Howard Marks on Credit Cycles

Substitute direct lending for high yield and add an element of technological creative destruction, and you have some of the same dynamics (including another war in the Middle East sparking fears of recession). Ultimately, high yield was fine (even great), and direct lending will be as well, but it may have to go through a credit cycle to get to a better place.2026

We saw a very strong reaction in this case: notably, the stock prices of some prominent alternative asset managers were down 5-7% on October 16, close on the heels of the regional banks’ disclosures. The truth is that there are always defaults and not infrequently defalcations (how’s that for a good old- fashioned word?) Over my 47 years in the high yield bond market, more than 2% of all bonds by value have defaulted in a typical year, and many more during crises. If you apply that percentage to the number of sub-investment grade issuers, which runs in the thousands, it shouldn’t come as a surprise if there are a few dozen defaults in a normal year. So no, I don’t think this is necessarily the beginning of a trend. It’s not an indictment of the whole sub- investment grade debt market, or the whole private credit market. Rather, it’s just a reminder that the yield spreads people care about so much are there for a reason: because sub-investment grade debt entails credit risk. And thus a reminder that credit skills are always a necessity for debt investors . . . even if the need for those skills isn’t apparent in good times. The Cycle in Attitudes Toward Risk In 2016, when I first sat down to write my book Mastering the Market Cycle: Getting the Odds on Your Side, I had an idea what topics I would cover – the economic cycle, the profit cycle, the cycle in investor psychology, the credit cycle, the distressed debt cycle, and the real estate cycle.

That’s an inevitable part of life when your business consists of knowingly bearing credit risk for profit. But these caveats don’t keep the First Brands case from proving a valuable opportunity for learning. What are the key takeaways? • Defaults are a normal part of life in sub-investment grade investing. • However, bullish conditions in good times usually lead to a lowering of lending standards, giving rise to elevated defaults and an occasional fraud. • It’s absolutely essential to always balance the desire to put money to work with the need for prudence. • Superior credit analysis is a matter of second-level thinking – thinking that’s different from that of others and better – based on a mosaic of information and inferences. • In detecting credit defects, the big payoff is for being early. If you reach a negative conclusion at the same time as everyone else, the price you’ll get for your holdings is likely to be marked down to fully reflect the negatives – that’s market efficiency. • It’s important to note that whereas private credit has been the rage of late, all else being equal, it’s great to hold public debt that can be exited more readily if you sour on the credit. We’ve lived through generally good times in the last 16 years. The coming period is likely to be more “interesting,” as errors that were made in those good times come to light. On the other hand, the frauds described above have probably chastened lenders and investors, putting them on alert.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Memo to: Oaktree Clients From: Howard Marks Re: Easy Money The backstory: I began writing these memos in 1990 and continued to do so for ten years despite never receiving a single response. Then, on the first business day of 2000, I published bubble.com, a memo with warnings about excesses in the tech sector that turned out to be timely. The inspiration for the memo came from a book I’d read the preceding autumn: Devil Take the Hindmost: A History of Financial Speculation, by Edward Chancellor, an account of speculative excesses starting with the South Sea Bubble of the early 1700s. The book’s description of behavior surrounding the mania for the South Sea Company jibed with what I was seeing in the tech/media/telecom bubble that was underway. I received excellent feedback on the memo from clients – encouragement that prompted the many memos that have followed. I consider it highly coincidental that 24 years later, I devoted another autumn to reading another Chancellor book, The Price of Time: The Real Story of Interest, his history of interest rates and central bank behavior. I thank Zach Kessler, a regular memo reader, for sending it. The relevance of The Price of Time to the trends I’ve been discussing for the last year occasions this memo. * * * In December 2022, I published Sea Change, a memo that primarily discussed the 13-year period from the end of 2008, when the U.S.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • easy and cheap to lever investments; • easy and cheap for businesses to obtain financing; and • easy to avoid default and bankruptcy. In short, these were easy times, fueled by easy money. Like travelers on the moving walkway, it was easy for businesspeople and investors to think they were doing a great job all on their own. In particular, market participants got a lot of help in this period as they rode the 10-year-plus bull market, the longest in U.S. history. Many disregarded the benefits that ensued from low interest rates. But as one of the oldest investment adages says, we should never confuse brains with a bull market. As I’ve continued to think and talk about the switch from declining and/or ultra-low interest rates to more normal, stable ones, I’ve emphasized the fact that low rates alter investor behavior, distorting it in ways that have serious consequences. Thinking about the change in interest rates sensitized me to media mentions of low rates, and I’ve noticed many. This was particularly true following Silicon Valley Bank’s meltdown last March, which many articles attributed to faulty managerial decisions made “during the preceding period of easy money.” More recently, there’s been much discussion of the less-favorable outlook for private equity, usually related to expectations that interest rates aren’t going to return to the low levels of the recent past.

The effects of low interest rates are multi-faceted and ubiquitous, yet frequently overlooked. I became more conscious of them as I read The Price of Time, and I want to catalog them here: i. Low interest rates stimulate the economy Everyone knows that when central banks want to stimulate their countries’ economies, they cut interest rates. Lower rates reduce costs for businesses and put money into the hands of consumers. For example, since most people buy cars on credit or lease them, lower interest rates make cars more affordable, increasing demand. The result is typically good for automakers, their suppliers, and their workers, and thus for the economy in general. It’s important to realize that easy money keeps the economy aloft, at least temporarily. But low interest rates can make the economy grow too fast, bringing on higher inflation and increasing the probability that rates will have to be raised to fight it, discouraging further economic activity. This oscillation of interest rates between extremes can have effects and encourage behavior that natural/neutral rates (see p. 13) would be less likely to induce. ii. Low interest rates reduce perceived opportunity costs Opportunity cost is a major consideration in most financial decisions. But in low-interest-rate environments, the rate earned on cash balances is minimal.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: speculation. Long periods of easy money, wrote Fullarton, engender “a wild spirit of speculation and adventure.” Fullarton noted that financial euphoria occurred after a period of falling interest rates: “From the Bubble year [i.e., the South Sea Bubble of 1720] downwards, I question much if an instance could be shown of any great or concurrent speculative movement on the part of capitalists, which had not been preceded by a marked decline of the current rate of interest.” (TPOT) The risk-free rate is the point of origin, or jumping-off point, for returns and risk premia. When a central bank cuts the risk-free rate: • the rest of the yield curve usually follows; • the capital market line governing asset-class returns also shifts downward, especially if the desire for higher returns in the low-return environment causes riskier investments to be aggressively pursued as described above; • in addition to moving lower, the capital market line also can flatten, reducing risk premia, if investors are paying little heed to fundamental/credit risk; and • the liquidity premium – the increment in expected return for owning illiquid rather than readily saleable assets – can also shrink, as return-seeking investors embrace illiquid investments. In all these ways, the return increments associated with longer-term, riskier, or less-liquid assets can become inadequate to fully compensate for the increase in risk.

Nevertheless, the low prospective returns on safe securities cause investors to look past these factors and lower their standards, encouraging speculation and causing questionable investments to be made in pursuit of higher returns: For [Austrian-school economist Friedrich] Hayek, it was axiomatic, but all too often overlooked, that “all economic activity is carried out through time.” When interest rates decline, he said, businesses are inclined to invest in projects with more distant payoffs – in Hayek’s terminology, the “structure of production” lengthens. If interest rates are kept below their natural level [see p. 13], misguided investments occur: too much time is used in production, or, put another way, the investment returns don’t justify the initial outlay. “Malinvestment”, to use a term popularized by Austrian economists, comes in many shapes and sizes. It might involve some expensive white-elephant project, such as constructing a tunnel under the sea, or a pie-in-the-sky technology scheme with no serious prospect of ever turning a profit. (TPOT, emphasis added; the quotation is from 1928) I’ll provide a few examples of imprudent investments made during the recent easy money period: • In the low-return environment of 2017, Argentina once again became the poster child for questionable investment opportunities, when it offered 100-year bonds. As I asked at the time in my memo There They Go Again . . .

