowing free enterprise to reign supreme.  Over the past month, government intervention increased and free market ideology was swept aside.

To gain perspective, during September we have seen key linchpins of the housing market placed into conservatorship (Fannie Mae and Freddie Mac), the failure of two large banks (Washington Mutual and Wachovia), the nationalization of the largest insurance company (American International Group), the elimination of the stand alone investment bank (Lehman’s bankruptcy and Morgan Stanley and Goldman Sachs becoming commercial banks) and the disappearance of the largest brokerage firm (Merrill Lynch merging with Bank America).  With the government failing to approve a rescue bill, we have entered a period of heightened uncertainty, lower tolerance for risk, lower levels of financial leverage and lower innovation.

These expected changes have a dramatic implication over how we will invest.  To consider the effects, I have developed the “Five Lessons of the Crisis”.  They are as follows:

  1. Solvency, not liquidity, is king.  After the collapse of Bear Stearns in March, many investors believed that a lack of liquidity had lead to Bear’s demise.  Following this script, the Fed began allowing broker-dealers to access the Fed window and broadened their list of acceptable collateral with the intent of allowing firms to conquer short term funding issues.  As we learned from Lehman, Wamu and others, this is not the case.  Bad loans and poor trades eroded the capital base and left these companies insolvent.  Rather than allow an insolvent company to grow out of its problems, we have seen bankruptcy, nationalization and asset seizures.
  2. Valuation is in the eye of the beholder.  As a value investor, I have watched stock prices drop to levels I never thought possible as companies I thought would never be attractively priced are now outright cheap.  However, these same stocks have become even cheaper.  At a certain point we will look back at this period and discuss how shrewd investors snapped up shares at bargain prices.  For now, those same investors are experiencing escalating losses.
  3. Public policy cannot cure private market woes.  As of now, every piece of government policy has failed.  With each proposed measure, markets have rallied.  Inevitably the measure fails and markets swoon.  Only through time and pain will excesses in the private markets be purged, bottom and lead to rebound.
  4. Deleveraging markets kill innovation.  What started as a credit crisis has morphed into a Main Street crisis.  The major negative to deleveraging is that new loans are not being made.  Without new loans, companies do not expand, employment does not grow, the incentive to create and market new products declines and economic growth declines.  Together, we have a weaker economy and a lower standard of living.
  5. No company is too big to fail.  For years, the presence of the Greenspan Put and Helicopter Ben has led many to believe that certain companies are too big to fail.  This thought no longer holds.   Going forward we should expect investors’ required return hurdle to increase as old rules no longer apply.  The result will be lower future gains as the days of P/E multiple expansion are now past.

Knowing the rules of the market have changed, we need to decide how to progress.  The answer is cautiously.  Right now, buying stocks remains far from anyone’s mind.  However, within fear opportunities exist.  Capitulation is needed for a market bottom and that has finally arrived.   An investor looking for an excellent business at a cheap price should look toward XTO Energy.  XTO possesses oil and gas reserves in geopolitically safe areas.   Market value of their natural reserves exceeds $60 per share and a high amount of 2009 production has been hedged at energy prices that are higher than prevails today.  Therefore, XTO offers excellent value with limited exposure to volatile commodity prices.

Disclosure: At the time of this post Sean is long XTO.

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  1. says

    From a value investor perspective, the market is oh so attractive. But the question is what is “attractive” ? How do we value these erratic pieces of paper that move on the pulse of investor’s emotions? The curtain of the free market system is slowly but surely falling. The government is too involved for our CURRENT market to be labeled as “free”. I agree with your 5 lessons learned and it’s important that since we KNOW where we went wrong, that we NEVER repeat this. But I can assume the survivors from the Great Depression must be thinking the same thing. “we’ve already gone through this, why haven’t we learned?”
    I read that “Few people have a 20,000-foot view, and most commentators speak from a ‘vested interest position’.”


    Which is absolutely correct, our policy makers are viewing issues from a micro perspective and not truly grasping how the various factors that have caused our downfall relates to each other. It’s called CONTAGION. The DOMINO EFFECT. Wake up people, let’s get to the root of the problem

  2. says

    agree with the XTO assessment. however, you have to realize that it also is a large holding by numerous big hedge funds, particularly energy/commodity funds. so, xto becomes a “trade the perception, not the reality”. valuation gets thrown out the window when you’re going to have numerous hedge funds forced to reduce their positions in the name due to redemptions/liquidations. a ton of the hedge funds i track hold this name.

  3. Sean Hannon says

    Market Folly – excellent point. This should put pressure on XTO, but with that pressure the stock becomes cheaper and the valuation more attractive. In this environment a discplined investor can add shares, increase their holding period and reap the rewards. As always, the question is where the ultimate entry price should be.

    Vidonediv – I do own XTO and will inquire with Blain about putting better disclosures on the website. This is the first post I have recommened a specific name and I apologize for any confusion this may have caused.

  4. Matt B says

    How does an insolvent financial company grow out of it’s problem?

    What are the alternatives to “bankruptcy, nationalization and asset seizures”?

  5. Sean Hannon says


    With the yeild curve so steep, banks are writing loans at huge profits as they borrow short and lend long. As new loans reap profits they make up for past poor decisions. If you look at the S&L crisis, many banks were insolvent, but the regulators looked the other way as a steep yield curve allowed banks to grow profits and reliquidate themselves. Now the regulators do not provide the same room for error and are pushing weak companies from the market.

  6. says


    yea, like I said, totally agree with your assessment on XTO.. been watching it for a while myself waiting patiently. your comment on the ultimate entry price is the real question here. at what point do fundamentals matter again and at what point do hedge funds stop liquidating/front running each other? I do hedge fund tracking over on my site and let me tell you, with all the funds in this name, its going to be a looong unwind unfortunately. I hate to be mr. “market timer” here, but until the trend reverses, it could be ugly.

    I admire your fortitude to pick it up at these levels and be able to stomach it haha, I don’t think I could handle it! I’m not really a value investor though either so different investment styles conflict here. Although, I will be the first to admit that XTO is reaching borderline ridiculous valuation based on their fundamentals and future prospects.