2009 03 05 Will It Work

© Oaktree Capital Management, L.P. All Rights ReservedMemo to: Oaktree Clients From: Howard Marks Re: Will It Work? The other day, my son Andrew – college senior and credit-analyst-to-be – asked whether I think Treasury Secretary Geithner is doing the right things. As ha s happened before, his question elicited a fatherly respons e that grew into this memo. When you want a bridge built, you hire a ci vil engineer whose “calcs” will determine exactly how much concrete and steel should be used. Then it’ll be sure to hold the weight of the cars you expect to cross it. And if you have to perform a task in carpentry, you can employ specialized tools developed and tested expressly for the job: esoteric things like miter boxes, r outers and extractors. One of the most important things to bear in mind today is that economics isn’t an exact science. It may not even be much of a science at all, in the sense that in science, controlled experiments can be conducted, past results can be replicat ed with confidence, and cause-and-effect relationships can be depe nded on to hold. It’s not for nothing that economics is called “the dismal science.” Solutions in economics aren’t nearly as depe ndable as engineers’ ca lculations, and there may not be a tool that’s just right for fixing an economy. Of course, the toolbox offers lots of possibilities, includi ng interest rate reductions; qu antitative easing; tax cuts, rebates and credits; stimulus checks; infrastr ucture spending; capital injections; loans, rescues and takeovers; regulator y forebearances and on and on. But no one should think there’s a “golden tool,” su ch that solving the prob lem is just a matter of figuring out which one it is and applying it. Anyone who holds the problem solvers to that standard is being unfair and unrealis tic. There are a number of reasons why, including these:  Every situation is different, and none is exac tly like any that has come before. That means fixed recipes can’t work. Certainly this one has never been seen before.  Most policy actions aren’t all good or all bad. They merely represent imperfect compromises as to ideology, goals, problem solving and resource allocation.  Economic problems are multi-faceted, meaning the solution for one aspect might not work on – and in fact might exacerbate – another aspect.  Economies are dynamic, and the problems are moving targets. The environment changes constantly, rather than sitting still and waiting for a solution to work.  The main ingredient in economics is psychology, and the workings of psychology clearly can’t be fully known, controlled or fixed. © Oaktree Capital Management, L.P. All Rights Reserved 2Here’s how Thomas Friedman put it in The New York Times of January 31: Everyone is looking for the guy – the guy who can tell you exactly what ails the world’s financial system, exactly how we get out of this mess and exactly what you should be doing to prot ect your savings. . . . But here’s what’s really scary: the guy isn’t he re. He’s left the building. . . . There is no magic bullet for this economic crisis, no magic bailout package, no magic stimulus. We have woven such a tangled financial mess with subprime mortgages wrapped in complex bonds and derivatives, pumped up with leverage , and then globalized to the far corners of the earth that, much as we want to think this will soon be over, that is highly unlikely. The “I know” school (which first appeared in a memo in 2001) is still making predictions. Statistical comp arisons are being made to pa st recessions and solutions extrapolated from those experiences. Thus it’s the consensus of this school that the recovery will start during th e first quarter of 2010. I also see people projecting a stock market rebound based on the average time betw een past declines and the recoveries therefrom. I think it’s a mistake to hold confident opinions about the ev ents of today. Instead, I think this is a great time to reaffirm faith in the “I don’t know” school, of which I’m a card-carrying member. No one should feel ce rtain they know what’s going to unfold, or when. The only things we have to fall back on at this juncture are intrinsic value, company survival and our own staying power as investors . Of course, even these things mean we have to make judgments about what the future is li kely to look like. That requirement, in turn, means nothing can be approached with complete safety or certainty. Nevertheless, we can take ac tion if we think th ose three elements will be present under most circumstances. That’s the right mindset for today. Harder Than Sudoku The impossibility of reaching into the economic toolbox for that one perfect tool is easily illustrated with a list of some of the challe nges present today. For a learning exercise, skip today’s Sudoku or crossword puzzle and ta ke a crack at resolving these dilemmas:  Consumer confidence and spending are weak. We want to stimulate, but we don’t want to replace weakness with hyperinflation.  