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: January’s memo Easy Money: The Manchester Banker John Mills commented perceptively [in 1865] that “as a rule, panics do not destroy capital; they merely reveal the extent to which it has previously been destroyed by [the taking on of excessive leverage in good times].” Using Debt Prudently As with so many aspects of investing, determining the proper amount of leverage has to be a function of optimizing, not maximizing. Given that leverage magnifies gains when there are gains and that investors only invest when they expect there to be gains, it can be tempting to think the right amount of leverage is “all you can get.” But if you bear in mind (a) leverage’s potential to magnify losses when there are losses and (b) the risk of ruin under extreme negative circumstances, investors should usually use less than the maximum available. Successful investments, perhaps enhanced by the moderate use of leverage, should usually provide a good-enough return – something few people think about in good times. Here’s how I summed it up in Volatility + Leverage = Dynamite: Clearly, it’s difficult to always use the right amount of leverage, because it’s difficult to be sure you’re allowing sufficiently for risk. Leverage should only be used on the basis of demonstrably cautious assumptions.

Under easy-money conditions, long-dated bonds may appear particularly desirable; since the yield curve usually slopes upward, they typically offer higher yields. It should be noted, however, that long bonds are more rate-sensitive than short ones, meaning their prices change more in response to a given change in interest rates. As a result, the higher yields on more- volatile long bonds can attract capital in times of low rates, just when the odds usually favor a subsequent increase in yields (and thus a rapid decline in long bond prices). It seems to me that there’s often a similar movement of capital toward “long stocks” when interest rates are low. By this I mean the stocks of companies believed to have many years of rapid growth ahead. For these companies, more of the projected cash flows are, by definition, in the distant future. Yet, investors may become more attracted to these stocks when rates are low because they want the higher returns that such rapid growth would bring, and there’s less opportunity cost associated with the long wait for the relevant cash flows. (These sound like Hayek’s “projects with more distant payoffs.” See the quote on the previous page.) Just as the prices of longer bonds fluctuate more in response to a given change in interest rates, so-called “growth stocks” usually rise more than others in times of easy money and fall more when money dries up. The former was certainly the case in late 2020 and in 2021 . . . and the latter in 2022.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: v. Low rates enable deals to be financed readily and cheaply Related to the above, low rates make people more willing to lend for risky propositions. Providers of capital vie to be the one who gets the deal. To compete for deals, the “winner” must be willing to accept low returns from possibly questionable projects and reduced safety, including weaker documentation. For this reason, it’s often said that “the worst of loans are made at the best of times.” The availability of capital fluctuates radically. Whereas in times of stringency, capital may not be available even to quality borrowers for valid purposes, in periods of easy money, capital typically becomes available to weaker borrowers, in large amounts, for almost any purpose. Things that couldn’t be financed in tighter times are deemed acceptable. For one example, consider the shifting perception of high-tech companies. Prior to roughly 2005, they were usually considered too undependable to be creditworthy, since outcomes for tech investments are generally asymmetric. If the company succeeds, the equity owners get rich. If it fails, there’s little asset value for creditors to recover. But in the years following the tech/media/telecom meltdown of 2000-02, when interest in public equities declined and large sums flooded into private equity funds, tech companies began to be bought out, often with financing from the newly popular field of private credit.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: politics. A central bank’s decision to set rates that subsidize some and penalize others clearly has consequences. x. Low rates induce optimistic behavior that lays the groundwork for the next crisis Elevated risk taking, underestimating future financing costs, and increased use of leverage often lie behind investments that fail when tested in subsequent periods of stringency, bringing on the next crisis and perhaps the need for the next rescue. In this way, excesses in one direction typically precede excesses in the other direction. In October 1889, the Governor of the Bank of England, William Lidderdale, delivered a stern warning to the City: The present tendency of finance . . . is distinctly in the direction of danger, too much capital is being forced into industrial developments, financiers are taking larger & larger risks in securities which require prosperity & easy money to carry without becoming a burden, & an increased number of investments have been driven up in price by the combined efforts of a long period of cheap money & depression in trade . . . we have most of the elements of a Crisis. (TPOT) The Never-Ending Story One of the quotes I return to most frequently is Mark Twain’s purported observation that “history doesn’t repeat itself, but it often rhymes.

” For investors, cycles, along with their causes and effects, are among the influential matters that invariably rhyme from one period to the next. Roughly 30 years ago – largely thanks to my involvement with my partner Bruce Karsh and his distressed debt funds – I became much more conscious of the importance of fluctuations in the availability and cost of money. Thus, I wrote as follows in my memo You Can’t Predict. You Can Prepare. (November 2002): The longer I’m involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself. I reused that paragraph in my 2018 book Mastering the Market Cycle: Getting the Odds on Your Side, adding this: . . . the credit cycle can be easily understood through the metaphor of a window. In short, sometimes it’s open and sometimes it’s closed. And, in fact, people in the financial world make frequent reference to just that: “the credit window,” as in “the place you go to borrow money.” When the window is open, financing is plentiful and easily obtained, and when it’s closed, financing is scarce and hard to get. . . . © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• First, stimulative rate cuts bring on easy money and positive market developments; • which reduce prospective returns; • which leads to willingness to bear increased risk; • which results in unwise decisions and, eventually, investment losses; • which bring on a period of fear, stringency, tight money, and economic contraction; • which leads to stimulative rate cuts, easy money, and positive market developments. Here’s an especially trenchant observation on the cyclical process: The Manchester banker John Mills commented perceptively [in 1865] that “as a rule, panics do not destroy capital; they merely reveal the extent to which it has previously been destroyed by its betrayal into hopelessly unproductive works.” (TPOT, emphasis added) As readers know, I believe investors can gain an advantage by studying cycles, understanding their causes, and watching for excesses in one direction that are likely to lead to corrections in the opposite direction. Walter Bagehot, the editor of The Economist in the 1860s, is described as having demonstrated an exceptional understanding of cycles and cycle-related behavior: . . . our modern monetary mandarins never stop to consider Bagehot’s warnings about the adverse consequences of easy money – how interest rates set at 2 per cent or less fuel speculative manias, drive savers to make risky investments, encourage bad lending and weaken the financial system.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Easy Money Observed The behavior brought on by low rates takes place in plain sight. Some people take note of it, and a subset of them talk about it rather than let it pass unremarked. Fewer still understand its real implications. And almost no one alters their investment approach to take them into account. The low-rate period that immediately preceded the Global Financial Crisis of 2008-09 was marked by the kind of spirited competition to make investments and provide financing described above. It was in this climate that Chuck Prince, then CEO of Citi, made the statement for which he is remembered: When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. (July 14, 2007) When money is easy, few people opt to sit out the dance, even though the adverse results described above can reasonably be anticipated. When faced with the choice between (a) maintaining high standards and missing deals and (b) making risky investments, most people will choose the latter. Professional investment managers especially may fear the consequences of idiosyncratic behavior that’s bound to look wrong for a while. Abstaining demands uncommon strength when doing so means departing from herd behavior.

And this gives me a great opportunity to reference one of my favorite quotations from John Kenneth Galbraith’s wonderful book on market excesses: Contributing to and supporting this euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten. . . . There can be few fields of human endeavor in which history counts for so little as in the world of finance. (A Short History of Financial Euphoria) The lessons from past periods of easy money usually fall on deaf ears since they come up against (a) ignorance of history, (b) the dream of profit, (c) the fear of missing out, and (d) the ability of cognitive dissonance to make people dismiss information that is inconsistent with their beliefs or perceived self-interest. These things are invariably enough to discourage prudence in times of low interest rates, despite the likely consequences. As you no doubt know, Charlie Munger passed away on November 28 at the age of 99. I want to pay a small tribute to Charlie’s life and wisdom by sharing something he wrote me in 2001: “Maybe we have a new version of Lord Acton’s law: easy money corrupts, and really easy money corrupts absolutely.” Will We Go Back to Easy Money? Before I turn to the above question, I want to answer the one I’m asked most often these days: “Are you saying interest rates are going to be higher for longer?

