Lessons From 2007

The last half of 2007 was brutal, and many investors -- myself included -- made some bad calls. Although mistakes are tough, the biggest mistake of all would be to ignore them and not learn anything. Here's what I learned this year.

Complexity is thy enemy
Some of the biggest losers in 2007 were companies for which you'd need an army of forensic analysts and accountants to get a hint of the bombs hidden in their balance sheets.

Most investors really don't stand a chance understanding the exposures embedded within Countrywide (NYSE: CFC  ) , MBIA (NYSE: MBI  ) , or Merrill Lynch (NYSE: MER  ) . Given the shocking losses some of those companies have taken, even company managers were apparently blindsided by how complex -- and risky -- their businesses had become.

It's true that some of those companies may now be undervalued. But Fools need to learn to take a tough stance when it comes to putting some companies into the "too hard" pile and instead say, "Thanks, but no thanks."

Liquidity dries up when you need it most
One of the biggest problems with the financial system is that it doesn't self-correct. When corporations or homeowners need loans the least, lenders fall all over themselves to provide cheap and low- or no-equity financing.

However, when the music stops, that freewheeling deals come to a screeching halt. Now the once-promiscuous lenders find themselves overleveraged and unable or unwilling to extend further credit. Meanwhile, borrowers who had grown addicted to cheap liquidity are left to wilt. The moral of the story? Don't depend on cheap liquidity.

Fortune favors the prepared
For many years, Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) hoarded cash on the balance sheet because Chairman Warren Buffett couldn't find bargains in the stock market. No matter how agitated analysts and shareholders got, Buffett refused to make a move until the time was right.

With $38.6 billion in cash as of the latest quarter, this company is better poised than any other to take advantage of a possible stock-market crash. How enormous is Berkshire's war chest? Consider this: It has enough cash to buy Colgate, DuPont, or Target in their entirety.

Don't dance just because music's playing
One of the most notorious quotes from the now-defunct "cheap liquidity" era came from former Citigroup (NYSE: C  ) CEO Chuck Prince, who said, "As long as the music is playing, you've got to get up and dance. ... We're still dancing." Citigroup subsequently got blindsided by its exposure to collateralized debt obligations, structured investment vehicles, and the subprime mess, and the stock has ended up falling 45% in the past year. Prince stepped off the dance floor and resigned.

Don't reach for yield. Ever.
A lot of companies decided that it'd be better to invest in mortgage-backed securities. After all, they sported AAA ratings -- the top debt rating possible -- and had slightly higher yields than did similar AAA-rated corporate bonds backed by companies such as General Electric.

Whoops. E*Trade Financial (Nasdaq: ETFC  ) was one of those companies, and it recently sold its mortgage-backed securities at a price estimated at 27 cents on the dollar. A little bit of yield is a poor trade-off if it comes with a lot more risk.

Live and learn
Most of these mistakes were easy to make at the time. It's easy now to point fingers, but even just six months ago, very few people believed that the housing and mortgage markets would implode seemingly overnight. In time, most people will probably forget the turmoil and crises that started in 2007. However, those who take the lessons of 2007 to heart and remain vigilant will be prepared the next time around.

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