Jack Brennan Speaks on ‘Morals of the Story: the Financial Crisis, 2007-2009’
Following is a summary of his presentation on the ‘ten lessons learned’ in the 2007-2009 financial crisis. Brennan’s full presentation is available at our Wachovia Executive Lecture Series podcast index page, under the title: Morals of the Story: The Financial Crisis, 2007-2009 – John J. Brennan.
“I’ll say right up front that the lessons are mostly nothing new,” Brennan said. “There’s a great quote that I repeat to the people I work with continually. It’s from Willa Cather in her book O Pioneers! about the human condition, and she said, ‘There are only two or three human stories and they go on repeating themselves as fiercely as if they had never happened before. Like the larks in the country that have been singing the same five notes over and over and over for a thousand years.’ The lessons I’ll share with you are very much repeated. The opportunity for all of us is to not be part of the process that repeats them.” Following are his ten key lessons learned.
1. Leadership matters
Leadership with a finely-honed sense of strategy; leadership with a ‘more than today’ perspective; with an intense and intuitive sense of risk, risk awareness, risk prevention. But with the backbone, frankly, to go a different way from your competition and your peers when they are marching off a cliff.
2. Prudence matters
The math of leverage never works with you when times get tough. It simply does not. A lot of firms said, “Cheap money? I’ll take it.” But being over leveraged, borrowing too much money, is lethal in a difficult market, and it proved to be lethal for many firms.
3. Humility matters
It was a lack of humility that led to excess leverage and overdevelopment, and that allowed the worst expression in the investment business to creep back into management parlance: ‘It’s different this time.’ If there’s one thing you should remember from my comments today it’s that when you hear someone justify an investment because ‘it’s different this time,’ run the other way. Because it’s not.
4. Simplicity matters
During the good times leading into the financial crisis, far too many people purchased complex and seemingly too-good-to-be-true investments that they simply didn’t understand. CDOs, CDOs squared, CDOs cubed, SIVs, the list goes on and on and on. That is how the scale of this problem went from controllable to out of control. “If you don’t understand the thesis of an underlying investment in five minutes or less, take a pass.”
5. Liquidity matters
One of the common expressions you hear during a bull market is, “Cash is trash.” Cash is generally a low-earning asset, so people ask, “Why do I want to have it when stocks and bonds are doing so well? It’s a drag on my portfolio.” The counter to this is, “Cash is priceless.” The problem is, people only realize this when cash is unavailable.
6. Diversification matters
From an academic and intellectual perspective, diversification is a slam dunk. But from an emotional perspective, diversification is awful, because one of the asset classes you own is always underperforming the other asset classes. So the regret is common, and the temptation to sell the trailer and buy the leader is substantial. But the case for diversification as an investment and business strategy was reinforced yet again during this very challenging period of time.
7. Incentives matter
This is one of the root cause problems of the financial crisis. People were motivated and got confused. Think about the basic hedge fund compensation structure: a 2 percent fee plus 20 percent of the profits. Look closely at those incentives They’re really, Heads, I win; tails, I give you back what I have left. And I fold the tent.” And that’s what happened in this financial crisis. Bad incentive structures. If you’re going to invest in it, you ought to understand how that manager is motivated.
8. Regulatory structure matters
In-touch regulators are a critical element to the success of the financial markets. There are basic questions about the mess we went through. Who was watching Bear Stearns and assessing their financial strategy? And who was looking at the whole picture of the risks that AIG was taking? I don’t see anyone raising their hand saying, ‘I was doing that.’ Who should have warned the entire regulatory apparatus about the scope, scale, and breadth of the sub-prime mortgage business? There’s a lot of talk in Washington about regulatory reform. Those questions are symptoms of ineffective regulatory structure that allowed us to get to where we are. I think we were very fortunate to have ‘in touch’ regulators when the crisis hit, and in-touch regulators will be critical in helping us to prevent a similar crisis in the future.
9. Free markets matter
We need free markets. It sounds contradictory to my previous point, because we got through this crisis with intervention from the regulatory infrastructure, and markets weren’t allowed to be free. But that’s not a solution for the long term. This country needs free, vibrant capital markets where you are allowed to fail and succeed.
10. Trust matters
The crisis we went through was a crisis of trust. A collapse of trust. Think about the bankruptcies and the loss of wealth. There’s a risk that Americans will think “safe and secure” is the way to go, and buy CDs instead of invest in the market. But CDs don’t create capital for the markets. We need people to trust in the markets and trust in each other. Markets don’t work and we don’t create wealth for ourselves if we don’t trust one another.
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