This rate, which is neither stimulative nor restrictive, has most recently been estimated to be 2.5%. • The Fed might want to get out of the business of controlling rates and let supply and demand set the price of money, which hasn’t been the case for a quarter century. • Having had a taste of inflation for the first time in decades, the Fed might keep the fed funds rate high enough to avoid encouraging another bout. To control inflation, one would think the rate would need to be kept positive in real terms. If inflation will be, say, 2.5%, the fed funds rate would by definition have to be above that. • Perhaps most importantly, one of the Fed’s essential jobs is to enact stimulative monetary policy if the economy falls into recession, largely by cutting rates. It can’t do that effectively if the rate is already zero or 1%. To this list, I would add a few more reasons for not returning to ultra-low interest rates, including the tendency of easy money to (a) induce risk taking and “malinvestment”; (b) encourage increased use of leverage; (c) produce asset bubbles; and (d) create economic winners and losers. Finally, cutting rates to stimulative territory as soon as inflation hits 2% could cause it to reaccelerate. Instead, the plan should be to get inflation to 2% and then keep rates at a level that is neither stimulative nor restrictive.

(TPOT) Even though it cannot be known with certainty, it is useful to hold in mind how the world would look if the natural rate held sway; . . . a rate that accurately reflects society’s time preference; which ensures that we neither borrow too much nor save too little; which ensures capital is used efficiently, and puts an accurate value on land and other assets; a rate which provides savers with a fair return and is not so low as to subsidize bankers and their financial friends, nor so high as to bite borrowers. (TPOT) Or as the central bank head of Germany said in 1927, a time when his counterparts in the U.S. and Great Britain were arguing for easy money, “Don’t give me a low rate, give me a true rate, and then I shall know how to keep my house in order.” (TPOT) Natural rates seem to me to be related to but not quite the same thing as “neutral rates,” which are rates that are neither stimulative nor restrictive. Neutral rates are less likely than administered rates to be super-high or super-low, and thus less likely to encourage extreme behavior. As Swedish economist Knut Wicksell said in 1936: . . . if the rate of interest was too low, credit would expand rapidly, and inflation would appear. On the other hand, if the rate was kept too high, credit would contract and prices would decline.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * The upshot of my sea change thesis is simple: 1. The period from 1980 through 2021 was generally one of declining and/or ultra-low interest rates. 2. This had profound ramifications in many areas, including determining which investment strategies would be the winners and losers. 3. That changed in 2022, when the Fed was forced to begin raising interest rates to combat inflation. 4. We’re unlikely to go back to such easy money conditions, other than temporarily in response to recessions. 5. Therefore, the investment environment in the coming years will feature higher interest rates than those we saw in 2009-21. Different strategies will outperform in the period ahead, and thus a different asset allocation is called for. Bullet points one through three above are statements of fact and not controvertible. Consequently, the conclusion – number five – depends exclusively on whether number four is correct. The question is simple: do you agree with it or don’t you? If you agree, we have a host of solutions to propose. January 9, 2024 © 2024 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED

In other words, after a long period when everything was unusually easy in the world of investing, something closer to normalcy is likely to set in. Please note that I’m not saying interest rates, having declined by 2,000 basis points over the last 40 or so years, are going back up to the levels seen in the 1980s. In fact, I see no reason why short-term interest rates five years from now should be appreciably higher than they are today. But still, I think the easy times – and easy money – are largely over. How can I best communicate what I’m talking about? Try this: Five years ago, an investor went to the bank for a loan, and the banker said, “We’ll give you $800 million at 5%.” Now the loan has to be refinanced, and the banker says, “We’ll give you $500 million at 8%.” That means the investor’s cost of capital is up, his net return on the investment is down (or negative), and he has a $300 million hole to fill. What Strategies Will Work Best? It seems obvious that if certain strategies were the best performers in a period with a given set of characteristics, it must be true that a starkly different environment will produce a dramatically altered list of winners. • As mentioned above in the recap of Sea Change, the 40 years of low and declining interest rates were hugely beneficial for asset owners. Declining discount rates and the associated reduction in the competitiveness of bond returns led to substantial asset appreciation.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: While I want to state clearly that I’m not an expert on banks or their regulation, I think the similarities between 2008 and 2023 are limited to the mere fact that, in both instances, problems existed at a few financial institutions. I find the common elements mostly superficial. What follows are the differences. By far most importantly, the GFC occurred for the simple reason that investors and financial institutions experienced temporary insanity with respect to residential mortgages. They: • accepted unquestioningly that mortgages’ low-default history could be extrapolated; • forced massive amounts of money into the mortgage market; • loaned lots of it to subprime borrowers who couldn’t or wouldn’t document income or assets; • built tranched and levered mortgage-backed securities using subprime mortgages; and • in many cases, invested their own capital in the riskiest tranches of the RMBS to enable the formation process to be repeated. These parties ignored the possibility that excessive faith in mortgages – and the resultant lowering of lending standards – could precipitate massive numbers of mortgage defaults. Further, they ignored the fragility of the structured securities built out of those mortgages.

• Remember that in extreme times, because of the above, the secret to making money lies in contrarianism, not conformity. When emotional investors take an extreme view of an asset’s future and, as a result, take the price to unjustified levels, the “easy money” is usually made by doing the opposite. This is, however, very different from simply diverging from the consensus all the time. Indeed, most of the time, the consensus is as close to right as most individuals can get. So to be successful at contrarianism, you have to understand (a) what the herd is doing, (b) why it’s doing it, (c) what’s wrong with it, and (d) what should be done instead and why. • Bear in mind that much of what happens in economies and markets doesn’t result from a mechanical process, but from the to and fro of investors’ emotions. Take note of the swings and capitalize whenever possible. • Resist your own emotionality. Stand apart from the crowd and its psychology; don’t join in! © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

For most of my career, the prevailing assumption was that interest rates were destined to remain low forever. Bonds offered yield, central banks were predictable, and the macro backdrop felt like an immutable fact of investing life. That assumption now looks like it belongs to a chapter that has closed rather than a permanent feature of the environment. The shift from a forty-year tailwind for falling rates into a regime where inflation has returned and policy is being aggressively tightened is not a cyclical fluctuation — it is a sea change. The implications ripple across every asset class. The discount rate that anchors valuation has moved materially higher, dragging down the present value of distant cash flows. The cost of leverage, the price of optionality, and the math of buyouts all reprice. Investors who built portfolios on the assumption that capital would remain cheap must now reckon with the reality that the spread between safe and risky assets has narrowed at exactly the wrong time. What I keep emphasizing is that a sea change is not a forecast of doom — it is a call to revise assumptions that no longer hold. The dominant market regime of the prior four decades was an aberration in financial history, not its natural state. Acknowledging this is the prerequisite for sensible forward-looking decisions, even when those decisions are uncomfortable to make.

Credit cycles are driven by the pendulum between fear and greed. For most of the post-2008 era, the pendulum sat squarely on the side of greed — capital was abundant, covenants were loose, and access to financing was assumed. The pendulum's swing back toward fear, even modestly, exposes everything that was financed under optimistic assumptions. Loan structures designed for a low-default world face their first real test. Liquidity is the asset that matters most when credit conditions tighten because it is the optionality that lets an investor act rather than react. Many investors learned in 2022 that the liquidity they assumed was on call from credit facilities and prime brokers had been pulled. The illusion of liquidity is the most expensive discovery an investor can make at exactly the moment when actual liquidity matters most. What we have observed across cycles is that the firms which pre-arranged financing, kept dry powder available, and resisted the temptation to deploy fully into late-cycle exuberance were the ones able to act when the cycle turned. Sea Change is, in part, a reminder that the credit cycle has not been repealed — it was merely suspended, and the suspension has ended.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The anticipated effect of that recession on earnings dampened investors’ spirits. Thus, the fall of the S&P 500 over the first nine months of 2022 rivaled the greatest full-year declines of the last century. (It has now recovered a fair bit.) • The expectation of a recession also increased the fear of rising debt defaults. • New security issuance became difficult. • Having committed to fund buyouts in a lower-interest-rate environment, banks found themselves with many billions of dollars of “hung” bridge loans unsaleable at par. These loans have saddled the banks with big losses. • These hung loans forced banks to reduce the amounts they could commit to new deals, making it harder for buyers to finance acquisitions. The progression of events described above caused pessimism to take over from optimism. The market characterized by easy money and upbeat borrowers and asset owners disappeared; now lenders and buyers held better cards. Credit investors became able to demand higher returns and better creditor protections. The list of candidates for distress – loans and bonds offering yield spreads of more than 1,000 basis points over Treasurys – grew from dozens to hundreds.

