2008 09 19 Nobody Knows

© Oaktree Capital Management, L.P. All Rights ReservedMemo to: Oaktree Clients From: Howard Marks Re: Nobody Knows The title of this memo isn’t a joke; I mean it. Nobody knows the real significance of the recent events in the financial world, or what the future holds. Everyone has an opinion – there’s an off-color joke to that effect – but opinion s are entirely different from knowledge. As usual, the bulls are optimistic, the bears are pessimistic, and the rest are uncertain. This is a great time for my favorite quote from John Kenneth Galbraith: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.” No one knows about the future, and that’s more true now than ever . . . literally. Excesses were committed at financial institutions that we’ve never seen before in terms of their scale or their breadth, and many new inventions are in pla ce that never existed before. So clearly no one can know how things will pan out. My conviction that this is tr ue frees me from having to methodically assess the strength and weakness of economies and institutions, and it permits me to limit my comments to what I consider strategic realities. I’m flattered that people have asked for my opi nion, and I will give it. But that’s all it is: an opinion. In setting it down, I will repeat things I’ve written before. So if you find something that you think you’re reading fo r the second time, you’re probably right. UBoom-Bust Those two words say it all. If you have a boom, eventually you’ll have a bust. And the further the boom goes, the worse the bust is likely to be. If there’s no boom, on the other hand, there needn’t be a bust. There was no great boom in the U.S. econom y in 2003-07, and that’s one of the reasons why it has held up reasonably well despite the recent turmoil. But there was an incredible boom in the financ ial sector, and it has led to an incredible bust. (It remains to be seen whether its e ffects will slop over into the real economy. As you know, we think they will.) Finally, there wasn’t a boom in the U.S. st ock market, and so it hasn’t busted. (If you think your stocks have given you pain, realize th at their decline isn’t at all commensurate with the end-of-the-world thinki ng roiling the financial sector). © Oaktree Capital Management, L.P. All Rights ReservedUHow Things Got This Way Much of the current problem can be attribut ed to a decades-long bubble in the financial sector that made it the employer of obvious choice; attracted employees who were “the best and the brightest” (alt hough often untrammeled by experience); contributed to greed and risk taking; drove out fear and skepticism; and carried institutions, behavior, expectations and asset prices to unsustainable levels. What are the factors that got us in the current mess?  Excess liquidity, which had to find a home.  Interest rates that had been re duced to stimulate the economy.  Dissatisfaction with the resulting prosp ective returns on low-risk investments.  Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.  A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.  A desire on the part of financial institu tions to supplement ope rating income with profits from proprietary risk taking – that is, to be “more like Goldman.”  A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.  Excessive reliance on rating agencies which we re far from competent to cope with the new instruments, and on black-box financial mo dels that extrapolat ed recent history.  Unquestioning acceptance of financial plat itudes without wondering whether altered circumstances and elevated asset prices had rendered them irrelevant: o Houses and condos are good investments and can be counted on to appreciate. o Mortgages rarely go into default. o There can never be a nation-wide decline in home prices. o It’s okay to grossly lever a balan ce sheet if you’ve hedged enough through derivatives. o It’s safe to borrow and invest funds equal to a huge multiple of your equity capital if the probabilistic expected value is positive, because “disasters rarely happen.”  Individuals such as mortgage brokers and mortgage borrowers who were given incentives to do the wrong thing.  Newly minted financial “masters of the unive rse” encouraged to maximize returns for themselves and their employers without c oncern for whether they were adding value to the financial system or endangering it. In general, the above can be summed up as a shortage of adu lt supervision, common sense, skepticism, ethical concern and good old- fashioned prudence. As often happens in booms, the kids shouldered the adults aside or impressed them too much. The list of errors can make you laugh . . . or cr y. I mentioned in “Hindsight First, Please” how often financial people do th ings that look downright silly afterwards. But that never stops them from repeating the old mistakes or making new ones. © Oaktree Capital Management, L.P. All Rights Reserved So now w e find financial institutions that endangered themselves by using extensive short-term borrowings or deposits to make investments that turned out to be enormously risky when an unlikely disaster – a nationwide decline in home prices – occurred. In many ways, changes in the environment c ontributed as well. They crept up one by one, unnoticed, but their combined eff ect is significant. For example,  The Glass-Steagall Act was repealed, permitting banks and investment banks to combine. (It had been enacted in 1933 to outlaw such combinations because they were felt to have contributed to the Crash of ‘29. It’s ironic – and certainly not irrelevant – that it was repealed in 1999, in time to contribute to the current credit crunch.)  The rule limiting short sales to up-ticks was revoked in July 2007, enabling short selling to force stock prices down unabated.  