Investors’ nerves were rattled when oil fell below $27 a barrel, sending global equity markets into a tailspin and Russia’s rouble to an all-time low against the US dollar. For some, the rout evoked memories of the uncertainty that roiled the markets during the 1998 financial crisis.
But according to Bob Browne, CFA, an executive vice president and CIO of Northern Trust, the current environment is “nothing like 1998,” although investors would be well served to heed some of the lessons of that crisis.
“Throughout the past several months, and in particular the last few weeks, I’ve been reading and hearing various commentators starting to compare what is happening now to 1998, a year I remember well,” Browne told delegates at the recent CFA Institute 6th India Investment Conference in Mumbai. “I can tell you right off the bat: This is nothing like 1998.”
That’s not to say there aren’t similar opportunities. In the late 1990s, the world was very jittery, just as it is today. The 1998 crisis fed that uneasiness, first with the earlier currency devaluation in Thailand, the larger emerging market crisis, and then the collapse of Long-Term Capital Management (LTCM). “There was so much going on,” Brown said, “so much risk but so much opportunity.”
He reminded the audience of the vast potential offered by the turmoil. “This is the environment when you distinguish yourself as an investor,” he said. “The decisions you make in this environment are the ones that make you wealthy.”
Browne recounted “the infamous Russian 10s of 2007.” These were Russian government bonds, with a 10% coupon bond maturing in 2007. The debt was issued in 1997, so when the ruble crisis started in 1998, the bonds hadn’t been on the market for very long, Brown recalled.
As Browne tells it:
“Russian Federation debt post-Soviet Union started to have some trouble, and we did our analysis. I often tell credit analysts: ‘Know where you stand in line in case of default, who’s ahead of you and who’s behind you.’ It’s really quite important to know where you are in the hierarchy of priority. And we applied the same analysis to Russian debt compared to Ministry of Finance debt — the old Soviet Union debt that was issued before the break-up of the Soviet Union — and knew the Russian Federation would likely default on the Ministry of Finance debt. But the last thing they would default on is Russian Federation debt. So you can think of it as a typical waterfall, where you are in an operating company versus a holding company and which subsidiary had priority and real collateral. Russian Federation debt was that very valuable subsidiary with operating cash flow that was legally distinct from the Ministry of Finance debt.”
Soon the bonds drifted from 90 cents down to 75 cents on the dollar. And that’s when Browne’s firm got very interested. “We bought a little bit at 75 cents on the dollar and then the big move down to the 50s, and that’s when we bought a lot,” he said. “In fact — almost everyone on my team — not only did we buy for our clients’ portfolios, but we bought for our personal account. We had that much confidence in the analysis.”
And then the bonds went from 50 cents on the dollar, to the high 20s, to the mid 20s. “Losing 50% in two weeks is not a good result as an investor,” Browne said. “We did the analysis, but we couldn’t understand why the market wasn’t making the distinction. At 25 cents on the dollar, we doubled up, and then they went down to the high teens, and in a short period, we had lost a boatload of money both personally and for our clients, and we thought maybe we had to get out of this.”
But they hung in there for a bit longer, and over time the bonds got back to par and matured. “It was a rocky road,” Browne said.
So what are the lessons for investors today?
- Timing is important: The Russian 10s of 2007 “turned out to be a very good investment, Browne said. “But it could have been a once-in-a-lifetime great investment if we just waited two or three weeks and understood the market dynamics a bit longer. And it could have been a disastrous investment if we bailed out at 18 cents on the dollar. . . . What advantage did we have — a very important one — over LTCM? We had long-only money. We were not levered. If you are managing levered money, the importance of timing and understanding the stability of your investor base is absolutely critical. At the end of the day, we could wait and just wait for the coupon to come in, wait the news flow to stabilize the situation. If you are getting a call from your prime broker at 11 o’clock and you have to deposit $500 million in additional collateral by the end of the day, that’s the only thing that matters. Your fundamentals analysis does not. Your approach to risk taking really does depend on the nature of the type of leverage you have or not.”
- Understand your investor base: “Make sure that your risk taking is aligned with that of your investor base.” Browne said. “Do they have the same horizon that you do? Do they understand your process? Do they understand your analysis? Will they give you time to see it work out? If not, you’re going to have a problem.”
- Different decision makers have different priorities in the capital markets: “You might think that we are all trying to achieve risk-adjusted returns and maximization of wealth,” Browne said. “You absolutely need to understand who your constituencies are internally and externally in the marketplace. The cycle of investing, what often happens — more so today than even then — you see this evolution where the risk takers put the trades on, then the risk managers take over. Either the CFO or CEO. Be conscious of that.”
- A further lesson: “Think about the markets and what is going on,” Browne said. “Think about how different segments of investors are optimizing for different goals, and that those goals can change over time and the influence of investors can change over time.”
The article was first published on blogs.cfainstitute.org
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