We’re willing to drop fiscal discipline in favor of stim ulus through deficit spending, but we don’t want to scare away offshore investors from the Treasury securities we’ll issue to fund our deficits.  We’re willing to distribute stimulus checks, but we seem unable to make frightened individuals spend the money rather than save it.  In fact, we know consumers got into trouble by spending mo re than they earned, and © Oaktree Capital Management, L.P. All Rights Reserved 3now they should build some savings. But whereas in the recent past consumer spending grew faster than incomes, a rising savings rate means spending would grow slower than incomes, just at a time when in comes are falling and spending is needed.  Likewise, with tax revenues down, states and cities have to balance their budgets. One way to do so is to raise income tax and sales tax rates, but this will further depress local economies and increase the bur den on their beleaguered citizens.  We want to recapitalize the banks, but we don’t want to reward past mistakes.  We’re thinking about buying the banks’ “tox ic” assets. But if we pay above-market prices, that’s a subsidy to the reckless (see above), and if we pay market or below-market prices, that will further er ode bank capital th rough write-downs.  We know suspending mark-to-market acc ounting would end write-downs, but doing so might also reduce confidence in balance sheets and postpone the day of reckoning needed for our financial institutions to reach bottom and recover.  We want the banks to lend, but we can’t – and shouldn’t – make them extend loans to non-creditworthy borrowers.  We want to reduce the incidence of home foreclosure, but we don’t want to reward people who speculated by buying multiple homes or lied on mortgage applications. And we’d rather not treat people who bought more house than they could afford better than those who acted prudently.  We want to make mortgage relief availabl e to those who are unable to service their mortgages, but we don’t want to give people incentives to stop making payments.  We’re considering letting bankruptcy judges reset mortgage contracts, but we don’t want to tell lenders that lo an contracts are no longer sacrosanct, which certainly would deter them from making new loans.  We don’t want the depressant impact of auto companies going bankrupt and suppliers and dealers following suit. But we also don’t want to pump money into the industry unless we’re confident it can pr oduce good cars at competitive prices.  We want to see the auto i ndustry “rationalized,” but that means seeing people lose their jobs or have their paychecks redu ced, which would spread pain, put stress on benefit funds, and cut into GDP.  We want taxpayer-supported automakers to use American steel , but (assuming it’s more expensive than imported steel) that wi ll either (a) raise ca r prices, making cars more expensive for hard-pressed buyers and making the Big 3 less competitive, or (b) require the companies to eat the differen ce, making it harder for them to achieve profitability.  We want to curb speculation in derivatives, but we don’t want to make it harder for businesses, farmers, insurers and in vestors to legitimately hedge risk.  In fact, we want to prevent excesses on th e part of business, but most people don’t think it’s a good idea to nati onalize companies or have the government tell them how to operate. It’s abundantly clear from th is list – and it’s only a pa rtial list – that solving the current problem w ill require compromises and a combination of disparate elements. Some will work, while others will fail and have to be replaced. And some will work with regard to one facet of the problem but aggravate another. Lastly, no one should think that even a wise co mbination will produce quick results. © Oaktree Capital Management, L.P. All Rights Reserved 4Regulating Excess Compensation Some of the excesses the government wants to stop are in the area of compensation at rescued banks. Excessive compensation seem s to have a lot in common with hard-core pornography: As Potter Stewart, Associate Justice of the Un ited States Supreme Court, wrote about the latter, it’s hard to de fine but “I know it when I see it.” It’s easy to react adversely when an institu tion that lost billions and needed a taxpayer bailout is seen paying millions or billions in executive bonuses. But how do we define excessive compensation, and what should be done about it? More importantly, how do we make sure the cure won’t be worse than the disease? On February 14, The Wall Street Journal reported that, The giant stimulus package that cleare d Congress Friday includes a last- minute addition that restricts bonuses for top earners at firms receiving federal cash . . . The most stringe nt pay restriction bars any company receiving funds from paying top earn ers bonuses equal to more than one- third of their total annual compensation. Some limitation on compensation at taxpayer-s upported institutions seems reasonable and unavoidable. But is this provision a good thing? Here are some of the problems:  It doesn’t limit comp ensation, just bonuses.  