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Memo to: Oaktree Clients
From: Howard Marks
Re: The Tide Goes Out
For every period, there's a quotation which serves perfectly to explain what's going on,
and I often find myself borrowing it. Warren Buffett provides more than his share; not
only is his insight unmatched, but so is his ability to express it. Thus, starting with "It's
All Good" last July, I've found frequent use for this one:
When the tide goes out, we find out who's been swimming without a
Certainly, "swimming without a bathing suit" - or perhaps a life preserver - serves
beautifully to describe investor behavior during the carefree period that ended last
summer. And equally, the ebbing of the tide - and the exposing of those who
engaged in that behavior - sums up the unpleasant disclosures which have taken
place since. Financial sector participants indulged in unprecedented amounts of
leverage, innovation and risk taking between late 2002 and mid-2007, the consequences
of which have become readily apparent.
Leveraging and Inflating
When we look at the last few years, we see a rather ordinary period of economic growth
and prosperity, accompanied by good corporate health and profitability. But what
distinguished this period from all others was a runaway boom in financial sector
activity. The whole financial sector inflated, like a balloon into which increasingly more
hot air was forced.
The greatest contributor to the 2002-07 boom likely was leverage; the recent past saw a
steady flow of equity capital to levered entities, accompanied by willingness on the part
of lenders to provide unprecedented amounts of leverage. Now the reversal of that
process is underway, with consequences that are equally dramatic but much less pleasant.
Let's review the process which was often described and embraced as a virtuous circle:
? Equity capital was provided to would-be leveraged entities.
? Debt was readily available for them to use in expanding their total capital and thus
their ability to pursue profit.
? This combined capital was used to purchase assets, forcing prices higher.
? Price appreciation caused the entities' equity to expand at a faster rate thanks to their
? The increases in equity were matched by further increases in borrowings.
? In fact, the good performance convinced lenders to increase the amount of leverage
they would supply per dollar of equity. This meant the entities could grow their
portfolios even faster than the rates at which equity capital flowed in and assets
? Further, because of the seeming impregnability of the leveraged entities' profitability,
risk aversion shrank and the risk premiums and returns demanded by lenders
declined. Leverage became cheaper and thus even more attractive.
? As is typical of virtuous circles, everything ran smoothly . . . for a while: additional
equity flowed in; it was leveraged up increasingly; buying caused assets to appreciate
further; and the upward spiral continued.
With things working increasingly well and investors becoming more and more
excited, processes like this one seem destined to go on forever. Of course, they
cannot. But people forget that, satisfying one of the key prerequisites for a cycle
that goes to excess. Overestimating the longevity of up legs and down legs is one of
the mistakes that investors insist on repeating.
Deleveraging and Deflating
Over the years I've written a number of memos about cycles, and in each one I've
tried to remind readers that trees don't grow to the sky, and that success carries
within itself the seeds of failure. Just as the balloon of levered entities expanded
beyond reason in the last few years, now it's well into the process of deflating. And, as I
mentioned in "Now What?" the air always goes out a lot faster than it went in.
Eventually, developments that are exogenous to the process interfere, or perhaps the
process collapses of its own weight. In the current instance, consider subprime
mortgages. The process described above was going along just fine, with increasing
numbers of ever-larger mortgages being granted to cover a rising percentage of the cost
of houses bought at rising prices by borrowers of declining creditworthiness. So far, so
good: a process unhampered by discipline or restraint. But it must be seen that,
eventually, reality will intrude. For example, eventually the amounts borrowed will
necessitate payments that exceed what the borrowers can afford. Oops; investors forgot
To understand what's going on now, all you have to do is reverse the process described
above and squeeze (the squeeze - the force behind the deflating - comes from the pain
that accompanies disclosure of the process's flaws).
? Something causes asset prices to weaken.
? Now the leverage works in reverse, causing the entities' equity to shrink faster than
the rate of decline in asset prices, and their ratios of borrowings to assets to rise.
? Lenders, worried about declining asset prices, either call in their loans or refuse to roll
over debt when it matures. In some cases, the entities' now-shrunken collateral fails a
market value test and triggers a margin call, which can be met only through the
posting of additional collateral (which usually isn't available) or sales of assets
(which add to market weakness).
? Further, with the world suddenly feeling much riskier, lenders demand increased risk
premiums, raising the cost of borrowed funds and further impairing borrowers'
? Equity investors - panicked by the combination of asset price declines, leveraged
equity losses and margin calls - withdraw equity capital to the extent they can. The
sight of investors lining up at the withdrawal window, and often being told they can't
have their money, adds to the negative climate.
? The need to raise cash with which to satisfy the demands of lenders and equity
investors places further downward pressure on asset prices, reinforcing what is
suddenly a vicious circle. Fire sales of collateral add to this pressure.
? In particular, think what happens to banks. In this negative environment, it's hard to
imagine these highly leveraged entities extending credit, given that (a) banks' equity
is shrinking, (b) they feel they may need the money themselves, and (c) they fear
further losses on loans and assets.
It shouldn't come as a surprise that this vicious circle seems as obvious and inescapable
as did the virtuous one just a short time earlier. This is the point at which we may start to
hear talk about the unstoppable downward spiral and thus the pending collapse of the
financial system. Unquestioning euphoria gives way to full-blown depression.
If you watch enough cop shows on TV, you know that investigators of suspicious fires
use the term "accelerant" for the chemical used by an arsonist to encourage the spread of
a blaze. The current capital market cycle has been accelerated by an element that was
added to the capital market equation in the 1990s: mark-to-market accounting.
In the simpler but still not totally stable financial world I entered forty years ago, stability
was desired in financial institutions. So, for example, banks and insurance companies
were allowed to carry a loan or a bond at cost on their balance sheets as long as it was (a)
fundamentally unimpaired and (b) intended to be held to maturity. Even if its market
value fell temporarily, it was assumed that a creditworthy claim would be repaid in full at
maturity. Thus, price fluctuations were ignored as long as fundamentals were sound.
More recently, "transparency," "accountability" and "market signals" became
more highly prized. A lot of this had to do with skullduggery unearthed at companies
like Enron. As a result, accounting increasingly came to require that assets be valued at
actual or estimated market prices. I'd had a preview of this in 1990 when, as part of
efforts to "get" the high yield bond industry (and Drexel and Milken), S&Ls were
required to market price their holdings of high yield bonds - dooming many of them in a
time of price weakness.
What is a memo to Oaktree clients? Memo to: Oaktree Clients From: Howard Marks Re: Now What? My memos mostly try to explain what’s been going on in the financial arena and how things got that way.
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