Howard Marks: "How Quickly They Forget"

One of the most important things we can do is take note of other investors’ attitudes and behavior regarding risk. Fear, worry, skepticism and risk aversion are the things that keep the market at equilibrium and prospective returns fair. When investors fear loss appropriately, too-risky deals can’t get done, and risky investments are required to offer high prospective returns and generous risk premiums. (And when fear reaches extreme levels during crises, the capital markets turn too stingy, asset prices sink too low, and potential returns become excessive.)

But when investors don’t fear sufficiently – when they’re risk tolerant rather than risk averse – they let down their guard, surrender their discipline, accept rosy projections, enter into unwise deals, and settle for too little in the way of prospective returns and risk premiums.

The years immediately preceding the onset of the crisis in mid-2007 constituted nothing short of a “silly season.” It seemed the financial world had gone crazy, with deals getting done that were beyond reason. Investors acted as if risk had been banished. They believed that the markets had been rendered safe by the combination of (a) an omniscient, omnipotent Fed providing a “Greenspan put,” (b) the wonders of securitization, tranching and selling onward and (c) the “wall of liquidity” coming toward our markets, composed of excess reserves being recycled by China and the oil-producing nations. They accepted the alchemy under which financial engineering could turn sub-prime mortgages into triple-A debt. And they viewed leverage as sure to have a salutary effect on returns.

There’s nothing more risky than a widespread belief that there’s no risk . . . but that’s what characterized the investment world. It was possible to conclude in 2005-07 that investors were applying insufficient risk aversion and thus engaging in risky behavior, elevating asset prices, reducing prospective returns, and raising risk levels. What were the signs?

• The issuance of non-investment grade debt was at record levels.
• An unusually high percentage of the issuance was rated triple-C, something that’s not possible when attitudes toward risk are sober.
• “Dividend recaps” went unquestioned, with buyout companies borrowing money with which to pay dividends, vastly increasing their leverage and reducing their ability to get through tough times.
• Credit instruments were increasingly marked by few or no covenants to protect lenders from managements’ machinations, and by interest payments that could be made with debt rather than cash at the companies’ discretion.
• Collateralized loan and debt obligations were accepted as being respectable instruments – with the risk made to vanish – despite the questionable underlying assets.
• Buyouts of larger and larger companies were done at increasing valuation multiples, with rising debt ratios and shrinking equity contributions, and despite the fact that the target companies were increasingly cyclical.
• Despite all of these indications of falling credit standards and rising riskiness, the yield spread between high yield bonds and Treasury notes shrank to record lows.
• The generous capital market conditions and low cost of capital for borrowers caused buyout fund managers to describe the period as “the golden age of private equity.” Conversely, then, for lenders it was the pits.

In 2005-07, investors suspended skepticism and disbelief, ignored the risk of loss, and obsessed instead about avoiding the risk of missing opportunities. This caused them to buy securities at low implied returns; employ vast amounts of low-cost debt to lever up those returns; loosen the terms on debt they would provide; and participate in black-box vehicles on the basis of investment banks’ recommendations, the nontransparent machinations of financial engineers, and the imprimatur of far-from-perfect rating agencies.

In short, investors were oblivious to risk and thus failed to demand adequate risk premiums. The environment could only be described as euphoric. Here’s how I put it in “It Is What It Is” (March 2006):

The skinniness of today’s risk premiums can be observed most clearly in the high yield bond market, where prospective returns can be calculated with precision and yield spreads are in the vicinity of historic lows, and in certain real estate markets, where actual cash returns are similarly low. But the difficulty of quantifying prospective returns in public and private equity doesn’t mean the offerings there are any less paltry. And, as Alan Greenspan said, “. . . history has not dealt kindly with the aftermath of protracted periods of low risk premiums.”

Market Conditions Today

In May 2005, I wrote a memo entitled “There They Go Again,” complaining that investors were taking excessive comfort from mindless platitude of the type that accompany and abet the creation of every bubble. These are accepted as a substitute for putting rational intrinsic valuations on the assets that are the subject of the bubble, and despite repeated evidence that trees can’t grow to the sky. I touched on the mania for real estate, as well as the growing popularity of hedge funds and private equity. I went on to assert that this behavior – and the supportive underlying capital market trends – had turned the markets into a “low-return world.”

I recite all of this because I have no doubt that investors are making substantial movement back in the same direction. To illustrate, here’s an account of capital market conditions in 2011 (Bridgewater Daily Observations, February 15):

Consistent with the pickup in credit creation that we have seen elsewhere, LBO activity and the credit pipes that are supporting it have recently improved. Since the first quarter of 2010 we have seen a steady rise in LBO activity, starting from a very low base. The rate of activity is now roughly similar to the average level of activity since 1985, excluding the boom and bust period of 2006 to 2009. . . . today’s deals are similar in size but the number of deals has risen by more than the dollar value of deals. We also see that the leverage in the deals is increasing. For example, so far this year the average deal was financed with 30% equity, down from last year’s 38%, though still up from the most leveraged period of 2005 to 2009 when deals were financed with an average of 25% equity. The leveraged loan market has also picked up and an increasing percentage of leveraged loans are going toward LBOs. A few new CLOs and mutual funds have been created that are concentrated on the leveraged loan market, indicative of renewed demand. Investor demand has pushed prices back up to par and allowed a decline in the average credit quality of the loans, with increasing indications of “covenant light” loans getting done.