Bonuses – especially if tied to achiev ements – should be preferable to high salaries from the point of view of shareholders and taxpayers . In fact, it was just a few years ago that federal legislat ion created a preference for incentive compensation tied to benchmarks.  An executive with a $1 million salary is in compliance with this restriction if he receives a bonus of $500,000. But one who’s paid $250,000 is in violation if he receives a bonus of $200,000. S hould the taxpayer prefer the former to the latter?  Past challenges, like mobilizing industry for World War II, were met by recruiting “dollar-a-year” leaders. One hope here might be that able businesspeople will come forward to work for nothing but a big success fee . Citigroup CEO Vikram Pandit is receiving a salary of $1. Shoul d we really limit his bonus to 50 cents?  The new law will limit bonuses at taxpayer-assisted banks, not all banks. Will that doom the rescued banks to second-ra te management? And thus second-rate profitability? Is that desirable?  Bank managements and boards may want to avoid this limitation, and to do that they may turn down or rush to repay federal money. Doing so may reduce the banks’ capital, weakening them and inhibiting their ability to lend.  Even the biggest losers among the banks had some profitable units and excellent managers. Do we want the weak institutions to lose these to their stronger peers because they can’t pay competitively?  Does the fact that some bank managers made grave mistakes in recent years mean no bank executives can be deserving of high compensation? Does the © Oaktree Capital Management, L.P. All Rights Reserved 5government really want to stigmatize the field of banking and chase able executives from it to industries where compensation is unregulated?  The last time I saw legislation with near-u nanimous appeal on a corporate-behavior issue was in 2002, after the Enron scandal. American business is still suffering from some of Sarbanes-Oxley’s less -well-conceived provisions. Observers are disappointed when recovery plan s aren’t announced quickly or in detail. Yet here’s a provision that was inserted quickly and in deta il, and it doesn’t do a lot to advance the ball. Bottom line: a quick fix will prove hard to come by. Who’s Right? My mother used to tell a story about the shtetls – villages – in the old country where disagreements were settled by the rabbi. In one, an argument was raging with no possible grounds for compromise. The villagers brought th e two parties to the rabbi. “Tell your side,” the rabbi said to one fellow, and he did. “ You’re right ,” the rabbi declared. One of the bystanders piped up: “You can’t te ll him he’s right, rabbi; you haven’t heard the other side of the story.” So the rabbi told the other party to tell his side, and he did. His story was the polar opposite of the other party’s. “ You’re right ,” said the rabbi. “Hold on, rabbi,” a villager said, “the first guy told his story and you sa id he was right. Then the other guy told his story – different in every regard – and you said he was right. They both can’t be right.” “ And you’re right ,” said the rabbi. The current disagreement over bank nationaliz ation shows that (a) there can be valid arguments on both sides of an issue and (b) it can be hard to figure out who’s right. Here are a few of the pros and cons as advanced by The Wall Street Journal on February 24: What are the pluses to nationalizing firms? Some banks are bleeding slowly toward insolvency. Nationalizing them promptly would allow the government to wipe out the most toxic assets, reorganize what is left and sell the remains to private investors. On a broader front, nationalization could help heal the banking system and encourage the remaining firms to boost lending. What are the minuses? Investors in the nationalized bank would likely be wiped out. And nationalizing even one or two banks could create a chain reaction of failing confidence. . . . Nationalization would also be e xpensive and complicated, taxing a bureaucracy that isn’t set up to operate mega-firms. And while the goal of © Oaktree Capital Management, L.P. All Rights Reserved 6nationalization may be to return companies to private hands, the temptation to run them for political purposes would be immense. Obviously, there are arguments on both sides. One Proposal The other night, I had dinner with my frie nd Richard Ressler, principal and founder of CIM Group. He has an idea as to how things can be fixed (as usual), and it’s a pretty good one. I’ll summarize below hi s thoughts on the banking industry:  There are banking institutions which, because of their magnitude and significance, should be supported through deposit insurance, government guarantees and rescues.  