We’ve never had such a catalyst for technology adoption as we’ve had in the coronavirus pandemic. We’ve had a boom of new public companies coming to market, both through IPOs and SPACs, reversing the long trend of a shrinkage in the number of public companies. We’ve never had interest rates as low as they are and as likely to stay low for as long as has been telegraphed. The Internet has permeated the world and changed it, and business models have evolved in a way that makes today’s situation incomparable to the Nifty Fifty or the Dot Com Bubble of the late ’90s (for example, in 1998 there were 150 million Internet users globally; today there are more than that in Indonesia alone). I believe most types of investment are likely to go through periods of both outperformance and underperformance. There are reasons to believe (with ample counterarguments) that as the tide turns on monetary policy (if it ever does), rising interest rates will disproportionately hurt growth stocks, just as they’ve been disproportionately helped during this period of easy money. More importantly, it has long been true that when something works, people follow the herd, chase the gains, and bid it up to the point where prospective returns are paltry, thus positioning investments that have been out of favor to become the new outperformers. But, as I said earlier, broad observations about historic valuations are not a sufficient foundation for market opinions today.

 The Fed and Treasury have taken other extraordinary actions to aid market functioning and financial system liquidity. The commercial paper market will be supported. Tax holidays and asset purchases are possible.  Banks are likely to be hard-hit as a result of borrowers’ defaults or moratoria on customers’ payments. Thus we’re highly likely to see steps designed to bolster the solvency of financial institutions and the availability of credit. Since banks need equity, dividends could be prohibited/discouraged. Economists and forecasters are still plentiful – the challenging environment hasn’t created a shortage there – and each one has an opinion. I never know which ones are right, but I find myself drawn to the views of Conrad DeQuadros of Brean Capital: In addition to Sunday’s actions [cutting rates and initiating asset purchases], the alphabet soup of liquidity facilities is back with the relaunch of the Commercial Paper Funding Facility and the Primary Dealer Credit Facility yesterday. With the PDCF, dealers can even pledge equities to the Fed, with only a 16% haircut, and receive a 90-day loan at 0.25%. Non-investment grade corporate debt gets a 20% haircut. We also have continued actions by the Fed to encourage discount window loans. A key difference between now and 2008 is the speed with which the Fed is launching these facilities. In 2008, the PDCF was rolled out in March, the CPFF in October, and the first round of Large-Scale Asset Purchases in November.

In my view, the macro uncertainties, high valuations and risky investor behavior rule out aggressiveness and render defensiveness more sensible. For one thing, I’m convinced the easy money has been made. For example, the S&P 500 has roughly quadrupled, including income, from its low in 2009. It was certainly easier for the p/e ratio to go from the low teens in 2011-12 to 25 today than it would be for it to double again from here. Thus the one thing we can say for sure is that the current prospects for making money in U.S. equities aren’t what they were half a dozen years ago. And if that’s the case, isn’t it appropriate to take less risk in equities than one took six years ago? Prospective returns are well below normal for virtually every asset class. Thus I don’t see a reason to be aggressive. Some investors may adopt an aggressive stance to be in the riskiest (and thus hopefully the highest-returning) assets; to squeeze out the last drop of return as the markets continue to rise (under the assumption they’ll be able to get out at the top, something that’s present in every strongly rising market); or to achieve a high return in this low-return world. I don’t view any of those as good ideas. © 2018 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: * * * In memos and presentations over the last 14 months, I’ve made reference to some specific aspects of the investment environment. These have included:  the FAANG companies (Facebook, Amazon, Apple, Netflix and Google/Alphabet), whose stock prices incorporated lofty expectations for future growth;  corporate credit, where the amounts outstanding were increasing, debt ratios were rising, covenants were disappearing, and yield spreads were shrinking;  emerging market debt, where yields were below those on U.S. high yield bonds for only the third time in history;  SoftBank, which was organizing a $100 billion fund for technology investment;  private equity, which was able to raise more capital than at any other time in history; and  cryptocurrencies led by Bitcoin, which appreciated by 1,400% in 2017. I didn’t cite these things to criticize them or to blow the whistle on something amiss. Rather I did so because phenomena like these tell me the market is being driven by:  optimism,  trust in the future,  faith in investments and investment managers,  a low level of skepticism, and  risk tolerance, not risk aversion. In short, attributes like these don’t make for a positive climate for returns and safety. Assuming you have the requisite capital and nerve, the big and relatively easy money in investing is made when prices are low, pessimism is widespread and investors are fleeing from risk.

But I think this continues to be a time to incorporate a good helping of defensiveness in portfolio management. Being fully invested in a cautious portfolio has been an appropriate stance over the last few years. It gave Oaktree performance that in general was respectable or better. Aggressiveness would have produced higher returns, of course, but I don’t think it could have been justified a priori. (Is an incorrect decision one that didn’t work out well, or one that was wrong at the time it was made? I insist it’s the latter, as you know.) And today? What has changed? To the four descriptors of the investment environment listed above, I would add three more:  the economy is strengthening, not slowing, and Washington is supporting its progress,  prices are even higher and valuation metrics have moved up,  and, as I said, the easy money has been made. Thus the current environment is still mixed – better fundamentally and worse price-wise. The positive near-term economic outlook, lowness of interest rates, need of most investors for return and moderate psychology all seem to suggest it would be a mistake to get out. On the other hand, the extremely high asset prices, macro-fragility and risky behavior going on all around us argue for considerable caution.

That makes this form of lending less attractive than it used to be, all else being equal. Has direct lending reached the point at which it’s wrong to do? Nothing in the investment world is a good idea or a bad idea per se. It all depends on when it’s being done, and at what price and terms, and whether the person doing it has enough skill to take advantage of the mistakes of others, or so little skill that he or she is the one committing the mistakes. At the present time, the managers raising and investing large funds are showing the most growth. But in the eventual economic correction, they may be shown to have pursued asset growth and management fees over the ability to be selective regarding the credits they backed. Lending standards and credit skills are seldom tested in positive times like we’ve been enjoying. That’s what Warren Buffett had in mind when he said, “It’s only when the tide goes out that you learn who has been swimming naked.” Skillful, disciplined, careful lenders are likely to get through the next recession and credit crunch. Less-skilled managers may not. Signs of the Times Unfortunately, there is no single reliable gauge that one can look to for an indication of whether market participants’ behavior at a point in time is prudent or imprudent. All we can do is assemble anecdotal evidence and try to draw the correct inferences from it. Here are a few observations regarding the current environment (all relating to the U.S.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: And as I told CNBC, what matters is “the level that securities are trading at and the emotion that is embodied in prices.” Investors’ actions should be governed by the relationship between each asset’s price and its intrinsic value. “It’s not what’s going on; it’s how it’s priced. . . . When we’re getting value cheap, we should be aggressive; when we’re getting value expensive, we should pull back.” Here’s how I summed up on Bloomberg: It’s all about investors’ willingness to take risk as opposed to insisting on safety. And when people are highly willing to take risk, and not concerned about safety, that’s when I get worried. If it’s true, as I believe, that (a) the easy money in this cycle has been made, (b) the world is a risky place, and (c) securities are priced high, then people should probably be taking less risk today than they did three, five or seven years ago. Not “out,” but “less risk” and “more caution.” And from my visit to CNBC: All I’m saying is that prices are elevated; prospective returns are low; risks are high; people are engaging in risky behavior. Now nobody disagrees with any of the four of those, and if not, then it seems to me that this is a time for increased caution. . . . It’s maybe “in, but maybe a little less than you used to be in.” Or maybe “in as much as you used to be in, but with less-risky securities.

