The Forgotten Lesson of the Global Financial Crisis

Ralph Cioffi launched his hedge fund in 2003...

He gave it about as boring a name as you could imagine: the High-Grade Structured Credit Strategies Fund. He didn't need a flashy name, because attracting investors wasn't his job.

The fund launched from within investment bank Bear Stearns... a rock-solid establishment. So Cioffi – who was a longtime bond salesman at the firm – just needed to make money.

And that's exactly what he did...

The fund invested in boring, low-risk bonds and securities. But it managed to return about 1% to 1.5% per month, without ever losing money... thanks to leverage.

Those steady returns caught the eye of investors. So in August 2006, Bear Stearns raised $642 million to launch a sister fund: the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund.

The second fund operated the same way as the first, but with more leverage (as high as 25 times!). More leverage should have meant even higher gains.

Instead, these two funds helped kick off the great financial crisis.

Today, I'll share a forgotten lesson from that time... and how you can use it to navigate today's bear market.

Bear Stearns' two funds were mostly backed by subprime mortgages. They became some of the biggest buyers of the collateralized debt obligations ("CDOs") that helped bring the financial system to its knees.

I'm sure you know how this story ended – bankruptcy. But the timeline wasn't what you might expect...

The funds started running into trouble in early 2007. Then, in June, the more-leveraged fund announced losses of 23% for the year. Bear Stearns froze redemptions to stop investors from pulling out... And Bank of America stepped in and guaranteed $4 billion of the funds' debt.

It was a disaster. The S&P 500 Index fell nearly 2% the day the news broke. The index regained all the losses within a week, though. Even more incredible, this was a full four months before the market peaked.

Think about that... The world got its first look at the mess of subprime lending. Major Wall Street players were blowing up.

It should have been a watershed moment. But stocks shrugged it off.

The news only got worse for Bear Stearns. By March 2008, the firm was hemorrhaging cash. On March 10, its trading partners cut it off... And by the end of the week, JPMorgan Chase bought the company with a loss guarantee from the Federal Reserve.

If the mess the year before didn't tank stocks, that should have been the final blow. Bear Stearns was founded in 1923. It weathered the Great Depression and grew into the fifth-largest U.S. investment bank. Despite all that prestige, it had effectively gone under... only saved by a backstop bailout from the Fed.

The S&P 500 was already reeling. It was down 19% from its high at the time. But the bottom was still a year away... And stocks went on to fall another 47% over that period.

That's how painful a bear market can get. When it begins, the market will shrug off bad news. But once it gets going, even the seemingly worst possible outcome will get topped.

The Lehman Brothers bankruptcy topped the Bear Stearns scandal with ease. Lehman was once the fourth-largest U.S. investment bank. It filed for bankruptcy on September 15, 2008. And the entire financial system unraveled.

Again, stocks were already crashing. The S&P 500 was down 23% from its high. But the losses had just begun...

The market bottom didn't happen for another seven months. And stocks dropped another 43% along the way.

The timeline of the financial crisis would surprise most folks, looking back. Most people expect the market to bottom once the bad news is out there. But in a bear market, it doesn't always work that way. That's why you need to understand this right now...

In a bear market, your No. 1 goal isn't profiting... It's survival.

Sure, the bad times set up the good times. And that's what we expect – eventually. But that won't help you if you go broke along the way.

Things can always get worse. That's the important lesson of the financial crisis.

To avoid ruining yourself, you need to have a plan. And that doesn't mean a plan for timing the market bottom... or for aggressively buying if prices fall.

Instead, having stop losses in place – and sticking with them – should be your priority right now. That's how you can protect yourself in a bear market. It's how you survive so that you can invest safely again on the other side.

It might seem bad out there now. But things can always get worse. So right now, before anything else, focus on protecting yourself from that possibility.

Good investing,

Brett Eversole

P.S. Tomorrow, my colleague Dr. David Eifrig is coming forward with a huge retirement story. It centers on what he calls "the single best hedge against inflation anywhere in the markets"... And it's a big part of the answer to the pain and worry most investors are feeling right now.

So make sure you tune in to his free online event. Again, it's TOMORROW at 10 a.m. Eastern time... You can find all the details here.

Further Reading

"The more you let emotion affect your decisions, the worse off you'll be," Brett writes. Right now, with your favorite stocks dropping in value, you might be tempted to hold on and wait for a reversal. But this tool can help you avoid losses when emotions run high... Learn more here.

Amateur investors tend to make risky trades without considering their potential losses. But the pros use this simple technique to increase their profit potential while limiting their risk... Read more here: We're Teetering on the Edge of a Bear Market... Use This Tool to Survive.

Market Notes
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