These banks should engage only in the pr osaic acts of accepting deposits and making loans. They should not take on ultra-high le verage or make exotic investments. And they shouldn’t do business through unregul ated, off-balance-sh eet subsidiaries.  Institutions that wish to do things that are off-limits to these banks should do so, but without the benefit of govern ment protection. If they want to take on 30-times leverage and pursue proprietary profits, they should bear the consequences themselves.  Thus banking and risky inve sting should be separated. In The New York Times of February 2, Professor Paul Krugman of Princeton argued that we have to avoid “lemon socialism: taxpaye rs bear the cost if things go wrong, but stockholders and executives get the benefits if things go right.” One way to prevent this, as Richard suggests, is to make sure gove rnment support and high-octane risk taking don’t take place in the same firms. I’ve been told it isn’t his, but a saying wide ly attributed to Mark Twain seems to be on the mark: “History doesn’t repeat itself, but it does rhyme.” There’s no need to invent the mechanism through which to accomplish th e above; we can look to history and gain inspiration from the Glass-Steagall Act. After the Great Crash, congressional committees investigated its causes, some of which remind one of today’s. The result was th is 1933 law, which mandated that banking be separated from investment banking and investment services. It ’s far from irrelevant to the current situation that Gl ass-Steagall’s powers ended in 1999, when key parts were repealed by the Gramm-Leach-Bliley Act. This new law had the goal of encouraging competition in banking, investment servic es and insurance, by permitting common ownership by financial conglomerates. Protecting society against risky investment activities on the part of government- insured institutions is a good thing. And co mpetition in providing financial services is a good thing. But the two goals can be in conflict and have to be balanced, and the consensus as to which should prevail will oscillate from time to time. So in addition to © Oaktree Capital Management, L.P. All Rights Reserved 7there not being perfect solutions, there also may not be permanent solutions. That’s why crises will recur and history will continue to rhyme. Politics as Usual Few phrases strike terror in the hearts of businesspeople and many just-plain-citizens more than the three little word s that are the title of this section. The other day, a friend with high-up experience explained the facts of life in Washington. He organized his observations into the “Three P’s.”  Policy is fashioned through intellectual de bate conducted on a high plane. Well- meaning people can disagree, but policy an alysis follows from facts and underlying ideology in a relativel y straightforward way.  Process is the mechanism through which policy is turned into action. It is complex and arcane and the exclusive province of people with experience in Washington.  Politics shapes the law that policy becomes. My friend had lots of words for it, but the one that stood out to me was “distasteful.” As an aside, my friend laid out an im portant difference between government and business, in which he’s also highly experienced. In business, he says, everyone’s main goal is the success of the company. Contributing to the succe ss of the company enables an individual to demonstrate ability and thus rise in the organization. Success for the company creates a pool of profits from which the individual can be well paid. It also amounts to a “win” for a team of whic h every person wants to be a member. But in government, success is hard to measure, difficult to connect to any one individual’s contribution, and slow in coming. Thus it’s hard to view success for the government as constituting el ected officials’ primary mo tivation. Instead, the most important thing is getting re-e lected. That personal, short-term consideration can have nothing to do with the long-term well-being of the nation. This is especially true in the House of Representatives, he says, where two-year terms mean the members are never done running for re-election. Despite the crisis facing the country and the crying need for prompt action, we’re seeing a good dose of politics as usual. YouTube provides an up-close look at this stuff. It also gives politicians the audi ence many seem to crave. Today a lynch-mob attitude prevails toward bankers, mortgage