Howard Marks: "Markets Are Riskier Than At Any Time Since The Depths Of The 2008/9 Crisis"

Tyler Durden's picture

In Feb 2007, Oaktree Capital's Howard Marks wrote 'The Race to the Bottom', providing a timely warning about the capital market behavior that ultimately led to the mortgage meltdown of 2007 and the crisis of 2008 as he worried about "carelessness-induced behavior." In the pre-crisis years, as described in his 2007 memo, the race to the bottom manifested itself in a number of ways, and as Marks notes, "now we’re seeing another upswing in risky behavior." Simply put, Marks warns, "when people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed," adding that "the riskiest thing in the investment world is the belief that there’s no risk."

Excerpted from OakTree Capitals' Howards Marks most recent letter to investors:

Of all the cycles I write about, I feel the capital market cycle is among the most volatile, prone to some of the greatest extremes. It is also one of the most impactful for investors. In short, sometimes the credit window is open to anyone in search of capital (meaning dumb deals get done), and sometimes it slams shut (meaning even deserving companies can’t raise money).


The cycles I describe aren’t predictable as to timing or extent. However, their fluctuations absolutely can be counted on to recur, and that’s what matters to me. I think it’s also what Mark Twain had in mind when he said “History doesn’t repeat itself, but it does rhyme.” The details don’t repeat, but the rhyming patterns are extremely reliable.

Competing to Provide Capital

When the economy is doing well and companies’ profits are rising, people become increasingly comfortable making loans and investing in equity. As the environment becomes more salutary, lenders and investors enjoy gains. This makes them want to do more; gives them the capital to do it with; and makes them more aggressive. Since this happens to all of them at the same time, the competition to lend and invest becomes increasingly heated.

When investors and lenders want to make investments in greater quantity, I think it’s also inescapable that they become willing to accept lower quality. They don’t just provide more money on the same old terms; they also become willing – even eager – to do so on weaker terms. In fact, one way they strive to win the opportunity to put money to work is by doing increasingly dangerous things.

This behavior was the subject of The Race to the Bottom. In it I said to buy a painting in an auction, you have to be willing to pay the highest price. To buy a company, a share of stock or a building – or to make a loan – you also have to pay the highest price. And when the competition is heated, the bidding goes higher. This doesn’t always – or exclusively – result in a higher explicit price; for example, bonds rarely come to market at prices above par. Instead, paying the highest price may take the form of accepting a higher valuation parameter (e.g., a higher price/earnings ratio for a stock or a higher multiple of EBITDA for a buyout) or accepting a lower return (e.g., a lower yield for a bond or a lower capitalization rate for an office building).

Further, rather than paying more for the asset purchased, there are other ways for an investor or lender to get less for his money. This can come through tolerating a weaker deal structure or through an increase in risk. It’s primarily these latter elements – rather than securities merely getting pricier – with which this memo is concerned.

History Rhymes

In the pre-crisis years, as described in the 2007 memo, the race to the bottom manifested itself in a number of ways:

There was widespread acceptance of financial engineering techniques, some newly minted, such as derivatives creation, securitization, tranching and selling onward. These innovations resulted in the creation of such things as highly levered mortgage-backed securities, CDOs and CLOs (structured credit instruments offering tiered debt levels of varying riskiness); credit default swaps (enabling investors to place bets regarding the creditworthiness of debtors); and SPACs (Special Purpose Acquisition Companies, or blind-pool acquisition vehicles). Further, the development of derivatives, in particular, vastly increased the ease with which risk could be shouldered (often without a complete understanding) as well as the amount of risk that could be garnered per dollar of capital committed.


While not a novel development, there was an enormous upsurge in buyouts. These included the biggest deals ever; higher enterprise values as a multiple of cash flow; increased leverage ratios; and riskier, more cyclical target companies, such as semiconductor manufacturers.


There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for, and PIK-toggle debt on which the obligors could elect to pay interest “in kind” with additional securities rather than cash.


