Lessons from the financial crisis

You know the world is not quite the same when your wife says, “I would rather tell someone that my husband is a stripper in a gay club than say he is a banker.” Yes, bankers the world over have been subject to ridicule, scorn, pity, sympathy and schadenfraude – depending on their levels of under- or unemployment – in the aftermath of the global financial crisis. Of course, bankers are to blame, but so are governments, regulators and anyone who mistook this upcycle to be the new world order. Much has been said and written about why this happened and what could have stopped it from happening. Equally extensive has been the coverage of the response of different stakeholders – from governments to the taxpayers – to this situation. Without getting into these areas, I would like to share some thoughts on what we can learn from the recent events and how that can help us lead a better life.

Surprisingly, all of these are simple axioms and principles that we have learnt from parents and teachers, but had forgotten. The banker in me cannot resist a disclaimer: I have been guilty of some of these mistakes myself. Thankfully, I have been able to spot these. Hopefully, I was not too late. So in no particular order, here is the list of do’s and don’ts …

Do not live beyond your means:

The root of the current financial crisis lies in individuals, financial institutions and companies borrowing way more than they could afford to. You must have heard the golden rule of banking: “Lend only to those who don’t need the money”. What we should realize is that the other side of the argument is as true: “Borrow only when you can afford not to”. A rather strong assertion, but let me elaborate.

When we borrow, we postpone our expenses by paying a price in the form of interest to the bank. This is essentially a bet on our future earning potential, as well as a vote of confidence in the liquid nature of our present and future assets. When I take a loan to buy a house, I am expressing confidence that my future earnings will be sufficient to service the periodic installments to repay the loan with interest. Linked to this is the belief that, if required, I will have assets, such as gold, equity shares of companies, or even another property, which I can easily sell to generate cash for repayment of the loan. The mistakes we make are twofold: one, we overestimate the quantum or certainty of future income; two, we perceive present and future assets to be more liquid than they really are. What we conveniently forget is that we may not have our jobs tomorrow, or may be engaged in lower-paying professions. Or the plot of land that we own in our hometowns may find no takers in a recessionary environment, resulting in its disposal only at a very low price. Therefore, we should borrow only when we are certain that our future earnings, adjusted for the risks of illiquidity, low prices or unforeseen events, will be sufficient to retire the loan.

No rocket science there – did you say? Well, that is true, but is it not surprising the number of people who seem to recognize this simple fact? The reason behind this is our tendency to often live beyond our means. That is what leads us to borrow more and more, and spend money on goods and services that we actually cannot afford. The solution: know what you can afford, and what you cannot. And when you borrow, do it sensibly. As a matter of policy, I use my credit card only when I am sure that I can pay for the same good or service in cash. In fact, I view credit card as a convenience – for example, it makes it easier to book flight or movie tickets online – than as a credit line.

Keep your head in the clouds, but feet firmly on the ground:

In times such as these, the refrain one hears the most at work and elsewhere goes along these lines: “cut all excesses”, “stay down-to earth, you never know what the future holds”, “be humble” and the like. The risk lies in getting too pessimistic about the state of affairs. Whatever happened to the gung-ho, can-do optimism that has spawned entrepreneurialism and laid the foundation for talented and resourceful men and women to flourish the world over? The answer lies in the middle path. It is indeed a delicate balance that one needs to strike to stay focused yet grounded, ambitious yet realistic, hungry yet satisfied.

Over the last couple of years that represented the height of the bubble, I have noticed a tendency of my fellow Indians to get carried away by the success that individuals and the society have achieved, especially in the large cities. They had come to think that India was on the path of overtaking China, just as many Chinese suffered from the misplaced overconfidence leading to the belief that they had bested the United States. The Sensex was being taken as the barometer of India’s development, and the massively overpriced commercial rents of south Mumbai were considered representative of the country’s position in the global league tables. The same excesses were rubbing off on the young Indians who thought that making thousands of rupees by answering phone calls at the ripe old age of twenty was the be-all and end-all of life.

Now, make no mistake – I am as patriotic as one can be, and I do not mind young guys making a lot of money at BPOs or trading stocks. Nor do I believe that celebrating our successes is necessarily a bad thing. But in these matters, it easy to confuse ends with means, and the substantial with the superficial. The best way to guard against any missteps is to be firmly grounded. Whenever you feel you have achieved a lot and have arrived on the world stage, remind yourself where you would be if you were to lose your job tomorrow, or you were to start your own company on zero salary. Now that is a sobering thought! For those of us who were not born with a silver spoon, think of where your roots are. Think of the sacrifices that you and your loved ones made to enable you to reach wherever you are today. In fact, those acts of sacrifice and struggle themselves are good enough reasons to always aspire for something greater and better. In fact, knowing where we came from and knowing how we reached where we stand today is the best way to stay grounded yet ambitious.

Always question the salesperson:

A key reason behind the collapse of several financial institutions and banks in the Western world is that they bought complex financial instruments that promised high returns in return for taking on higher risk. Sure, greed played a part, and these supposedly smart individuals either thought that the chance of them getting hit was small, or they thought their risk management systems were foolproof. None of these turned out to be true. But of no less importance is the fact that many of them did not understand what they were getting into. They were persuaded by the smooth-talking salesman at the other end of the phone line or across the table.

Familiar, is it not? How often have we been tricked into buying a product we do not need by a salesperson whose income is linked to – you guessed it – how much she sells? Or in the hope of earning “bonus points” which you would be lucky to redeem in twenty years’ time? How about instances when the “free gift” was more important to you than the original product or service which, by the way, cost you a fortune?

I cannot escape feeling a tinge of hypocrisy here, since I spend a good deal of time doing work which centers around getting clients to hire our bank for advising on raising funds. The good news is that this gives me a decent feel of the whole circus. The key question to ask when faced with anyone trying to sell you stuff is this: will this person be comfortable selling this to his best friend or parents or family? If the answer is “no”, you should probe further. Things to watch out for include selective disclosure (what you are not told is as important as what you are told) and the fine print (sometimes these masquerade as “risk factors” which, from a purely legal point of view, can make the seller get away with murder). It is also perfectly legitimate to ask the seller or marketer how he stands to be rewarded on a successful sale. Sometimes, the answers are obvious. It is in those cases where they are not that you should be doubly sure of what you are signing up to. Your reward will be peace of mind, as well as better use of your hard-earned money.

Read the history books:

It is not everyone’s favorite subject in school, but history does tell us as much about the future as about the past. In the credit bubble of the past few years, as well as in the other bubble I distinctly remember – the late 90s’ frenzy around tech stocks – commentators have tried to justify the excesses by proclaiming: “this time it’s different”. Different in the nature of the bubble and some of the dramatis personae, but surely not in the way things fall apart. As any student of economic and social history would know, similar fate had befallen investors during the “Tulip craze” of the 16th and 17th centuries, and in the run-up to the 1929 crash. History does repeat itself, and at times it is merciless.

So for those of us who were repelled by the history taught at school that rewarded memorizing long chapters full of names, dates and events, here is an interesting exercise. Go back to those texts, or read books on historical events; or for that matter historical novels. You will be surprised to know how much of the present and the future is written in the past.