lenders and credit-rating agencies. I’m not saying a lot of it isn’t dese rved, but it still can be overdone. It’s always good political theater to pile on a purported villain, whet her through a perp-walk for handcuffed inside traders in 1986 or a televi sed congressional hearing for bankers in 2009. Check out Congress’s grilling of bankers on YouTube and you’ll see what I think is vilification and ad hominem attack (“appealing to one’s pr ejudices, emotions, or special © Oaktree Capital Management, L.P. All Rights Reserved 8interests rather than to one’s intellect or reason” – Random Hous e Dictionary) intended for public consumption. One congressman told Vikram Pandit, Citibank’s CEO, he was amazed by a deal the bank had made: “The government gets $7 billion in preferred stock and the government’s on the hook for $250 billion of losses. . . . You tell me, Mr. Pandit: where can I get a deal like this?” Pandit expl ained that it was insurance: for a premium of $7 billion, Citibank got a policy covering $301 billion of mortgage securities, with Citi taking the first $30 billio n of losses and 10% of any losses beyond that. Should it come as a surprise that an insuran ce policy costs significantly less to buy than the amount of risk assumed by the insurer? If it didn’t, why would anyone buy one? Under this policy, Citi will lose money if there aren’t $38 billion in losses (in which case Citi would receive nothing on the first $30 bil lion but 90% of the next $8 billion, so proceeds would be equal to the $7 billion premium it had paid). Was this deal really such a giveaway? And should the Congressman real ly be surprised to learn the government has a preference for seeing Citi surviv e and is willing to cut it a good deal? On the campaign trail and in victory, Pres ident Obama called for non-partisanship and united action. With Democrats controlling th e White House and Congress, to him that means Republicans should vote in favor of solutions crafted pr imarily by Democrats. So far, it’s not happening. On the stimulus p ackage, only three of the 217 Republican votes in Congress – just over one percent – were cas t with the Democratic majority. (And only seven of the 308 Democratic votes went with the Republicans.) Not much aisle crossing in either direction. Of course, there are lots of reasons why broad agreement is rarely seen:  Genuine ideological differences exist between in dividuals and between parties. Some want an expanded government to fix pr oblems, and others prefer to rely on free markets to do so. Some view increased government spending as holding the key to the solution, and others prefer to reduce taxes. Some want to rescue weak financial institutions, and others want only the strongest, best-run to survive. Thus, failing to go along with the majority isn’t neces sarily a sign of a character flaw.  There are also valid differences in motivation. The president is a national officer whose job it is to find an overall soluti on. But legislators ar e elected locally to represent local interests, and those can diverge from the interests of other regions or the nation. It shouldn’t come as a surprise that they push for particular benefits for their constituents.  Finally there comes self-interest. The truth is that each party has the underlying goal of wanting to elect its members and make th e other side look bad. And even if it’s needed to solve a grave national problem, a conservative answer might be repugnant and unacceptable to voters in a liberal distri ct, and vice versa. Thus, doing the “right thing” can be tantamount to political suic ide. How many elected officials will choose the latter? © Oaktree Capital Management, L.P. All Rights Reserved 9Today’s Rhetoric I think people in government who’re addressing th e situation have a difficult row to hoe:  First and most immediately, they’ve had to play up the emergency in order to convince legislators (and the vot ers who put them in office) that the situation is dire and strong action is required. Thus we’ve heard words like “catastrophe,” “collapse” and “worst since the Great Depression.”  Second, however, they’re well advised to pl ay down the threat. Franklin D. Roosevelt receives a lot of cr edit for having said, “The only thing we have to fear is fear itself.” Given the cruc ial role of confidence in the functioning of an economy, it’s not a great idea to spread panic. The rational response of fri ghtened people is to save rather than spend, and to sell invest ments rather than buy, making things worse.  