Finally, there was simply a willingness to buy riskier securities. Examples here included large quantities of CCC-rated debt, as well as debt issued to finance dividend payments and stock buybacks. The last two increase a company’s leverage without adding any productive assets that can help service the new debt.

Toward the end, my 2007 memo included the following paragraph:

Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. (emphasis in the original)

Now we’re seeing another upswing in risky behavior. It began surprisingly soon after the crisis (see Warning Flags, May 2010), spurred on by central bank policies that depressed the return on safe investments. It has gathered steam ever since, but not to anywhere near the same degree as in 2006-07.

  • Wall Street has, thus far, been less creative in terms of financial engineering innovations. I can’t think of a single new “modern miracle” that’s been popularized since the crisis.
  • Likewise, derivatives are off the front page and seem to be created at a much slower pace. A full resumption of derivatives creation and other forms of financial innovation appears to be on hold pending clarification of the regulatory uncertainty surrounding acceptable activity for banks.
  • Buyout activity seems relatively subdued. In 2006-07, it seemed a buyout in the tens of billions was being announced every week; now they’re quite scarce. Many smaller deals are taking place, however, including a large number of “flips” from one buyout fund to another, and leverage ratios have moved back up toward the highs of the last cycle.
  • “Cov-lite” and PIK-toggle debt issuance is in full flower, as are triple-Cs, dividend recaps and stock buybacks.

It’s highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:

  • global glut of liquidity – check
  • minimal interest in traditional investments – check (relatively little is expected today from Treasurys, high grade bonds or equities, encouraging investors to shift toward alternatives)
  • little apparent concern about risk – check
  • skimpy prospective returns everywhere – check

Risk tolerance and leverage haven’t returned to their pre-crisis highs in quantitative terms, but there’s no doubt in my mind that risk bearing is back in vogue.


Perhaps most tellingly, the November 19 Bloomberg story referenced above included the following observation from a strategist whom I’ll allow to go nameless: “The analysis at some point shifts from fundamentals to being purely based on the price action of the stock.” When people start to posit that fundamentals don’t matter and momentum will carry the day, it’s an omen we must heed.

While the extent is nowhere as dramatic as in 2006-07 – and the psychology behind it isn’t close to being as bullish or risk-blind – I certainly sense a significant increase in the acceptance of risk. The bottom line is that when risk aversion declines and the pursuit of return gathers steam, issuers can do things in the capital markets that are impossible in more prudent times.


Why Is Risk Bearing on the Rise, and What Are the Implications?

To set the scene for answering the above questions, I’m going to reiterate and pull together some observations from recent memos.

Psychologically and attitudinally, I don’t think the current capital market atmosphere bears much of a resemblance to that of 2006-07. Then I used words like “optimistic,” “ebullient” and “risk-oblivious” to describe the players. Returns on risky assets were running high, and a number of factors were cited as having eliminated risk:

  • The Fed was considered capable of restoring growth come what may.
  • A global “wall of liquidity” was coming toward us, derived from China’s and the oil producers’ excess reserves; it could be counted on to keep asset prices aloft.
  • The Wall Street miracles of securitization, tranching, selling onward and derivatives creation had “sliced and diced” risk so finely – and directed it where it could most readily be borne – that risk really didn’t require much thought.

In short, in those days, most people couldn’t imagine a way to lose money.

I believe most strongly that the riskiest thing in the investment world is the belief that there’s no risk. When that kind of sentiment prevails, investors will engage in otherwise-risky behavior. By doing so, they make the world a risky place. And that’s what happened in those pre-crisis years. When The New York Times asked a dozen people for articles about the cause of the crisis, I wrote one titled “Too Much Trust; Too Little Worry.” Certainly a dearth of fear and a resulting high degree of risk taking accurately characterize the pre-crisis environment. But that was then. It’s different today.

