Insights on The Crisis.
The Race Is On.
Summary of A Howard MARKS Memo.
In a memo which he is particularly proud of, The Race to the Bottom from February 2007, Howard Marks of Oaktree Capital provided a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008. He frankly confessed that he wasn't aware and didn't explicitly predict that the unwise lending practices that were exemplified in sub-prime mortgages would lead to a global financial crisis of multi-generational proportions. But in essence, he did detect carelessness-induced behavior, and he considered it worrisome.
Howard strongly believes that:
most of the key phenomena in the investment world are inherently cyclical,
these cycles repeat, reflecting consistent patterns of behavior, and
the results of that behavior are predictable.
Howard Marks (hereafter referred to as “HM”): “Of all the cycles I write about, I feel the capital market cycle is among the most volatile, prone to some of the greatest extremes. It is also one of the most impactful for investors.
In short, sometimes the credit window is open to anyone in search of capital (meaning dumb deals get done), and sometimes it slams shut (meaning even deserving companies can't raise money).”
This summary is about the cycle's first half: the manic swing toward accommodativeness.
Competing to Provide Capital.
When the economy is doing well and companies' profits are rising, people become increasingly comfortable making loans and investing in equity. As the environment becomes more salutary, lenders and investors enjoy gains. This makes them want to do more; gives them the capital to do it with; and makes them more aggressive. Since this happens to all of them at the same time, the competition to lend and invest becomes increasingly heated.
When investors and lenders want to make investments in greater quantity, it's also inescapable that they become willing to accept lower quality. They don't just provide more money on the same old terms; they also become willing – even eager – to do so on weaker terms. In fact, one way they strive to win the opportunity to put money to work is by doing increasingly dangerous things.
This behavior was the subject of The Race to the Bottom. In it I said to buy a painting in an auction, you have to be willing to pay the highest price. To buy a company, a share of stock or a building – or to make a loan – you also have to pay the highest price. And when the competition is heated, the bidding goes higher. This doesn't always – or exclusively – result in a higher explicit price; for example, bonds rarely come to market at prices above par. Instead, paying the highest price may take the form of accepting a higher valuation parameter (e.g., a higher price/earnings ratio for a stock or a higher multiple of EBITDA for a buyout) or accepting a lower return (e.g., a lower yield for a bond or a lower capitalization rate for an office building).
Further, rather than paying more for the asset purchased, there are other ways for an investor or lender to get less for his money. This can come through tolerating a weaker deal structure or through an increase in risk. It's primarily these latter elements – rather than securities merely getting pricier – with which this memo is concerned.
History Rhymes.
In the pre-crisis years, as described in the 2007 memo, the race to the bottom manifested itself in a number of ways:
There was widespread acceptance of financial engineering techniques, some newly minted, such as derivatives creation, securitization, tranching and selling onward; and SPACs (Special Purpose Acquisition Companies, or blind-pool acquisition vehicles). Further, the development of derivatives, in particular, vastly increased the ease with which risk could be shouldered (often without a complete understanding) as well as the amount of risk that could be garnered per dollar of capital committed.
While not a novel development, there was an enormous upsurge in buyouts. These included the biggest deals ever; higher enterprise values as a multiple of cash flow; and increased leverage ratios.
There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for.
Finally, there was simply a willingness to increase a company's leverage without adding any productive assets that can help service the new debt.
HM's 2007 memo included the following paragraph:
Today's financial market conditions are easily summed up: There's a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn't unusual in its form, only its extent.
Now we're seeing another upswing in risky behavior. It began surprisingly soon after the crisis, spurred on by central bank policies that depressed the return on safe investments. It has gathered steam ever since, but not to anywhere near the same degree as in 2006-07.
Wall Street has, thus far, been less creative in terms of financial engineering innovations.
Likewise, derivatives are off the front page and seem to be created at a much slower pace.
Buyout activity seems relatively subdued. Many smaller deals are taking place, however, including a large number of “flips” from one buyout fund to another, and leverage ratios have moved back up toward the highs of the last cycle.
