In Feb 2007, Oaktree Capital’s Howard Marks wrote ‘The Race to the Bottom’, providing a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008 as he worried about “carelessness-induced behavior.” In the pre-crisis years, as described in his 2007 memo, the race to the bottom manifested itself in a number of ways, and as Marks notes, “now we’re seeing another upswing in risky behavior.” Simply put, Marks warns, “when people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed,” adding that “the riskiest thing in the investment world is the belief that there’s no risk.”
Excerpted from OakTree Capitals’ Howards Marks most recent letter to investors:
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).
The cycles I describe aren’t predictable as to timing or extent. However, their fluctuations absolutely can be counted on to recur, and that’s what matters to me. I think it’s also what Mark Twain had in mind when he said “History doesn’t repeat itself, but it does rhyme.” The details don’t repeat, but the rhyming patterns are extremely reliable.
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, I think 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).