Today, unlike 2006-07, uncertainty is everywhere:

  • Will the rate of economic growth in the U.S. get back to its prior norm? Will unemployment fall to the old “structural” level?
  • Can America’s elected officials possibly reach agreement on long-term solutions to the problems of deficits and debt? Or will the national debt expand unchecked?
  • Will Europe improve in terms of GDP growth, competitiveness and fiscal governance? Will its leaders be able to reconcile the various nations’ opposing priorities?
  • Can Abenomics transform Japan’s economy from lethargy to dynamism? The policies appear on paper to be the right ones, but will they work?
  • Can China transition from a highly stimulated economy based on easy money, an excess of fixed investment and an overactive non-bank financial system, without producing a hard landing that keeps it from reaching its economic goals?
  • Can the emerging market economies prosper if demand from China and the developed world expands more slowly than in the past?

Looking at the world more thematically, a lot of questions surround the ability to manage economies and regulate growth:

  • Can low interest rates and high levels of money creation return economic growth rates to previous levels? (To date, the evidence is mixed.)
  • Can inflation be returned to a salutary level somewhat above that of today? Right now, insufficient inflation is the subject of complaints almost everywhere. Can the desired inflation rate be reinstated without going beyond, to undesirable levels?
  • Programs like Quantitative Easing are novel inventions. How much do we know about how to end them, and about what the effects of doing so will be? Will it prove possible to wind down the stimulus – the word du jour is “taper” – without jeopardizing today’s unsteady, non-dynamic recoveries? Can the central banks back off from interest rate suppression, bond buying and easy money policies without causing interest rates to rise enough to choke off growth?
  • How will governments reconcile the opposing goals of stimulating growth (lower taxes, increased spending) and reining in deficits (increased taxes, less spending)?
  • Will prosperous regions (e.g., Germany) continue to be willing to subsidize profligate and poorer ones (e.g., Spain and Portugal)?

As to investments:

  • When the Fed stops buying bonds, will interest rates rise a little or a lot? Does that mean bonds are unattractive?
  • Are U.S. stocks still attractive after having risen strongly over the last 18 months?
  • Ditto for real estate following its post-crash recovery?
  • Can private equity funds buy companies at attractive prices in an environment where few owners are motivated to sell?

As I’ve said before, most people are aware of these uncertainties. Unlike the smugness, complacency and obliviousness of the pre-crisis years, today few people are as confident as they used to be about their ability to predict the future, or as certain that it will be rosy. Nevertheless, many investors are accepting (or maybe pursuing) increased risk.

The reason, of course, is that they feel they have to. The actions of the central banks to lower interest rates to stimulate economies have made this a low-return world. This has caused investors to move out on the risk curve in pursuit of the returns they want or need. Investors who used to get 6% from Treasurys have turned to high yield bonds for such a return, and so forth.

Movement up the risk curve brings cash inflows to riskier markets. Those cash inflows increase demand, cause prices to rise, enhance short-term returns, and contribute to the pro-risk behavior described above. Through this process, the race to the bottom is renewed.

In short, it’s my belief that when investors take on added risks – whether because of increased optimism or because they’re coerced to do so (as now) – they often forget to apply the caution they should. That’s bad for them. But if we’re not cognizant of the implications, it can also be bad for the rest of us.

Where does investment risk come from? Not, in my view, primarily from companies, securities – pieces of paper – or institutions such as exchanges. No, in my view the greatest risk comes from prices that are too high relative to fundamentals. And how do prices get too high? Mainly because the actions of market participants take them there.

Among the many pendulums that swing in the investments world – such as between fear and greed, and between depression and euphoria – one of the most important is the swing between risk aversion and risk tolerance.

Risk aversion is the essential element in sane markets. People are supposed to prefer safety over uncertainty, all other things being equal. When investors are sufficiently risk averse, they’ll (a) approach risky investments with caution and skepticism, (b) perform thorough due diligence, incorporating conservative assumptions, and (c) demand healthy incremental return as compensation for accepting incremental risk. This sort of behavior makes the market a relatively safe place.

