Jan 3, 2013

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Interesting article on how banks are really black boxes.

When I was in a hedge fund during the 2008 start of the financial crisis I was asked to look at Bear Stearns and Lehman as short ideas. I mainly covered technology stocks. These two were the weakest banks and the banks were getting hit hard.

The usual process for shorting a company involves going through the 10K and 10Q filings. These lay out most of the 'facts' and give you some sense of how a company operates. how it makes money, and how fiscally solvent it is.

After I did this I had no answers to any of those questions. I told my boss I cannot model these companies. He said just do it. I said I can't. He said go talk to the 'long' guys (the analysts who cover financials stocks and place long bets on them).

After I came back I said I still can't model them and they can't either. The difference is that I know I can't and they don't.

We ended up shorting Lehman purely on the fact that I couldn't believe the banks were still in existence. One thing that is clear about banks is that they are always incredibly close to having negative equity and any liquidity problems immediately put their solvency into potential question. The long guys merrily doubled down on their banks because their ROEs were so low. Sure enough that bet almost ruined the investment firm and I had a nice short under my belt. But really both bets were fool's folly. We had no idea what was going on.

Moral of the story is never invest in financial companies. You have no idea what they are doing.

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