Certain consequences are implied, but even if they’re going to happen, we have no way of knowing when. It feels like we’re in the eighth inning, but I have no idea how long the game will go on.  I’m never sure of my market observations. As you’ll see in my new book, I believe strongly that where we are in a cycle says a lot about the market’s likely tendencies, but I never state opinions on this subject with high confidence.  As a natural worrier, I tend to be early with warnings, as described on page one. ’Nuff said.  Finally, while my observations are uncertain and should be taken with a grain of salt, what I am sure of is that valuations and markets are elevated, and the easy money in this cycle has been made. What to Do To me, the four components of the current environment listed on pages 2 and 3 – high uncertainty, low prospective returns, high prices and pro-risk behavior – are indisputable. The question is whether you agree. If so, I trust you’ll grant that they make for a troubling combination. Markets normally respond to elevated uncertainty with lower asset prices and compensatorily higher returns. But not today. Thus we’re living in a low-return, high-risk world. Period. For that reason, this might seem like an attractive time to refrain from investing, or at least from bearing risk.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: It’s Not Easy In 2011, as I was putting the finishing touches on my book The Most Important Thing, I was fortunate to have one of my occasional lunches with Charlie Munger. As it ended and I got up to go, he said something about investing that I keep going back to: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” As usual, Charlie packed a great deal of wisdom into just a few words. Let’s take the first six: “It’s not supposed to be easy.” While it’s pretty simple to achieve average results, it shouldn’t be easy to make superior investments and earn outsized returns. John Kenneth Galbraith said something similar years ago: There is nothing reliable to be learned about making money. If there were, study would be intense and everyone with a positive IQ would be rich. What Charlie and Professor Galbraith meant is this: Everyone wants to make money, and especially to find the sure thing or “silver bullet” that will allow them to do it without commensurate risk. Thus they work hard (actually, study is intense), searching for bargain securities and approaches that will give them an edge. They buy up the bargains and apply the approaches. The result is that the efforts of these market participants tend to drive out opportunities for easy money. Securities become more fairly priced, and free lunches become harder to find.

© Oaktree Capital Management, L.P. All Rights Reserved.  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?

© Oaktree Capital Management, L.P. All Rights Reserved. Economic growth doesn’t just happen. Its vigor depends on a combination of population gains, a conducive infrastructure, positive aspiration and profit motive, advances in technology and productivity, and benign exogenous developments. In many ways and to varying degrees, I think the future for these things in the U.S. is less good than it was in the past. The birthrate is down; our infrastructure is out of date; it’s uncertain whether technology can add as much to productivity in the future as it has in the recent past (but perhaps it always is); and mobility up the income curve has stagnated. I think a lot about the role of deficit spending and credit. In the forty or so years leading up to the crisis of 2008, consumers could grow their spending faster than their incomes because of the increasing availability of credit (and their increasing willingness to make use of it). Likewise, generous capital markets greatly facilitated deficit spending on the part of governments. Economic units around the world were able to spend money they didn’t have and thus buy things they couldn’t afford. This made a big contribution to economic growth, but few people recognized the negative implications: increased leverage, increased dependency on the continued generosity of the capital markets, and thus increased precariousness. In other words, unwise behavior in the short run led directly to problems in the long run.

© Oaktree Capital Management, L.P. All Rights Reserved. o what will be done, and o what the ramifications will be, especially the second-order consequences. I imagine Europe’s leaders will muddle through, continuing to do the absolute minimum that suffices at the last possible moment. There will be palliatives, but solutions will be hard to achieve (the latter would require the nations of Europe to significantly surrender sovereignty). Last week the European Central Bank announced a program of bond buying, and this was viewed positively. Buying bonds will keep borrowing costs down for as long as it’s practiced, but it won’t solve the problems. The important tasks facing the peripheral nations are much greater: cutting deficits and policing them, reducing the excessive debt burden that was allowed to build up, and restoring growth and competitiveness. Thus the problem is likely to drag on for years, assuming it doesn’t flare up into a global crisis. Everyone hopes Europe will do what’s needed, but hope isn’t much of a plan.  The U.S. fiscal situation is less acute, less immediate, and easier to duck given that we can print the world’s reserve currency . . . but little better. In fact, in some ways it is more dangerous because the problems are more back-end loaded and perhaps less overt. Our politicians, too, used easy money to give everyone everything: generous benefit programs as well as significant tax reductions (and major stimulus programs when needed).

” (The New York Times, August 9) The European Version The problem in Europe isn’t overwhelmingly different, just manifested differently. In the credit boom of the last forty years, debtors all around the world – nations as well as states and cities, consumers, home buyers and buyout companies – borrowed amounts that they couldn’t repay now if required to do so. The key questions are whether the loans will be renewed, or who’ll pay them off, or how they’ll otherwise be discharged. Only the details vary from instance to instance. As I described in “It’s Greek to Me” (July 2010), for years, especially thanks to their membership in the European Union, peripheral nations with weak economies and little fiscal discipline were able to borrow sums disproportionate to their incomes. Thus Greece, Portugal, Spain and others could run continuous deficits to support excessively generous programs with features such as retirement ages in the fifties and a thirteenth month of pay each year. Lenders were unconcerned about the impossibility of repayment, it seemed, until early 2010. But then they awoke. Economically stronger nations such as Germany and France, on the other hand, applied much greater prudence. They and their citizens and financial institutions didn’t participate as much in the trend toward over-borrowing, and thus don’t share the © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

When the economy and markets boom, people tend to assume more of the same is in the offing. They find little to worry about, other than the possibility that others will make more money than they will. Fear of loss recedes, and fear of opportunity costs takes over. Thus risk aversion evaporates and risk tolerance rises. Risk aversion is absolutely essential in order for markets to function properly. When sufficient risk aversion is present, people shrink from riskier investments and prefer safer ones. Thus riskier investments have to appear to offer higher returns in order to attract capital. That’s as it should be. But when people get excited about the prospect of easy money – even if from assets or investment strategies that have become far too popular, turning into overpriced manias – they frequently drop their risk aversion and adopt risk tolerance instead. Thus they swarm into the investment du jour without concern for its elevated price and risk. This behavior should constitute an important warning flag for prudent investors. © Oaktree Capital Management, L.P.Reserved

it goes. If it works well this time, readers may conclude that in the future they can fashion their own memos from bits and pieces of my old ones. The Credit Cycle at Work Consider this: the ups and downs of economies are usually blamed for fluctuations in corporate profits, and fluctuations in profits for the rise and fall of securities markets. However, in recessions and recoveries, economic growth usually deviates from its trendline rate by only a few percentage points. Why, then, do corporate profits increase and decrease so much more? The answer lies in things like financial leverage and operating leverage, which magnify the impact on profits of rising and falling revenues. And if profits fluctuate this way – more than GDP, but still relatively moderately – why is it that securities markets soar and collapse so dramatically? I attribute this to fluctuations in psychology and, in particular, to the profound influence of psychology on the availability of capital. In short, whereas economies fluctuate a little and profits a fair bit, the credit window opens wide and then slams shut . . . thus the title of this memo. I believe the credit cycle is the most volatile of the cycles and has the greatest impact. Thus it deserves a great deal of attention. In “The Happy Medium,” I discussed the workings of the credit cycle in creating market extremes: Looking for the cause of a market extreme usually requires rewinding the videotape of the credit cycle a few months or years.

Impact of the Credit Cycle The section above describes how the capital cycle functions. My goal below is to describe its effect. From time to time, providers of capital simply turn the spigot on or off – as in so many things, to excess. There are times when anyone can get any amount of capital for any purpose, and times when even the most deserving borrowers can’t access reasonable amounts for worthwhile projects. The behavior of the capital markets is a great indicator of where we stand in terms of psychology and a great contributor to the supply of investment bargains. (“The Happy Medium”) © Oaktree Capital Management, L.P.Reserved

An uptight capital market usually stems from, leads to or connotes things like these:  Fear of losing money.  Heightened risk aversion and skepticism.  Unwillingness to lend and invest regardless of merit.  Shortages of capital everywhere.  Economic contraction and difficulty refinancing debt.  Defaults, bankruptcies and restructurings.  Low asset prices, high potential returns, low risk and excessive risk premiums. On the other hand, a generous capital market is usually associated with the following:  Fear of missing out on profitable opportunities.  Reduced risk aversion and skepticism (and, accordingly, reduced due diligence).  Too much money chasing too few deals.  Willingness to buy securities in increased quantity.  Willingness to buy securities of reduced quality.  High asset prices, low prospective returns, high risk and skimpy risk premiums. The point about the quality of new issue securities in a wide-open capital market deserves particular attention. A decrease in risk aversion and skepticism – and increased focus on making sure opportunities aren’t missed rather than on avoiding losses – makes investors open to a greater quantity of issuance. The same factors make investors willing to buy issues of lower quality. When the credit cycle is in its expansion phase, the statistics on new issuance make clear that investors are buying new issues in greater amounts. But the acceptance of securities of lower quality is a bit more subtle.