But when investors drop their risk aversion and become risk-tolerant instead, they turn bold and trusting, fail to do as much due diligence, base their analysis on aggressive assumptions, and forget to demand adequate risk premiums as a reward for bearing increased risk. The result is a more dangerous world where asset prices are higher, prospective returns are lower, risk is elevated, the quality and safety of new issues deteriorates, and the premium for bearing risk is insufficient.

It’s one of my first principles that we never know where we’re going – given the unreliability of macro forecasting – but we ought to know where we are. “Where we are” means what the temperature of the market is: Are investors risk-averse or risk-tolerant? Are they behaving cautiously or aggressively? And thus is the market a safe place or a risky one?

Certainly risk tolerance has been increasing of late; high returns on risky assets have encouraged more of the same; and the markets are becoming more heated. The bottom line varies from sector to sector, but I have no doubt that markets are riskier than at any other time since the depths of the crisis in late 2008 (for credit) or early 2009 (for equities), and they are becoming more so.


However, Marks has a silver lining,

No, I don’t think it’s time to bail out of the markets. Prices and valuation parameters are higher than they were a few years ago, and riskier behavior is observed. But what matters is the degree, and I don’t think it has reached the danger zone yet.


Over the last 2-3 years, my motto for Oaktree has been consistent: “move forward, but with caution."

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insanelysane's picture


I thought healthcare and education were free in Europe.  ???  Maybe you can run with this for our non-thanksgiving friends in the UK tomorrow while we are on holiday.


I am Jobe's picture

God Save the Queen , I say

Now repeat after me, God Save the Queen 


The man with pointy horns's picture

Nah! You silly twit you got the lyrics wrong! It should read;

God shave the Queen, God shave the Queen

The man with pointy horns's picture


Healthcare and education is NOT free in the UK because we brits pay for it via taxes, although -- as much as I despise taxes -- healthcare funded by taxation is better than the healthcare insurance system of the US (or at least the lesser of two evils).

Why? Dealing with banks is bad enough, dealing with his health insurance sharks would probably be just as bad.

Jlasoon's picture

Born and raised in Canada (Socialist Medecine). Both my wife and I left the Canadian system and we now live and work in Florida. Ill take no state income tax, low cost of living, and employment sponsored health insurance over that Canadian "Crapcare". What these countries are doing to people is inhumane and downright illogical all in the name of compassion. I wouldn't send my dog to a Canadian hospital. 

Lesser of 2 evils? And you pick the government run system LOL.  

runningman18's picture

We have government funded and administered healthcare in the U.S., at least for military veterans, and it runs just about as smoothly and transparently as the gov. run healthcare in the smooth...

BobRocket's picture

Those student loans were never meant to be repaid, they are created as undischargeable debt (which means AAA rated).

The (gov owned) student loans co. has a deliberate policy of being shit at collecting repayments, this is so that it can be sold cheaply to private financial institutions who take those AAA debts and use them as full value collateral at the central bank to borrow at .5%


Buy a $10bn AAA rated loan book for $3bn and use that to borrow $10bn in cash.


The degree is the vehicle for creating student debt in the same way that GM cars were a way to sell GMAC debt.


Education should be free to everyone at the point of delivery as it is self-financing and nett positive. (Graduates holders on average, in the UK, pay on average £50,000 more in income taxes over the working lifetime than non-graduates)



MrPoopypants's picture

But is the risk a market collapse in nominal terms? Or currency collapse along with markets that keep churning higher?

fonzannoon's picture

wow that was a lot of words to say BTFD

Groundhog Day's picture

The market will crash when Tyler capitulates

starman's picture

There are sheep and there are sheep herders. End of story.

bdub2's picture

The veritable lid must be blown off to such an extraordinary degree to turn this market. I'd thought trillions into this monstrosity with no effect, would signal yellow alert. Hell no.

This is the end. It will go beyond numbers. Trillions and Trillions. Until numbers are ridiculed. The End Game. And we're only in the sixth inning. No one. Has ever seen. Destruction like this. 