“Cov-lite” and PIK-toggle debt issuance is in full flower, as are triple-Cs, dividend recaps and stock buybacks.
It's highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:
global glut of liquidity,
minimal interest in traditional,
little apparent concern about risk,
skimpy prospective returns everywhere.
As one amongst many examples from the media, a November 19, 2013 Bloomberg story included the following observation from a strategist: “The analysis at some point shifts from fundamentals to being purely based on the price action of the stock.”
When people start to posit that fundamentals don't matter and momentum will carry the day, it's an omen we must heed.
While the extent is nowhere as dramatic as in 2006-07 – and the psychology behind it isn't close to being as bullish or risk-blind – I certainly sense a significant increase in the acceptance of risk. The bottom line is that when risk aversion declines and the pursuit of return gathers steam, issuers can do things in the capital markets that are impossible in more prudent times.
Why Is Risk Bearing on the Rise,
and What Are the Implications?
Psychologically and attitudinally, I don't think the current capital market atmosphere bears much of a resemblance to that of 2006-07. Then I used words like “optimistic,” “ebullient” and “risk-oblivious” to describe the players. Returns on risky assets were running high, and a number of factors were cited as having eliminated risk:
The Fed was considered capable of restoring growth come what may.
A global “wall of liquidity” was coming toward us, derived from China's and the oil producers' excess reserves; it could be counted on to keep asset prices aloft.
The Wall Street miracles of securitization, tranching, selling onward and derivatives creation had “sliced and diced” risk so finely – and directed it where it could most readily be borne – that risk really didn't require much thought.
In short, in those days, most people couldn't imagine a way to lose money.
I believe most strongly that the riskiest thing in the investment world is the belief that there's no risk. When that kind of sentiment prevails, investors will engage in otherwise-risky behavior. By doing so, they make the world a risky place. And that's what happened in those pre-crisis years. When The New York Times asked a dozen people for articles about the cause of the crisis, I wrote one titled “Too Much Trust; Too Little Worry.”.
Certainly a dearth of fear and a resulting high degree of risk taking accurately characterize the pre-crisis environment.
But that was then.
It's different today.
Insights on The Crisis.
The Race Is On.
Summary of A Howard MARKS Memo - part 2.
Today, unlike 2006-07, uncertainty is everywhere:
Will the rate of economic growth in the U.S. get back to its prior norm? Will unemployment fall to the old “structural” level?
Can America's elected officials possibly reach agreement on long-term solutions to the problems of deficits and debt? Or will the national debt expand unchecked?
Will Europe improve in terms of GDP growth, competitiveness and fiscal governance? Will its leaders be able to reconcile the various nations' opposing priorities?
Can Abenomics transform Japan's economy from lethargy to dynamism? The policies appear on paper to be the right ones, but will they work?
Can China transition from a highly stimulated economy based on easy money, an excess of fixed investment and an overactive non-bank financial system, without producing a hard landing that keeps it from reaching its economic goals?
Looking at the world more thematically, a lot of questions surround the ability to manage economies and regulate growth:
Can low interest rates and high levels of money creation return economic growth rates to previous levels? (To date, the evidence is mixed.)
Can inflation be returned to a salutary level somewhat above that of today? Right now, insufficient inflation is the subject of complaints almost everywhere. Can the desired inflation rate be reinstated without going beyond, to undesirable levels?
Programs like Quantitative Easing are novel inventions. How much do we know about how to end them, and about what the effects of doing so will be? Will it prove possible to wind down the stimulus – the word du jour is “taper” – without jeopardizing today's unsteady, non-dynamic recoveries? Can the central banks back off from interest rate suppression, bond buying and easy money policies without causing interest rates to rise enough to choke off growth?
How will governments reconcile the opposing goals of stimulating growth (lower taxes, increased spending) and reining in deficits (increased taxes, less spending)?
As to investments:
When the Fed stops buying bonds, will interest rates rise a little or a lot? Does that mean bonds are unattractive?