The results are well known: the first three-year decline for stocks since the Great Depression; a peak-to-trough decline of 51% for the S&P 500; massive losses for tech investors; shrunken 401-k accounts; and general disillusionment with stocks. Basically, I think equity investors had their hearts broken, as happens from time to time in the investment world. The promise of easy money turned out to be empty – as usual – and investors who had adopted overblown expectations promised “never again.” A good economy, low interest rates and resurgent general psychology brought stocks back between 2002 and 2007, but just to their 2000 peak. Versus the 11% prospective return they were sure of in 1999, by 2003 many investors expected only 6-7% from stocks (despite the fact that they were now much cheaper). With the bloom off the rose, people looked elsewhere – to private equity, real estate, hedge funds and mortgage backed securities, for example – for the next solution. I didn’t hear any investors say, “We don’t have enough stocks.” Their glory truly had faded. But having recovered to their previous high, stocks were buffeted again in the credit crisis. They fell 58% from their 2007 peak to their 2009 trough. Stocks weren’t singled out for punishment; non-government bonds, real estate, mortgage securities and private equity all shared the pain as panic and loss of confidence were everywhere. © Oaktree Capital Management, L.P.Reserved

While there are credit ratings and covenants to look at, it can take effort and inference to understand the significance of these things. In feeding frenzies caused by excess availability of funds, recognizing and resisting this trend seems to be beyond the majority of market participants. This is one of the many reasons why the aftermath of an overly generous capital market includes losses, economic contraction and a subsequent unwillingness to lend. The bottom line of all of the above is that generous credit markets usually are associated with elevated asset prices and subsequent losses, while credit crunches produce bargain-basement prices and great profit opportunities. The Events of the Past Decade The last several years have provided a typical example of the credit cycle at work – typical in its pattern, that is, but unique in its extent and impact. The highs in risk tolerance, credulity, financial innovation and leverage seen between 2004 and early 2007 gave rise to a credit crunch in late 2007 and 2008 – the © Oaktree Capital Management, L.P.Reserved

It’s not for nothing that they say “The worst of loans are made in the best of times.” The inspiration for today’s memo came as my pile of clippings began to swell with indications that pre-crisis behavior is coming back. Here are excerpts from a few, with emphasis added in each case: On covenant-lite loans – Are debt investors just stupid? That might help explain why they’re buying covenant-lite loans again. These deals, which carry few restrictions on borrowers, became a standard bearer for easy money. They may have helped some companies limp through the downturn – but they’ve left lenders saddled with lots of risk and little return. It’s easy to see why companies like covenant-lite loans. . . . But for owners of the debt, the attraction is far less clear beyond the familiar short-term reach for yield. . . . © Oaktree Capital Management, L.P.Reserved

the top of the credit boom. Caution is warranted when investors remove their trigger locks. (“Do you feel lucky?” breakingviews, March 31) On initial public offerings – It is springtime for IPOs. . . . KKR and Bain, two of the most aggressive private-equity firms during the buyout boom, are now as aggressively looking to cash out. They are leading what is expected to be a season of IPOs as long as the markets continue to stabilize or climb. The IPOs would allow the firms to partially cash out their stakes and return money to investors. They also could use the proceeds to pay down the sizable debt used to finance the takeovers. (“Bain, KKR to Push New Crop of IPOs,” The Wall Street Journal, April 9) On leveraged loans – Even as worries escalate about the ability of highly rated countries to fund themselves, there is a buzz at the other end of the credit spectrum. Leveraged loans, a source of funding for private-equity acquisitions, are drawing investor interest again after a long period in the doldrums. In the U.S., there are signs of life in the collateralized-loan-obligation market, with the year’s first deal not only refinancing an existing CLO but bringing in new money, too. In Europe, HarbourVest Partners is launching a listed fund to invest in mid-market leveraged loans. Leveraged-finance bankers are more bullish, and new loans have started to flow. . . .

They tend to think of the future in terms of a single scenario, whereas it really consists of a wide range of possibilities. (Remember Elroy Dimson’s trenchant observation that “risk means more things can happen than will happen.”) And to the extent they do consider a variety of possibilities, few people include ones that haven’t been part of recent experience. The uncertainties discussed above tell me today’s distribution of possibilities has a substantial left-hand (i.e., negative) tail, probably greater than at most times in the past. The proper response should be to discount asset prices, allowing a substantial margin for error. Forecasts should be conservative, yield spreads should incorporate ample risk premiums, valuation parameters should be below the long-term norms, and investor behavior should be prudent. And yet, the powerful rally of 2009 has more than offset the decline of 2008 in many asset classes. To the extent that the resultant valuations incorporate optimism, I would argue for caution today. A lot of “easy money” was made last year; in retrospect, all you had to do was have access to capital and the guts required to invest it at the absurd low prices of late 2008/early 2009 and hold on during the wild recovery. Of course, those things were far from easy at the time. The profits ahead won’t be easy money.

Such boom/bust sequences do not arise very often, but when they do, they can be very disruptive, exactly because they affect the fundamentals of the economy. . . . (George Soros, MIT Department of Economics World Economy Laboratory Conference, Washington, D.C., April 26, 1994) My son Andrew, now starting his investment career, has provided an illustration of reflexivity at work that’s clear and topical. For several years prior to the crisis, the desire for high returns with low risk (what else is new?) created strong demand for mortgage-based investment products such as RMBS and CDOs. Underpinning it all was the fact that there had never been a nationwide decline in home prices, and thus participants were confident that geographic diversification would render levered mortgage pools safe, warranting triple-A ratings for most of the resulting securities. Rising demand for these products required an increasing volume of underlying mortgages. This need caused lending standards to be weakened and loans to be provided to home buyers with dubious creditworthiness. Easy financing allowed buyers to bid up home prices to levels that exceeded the homes’ realistic values and made it tough for borrowers to make their mortgage payments. When the perpetual-motion machine of house appreciation ground to a halt in 2007, the combination of too-high prices and record mortgage defaults resulted in the first nationwide decline in home prices.

© Oaktree Capital Management, L.P. All Rights Reserved  to use past statistical averages – sometimes covering brief time periods – to gauge the safety of prospective investments,  to partake in financial innovation and invest in things too complex or opaque to be understood,  to believe that risk had been banished, most recently through securitization, tranching and decoupling,  to forgo liquidity,  to make increasing use of leverage (see separate section below),  to finance investment activities with undependable capital: short-term borrowings and deposits, impermanent equity, and future cash receipts,  to forget to worry and be risk-averse, and thus  to accept additional risk at shrinking risk premiums. The “era of increasing willingness” carried many trends to higher highs. The last ten listed above were the prime ingredients giving rise to the current crisis. Together they produced an investment house of cards that was enormously dependent on continued prosperity, bullishness and easy money. Expansiveness In addition to “willingness,” one of the most significant trends during the period under discussion has been a massive increase in “expansiveness,” my new label for the desire to increase the ratio of activity to capital. If that sounds unfamiliar, the common term in America is “leverage,” and in England it’s “gearing.” My last memo was on the subject of leverage and its major role in the crisis we’re all experiencing.

Those who expand the scope of their operations on the basis of borrowed money should always consider the possibility that lenders will change their mind. Use of Debt in the Corporate World Note three things regarding debt. First, all businesses borrow. Debt is used broadly to finance things ranging from inventories to capital investment. If companies had to wait to get paid by buyers before ordering new goods to sell, business would go much slower. And if all their capital had to be equity, capital would be much more costly and companies would be much smaller. Borrowing makes the business world go ’round. Second, debt is rarely repaid. Businesses rarely reduce their total indebtedness. Rather than being paid off, debt is simply rolled over. That makes the solvency of the borrowers contingent on the continuous availability of credit. Third, given that the yield curve normally slopes upward, short-term borrowing is almost always the least expensive. That’s what led First National City Bank to invent commercial paper in the 1960s, enabling companies to borrow at short-term rates through short-dated paper that would be renewed every month or so. The upward slope of the yield curve encourages people to borrow short even when investing long, resulting in economic maximization when they’re able to roll over their debts but disaster when they aren’t.