Derivatives were created whos e prices were determined by the price of their “real” underlying securities; now we see that in an Alice-in-Wonderland way, they’re able to influence the price of real securities (see below).  And mark-to-market accounting exposed precariously leveraged institutions to the risk that technically-d riven declines in asset values might leave them too weak to make it through to a better day. It was during my working lifetime that the ph rase “too big to fail” was coined. More recently, Citibank caused some people to observe that it had become too big to manage. In the current go-round, financial institutions have been described as too big to understand and, finally, too big to disentangle (g iven the proliferation of derivatives and swap transactions, a key element in assessing an institution’s essentialness is the degree of counter-party risk it presents to others). There’s no doubt that these developments are frightening. But heroes aren’t people who’re unafraid, but rather those who act bravely despite their fears. Investors mustn’ t let emotion control their actions. Because of this combination of altered behavior, financial innovation and changes in the environment, I feel unabl e to tell you what lies ahead. But that doesn’t mean I’m not going to suggest a course of action. UDoes the Market Know? For reasons both systematic and unsystemat ic, the market is in many cases taking its lead from . . . the market. Price d eclines cause fear, and thus further price declines. In some cases, the signal for increased worry comes from increases in the price of credit default swaps, which provide insurance agains t debt defaults. Ri sing CDS prices imply that creditors have become more concer ned. This can send down the prices of a © Oaktree Capital Management, L.P. All Rights Reservedcomp any’s stock and debt instruments and frighten customers and depositors into withdrawing funds, potentially leading to dow ngrading and failure. In other words, increases in prices for credit in surance can serve as self-fulfilling prophesies. This is the unintended consequence of one of the recent innovations. I want to mention the potential for manipulati on present in this situ ation. One strong bid for default protection in the thin market for CDS on a given company can massively depress the price of billions of dollars worth of stock and/or debt. Clearly, an unscrupulous short-seller can use this tactic to his advantage. No one knows the extent to which it is in play . . . or how to stop it. In the end, people once again have to appl y skepticism and their own judgment, this time to bad news. Is the market smart or dumb? Is it giving us a valid signal to get out or the buying opportunity of a lifetime? I seem to remember a useful quotation to the effect that “The market is an ass.” Thus I think there’s more money to be made by being a contrarian than a trend follower. UThe End of the Financial System We’re seeing and hearing things today that we never imagined.  The demise or bailout of Lehman Brothe rs, Bear Stearns, Freddie Mac, Fannie Mae and AIG.  Concern about the viability of Goldma n Sachs and Morgan Stanley, and huge declines in their stocks.  Rising prices for CDS protecti on on U.S. Treasury securities.  Rates on short-term T-bills close to zero because of an extrem e flight to safety.  Awareness for the first time, I think, that the U.S. government’s financial resources are finite, and that there are limits on its ability to run the printing press and solve problems. Will the financial system melt down, or is this merely the greatest down cycle we’ve ever seen? My answer is simple: we have no choice but to assume that this isn’t the end, but just another cycle to take advantage of. I must admit it: I say that primarily b ecause it is the only viable position. Here are my reasons:  It’s impossible to assign a high enough probability to the meltdown scenario to justify acting on it.  Even if you did, there isn’t much you could do about it.*  The things you might do if c onvinced of a meltdown would tu rn out to be disastrous if the meltdown didn’t occur. © Oaktree Capital Management, L.P. All Rights Reserved Most of the time, the end of the world doe sn’t happen. The rum ored collapses due to Black Monday in 1987 and Long-Term Capital Management in 1998 turned out to be just that. * -- Money has to be someplace; where would you put yours? If you put it in T-bills, what purchasing power would be accorded the dollars in which they’re denominated? If the government’s finances collapsed, what good would your dollars be, anyway? What depository wouldn’t be in dange r? If you and many others deci ded to put billions into gold, what price would you have to pay for it? Where would you store it, and how would you pay for the truck to move it? How w ould you spend it to buy the things you need? What would people pay you for your gold, and wh at would they pay you with? And what if you bought credit insurance on all of your holdings: who would be able to make good on your claims? No, I don’t see any viable way to plan for the end of the world. I don’t know any more than anyone else about its probab ility, but I see no use in panicking. I think the outlook has to be viewed as bina ry: will the world end or won’t it? If you can’t say yes, you have to say no and act accordingly. In particular, saying it will end would lead to inaction, while saying it ’s not going to will permit us to do the things that always have worked in the past. We will invest on the assumption that it will go on, that companies will make money, that they’ll have value, and that buying claims on them at low prices will work in the long run. What alternative is there? UWhat Kind of Future Do We Face? Of course, even assuming there will be a recove ry, we have to think about what it will look like. As I wrote in “Doesn’t Make Se nse,” we aren’t counting on a “V.” We will continue to emphasize companies that we f eel serve