History as enshrined in law: Another lesson to remember from the credit-crisis.

We recently re-read a very good piece on Risk management lessons to remember from the credit-crisis 2007-2009 published by BlackRock. The document is well worth a read, and we recommend it highly for all professional investors.

There are, however, a couple of things we wish the authors had added to the note. Particularly with regard to understanding the institutional and legal context within which investments are made.

Portfolio managers must understand what happens when the market fails and a security enters liquidation: Investors should examine a potential investment through the eyes of a distressed investor prior to committing capital. Investing in distressed securities is a very specialized field that requires a lot of specific expertise. However, that should not dissuade the average investor from subjecting the investment to a  simple smell test. What happens to this security if the issuer becomes financially distressed?Who will they choose to pay first, and whom will the courts force them to pay and in which order. Part of our investment process focuses on what would happen in a distress or liquidation scenario (and what conditions would bring the issuer to that point). This occurs naturally to us because we invest in debt instruments, where return of principal is the paramount concern. We always evaluate both bonds and stock whenever we consider an investment in a company, i.e. look at the entire capital structure. We try to understand how decisions would be made in a liquidation, who would have authority to make decisions, and who would receive what portion of the liquidation proceeds in which order. We are generally wary of anything that has been through multiple layers of securitization. Understanding issuer and obligor motivation in a complex securitization requires peeling many layers of control. This is generally not worth the effort unless the returns being offered are extraordinary.

Investors should understand the financial history of the jurisdiction they are operating in, and how that impacts both law and convention: This usually falls under the rubric of operational risk, and is often an after-thought, but we believe portfolio managers must understand this. Many supposedly astute investors found themselves on the wrong side of the pond when Lehman Brothers failed (see NYTimes and DealBook). Hedge Funds with assets held within Lehman Brother’s UK prime brokerage operation found themselves facing an uncertain claim on securities they had believed were in segregated accounts. In marked contrast, the experience of the ’29 crash led to very different rules and conventions in the US, and this limited the impact on US prime brokerage clients. The lesson here is larger than a simple admonition to read custody and brokerage agreements carefully. You really do need to understand the cultural environment within which the law of the land came to be formed, and the environment in which it will be interpreted. This is part of the reason investments in China always give us pause. We’re simply not sure what underpins property rights in a jurisdiction where the collective memory of private ownership goes back half a generation at best. For that matter, we have similar concerns about Russia.

This brings up a much larger, third issue. As many ivory towers exist on Wall Street and the City of London as in Cambridge and Oxford. Many portfolio and risk managers in the institutional investment management world operate in the rarefied, highly specialized world of large corporations with armies of highly paid professionals in each division. The rough and tumble world of actual business, where businesses fail, frauds exist and people go bankrupt, is often as alien as Titan’s toxic atmosphere.