Third, the President likely wants to create m odest expectations. If there’s a feeling that a valid response should work right aw ay, slow progress will look like failure. No one wants consumers and businesses to fu rther pull in their horns if economic recovery isn’t forthcoming in 2009. It’s hard not to be sympathetic to this dile mma. It shows another of the ways in which conflicting goals have to be compromised in the real worl d of economics and politics. The Bottom Line There are so many moving parts to the current situation – and to its causes and what we hope will be its solution – th at I’ve tried to boil things down to the essentials. In order to right the system and get the economy m oving forward again, I think three main things have to be accomplished:  Our economy and its component pa rts have to be delevered;  The vast destruction of capita l has to be dealt with; and  Confidence has to be restored. Here’s how Paul Krugman described the challenge in The New York Times of February 16: For most of the last decade America was a nation of borrowers and spenders, not savers. . . . Yet until very recently Americans believed they were getting richer, because they received statements saying that their houses and stock portfolios were appreciating in value faster than their debts were increasing. . . . © Oaktree Capital Management, L.P. All Rights Reserved 10Then reality struck, and it turned out that the worriers had been right all along. The surge in asset values had been an illusion – but the surge in debt had been all too real. . . . . . . this is a broad-based mess. Ev eryone talks about the problems of the banks, which are indeed in even worse shape than the rest of the system. But the banks aren’t the only player s with too much debt and too few assets; the same description applies to the private sector as a whole. As the great American economist Irv ing Fisher pointed out in the 1930s, the things people and companies do when they realize they have too much debt tend to be self-defeating when ev eryone tries to do them at the same time. Attempts to sell assets and pay off debt deepen the plunge in asset prices, further reducing net worth. Atte mpts to save more translate into a collapse of consumer demand, deepening the economic slump. . . . Government officials understand the issue: we need to “contain what is a very damaging and potentially deflationary spiral,” says Lawrence Summers, a top Obama economic adviser. Debt has to be reduced, and it’s happening (other than at the federal level, of course). But the way it happens is usually unpleasan t: bankruptcies, for eclosures and debt restructurings. “Debt reduction” sounds like a good thing, but it’s likely to be accompanied by the painful loss of the assets that had been bought with borrowed money. Many assets are worth far less than they used to be – that’s one of the main reasons why the debt load has become unbearable and has to be reduced. Investors, consumers, homeowners and financial institutions will have to rebuild their capital as they – and the economy – attempt to again move ahead. And confidence has to be rebuilt, too. The willingness to borrow, spend and invest will rebound only when people believe in comes and asset values will resume their growth. In the past, we’ve seen a standard pattern unfold, with the best examples falling in the corporate debt arena. Once denial ends and people accept capital destruction as a fact, restructurings can take place in which debt is discharged and ownership changes hands. The transition of assets to new owners, who may have lower cost bases and the ability to inject additional capital, brings the possibility of attractive returns, the onset of which restores interest in investing. It seems inescapable that this pattern will be a major feature of the next few years. The government’s actions clearly are aimed at accomplishing the three things I say we need. Some will work, and some won’t. I believe that, eventually, the combination of things they try – along with the pattern de scribed above and the positive bent that © Oaktree Capital Management, L.P. All Rights Reserved 11underlies the free market system – will return us to an upward trajectory. It just won’t be easy, quick or painless. And that’s why I think the investment d ecisions we make today must emphasize value , survivability and staying power . I readily acknowledge th at assuring survival in bad times is inconsistent with return maxi mization in good times. Insistence on these three things won’t produce the greatest reward s if the economy and markets surprise on the upside, but that’s not my main concern. Given the uncertainty present today, it’s hard enough to find investments that can be relied on to deliver solid returns in good times but also assure survival in bad. In that interest, we’ve always been willing to cede to others much of that part of the return distribution lying between “solid” and “m aximum.” This time is no different. March 5, 2009 © Oaktree Capital Management, L.P. All Rights Reserved 12Legal 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. 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