Howard Marks Memo Breakdown: "The Race to the Bottom"

The Race to the Bottom

The primary subject of this memo is ways to cheapen your money. Marks starts this memo by laying out the differences in commodities and products. With goods and services, salespeople can claim their product is unique because it is cheaper and/or better. That hopefully drives more sales for that product compared to its competitors on the market. But, with commodities, the offerings don’t differ in quality. Therefore, to say a commodity is better quality has almost no effect on if it sells. Commodities are products that aren’t differentiable, such as gold and crude oil. So, for commodities dealers, the easiest way to sell more is to sell the commodity cheaper than everyone else. Money can be thought of as a commodity because money is the same for everyone.

Competition Among Financiers

Financing firms compete for funding people, and they compete with each other for it. Because money is the same, those looking for financing will go with the person offering the cheapest money. This may be confusing, but cheap money doesn’t refer to the lowest amount of money given for funding. There are different ways to cheapen money, including the financing firm setting a lower interest rate on the money you give or the financing firm paying a higher amount for the financing. The second option can be thought of as paying a higher price for a stock, compared to the P/E ratio, or a higher total transaction price when buying a whole company. But, with those two options — a lower interest rate and a higher price paid — the return is lower.

Marks also says that besides accepting a lower return on investment, with a lower interest rate or higher price paid per share would mean for an investor, there is something else that can be reduced in order to put your money to work in investments: safety. For a firm that wants to give more funding in its market, which means it takes up a larger portion of the investments made, it will take more risks to achieve that market share, which means less safety, in order to put its money to work in those investments.

Auctions and Capital Markets

Marks also draws a comparison between auctions and capital markets. In an auction, the person who wins the auction is the one who pays the most money. That winner is also the biggest loser. That winner paid more for the exact thing that people are willing to pay less for. Therefore, that winner is getting the least for his money.

When it comes to buying in capital markets, the person providing the capital who accepts the least by paying the most will get the deal but may be losing in the long-run if he or she accepts a level of safety that turns out to be inadequate. That means if the provider of capital, the investor, is taking too big or too small a risk, the investment will deliver the smallest returns because the investor took too little risk or will not pay out at all because the risk was too big. In the first scenario were true, with too little risk, the investor pays the highest amount for the smallest returns. In the second scenario, with too much risk, the investor pays the highest amount and loses it all.

Marks explains that one of his pet peeves is the number of articles written about the buyer of a company or who secured the deal on a certain investment. According to Marks, buying reveals the highest bidder, not necessarily the smartest bidder. The smartest bidder is the one who gets the most for the money he or she paid. In other words, the smartest bidder gets the most “bang for one’s buck.”

Abbey, the UK Loan Provider

The increase in the standard amount Abbey, UK’s 2nd-largest mortgage provider, will loan homebuyers prompted Marks to write this memo. It raised the amount it would loan from 3.5x the homebuyer’s salary to 5x the homebuyer’s salary. The larger amount Abbey was willing to loan represents a change from the generally accepted idea that homebuyers can safely handle a loan 3.5x their salary. It represents a shift in the amount of risk loan providers are willing to take because they wanted to put more money to work. Therefore, they are willing to give up more safety in order to put that money to work.

While Marks acknowledges that he was initially driven to write this memo because of Abbey’s loosening of standards. But, he makes it known that he wants to “comment on general capital market trends, not any one sector.”

Optimistic Lending Attitudes

Marks is known for his ideas on market cycles and cites that it’s at the late-stage belief of the cycle he was in during early 2007 as the reason the standard amount for loans changed. Marks wrote this memo in February 2007 at the start of the financial crisis. The attitude during the stage was one of plenty of optimism. The attitude in this cycle could be defined as one of greater risk-taking and more competition to invest more money.

Investors and lenders were optimistic that the money invested would yield great returns. This was especially true of lenders, as the housing market was reportedly strong and sturdy. This belief was ultimately falsified during the crisis. The usual late-stage belief is that current conditions are different than they were in the past and that those conditions justify a higher level of optimism for prospective returns.

Loosening Mortgage Standards

Marks explains the changes in the mortgage market as home prices increased and interest rates decreased. The summary is that the standards for mortgages were loosening to the point where loan providers were giving loans without requiring “documentation of employment or credit history.”

