How to make a crisis work for you
An exclusive excerpt from TN Hari and Sanjay Swamy's latest book, Sailing Through A Storm that brings us the hope for a crisis to be a great opportunity for innovation.
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The Covid-19 pandemic and the events it triggered made us ponder on the different crises that show up in our lives from time to time. The world never expected it; neither was it prepared for it. This is a kind of crisis that most of us are unlikely to experience more than once in our lifetimes. Yet, some deal with a crisis with equanimity and courage, while some others give up.
A crisis can be a great opportunity for innovation. Almost every great innovation has been in response to a crisis of some sort. We have seen this in recent times, and we have seen this throughout history.
Sailing Through A Storm brings us this hope. An inspiring read, this comprises beautiful stories of women and men who dealt with adversity, how they emerged strong and successful, and how drawing from their lives we too can turn the storm around to make it work for us.
We present an excerpt from the chapter titled Hope and Despair.
Sailing Through a Storm: Making a Crisis Work for You | Paperback | Rs 458 | Excerpt courtesy: Bloomsbury
Running with the herd is such a basic survival instinct that few can break away. In pre-historic times, this instinct had been the bedrock of survival and, hence, hardwired in our brain. Those that did not run with the herd were either eaten or starved to death. With such evolutionary muscle behind this instinct, it takes uncluttered thinking and immense courage to break away from the herd. In today’s world, this ‘herd mentality’ is not particularly useful, given that the threat of being eaten or starving to death is minimal.
Until the Korean War, wartime actions were the perfect source of leadership lessons. Today, financial crises (both of the local and the global kind), the stock market and the investing world are much better arenas for drawing leadership lessons from.
In this chapter, we will take three financial crises from relatively recent times that spread across the globe like pandemics and pick out some interesting lessons from there.
How Every Crisis Is a Test of Character
The global credit crisis of 2008, has arguably been one of the most debilitating financial and economic crises after the Great Depression. Like most financial crises, it was a collective loss of reason. Francisco José de Goya, a Spanish romantic painter of the late 18th and early 19th centuries, who was famed for his portraits, had once remarked, ‘Fantasy, abandoned by reason, produces impossible monsters.’
The investing cycle mirrors the eternal cycle of hope and despair. The top of the cycle is where fantasy is abandoned by reason. The positive aspect of this is, it generates optimism and encourages entrepreneurs to pursue audacious ideas. The negative aspect is, it creates irrational exuberance and impossible monsters. The bottom of the cycle is where fear is abandoned by reason. The positive aspect of this is, it encourages reality checks and drives responsible behaviours. On the flip side, it induces pessimism and shuts off the tap for even the best of ideas. Winning investors are those who recognise the cycle and avoid negative sentiments that each phase of the cycle invariably generates.
The fact that a crisis of this magnitude could recur in less than a decade of the dotcom bust was quite shocking. That human memory could be so short was a bit of a surprise. Therefore, when someone asks what we believe would be some of the long-term changes in the way we think and work as a result of the COVID-19 pandemic, we struggle to respond. It is because we still do not know how quickly people would regress to doing what they were always doing.
Let’s start by understanding the genesis of this crisis at a very simple level. The world comprises two kinds of people and two kinds of companies. Those with more money than they need and those with less money than they need. The first category of individuals and companies become lenders and the latter, borrowers. The lenders usually do not give money to the borrowers without performing some elementary checks that are essentially about evaluating the creditworthiness and intent of the borrower.
Only upon satisfying themselves on both these counts would a lender loan out money to a borrower. Imagine now, if this process is totally ignored and lenders recklessly loan out money. One can, of course, ask why would a lender do something like that? Wouldn’t they be afraid that they could lose their money? The answer is simple. Over the last 100 odd years, layers of intermediaries have emerged between lenders and borrowers. These are the banks, mortgage companies, etc. And, these institutions have employees who are responsible for the decisions to lend. It is not their money they are lending. Their decisions are determined by their incentive structures and plans. When banks begin to compete among themselves (and they always do), the competitive pressures can sometimes result in them bypassing the due processes. Additionally, if there are ‘perverse’ incentives for employees entrusted with the decisions to give out loans, you will see subversion and subterfuge. And, that is what exactly happened on a very large scale. Everyone in the system, including the great Alan Greenspan, chairman of the US Federal Reserve, were mute spectators, actually aiding and abetting this subterfuge. British philosopher and political thinker Edmund Burke had once said, ‘The only thing necessary for the triumph of evil is for the good men to do nothing.’ That is precisely what seems to be the precursor to every large crisis.
The mortgage companies gave out housing loans recklessly to people who were simply not creditworthy. However, this too would not have created a bubble of this magnitude, if it were not for a law that allowed banks to trade in derivatives that used home loans as the underlying collateral. So, smart financial engineers from some of the most coveted investment banks created mortgage-backed securities that were then sold to banks and institutions across the world. The money that these mortgage companies raised by selling these securities were further given out as fresh home loans, stoking the already raging fire. The financial engineers then created products that would insure against default on these securities. And, the rating agencies turned a blind eye and colluded quite shamelessly with the mortgage companies to give these securities a triple ‘A’ rating! The cycle of subterfuge and collusion was complete.
So, the bubble had been created and was waiting to burst. Some wise people like Raghuram Rajan, a noted economist, had warned against the impending bust, but when everyone in the system is playing a game of ‘you scratch my back, I scratch yours’, it is not easy to drive sense or prevail. However, intellect and wisdom are far easier to come by than real character. Character in this context is about putting your money where your mouth is—both literally and figuratively! Michael Lewis’s book, The Big Short, was a bestseller when it was published in 2010. It was later made into a movie with the same title. The book was based on real events leading up to the credit crisis. Michael Burry, the lead character and an eccentric hedge fund manager, discovers that the housing market in the US was a huge bubble, resting on a mountain of subprime loans. He chose to bet a billion dollars on the collapsing market (known as ‘shorting’ in financial parlance). However, the problem with ‘shorting’ is that you don’t know how long it would take for the market to collapse, reminding one of what the great British economist John Maynard Keynes had once said, ‘The markets can remain irrational for longer than you can remain solvent.’ Burry’s clients were seriously concerned, but eventually, the market collapsed and his fund’s value jumped by 489 per cent and the fund made a cool profit of $2.69 billion.
Michael Burry may have been a semi-fictional character, but John Paulson was for real. He ran a hedge fund called Paulson and Co. It was an obscure fund that had enjoyed moderate success. In 2007, his fund made over $15 billion, of which he took home $4 billion, by betting against subprime mortgages at the peak of the housing bubble.3 This was easily the biggest and the most audacious bet in the history of capital markets. This success catapulted Paulson, a relatively unremarkable money manager until then, into the league of investing legends.
There were many who knew that America was going through a mass illusion stoked by the likes of Alan Greenspan, but it needed the courage to bet the farm and the house on this knowledge. This is the difference between a great analyst and a great investor. When the rest of the world was exuberant about the housing market, one needed to have some conviction and nerve to go against the tide. A crisis or an impending crisis can suddenly bring out the extraordinary in seemingly ordinary people like it did in the case of John Paulson.