The purpose of looking back at the 2008 Financial Crisis is to learn to make better investment decisions the next time a crisis comes.  Making smart decisions during a crisis can lead to tremendous gains that cannot be achieved during any other time in the investing cycle.

The next crisis will present great opportunities for the investor willing to buy when others are panicking.

September 2008: The Financial Crisis

A tumultuous time on Wall Street (September 24, 2008):

• Late Sunday, both Goldman (GS) and Morgan Stanley (NYSE symbol MS),Fortune 500, were converted into bank holding companies by federal regulators, effectively closing the book on the stand-alone investment bank business model.
• Just a day earlier, Morgan agreed to sell up to a fifth of the company to Mitsubishi UFJ Financial Group (NYSE: symbol MTU), one of Japan’s largest banks.
• Merrill Lynch was acquired by Bank of America (Stock symbol: BAC) .Fortune 500 (via CNN).

During the 2008 financial crisis, I decided to re-read The Intelligent Investor by Benjamin Graham since things were very chaotic and I found it immensely helpful.

As most investors know, Benjamin Graham is known for having taught Warren Buffet about value investing.

The book is the Bible of value investing.

It is a template of how to filter the market for stocks that are truly undervalued. By using the principles in the book, many prominent investors like Warren Buffett have made significant fortunes in the stock market and avoided the losses and frustrations of average investors.

More on Benjamin Graham here.

As an avid follower of both Benjamin Graham and Warren Buffett, I was reminded that they often invested in bonds or preferred stock of companies depending on the situation.

As you will see, I found this flexibility to be a big asset.

This allows an investor to decide the best strategy based on risk and return.

Moving up the capital structure can be a big advantage for an investor during a financial crisis or panic, since it reduces the overall risk in the investment portfolio.

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Buffett takes a stake in Goldman Sachs:

Buffett agreed to purchase preferred stock, which worked out much better for his investment in the company. This allowed him to receive dividends on the shares.

Goldman, Sachs (GS) will sell $5 billion of preferred stock to the insurance and investment giant, which will also receive warrants to purchase $5 billion of common stock with a strike price of $115 per share, the company said.

Berkshire (BRK.A, Fortune 500) has five years to exercise the warrants.

Buffett will be paid a 10% dividend on his shares.

Warren Buffett (via  Berkshire Hathaway) moved up the capital structure when he negotiated his transaction with Goldman, Sachs & Co.

And these dividends enabled him to outperform the performance of the common stock.

If I didn’t think the government was going to act, I would not be doing anything this week,  Buffett told CNBC. “It would be a mistake to be buying anything now if the government was going to walk away from the Paulson proposal.”

Genworth: (GNW):

An undervalued insurance giant.

In the financial crisis, instead of buying common stock, I looked at preferred stock, bonds, or used options to hedge. This allowed me to keep adding undervalued investments to my portfolio in an uncertain time and be comfortable with the overall risk.  Genworth is provided as an example.  (via Morningstar)

Based on the price to cash flow, the current ratio, and the price to book, Genworth’s stock was already on my radar as an undervalued situation.

The decision to opt for the bonds was an attempt to move up the capital structure and take less risk as the uncertainty of how the financial crisis would play out was very much on my mind and created an added level of worry. In addition, the large debt level was a concern and made the common stock less attractive and riskier.

Genworth: Bonds Vs. Stock

It seemed a good strategy in individual situations and in my overall portfolio to move up the capital structure, as Warren Buffett had done.

I decided to purchase the Genworth bonds (6.515% 2018) and paid 63 cents on the dollar during the financial crisis in October 2008.

As we see from the price action of the bonds, I was very early and could have purchased the bonds much later at a bargain price of 23 cents on the dollar. In hindsight, the best move I could have made was to sell the common stock (even at a loss) and purchase more bonds at 23.

However, it also speaks to the volatility of the financial crisis. I purchased a bond I thought was attractive at 63. Within a few weeks, as the crisis worsens, the bonds had plummeted to 23 cents on the dollar, a massive paper loss.