That’s like paying money to a doctor to give you a surgery when the doctor isn’t providing any proof he can do the surgery successfully. That is obviously an extremely risky surgery. But this was the risk that lenders were taking in order to put more money to work to get greater returns.

This type of risk that lenders engaged in during the period of extremely high home prices and record-low interest rates led to buyers taking out the biggest possible mortgage and using it to pay for the house of their dreams. These types of mortgages with low, fixed interest rates would allow buyers to remain in their homes, but only under that condition. Ultimately, conditions deteriorated, which led to the mortgage crisis.

The investor who invests his money with the least amount of information is accepting the highest level of risk. With lending institutions, such as the previously mentioned Abbey, the one that makes the loan, the “winner” of the “loan auction”, is the one who invests the most with the least amount of safety.

Most of Wall Street remained optimistic about the mortgage market’s strength and encouraged more risk. Marks, however, questioned whether more risk in mortgage lending was intelligent or excessive. That question raised doubts about the strength of the mortgage market. As the mortgage market crashed, those doubts were verified.

Over-leveraging

Marks continues to talk about risky investing behaviors when he talks about over-leveraged companies. Over-leveraged simply means having too much debt.

Companies were leveraging themselves, or borrowing money, and using that money to pay shareholders dividends. The goal was to see how much in dividends investors could squeeze out from the company before the over-leveraging caught up. The company is already making a risky decision using borrowed money to pay dividends. Investors are also making a risky decision by investing in that company. It’s risky because they do not know when the company will no longer be able to pay its dividends. Investors commonly say that if “things take a turn for the worse,” then they’ll get out of their investment. That means that they expect to exit out of their investment before the company begins to lose money. That exit timing rarely works out.

SPACs

The subject of Marks’s next thoughts is SPACS. SPACs, or Special Purpose Acquisition Companies, are “blank check companies” or “blind pools.”

They work like this: a shell company is created by founders. That company then goes public just like any other company does. The money raised from the IPO goes into a trust. It is later used to acquire a company or multiple companies. The acquired company (or companies) is now effectively publicly traded. They are often explored by VCs and startups that would like to go public but don’t want to pay the expensive fees associated with traditional IPOs.

A SPAC has an agreement with investors that if the SPAC managers don’t find a company within a specific time range, usually 18-24 months, then the money is returned to the investors in the SPAC.

Risk in SPACs

Marks says investing in SPACs is a “good example of miscalibration,” meaning that SPAC investors don’t balance “upside potential, downside risk, and who gets what well”. He says this for a few reasons.

First, investors in SPACs don’t know what their money will be used to acquire.

Second, if the SPAC cannot find a company to invest in, then the investor gets his money back after 18-24 months. That may sound good, but the investor has to pay fees on it. The investor also misses out on the duration of the SPAC’s time to find an investment. That investment could have grown for that time. So, the investor ultimately can lose money through fees and missed opportunities. That, again, relates to understanding the upside potential and downside risk.

Third, the founders of the SPAC, known as the sponsors, get 20% of any profits. There is no minimum return that investors in the SPAC must get paid before the founders get paid.

While Marks uses the example of SPACs to explain his thinking on the risk-reward balance, the case presented applies to other investments as well.

Losing Out?

One of the stories that Marks tells is about how Oaktree lost out on a loan to a bankrupt company. This bankrupt company had long-standing accounting problems, which led to an inability to issue audited financial statements. This company had an offer from Oaktree for a debtor-in-possession loan. This is a special kind of loan offered to bankrupt companies. But, before Oaktree could make that loan, another firm offered a larger loan with a cheaper interest rate. That offer was more appealing to the bankrupt company, so it went with it.

The other loan also included no provision for accounting due diligence, which is a process that accounts go through to ensure accounting is truly representing the company’s financial position. That is important, as the other firm was willing to take a greater risk to put more money to work with less information about the financial health of the company. The other firm, however, didn’t provide all of the money for the loan. Instead, it had “pre-syndicated,” which means it grouped with other firms to offer the loan. In fact, most of the loan was given not by the firm that beat Oaktree to the deal. Rather, hedge funds made up most of that loan.

The other firm, which was the managing lender, or the lender which administers the loan for the other lenders, limited its risk. The funds who bought the loan, the hedge funds, were exposed to much more risk. This story ties up to one of the points Marks is making in his memo about how paying more for less, which means more money is invested, is leading to looser standards and more risk in investments.