basic economi c functions and can do relatively well even in bad times. Many elem ents in the economy are being damaged, especially confidence, and they may take a relatively long time to recover. In particular, the mechanism for providing capital is in great disrepair, and less credit certainly means a slower recovery and less growth. The financial institutions deserv e a special mention. If there’ s ever been a sector that’s down-and-out, this is probably it. Neve rtheless, Oaktree generally demands more transparency in order to invest than most of them provide. It can seem almost impossible to ascertain their condition through due diligence, and ab solutely impossible without access to their books. For example, possible buyers probably found the risks at Lehman Brothers to be unanalyzable. As The Wall Street Journal said on Tuesday, © Oaktree Capital Management, L.P. All Rights ReservedEven understanding Leh man’s current trading positions was tough. Lehman’s roster of interest-rate swap s (a type of derivative investment) ran about two million strong . . . What kind of effort would it require to understand the significance of two million derivatives positions: are they thoroughl y hedged, or bullish or bearish on balance? And what about Lehman’s m illions of other derivatives and complex securities? This opacity, combined with heavy leverage, reliance on short-term funds, liquidity and conscious risk taki ng, is the reason why a loss of confidence is conceivable at any financial institution in times of panic. What will the Wall Street of the future look like? We read – and I don’t doubt – that for at least a while it will be smaller, less leveraged, less profitable, and more highly regulated. But I also think it will be less competitive and less risky. In the course of my career, Wall Street went from being (1) brokers handling riskless trades for commission to (2) d ealers buying and selling inventory for a spread to (3) block traders purchasing large amounts of stock when market liquidity was inadequate to (4) proprietary traders risking their own capital in pursuit of profit for the house. Backing down this progression wouldn’t be the worst thing in the world. UWhat Will Start the Recovery? Eventually, someone will walk out of the crowd and take advantage of the lows. He may start an investment bank unburdene d with a legacy of losing positions. Or a bond insurer like Warren Buffett did when MBIA and Ambac became impaired. The cause of the recovery can’t be predicted. There may not even be a visible one. Maybe things will just get so cheap that they can’t stay down. (In ancient history – November 2001 – I wrote “You Can’t Predict; You Can Prepare,” with a thorough description of how cycles happen, based on energy all their own. It might be worth digging up.) I like to point out that, even in retrospect, no one can sa y what started the collapse of the tech stock bubble in 2000. But it did start . . . just, I think, because stock prices rose far too high. Th at works in reverse, too. In March, in “The Tide Goes Out,” I men tioned the three stages of a bull market, a notion I’ve been carrying around in my head for about 35 years:  the first, when a few forward-looking peopl e begin to believe things will get better,  the second, when most investors reali ze improvement is actually underway, and  the third, when everyone’s sure things will get better forever. © Oaktree Capital Management, L.P. All Rights ReservedAs we all know, buying during the first st age can be highly profitable, while buying during the last euphoric stage us ually leads to disaster. Then I went on to create the converse of th e above, the three stages of a bear ma rket:  the first, when just a few prudent invest ors recognize that, despite the prevailing bullishness, things won’t always be rosy,  the second, when most investors rec ognize things are deteriorating, and  the third, when everyone’s convinced things can only get worse. In the final stage, you can buy assets at prices that reflect litt le or no optimism. There can be no doubt that we are in the th ird stage with regard to many financial institutions. Not necessarily at the bo ttom, but in a serious period of unremitting pessimism. No one seems able to imagine how the current vicious circle will be interrupted. But I think we must assume it will be. It must be noted that, just like two years ago, people are accepting as true something that has never held true befo re. Then, it was the proposition that massively levered balance sheets had been rendered safe by the miracle of financial engineering. Today, it’s the non-viability of the essential financial sector and its greatest institutions. Everyone was happy to buy 18-24-36 months ago, when the horizon was cloudless and asset prices were sky-high. Now, with heretofore unimaginable risks on the table and priced in, it’s appropriate to sniff around for bargains: the babies that are being thrown out with the bath water. We’re on the case. September 19, 2008 © Oaktree Capital Management, L.P. All Rights Reserved 8Legal Information and Disclosures This memorandum expresses the views of the author as of the date indicated and such views are subject to change without notice. Oaktree has no duty or obligation to update the information contained herein. Further, Oaktree makes no rep resentation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contai ned herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performan ce is based on or derived from information provided by independent third- party sources. Oaktree Capita l Management, L.P. (“Oaktree”) believes that the sources from which such informa tion has been obtained are reliable; however, it cannot guarantee the accuracy of such inform ation and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information cont ained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Oaktree.