Debeachesand Jerseyshores's picture

Beware of the "7th Inning Stretch".

Oldwood's picture

If investors can ignore fundamentals and move forward with caution when so many have been eaten whole by the "corrections", what makes them think any amount of caution is adequate when they admit the fundamentals are screwed? It seems everyone is convinced that they can time this thing. Everyone is the exception to the rule. I'm surprised more don't smoke that they do given reality and statistics are always for the other guy.

Debeachesand Jerseyshores's picture

"move forward,but with caution".  But be prepare to abandon ship before the SHTF.

I am Jobe's picture

can it wait till after Christmas is what sheeples want to know? 

bdub2's picture

Schiff, soon, should apologize to Laffer. Laffer for Fed Charwomen's exec council.

spinone's picture

I'm feeling greedy.  I should have bought Bitcoin.  Watching the bears capitulate, feeling like I'm missing the the DOW boat.  I know that CAPE is overbought, but its different this time.  Feeling greedy.....

When you're feeling greedy and think its different this time, sell.  When you're scared shitless and want to dump everything you have, its time to buy.

chump666's picture

China ready to blow:

*Chinese 10-yr govt bond yield hit 4.72% last week, highest since 2005


Everybodys All American's picture

Now that's interesting. I'm guessing they aren't ready to be the reserve currency nation just yet ...

chump666's picture

With their debt load.  That and China is eating into it's reserves like no tomorrow. 

What China will most likely do to payback Obama meddling with the South/East China sea dispute with Japan, is boycott the USD, issue widespread capital controls, just deal with the Yuan.  I'd say they are setting that up now.

Spanky's picture

My wife managed regional clinical operations for a very large multinational ALF operator. Management was poor by any objective standard, with only a few facilities and regions making any money, many barely breaking even, and most (over 60%) in the red.

Negative cash flow was dismissed as a by-product of an aggressive growth strategy, but direct observation suggested it was a lack of experience and poor business management (aided by cronyism) in addition to the chaos of a contentious three-way merger and the additional confusion of several other large property acquisitions. But the parent company and its hedge fund owners had ready access to cash, announcing three to four $30-150M loans and refinancings each year to fund both their operations and acquisitions during her tenure.

Having observed the reindeer games at close range, once consolidation was achieved vis-a-vie the merger, management proceeded to cannibalize their ranks based on personal loyalties and former company affiliation. In this factionalized environment, it became less important how good a manager was than where their personal loyalties lay. This state of affairs persisted, and many otherwise competent first and second line managers were sacked as the suites restocked their staffs with the supposedly faithful.

My point? We owned some shares. Once fully aware of their fundamentals, however, we sold them last year only to watch in amazement as it rose over $10 per share... The region my wife once managed profitably (one of only three consistently profitable regions in the U.S. during her tenure) is now in the red. The constant shuffle of first and second line management continues, along with substantial and increasing quantities of red ink, but as long as GE piplines them cheap cash the suites (and stockholders) seem content -- Laissez les bons temps rouler!

Escapeclaws's picture

Great article! Main idea I garnered from the article is that the Fed's QE is the Fed's way of opposing market forces. Martin Armstrong is adamant that market forces always prevail in the long run. Thus QE is bound to fail. But from Mike Malone we see that QE is a scheme for transfering money from you and me to the owners of the Fed. So from their point of view it is immaterial if QE ultimately fails. What counts is getting every last dime out of the middle class. The beauty of this is that they appear to be trying to SAVE the economy. Meanwhile, as the above article shows, everyone is forced into risking what remains of their wealth in the "buy low, sell high market for the rich/buy high, sell low market for 401k defined contribution plan holders". We can assume that QE will continue as long as there are assets to be plundered. (Basic thesis here--which I hereby christen the "duck principle"-- is that if it looks like a duck, walks like a duck, and talks like a duck, then you are on reasonably secure grounds, epistomologically speaking, in treating it as if it were a duck.)