Wall Street’s Undying Creativity

Wall Street is known for its creativity when making new financial products. Marks describes the risks of these new products using the example of a CPDO, or Constant Proportion Debt Obligation. The CPDO is a close cousin of the infamous synthetic CDO.

CPDO Basics

The CPDO, initially issued in 2006, is an extremely complex financial instrument that, simply put, investors can buy to potentially earn high yields similar to that of junk bonds while offering the best possible credit rating.

Usually, high yields on debt are representative of higher risk and lower creditworthiness. But, the CPDO offers investors a high yield, LIBOR + 2%, with higher creditworthiness. They do so through overleveraging the portfolio funded by investors and rolling over poorly performing companies in the portfolio. LIBOR is a benchmark interest rate that banks use for loans to other banks. Offering a 2% addition to LIBOR appealed to investors in the CPDO because yields on other highly rated debt were not this high. Yet, the way the issuer manages the money is risky. The CPDO utilizes credit default swaps to bet that financially “healthy” companies will repay their debt. Credit default swaps are essentially insurance against a bond’s default.

The issuer earns any money the portfolio returns in excess of the promised LIBOR + 2% to investors and pay investors if companies in the portfolio default. The investors earn the promised LIBOR + 2%. Rolling over means that poorly performing companies in the portfolio are swapped out. This is beneficial for the issuer as they limit their risk of paying out. The issuer also promises to increase the amount of leverage in the portfolio if the portfolio loses value. Leverage refers to borrowed money used to invest. Leverage in the portfolio could reach up to 15 times the amount of money investors put into the CPDO.

Overleveraged CPDOs

CPDOs were extremely complex financial instruments. They attracted investors because of their promise of a high return at a perceived low risk because of high creditworthiness. But, the way the issuer of the CPDO achieved that high return was through taking on extremely large amounts of debt, which they could continue increasing. Rating agencies rate a CPDO based on the riskiness of the debt, which was perceived to be low, and on the predicted returns, which were initially satisfying agreements on this investment.

But, with overleveraging, these ratings weren’t truly accurate. A CPDO whose portfolio lost value, due to company defaults, would get its rating downgraded. But, the issuer can leverage it more, therefore increasing the projected returns with the larger amount of money that could be invested to earn more at a faster rate, and could get its rating upgraded. Effectively, more leverage on a portfolio increased its rating.

Marks questions this investment, as a more leveraged portfolio has more to debt to pay back. It therefore should have a higher risk of failing. So, with CPDOs, if the portfolio was failing with a certain amount of leverage, the issuer tried to recoup its losses with much more leverage in the same portfolio. Marks’s main point with CPDOs is that Wall Street creates complex financial products with risky foundations. CPDOs are based on those poor and risky foundations.

After the crisis, CPDOs stopped getting issued, but with the cyclical nature of markets, the spirit of the CPDO could be coming back to haunt investors who want to put more money to work at the expense of safety through similarly structured products.

Goodbye Due Diligence

Marks revisits the trend in looser standards in how lenders became more competitive through requiring less and less due diligence. A major investment bank told Marks that on most syndicated loans, or loans in which a group of lenders loan money, 70% of the lenders in the group never facilitated due diligence. Due diligence is the process of finding and analyzing as much information about an investment before actually making an investment. In the case of loans, lenders do due diligence on the borrower.

Because the market for loans was getting competitive, lenders decided not to analyze borrowers. Instead, they gave loans with a poor understanding of the creditworthiness of the borrower. Looser standards on creditworthiness caused by a desire to invest more and more money led to conditions for a crisis.

Private Equity

Marks takes a look at the deployment of capital in the private equity sector for his next example of an increased desire to put more money to work. According to the Financial Times, private equity funds invested 10% of the money they raised in 2002 within a year. In 2005, private equity funds invested 30% of the money they raised within a year. Marks estimates that the amount of money private equity raised in 2005 was 3 times that of the amount in 2002. That means that private equity invested 9 times more money in 2005 than they did in 2002 within one year. This is another example of the rush to invest more and more money caused by the high levels of optimism in the markets.

