Journey · 12 steps · 11 sources

Financial crises, from the boom to the rescue

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Crises rhyme because the mechanics repeat: credit expands, a model is trusted past its limits, funding that can leave does leave. This path starts with the sequence every bubble follows, walks through 2008 and a bank run, and ends with how investors who kept their heads reasoned at the time.

12 steps

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Books
Films and series
Letters

A queue of Levs waits at a door marked aaa while one Lev lies on the floor looking through a crack at a heap of broken boxes, one marked default. — Everyone read the label. One Lev read the floor.

1
Start hereThe shape every boom and bust follows, so the later steps have somewhere to sit.
Every bubble runs displacement, boom, euphoria, distress, revulsion
Ask where a market is in the sequence rather than whether it is a bubble; the stages are more recognisable than the verdict.
BookManias, Panics, and Crashes· Charles P. Kindleberger
2
How it worksThe three conditions that have to be present together before the sequence can start.
A bubble needs marketability, money and credit, and speculation together
Check all three legs, marketability, cheap money and a population buying for resale, before calling something a bubble.
BookBoom and Bust· William Quinn and John D. Turner
3
How it worksWhere the 2008 losses were hidden: in an assumption inside the label everyone relied on.
A rating is a model output, and the model rests on a correlation assumption
Ask what a rating assumes about defaults happening together before trusting what it says about the pool.
FilmThe Big Short· 2015
4
See it happenWhy the assumption went unchallenged: who was paid for what.
The incentives ran through the ratings agencies and the academy, not only the banks
Follow the incentives through every institution in the chain, including the ones that were supposed to be the check.
DocumentaryInside Job· 2010
5
See it happenThe same failure seen by an investor at the time: a model fitted to calm years.
Beware of geeks bearing formulas: a model built on calm history cannot see the storm
Ask what period a model was fitted to, and whether that period contained the event you are worried about.
LetterBerkshire Hathaway's 2008 letter to shareholders· Warren Buffett
6
How it worksHow a bank can fail without being insolvent: the funding leaves before the assets mature.
A bank run is a maturity mismatch, not a solvency problem
A bank fails when its liabilities come due faster than its assets, which can happen to a solvent bank.
FilmIt's a Wonderful Life· 1946
7
How it worksWhy the diagnosis decides the cure, and why getting it wrong is expensive.
Illiquid and insolvent are different problems with different rescues
Lending cures illiquidity; only capital cures insolvency. Decide which problem you have before choosing the remedy.
FilmToo Big to Fail· 2011
8
The other sideAn argument, written in the worst weeks of 2008, about which kind of rescue actually adds capital.
Buying a bank's bad assets helps only if you overpay; giving it capital helps directly
A rescue that swaps assets at fair value changes nothing; only new capital changes a bank's solvency.
LetterJohn Hussman's October 2008 market comment on recapitalising the banks· John Hussman
9
The other sideA chief executive on where responsibility sits when the rules allowed what happened.
Responsibility for a company's actions sits with its management, not its regulators
A firm that did what the rules allowed and lost has not been excused by the rules; management chose the position.
LetterJPMorgan Chase letter to shareholders, 2008· Jamie Dimon
10
Use itHow to judge the people involved fairly: on what they could have known.
Judge a decision on what was knowable at the time, not on how it turned out
The fair test of a decision is the information available when it was made; hindsight is a different exam.
DocumentaryInside the Meltdown· 2009
11
Use itWhat a crash means for a buyer rather than a holder.
When investing, pessimism is your friend and euphoria the enemy
The price of risk tracks the mood, so the useful time to buy is when the mood is worst, and the dangerous time is when it is best.
LetterBerkshire Hathaway's 2008 letter to shareholders· Warren Buffett
12
Use itThe arithmetic behind staying invested, and the condition it depends on: staying solvent.
In a crash, long-duration cash flows move far less than the price, if you stay solvent
State the liquidity first, because the argument that prices overshoot value is only available to those who can wait.
LetterBruce Flatt's March 2020 update to Brookfield shareholders· Bruce Flatt

Financial crises, from the boom to the rescue

Every bubble runs displacement, boom, euphoria, distress, revulsion

A bubble needs marketability, money and credit, and speculation together

A rating is a model output, and the model rests on a correlation assumption

The incentives ran through the ratings agencies and the academy, not only the banks

Beware of geeks bearing formulas: a model built on calm history cannot see the storm

A bank run is a maturity mismatch, not a solvency problem

Illiquid and insolvent are different problems with different rescues

Buying a bank's bad assets helps only if you overpay; giving it capital helps directly

Responsibility for a company's actions sits with its management, not its regulators

Judge a decision on what was knowable at the time, not on how it turned out

When investing, pessimism is your friend and euphoria the enemy

In a crash, long-duration cash flows move far less than the price, if you stay solvent

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