Are U.S. stocks still attractive after having risen strongly over the last 18 months?
Ditto for real estate following its post-crash recovery?
Can private equity funds buy companies at attractive prices in an environment where few owners are motivated to sell?
Most people are aware of these uncertainties. Unlike the smugness, complacency and obliviousness of the pre-crisis years, today few people are as confident as they used to be about their ability to predict the future, or as certain that it will be rosy.
Nevertheless, many investors are accepting (or maybe pursuing) increased risk.
The reason, of course, is that they feel they have to.
The actions of the central banks to lower interest rates to stimulate economies have made this a low-return world. This has caused investors to move out on the risk curve in pursuit of the returns they want or need. Investors who used to get 6% from Treasuries have turned to high yield bonds for such a return, and so forth.
Movement up the risk curve brings cash inflows to riskier markets. Those cash inflows increase demand, cause prices to rise, enhance short-term returns, and contribute to the pro-risk behavior described above. Through this process, the race to the bottom is renewed.
In short, when investors take on added risks - whether because of increased optimism or because they're coerced to do so (as now) - they often forget to apply the caution they should. That's bad for them. But if we're not cognizant of the implications, it can also be bad for the rest of us.
Where does investment risk come from? Not, in my view, primarily from companies, securities – pieces of paper – or institutions such as exchanges.
No, in my view the greatest risk comes from prices that are too high relative to fundamentals. And how do prices get too high? Mainly because the actions of market participants take them there.
Among the many pendulums that swing in the investments world – such as between fear and greed, between depression and euphoria – one of the most important is the swing between risk aversion and risk tolerance.
Risk aversion is the essential element in sane markets.
People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they'll
approach risky investments with caution and skepticism,
perform thorough due diligence, incorporating conservative assumptions, and
demand healthy incremental return as compensation for accepting incremental risk.
This sort of behavior makes the market a relatively safe place.
But when investors drop their risk aversion and become risk-tolerant instead, they turn bold and trusting, fail to do as much due diligence, base their analysis on aggressive assumptions, and forget to demand adequate risk premiums as a reward for bearing increased risk. The result is a more dangerous world where asset prices are higher, prospective returns are lower, risk is elevated, the quality and safety of new issues deteriorates, and the premium for bearing risk is insufficient.
It's one of my first principles that we never know where we're going – given the unreliability of macro forecasting – but we ought to know where we are.
“Where we are” means what the temperature of the market is: Are investors risk-averse or risk-tolerant? Are they behaving cautiously or aggressively? And thus is the market a safe place or a risky one?
Certainly risk tolerance has been increasing of late; high returns on risky assets have encouraged more of the same; and the markets are becoming more heated. The bottom line varies from sector to sector, but I have no doubt that markets are riskier than at any other time since the depths of the crisis in late 2008 (for credit) or early 2009 (for equities), and they are becoming more so.
A rise in risk tolerance is something that should get your attention and focus your concentration. But for it to be highly worrisome, it has to be accompanied by extended valuations. I don't think we're there yet. I think most asset classes are priced fully – in many cases on the high side of fair – but not at bubble-type highs. Of course the exception is bonds in general, which the central banks are supporting at yields near all-time lows, meaning prices near all-time highs. But I don't find them scary (unless their duration is long), since – if the issuers prove to be money-good – they'll eventually pay off at par, erasing the interim mark-downs that will come when interest rates rise.
HM ends his memo with his favorite “Buffettism”:
... the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.
You just can't put it any better. When others are acting imprudently, making the world a riskier place, our caution level should rise in response. (It's equally true that when others become overly cautious and run from risk, assets get so cheap that we should turn aggressive.)
The trend is in the direction of increased risk, and there is no reason to think that trend will be arrested anytime soon. Risk is likely to reach extreme levels someday – it always does, eventually – and great caution will be called for.
Howard Mark's conclusion from the original 2007 “The Race to the Bottom” is still valid:
... there's a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won't exceed that of the naysayers. But that is the usual pattern.
