Howard Marks: "How Quickly They Forget"

Today, pension funds and endowments simply can’t achieve their goal of nominal returns in the vicinity of eight percent if they keep much money in Treasurys or high grade bonds, and they may not even expect public equities to be much help. They’ve moved into high yield bonds, private equity and hedge funds . . . not because they want to, but because they feel they have to. They just can’t settle for the returns available on more traditional investments. Thus their risk taking is in large part involuntary and perhaps unenthusiastic.

So where do we stand today?

• General interest rates are some of the lowest in history.
• Yield spreads are about normal.
• Returns on low-risk assets are reasonable in relative terms but skimpy in the absolute.
• Investors are forced toward pro-risk behavior because of the lowness of returns in the safer, low-risk portion of the risk/return curve.
• Thus investors are jettisoning the conservatism they adopted at the depths of the financial crisis, in many cases not out of choice.
• Investors are once again engaging in risky behavior, albeit not at peak levels of riskiness.

Those of us who calibrate our behavior based on what others are doing should increase watchfulness and, as Buffett suggests, apply rising amounts of prudence.

How Did Things Get This Way?

Just two and a half years ago, in the depths of the financial crisis, I was convinced that pro-risk psychology had undergone lasting damage. With investment banks, rating agencies and financial engineers defrocked, no-lose investments collapsing, account balances decimated and investors disillusioned, it seemed it might be years before market psychology recovered. And yet markets began a dramatic recovery in early 2009, investors have returned to bearing risk, and many indices are back in the vicinity of their pre-crisis peaks. What’s behind this turn of events?

In 2007 and 2008, governments around the world rushed to support financial institutions and stimulate economies. They did this by making liquidity readily available and cutting interest rates to near zero.

Everyone knew the rate cuts would stimulate the economy by encouraging borrowing and reducing the cost of doing business, and that they would increase the profit margin in lending, buttressing financial institutions. But I don’t think anyone fully appreciated the impact they would have on reviving pro-risk behavior.

In short, the rate cuts made it unrewarding to hold cash, T-bills and high grade bonds. Investors looking for returns in line with their needs – or income on which to live – were literally forced to move into riskier asset classes in pursuit of returns in excess of a few percent.

Much of the money that normally would be invested in the giant Treasury market simply couldn’t stay there because the yields were so low. Thus large amounts flowed toward smaller markets where they were quite capable of lifting prices. Nothing can reduce returns, worsen terms or raise risk faster than “too much money chasing too few deals.” It’s disproportionate flows of capital into a market that give rise to the disastrous race to the bottom such as we saw in 2005-07. Greater sums are provided to weaker borrowers at lower interest rates and with looser terms. Higher prices are paid for assets: first less of a discount from intrinsic value, then the full intrinsic value, and eventually premiums above intrinsic value. These processes account for many of the trends decried here.

In addition, I would point out that the pain of the crisis was surprisingly short-lived. The real panic began on September 15, 2008, the day Lehman Brothers filed for bankruptcy. Until then, the world seemed to be coping and investors retained their equanimity. But Lehman, Fannie Mae, Freddie Mac, Merrill Lynch, Washington Mutual and AIG fell like dominoes in short order, and in the last fifteen weeks of 2008 people were paralyzed by fear of a global financial meltdown.

And then things turned in the first quarter of 2009, primarily, I think, because people were coerced to move further out on the risk curve as described above. Since then the markets have risen dramatically from their lows.

In distressed debt, for example, the post-Lehman days and weeks were characterized by terror, uncertainty, forced selling, illiquidity and huge mark-to-market losses. But if you look back, you see that the panic and pain – and thus the greatest buying opportunity – really lasted only fifteen weeks, through the end of 2008. Prices continued downward in the first quarter of 2009, but without the deluge of supply brought on by the previous quarter’s forced selling. By April prices were headed up. So the lesson was painful but short-lived and, apparently, easily forgotten.

As usual, the cyclical upswing is circular and self-reinforcing. It takes on the appearance of a virtuous cycle that will proceed non-stop, and it does so . . . until it fails. Here’s an example of the process at work:

• The pursuit of return caused people to move from Treasurys to high yield bonds.
• The revival of demand enabled companies to raise money.
• The reopening of the capital markets made it possible for companies to do bond exchanges and refinancings: extending maturities, extinguishing covenants and capturing bond discounts, converting them into reduced amounts of debt outstanding. In some cases equity could be issued to delever balance sheets.
• These remedial actions improved companies’ creditworthiness and brought down the default rate on high yield bonds from 10.8% in 2009 to a startling 1.1% in 2010, the greatest one-year decline in history.
• The resulting price appreciation produced profits for those who’d bought, turning investor psychology more rosy and producing envy – and thus a rush to join in – among those who had been slow to invest.
• And the combination of these things convinced people that conditions had improved, making them still more willing to take on increased risk.

I thought the lessons of 2007-08 had been etched into people’s psyches, and that the return to pro-risk behavior would therefore be slow. But clearly that hasn’t been the case.