Likewise, a fatally flawed investment product can easily survive until it’s tested in a bear market. The extensive investment innovation of 2003-07 was driven by the poor performance of stocks in 2000-02 and the low yields available on high grade bonds. A large number of new products and strategies emerged, increasing in popularity in a salutary environment. Few investors were troubled by the products’ dependence on high leverage or suddenly commonplace triple-A ratings, or by the fact that they hadn’t been tested in tough times. It’s not surprising that bull market developments were defrocked in the tougher times of 2007- 08, but it’s somewhat shocking how many examples there are. It turned out that:  losses on investments involving leverage, illiquidity or risky assets could be much worse than the “worst case” that had been predicted,  beta had been confused for alpha, just as leverage had for value added,  there was nothing absolute about “absolute return,” and “market neutral” strategies were correlated with the market,  the “golden age of private equity” had been a function of easy money, not bargain purchases,  sharing the upside with investment managers isn’t sufficient to align their interests with those of their clients, and  things that “should happen” often don’t. While an extreme case, the story of Bernie Madoff presents an apt example of this phenomenon.

© Oaktree Capital Management, L.P. All Rights Reserved confidence in him, but they couldn’t get money they needed from other funds that had put up gates, or they didn’t want to sell other investments that, unlike Bernie’s, were showing big losses. So Madoff received requests for $7 billion of withdrawals, an amount he simply couldn’t raise from new suckers, and his nakedness became apparent. The Madoff story exemplifies the ability of ill-founded investments to prosper in bull markets, and the role of bear markets in exposing them. Now that the tide has gone out, many pre- crisis miracles have been exposed as non-value based, overly dependent on prosperity and easy money, pro-cyclical, over-hyped or just plain flawed. Hopefully next time, investors will give more thought to how their bull-market dalliances will fare when the tide goes out. The Opposite of a Bubble On the heels of the lessons regarding the run-up to the crash, the latter part of 2008 provided several lessons about behavior in times of crisis. With the fundamental outlook terrible, psychology depressed and technical conditions featuring a great deal of forced selling, that period represented one of the greatest buying opportunities I’ve ever seen. I expressed my view that, having been too optimistic before the crash, people were now taking things too far on the downside. It’s not easy to resist emotional excesses at highs and lows, but it’s by doing so that the best investment decisions can be made: . . .

© Oaktree Capital Management, L.P. All Rights Reserved Thus, you can imagine my reaction upon reading the following in the Financial Times of April 8: First-time buyers with no cash savings were shut out of the housing market yesterday after Abbey became the last mainstream lender to stop offering 100 per cent mortgages. Borrowers who a month ago had a choice of mortgages offering 100 per cent of a property’s value, will now need a deposit of at least 5 per cent . . . More than 20 lenders . . . offered 100 per cent mortgages at the start of last month. These have been pulled out of the market one by one as banks and building societies have distanced themselves from riskier lending. Eighteen months ago, Abbey was the first to take lending standards to a new low in terms of times-salary-loaned. Now, it’s the last to raise them with regard to down payments. Can there be a clearer example of the credit cycle at work? For now, high-risk, no-worries lending seems to be a dead duck, a casualty of the corrections in risk aversion and demanded returns that have accompanied – or are at the root of – the current credit crunch. At the highs of the credit cycle, anyone can get money for any purpose. At the lows, even deserving borrowers are shut out. The former is highly expansionary, and the latter depresses economic activity. It’ll always be so. UThe Canard of Free Market Infallibility “Canard” is the French word for “duck.

When they marshaled data with which to prove to customers and rating agencies that CDOs were secure, did they consider the data’s sparseness or limited relevance? Did they fail to disclose information regarding the “exceptions” in CDO portfolios – mortgages that didn’t meet minimum lending standards – as the New York Attorney General is investigating (WSJ, January 31)? Some of the same questions can be asked about the role of CDO managers. I haven’t been close to the process – Oaktree didn’t have any involvement – but I believe managers met with investment bankers who offered a near-turnkey proposal: “Here’s how it works. The documents are ready to go. We have the assets in inventory. The debt is teed up for issuance. Your fees will be x million per billion.” Did the managers vet the process? Did they undertake an independent effort to gauge the risks? Or did they just sign on to the magical fee machine? Next up, in my opinion, are the credit rating agencies. In summary, everything was wrong with the process through which CDO debt was rated, a process fed by the agencies’ hunger for profit. The agencies worked with CDO sponsors to design the products, so how could they then be objective in evaluating them? They accepted payment from the companies whose offerings they were rating; they all did, but that doesn’t mean the arrangement left them objective. They competed for the business, with the fees going to the agency that would assign the highest rating.

In sum, entities that had borrowed short to invest in longer-term, potentially illiquid assets fell victim to their funding mismatch. The precariousness of this position is easy to overlook when all is going well, asset prices are firm and capital is freely available. But it regularly leads to ruin when financial crises take hold.  With these developments, psychology turned from positive to negative overnight. Lenders became more nervous, requiring repayments, raising lending standards and refusing to roll over maturing loans. In particular, there was a dramatic contraction in the market for commercial paper backed by assets (rather than by promises from creditworthy firms).  Among other things, the investment banks found their balance sheets clogged with debt for buyouts that they had promised to place (“bridge loans”) before the music stopped, and the debt became unsalable on the agreed terms. This cut into their ability to make new loans. Discount sales were talked of, and funds were formed to buy up the loans.  Central banks stepped in to calm the waters. The European bank injected significant capital. The Fed cut short-term rates. The Bank of England guaranteed deposits at Northern Rock, a building society (S&L), and extended emergency loans. And so the panic eased. The reaction seemed to be “boy, I’m glad that’s over.” But the calm lasted only from early September to mid-October.

© Oaktree Capital Management, L.P. All Rights Reserved understand. Consumer confidence is at low levels, and fewer Americans expect an improving future. Much of the growth in consumer spending has been abetted by the more widespread availability of credit. Now, less credit should mean less spending. These aren’t the conditions for a vibrant economy. There’s a strong consensus that we’ll see a recession – and a possibility we’re in one already. GDP grew in the first quarter, but final sales were down and output increased only because businesses added to inventories. These additions likely were involuntary, and when stopped or reversed, GDP growth certainly could go negative. Please note that a depressed economy isn’t the end of the line. Slower consumer and industrial activity could feed back to the beginning of the process, causing further house price depreciation, further write-downs, a further credit contraction and so forth. And then, when levels get low enough, something mysteriously will cause the cycle to turn positive. Things don’t happen in isolation in economies and markets. Birds do flock together. The implications of past events will spread further. UPhoenix from the Ashes? As always, there’s a tug-of-war going on between the optimists and the pessimists. This time, however, the stakes are unusually high and the rhetoric proportional to the potentially momentous consequences.

© Oaktree Capital Management, L.P. All Rights Reserved defaults or economic weakness. Mortgages will continue to go unpaid, and the numbers may accelerate if interest rates take adjustable-rate loan payments higher and if house prices continue to fall. Further, nothing that was done in March will preclude economic slowdown, falling corporate profits or defaults on debt. Finally, it doesn’t seem to have done much for the availability of credit. Several elements are likely to remain – or become – further depressants:  Bank write-downs will continue to be reported. The majority of the banks’ subprime- related losses may have surfaced as relate to the current level of house price depreciation and mortgage default. That doesn’t mean these trends won’t go further, and thus that the reservoir of unreported losses won’t be refilled. The IMF has projected total mortgage- related losses of $1 trillion. Certainly the write-downs announced to date haven’t approached that figure. And there’s a broad consensus that most holders haven’t been as forthcoming on this subject as the U.S. banks. Progress is being made toward breaking the logjam, but we’re not done yet, and there continue to be additions to the backlog. As banks report large write-downs, I can’t help but sense that the immediate reaction is, “I wonder how much more remains.” Only when people stop thinking that way will real progress have been made toward easing the credit crunch.

 Similarly, sales of “hung” bridge loans are increasing, and clearly some investment banks are willing to take their medicine with regard to the extent to which loans bought in 2006 and 2007 are unsalable at par. Recently we have seen sales at 90, often with financing provided by the sellers. But just as in the case of mortgage losses, it’s quite possible that new obligations to lend will re-burden the financial institutions’ balance sheets, as companies draw against the excess credit lines that were arranged at the time they changed hands in buyouts.  The availability of credit is still a question mark, although things seem to be getting better. Despite the Fed’s low rates and all central banks’ massive injections of liquidity, inter-bank interest rates still incorporate significant yield spreads and volumes are limited. On April 28, the Financial Times quoted John Maynard Keynes: Whilst the weakening of credit is sufficient to bring about a collapse, its strengthening, though a necessary condition of recovery, is not a sufficient condition. In other words, the FT said, “just because the banks are not going bust does not mean that they can lend as before – nor would they if they could.”  Commercial real estate prices, like home prices, are coming off irrational highs achieved because of the oversupply of investment capital in the last few years. The coincidence of a broad real estate collapse with a significant recession has the potential to make this a painful episode.