November 26, 2013
The Race Is On.
Summary of A Howard MARKS Memo.
In a memo which he is particularly proud of, The Race to the Bottom from February 2007, Howard Marks of Oaktree Capital provided a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008. He frankly confessed that he wasn't aware and didn't explicitly predict that the unwise lending practices that were exemplified in sub-prime mortgages would lead to a global financial crisis of multi-generational proportions. But in essence, he did detect carelessness-induced behavior, and he considered it worrisome.
Howard strongly believes that:
most of the key phenomena in the investment world are inherently cyclical,
these cycles repeat, reflecting consistent patterns of behavior, and
the results of that behavior are predictable.
Howard Marks (hereafter referred to as “HM”): “Of all the cycles I write about, I feel the capital market cycle is among the most volatile, prone to some of the greatest extremes. It is also one of the most impactful for investors.
In short, sometimes the credit window is open to anyone in search of capital (meaning dumb deals get done), and sometimes it slams shut (meaning even deserving companies can't raise money).”
This summary is about the cycle's first half: the manic swing toward accommodativeness.
Competing to Provide Capital.
When the economy is doing well and companies' profits are rising, people become increasingly comfortable making loans and investing in equity. As the environment becomes more salutary, lenders and investors enjoy gains. This makes them want to do more; gives them the capital to do it with; and makes them more aggressive. Since this happens to all of them at the same time, the competition to lend and invest becomes increasingly heated.
When investors and lenders want to make investments in greater quantity, it's also inescapable that they become willing to accept lower quality. They don't just provide more money on the same old terms; they also become willing – even eager – to do so on weaker terms. In fact, one way they strive to win the opportunity to put money to work is by doing increasingly dangerous things.
This behavior was the subject of The Race to the Bottom. In it I said to buy a painting in an auction, you have to be willing to pay the highest price. To buy a company, a share of stock or a building – or to make a loan – you also have to pay the highest price. And when the competition is heated, the bidding goes higher. This doesn't always – or exclusively – result in a higher explicit price; for example, bonds rarely come to market at prices above par. Instead, paying the highest price may take the form of accepting a higher valuation parameter (e.g., a higher price/earnings ratio for a stock or a higher multiple of EBITDA for a buyout) or accepting a lower return (e.g., a lower yield for a bond or a lower capitalization rate for an office building).
Further, rather than paying more for the asset purchased, there are other ways for an investor or lender to get less for his money. This can come through tolerating a weaker deal structure or through an increase in risk. It's primarily these latter elements – rather than securities merely getting pricier – with which this memo is concerned.
History Rhymes.
In the pre-crisis years, as described in the 2007 memo, the race to the bottom manifested itself in a number of ways:
There was widespread acceptance of financial engineering techniques, some newly minted, such as derivatives creation, securitization, tranching and selling onward; and SPACs (Special Purpose Acquisition Companies, or blind-pool acquisition vehicles). Further, the development of derivatives, in particular, vastly increased the ease with which risk could be shouldered (often without a complete understanding) as well as the amount of risk that could be garnered per dollar of capital committed.
While not a novel development, there was an enormous upsurge in buyouts. These included the biggest deals ever; higher enterprise values as a multiple of cash flow; and increased leverage ratios.
There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for.
Finally, there was simply a willingness to increase a company's leverage without adding any productive assets that can help service the new debt.
HM's 2007 memo included the following paragraph:
Today's financial market conditions are easily summed up: There's a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn't unusual in its form, only its extent.
Now we're seeing another upswing in risky behavior. It began surprisingly soon after the crisis, spurred on by central bank policies that depressed the return on safe investments. It has gathered steam ever since, but not to anywhere near the same degree as in 2006-07.
Wall Street has, thus far, been less creative in terms of financial engineering innovations.
Likewise, derivatives are off the front page and seem to be created at a much slower pace.
Buyout activity seems relatively subdued. Many smaller deals are taking place, however, including a large number of “flips” from one buyout fund to another, and leverage ratios have moved back up toward the highs of the last cycle.