GNW Stock

I also purchased a small amount of stock and sold calls against the position. I made money on the shares and they were called away some time later. Because I owned the bonds, I didn’t want to have too much exposure to one name, so I let the shares get called away.

In the end, the bonds recovered and paid a healthy 13.49% yield for the past eight years and now trade above par at $102.50. The stock has had a couple of spikes in price into the teens, but is again back at the $3 level. It’s been a very difficult decade for Genworth shares.

The lack of progress in the shares since the financial crisis is striking. I now view Genworth as a classic value trap, a stock that has been perennially undervalued: lacks enough earnings power and cash flow to create value for shareholders, or a buyer willing to pay a significant premium.

The goal is not just to own an undervalued security. The goal is to profit from investing with a margin of safety. Over the past eight years, it was very difficult for any value investor to profit from owning Genworth shares.

This scenario is why a call selling strategy can be very helpful to the investor.

Washington Mutual: Unknown Investment Risks

At $2, I estimated the risk/ reward in Washington Mutual Preferreds to be 1,000% (not including dividends) on the upside with the potential of a 40% loss. Even with what I considered to be a very favorable risk/reward I kept my position size small.

My position in the Genworth bonds was five times the size of my position in WaMu.

It was a good speculation. I felt that the company had value since TPG, a prominent  global investment firm, and others were willing to bid on the company. But it had too much debt and risk for me to invest in the common shares.

WaMu Is Seized, Sold Off to J.P. Morgan, In Largest Failure in U.S. Banking History (Wall Street Journal)

In hindsight, as I read Warren Buffett’s previous quote, I realize he had a much better grasp on the investment situation than I did. He was not going to act in an investment during the crisis without some type of government approval.

The government had given an indication it would support Goldman Sachs via the TARP program. No such assurances or indications were ever given on Washington Mutual.

Moving up the capital structure didn’t protect the investor in this situation. I purchased the Preferred Shares in Washington Mutual along with some very successful hedge fund managers (David Bonderman and TPG).

The known risk was bankruptcy. The unknown risk was government intervention.

The end result was an orchestrated seizure of the bank and arranged sale, which wiped out both the equity holders and the preferred shareholders.

(Sept. 26, 2008 WaMu is Seized)

• The collapse of the Seattle thrift, which was triggered by a wave of deposit withdrawals, marks a new low point in the country’s financial crisis. But the deal, as constructed by the Federal Deposit Insurance Corp., could hold some glimmers of hope for the beleaguered banking system because it averts any hit to the bank-insurance fund. All WaMu depositors will have access to their cash, but holders of more than $30 billion in debt and preferred stock will likely see little if any recovery.
• In March,  J.P. Morgan offered to acquire WaMu but was spurned in favor of a $7 billion infusion led by the private-equity firm TPG, considered one of the savviest buyout firms. TPG, led by investor David Bonderman, said it will lose $1.35 billion, wiping out its investment.  (via WSJ)

Ego and Investing

Every investor dreams of a huge winner. And both Washington Mutual and Genworth seemed to have those characteristics.

Being able to tell people for years to come that I purchased the shares at $3 and have the stock at $20, $30, or higher would be great for my ego. However, I gave up on bragging rights to the situation when I bought the bonds. No one brags about buying bonds. But being able to measure risk and reward and keep my ego out of the decision was very helpful in hindsight.

In fact, looking at the performance of the S&P 500, Goldman Sachs and Genworth, it is striking how little reward Genworth shareholders received from buying during the crisis. However, the Genworth shareholders fared much better than the Washington Mutual preferreds, which were a complete loss.

Conclusion

The 2008 financial crisis provides many important lessons for investors on investing, risk, position sizing, moving up the capital structure, unknown risks, and security selection.  Learning from prominent investors like Warren Buffett and Benjamin Graham is always enlightening an helpful for the investor.

One never knows when another crisis will occur and create opportunities for the intelligent investor.