While Marks points out that the examples he used weren’t “evidence of misfeasance or terminal laxness by itself,” he does say that they describe an attitude favoring investing larger quantities of money for faster growth has prevailed over an attitude favoring proper safety and quality.

Covenants

The next section is about covenants, which is another word for rules and agreements set in place for an investment. There is no law mandating covenants, so covenants are a critical component in keeping creditors and bond investors safe. A bond investor would like the creditworthiness of companies they lend to remain unchanged. Good covenants will allow that to happen if certain conditions are met in regard to the company’s financial performance. Marks is saying that good covenants will protect bond investors. But, if people want to invest more money into bonds, they can do so by accepting less interest on the bond or by accepting weaker covenants, meaning looser standards for the company borrowing the money.

With the strictness of covenants, it depends on the supply and demand for credit. If demand for credit financing exceeds supply, or, in other words, if bond investors aren’t willing to invest as much as the companies in need of money want, then the bond investors can create covenants that ensure their protection as they have the negotiating power in this situation. But if the supply for credit financing exceeds demand, which means that more people are willing to buy into debt investments than companies want, then the companies have the negotiating power and can use it to create weaker covenants.

When this happens, bond buyers who are disciplined and seek protection with covenants have to compete with less disciplined, more risk-seeking bond buyers who accept more risk with less covenant protection for their investment. So, in order to stay competitive, the disciplined bond buyers must also lower the protection their covenants provide.

Gresham’s Law

Gresham’s Law is a principle of economics that states “bad money drives out good.”

With investing, the same principle holds true — bad investors drive out good ones. The higher risks the undisciplined bond investors are willing to take with weaker covenants forces disciplined bond buyers to also weaken their covenants, which will lead to looser standards on how companies that borrow money deal with debt. Marks points out that the quality of protection covenants offer indicates the market climate. This is because it ultimately represents the level of risk bond investors accept.

In specifying how covenants get weaker and weaker, Marks uses quotes from various sources that point to the fact that the competition to put out loans has led to less protection through covenants for lenders. This competition creates conditions that allow for a self-perpetuating cycle of erosion of covenants and, therefore, investor safety.

One of the short-term effects of what Marks describes as “generous capital market conditions,” what he has been describing the entire memo, is that more money is available to companies at a cheaper interest rate with fewer covenants. That leads to a higher level of financial activity, meaning more acquisitions, buyouts, etc.

Rewarding Uncreditworthiness

Another short-term effect is that financially weak companies can continue operating due to more money being available. That means those financially weak companies, given looser standards and conditions, work around default through forestalling. This often means postponing defaults, which has a snowball effect. The willingness for investors to finance uncreditworthy companies leads to more financial distress that companies, inevitably, will fall to. This leads Marks to his next conclusion: “the bigger the boom — the greater the excesses of the capital markets in the upward direction — the greater the bust.”

In other words, the greater the amount of money invested in highly risky investments such as uncreditworthy companies, the greater the loss will be when the optimism can’t sustain itself and companies begin to fail. Marks ties this to his view that the market operates on cycles. While the timing and extent of these cycles are not predictable, the fact that cycles occur is inevitable. When the cycle turns and the market falls, it will do so faster and harder than when it rose.

Market conditions in 2007, according to Marks, could be described as one in which investors are taking significantly more risk. This risk manifested itself in more leverage, less protection, and more complex financial products in hopes of adequate returns. These conditions describe a stage in the cycle where optimistic investors look smart. However, the ultimate outcome, according to Marks, is one in which the market crashes.

Conclusion

Marks invokes a quote from legendary economist John Kenneth Galbraith’s book, “A Short History of Financial Euphoria,” which basically says that history matters very little in the world of finance and that the lessons learned from financial disasters are often forgotten, and that conditions for financial disasters will arise again inevitably as history is disregarded. This quote is pretty spot-on for describing the financial crisis. The second quote is from Warren Buffett.

The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.
Warren Buffett

It means that investors must carefully judge the behavior that other investors engage in. They must also adjust their own behavior accordingly in regard to risk and safety. The greater the risk other investors are taking, the greater the caution and safety an investor should have.

Marks summarizes his memo by saying that there is an overall decline in the standards and safety investors are accepting and putting their money in. He goes onto say that the historical pattern is that with conditions of 2007, those who participated in excessive risk-taking and accepted looser standards were going to lose the most. And they did.