“Cov-lite” and PIK-toggle debt issuance is in full flower, as are triple-Cs, dividend recaps and stock buybacks.
It's highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:
global glut of liquidity,
minimal interest in traditional,
little apparent concern about risk,
skimpy prospective returns everywhere.
As one amongst many examples from the media, a November 19, 2013 Bloomberg story included the following observation from a strategist: “The analysis at some point shifts from fundamentals to being purely based on the price action of the stock.”
When people start to posit that fundamentals don't matter and momentum will carry the day, it's an omen we must heed.
While the extent is nowhere as dramatic as in 2006-07 – and the psychology behind it isn't close to being as bullish or risk-blind – I certainly sense a significant increase in the acceptance of risk. The bottom line is that when risk aversion declines and the pursuit of return gathers steam, issuers can do things in the capital markets that are impossible in more prudent times.
Why Is Risk Bearing on the Rise,
and What Are the Implications?
Psychologically and attitudinally, I don't think the current capital market atmosphere bears much of a resemblance to that of 2006-07. Then I used words like “optimistic,” “ebullient” and “risk-oblivious” to describe the players. Returns on risky assets were running high, and a number of factors were cited as having eliminated risk:
The Fed was considered capable of restoring growth come what may.
A global “wall of liquidity” was coming toward us, derived from China's and the oil producers' excess reserves; it could be counted on to keep asset prices aloft.
The Wall Street miracles of securitization, tranching, selling onward and derivatives creation had “sliced and diced” risk so finely – and directed it where it could most readily be borne – that risk really didn't require much thought.
In short, in those days, most people couldn't imagine a way to lose money.
I believe most strongly that the riskiest thing in the investment world is the belief that there's no risk. When that kind of sentiment prevails, investors will engage in otherwise-risky behavior. By doing so, they make the world a risky place. And that's what happened in those pre-crisis years. When The New York Times asked a dozen people for articles about the cause of the crisis, I wrote one titled “Too Much Trust; Too Little Worry.”.
Certainly a dearth of fear and a resulting high degree of risk taking accurately characterize the pre-crisis environment.
But that was then.
It's different today.
Insights on The Crisis.
The Race Is On.
Summary of A Howard MARKS Memo - part 2.
Today, unlike 2006-07, uncertainty is everywhere:
Will the rate of economic growth in the U.S. get back to its prior norm? Will unemployment fall to the old “structural” level?
Can America's elected officials possibly reach agreement on long-term solutions to the problems of deficits and debt? Or will the national debt expand unchecked?
Will Europe improve in terms of GDP growth, competitiveness and fiscal governance? Will its leaders be able to reconcile the various nations' opposing priorities?
Can Abenomics transform Japan's economy from lethargy to dynamism? The policies appear on paper to be the right ones, but will they work?
Can China transition from a highly stimulated economy based on easy money, an excess of fixed investment and an overactive non-bank financial system, without producing a hard landing that keeps it from reaching its economic goals?
Looking at the world more thematically, a lot of questions surround the ability to manage economies and regulate growth:
Can low interest rates and high levels of money creation return economic growth rates to previous levels? (To date, the evidence is mixed.)
Can inflation be returned to a salutary level somewhat above that of today? Right now, insufficient inflation is the subject of complaints almost everywhere. Can the desired inflation rate be reinstated without going beyond, to undesirable levels?
Programs like Quantitative Easing are novel inventions. How much do we know about how to end them, and about what the effects of doing so will be? Will it prove possible to wind down the stimulus – the word du jour is “taper” – without jeopardizing today's unsteady, non-dynamic recoveries? Can the central banks back off from interest rate suppression, bond buying and easy money policies without causing interest rates to rise enough to choke off growth?
How will governments reconcile the opposing goals of stimulating growth (lower taxes, increased spending) and reining in deficits (increased taxes, less spending)?
As to investments:
When the Fed stops buying bonds, will interest rates rise a little or a lot? Does that mean bonds are unattractive?
Are U.S. stocks still attractive after having risen strongly over the last 18 months?
Ditto for real estate following its post-crash recovery?
Can private equity funds buy companies at attractive prices in an environment where few owners are motivated to sell?
Most people are aware of these uncertainties. Unlike the smugness, complacency and obliviousness of the pre-crisis years, today few people are as confident as they used to be about their ability to predict the future, or as certain that it will be rosy.
Nevertheless, many investors are accepting (or maybe pursuing) increased risk.
The reason, of course, is that they feel they have to.
The actions of the central banks to lower interest rates to stimulate economies have made this a low-return world. This has caused investors to move out on the risk curve in pursuit of the returns they want or need. Investors who used to get 6% from Treasuries have turned to high yield bonds for such a return, and so forth.
Movement up the risk curve brings cash inflows to riskier markets. Those cash inflows increase demand, cause prices to rise, enhance short-term returns, and contribute to the pro-risk behavior described above. Through this process, the race to the bottom is renewed.
In short, when investors take on added risks - whether because of increased optimism or because they're coerced to do so (as now) - they often forget to apply the caution they should. That's bad for them. But if we're not cognizant of the implications, it can also be bad for the rest of us.
Where does investment risk come from? Not, in my view, primarily from companies, securities – pieces of paper – or institutions such as exchanges.
No, in my view the greatest risk comes from prices that are too high relative to fundamentals. And how do prices get too high? Mainly because the actions of market participants take them there.
Among the many pendulums that swing in the investments world – such as between fear and greed, between depression and euphoria – one of the most important is the swing between risk aversion and risk tolerance.
Risk aversion is the essential element in sane markets.
People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they'll
approach risky investments with caution and skepticism,
perform thorough due diligence, incorporating conservative assumptions, and
demand healthy incremental return as compensation for accepting incremental risk.
This sort of behavior makes the market a relatively safe place.
But when investors drop their risk aversion and become risk-tolerant instead, they turn bold and trusting, fail to do as much due diligence, base their analysis on aggressive assumptions, and forget to demand adequate risk premiums as a reward for bearing increased risk. The result is a more dangerous world where asset prices are higher, prospective returns are lower, risk is elevated, the quality and safety of new issues deteriorates, and the premium for bearing risk is insufficient.
It's one of my first principles that we never know where we're going – given the unreliability of macro forecasting – but we ought to know where we are.
“Where we are” means what the temperature of the market is: Are investors risk-averse or risk-tolerant? Are they behaving cautiously or aggressively? And thus is the market a safe place or a risky one?
Certainly risk tolerance has been increasing of late; high returns on risky assets have encouraged more of the same; and the markets are becoming more heated. The bottom line varies from sector to sector, but I have no doubt that markets are riskier than at any other time since the depths of the crisis in late 2008 (for credit) or early 2009 (for equities), and they are becoming more so.
A rise in risk tolerance is something that should get your attention and focus your concentration. But for it to be highly worrisome, it has to be accompanied by extended valuations. I don't think we're there yet. I think most asset classes are priced fully – in many cases on the high side of fair – but not at bubble-type highs. Of course the exception is bonds in general, which the central banks are supporting at yields near all-time lows, meaning prices near all-time highs. But I don't find them scary (unless their duration is long), since – if the issuers prove to be money-good – they'll eventually pay off at par, erasing the interim mark-downs that will come when interest rates rise.
HM ends his memo with his favorite “Buffettism”:
... the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.
You just can't put it any better. When others are acting imprudently, making the world a riskier place, our caution level should rise in response. (It's equally true that when others become overly cautious and run from risk, assets get so cheap that we should turn aggressive.)
The trend is in the direction of increased risk, and there is no reason to think that trend will be arrested anytime soon. Risk is likely to reach extreme levels someday – it always does, eventually – and great caution will be called for.
Howard Mark's conclusion from the original 2007 “The Race to the Bottom” is still valid:
... there's a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won't exceed that of the naysayers. But that is the usual pattern.
November 26, 2013
No comments:
Post a Comment