A lot of this is because people seem to think everything’s good and likely to stay that way. UCycles in the World of Investing The basics of cycles are simple. The economic cycle gives rise to recessions and recoveries, creating the business environment. This produces a business cycle marked by rising and falling sales and profits. The credit cycle swings more radically, such that capital market conditions alternate between irrationally generous and unfairly restrictive. Likewise, market cycles fluctuate much more than do the more “fundamental” economic and business cycles, due largely to the volatile cycle in investor psychology. In this latter regard, I’ll reprint a few paragraphs from “First Quarter Performance,” the 1991 memo cited above. I think they capture investors’ pattern of behavior. The mood swings of the securities markets resemble the movement of a pendulum. Although the midpoint of its arc best describes the location of the pendulum “on average,” it actually spends very little of its time there. Instead, it is almost always swinging toward or away from the extremes of its arc. But whenever the pendulum is near either extreme, it is inevitable that it will move back toward the midpoint sooner or later. In fact, it is the movement toward the extreme itself that supplies the energy for the swing back.

© Oaktree Capital Management, L.P. All Rights Reserved making of those loans didn’t create the problem. Rather, it’s the fact that both borrowing and lending decisions were quite poor and in many cases misguided. As I described in “It’s All Good,” loan originators and mortgage brokers were incentivized by fees to generate loan volume and often were able to do so without having to risk their own capital. They were paid to produce quantity, not quality, and – surprise! – they did. Capital providers’ lack of concern regarding creditworthiness enabled borrowers to borrow more than they could repay and more than was justified under prudent lending standards . . . at adjustable rates even if the borrowers couldn’t withstand an upward adjustment . . . often supported by inadequate documentation regarding incomes and assets. Deficiencies in due diligence even permitted numerous cases of mortgage fraud, where borrowers bought houses, marked them up through sales to related parties, and then borrowed against them in amounts far in excess of their actual value (and their cost). It’s not surprising that these circumstances combined to produce a high volume of deficient loans. In fact, it would be amazing if they hadn’t. Who could have looked at this system without expecting this outcome? Okay – bad loans were made, and delinquencies and foreclosures have been rising among the weakest of mortgage borrowers.

© Oaktree Capital Management, L.P. All Rights Reserved A system designed to distribute and absorb risk might, instead, have bred it, by making it so easy for investors to buy complex securities they didn’t fully understand. (The Wall Street Journal, August 7) [Loans] are now often bundled into securities that are sold in pieces to investors around the world, changing hands many times. It spreads risk, which policy makers believe keeps the overall financial system sound and stable. But the downside to this system could be serious. (WSJ, August 10) “The market appears to be finding it harder to truly understand the inherent and underlying risks involved,” [according to Chris Rexworthy, a former regulator with Britain’s FSA]. The backlash is particularly sharp abroad, in countries that were surprised to find that problems with United States homeowners could be felt so keenly in their home markets. (New York Times, August 31) “Low volatility has created complacency, and that has translated into poorly structured derivative markets,” says Randall Dodd, director of the Financial Policy Forum . . . The low volatility world of the past few years may have worsened the situation, leading to lax lending standards for derivative investors. (WSJ, August 2) It is estimated that there are seven times as many credit derivatives outstanding as there are outstanding bonds. You need to ask the question: is risk being transferred or created?

It’s the capital layer that absorbs the first blow in tough times without occasioning an event of default. While leverage may magnify gains in good times, it’s a healthy layer of equity that gets companies through the bad times. It’s inescapable that, all other things equal, greater leverage increases a company’s likelihood of experiencing financial distress. Thus, with lenders enjoying a carefree recent experience and consequently financing some unwise deals – and with borrowers eager for the enhanced upside potential that comes with leverage – it seems clear that we’ll see rising rates of default and bankruptcy a few years down the pike. This is especially true if, as has often been the case recently, debt is incurred not just to leverage the company’s equity, but to finance payouts to equity holders that reduce or eliminate the equity. So then, are private equity funds – raising much more equity capital than ever, and doing the biggest deals in history at a rapid-fire pace, at rising transaction prices and rising leverage ratios – doing a smart thing or making a mistake? It all depends on how you look at things. The funds seem to be looking in terms of optionality. UKetchup, Easy Money and Optionality I was a picky eater when I was a kid, but I loved ketchup, and my pickiness could be overcome with ketchup. I would eat hamburgers, frankfurters, veal cutlets, filet of sole and frozen fish sticks, but as far as I was concerned, they were all just vehicles for ketchup.

© Oaktree Capital Management, L.P. All Rights Reserved I think the credit cycle that began around 2002 will go down as one of the most extreme on record and be the subject of discussion for years to come. It is one of the most important, potentially most serious financial episodes I’ve witnessed, and it presents a great learning experience. (Of course, it’s said that “experience is what you got when you didn’t get what you wanted.”) People were blindsided this summer when the financial markets went wobbly in just a few weeks on the basis of unhappiness in a remote corner of the mortgage market. But nothing that happened should have come as a surprise. While the details of each financial crisis may seem new and different, the major themes behind them are usually the same, and several were repeated in the current cycle. Not one of the following twelve lessons is specific to 2007 or to subprime mortgages or CDOs. And each one is something I’ve seen at work before. 1. Too much capital availability makes money flow to the wrong places. When capital is scarce and in demand, investors are faced with allocation choices regarding the best use for their capital, and they get to make their decisions with patience and discipline. But when there’s too much capital chasing too few ideas, investments will be made that do not deserve to be made. 2. When capital goes where it shouldn’t, bad things happen. In times of capital market stringency, deserving borrowers are turned away.

It certainly seems inevitable that, eventually, investment merit becomes overpriced, and the combination of good results and easy money causes dangerous leverage to be employed in the pursuit of profit. When will market cycles be banished or made more muted? That’ll happen when greed, human failings and herd behavior are eliminated. Or, in other words, never. In “You Can’t Predict. You Can Prepare.” I wrote of cycles that success carries within itself the seeds of failure, and failure carries the seeds of success. It’ll always be so.2007

© Oaktree Capital Management, L.P. All Rights Reserved Discussions with market participants raised questions as to whether the increased focus on structuring skills, relative to “credit” analysis, may itself present a concern. The structurers are “risk managers.” They assemble mathematical models that extrapolate historic default rates and recovery rates (which may or may not have relevance in today’s environment). They look at probabilities, expected values and correlations. But they count heavily on the statistical properties of the universe as it has been and may know rather little about the actual assets contained in the portfolios. Of course, this sort of reliance on statistically derived expectations was behind the undoing of Long Term Capital Management in 1998 – of which so little seems to be remembered. Grant’s describes an interview with a junior analyst at a rating agency whose job it is to monitor the health of a large number of CDOs each day, plugging numbers into an Excel spreadsheet. According to Grant’s, “he doubts that many people really understand what these structures own, how their assets are correlated, or what might happen to them in the liquidation portion of a credit cycle.” To wrap up, Grant’s quotes Michael Lewitt of Harch Capital Manager, a manager of bank loans: . . . having a credit market priced on a non-credit basis – meaning priced off quantitative and arbitrage bases, and not on credit fundamentals – is not a healthy thing.

© Oaktree Capital Management, L.P. All Rights Reserved operating profits change more than revenues) and financial leverage (such that net income changes more than operating profits).  The credit cycle moves dramatically, usually oscillating between periods when the capital markets are wide open and periods when they’re slammed shut.  The market cycle reacts violently, as investor psychology magnifies all of the above. Security prices yo-yo in what can often be described as extreme over-reaction. Everyone’s aware of these cycles and their influence on the markets, but it’s important that their essence and origin be thoroughly understood. For me that means delving into human nature and emotion. The theme of this memo will be that the cyclical phenomena that so heavily influence our investment outcomes aren’t caused by the operation of institutions or physical laws. Rather, they largely result from people’s frailties and excesses. A thorough understanding of these things can increase an investor’s ability to achieve gains and avoid losses. 1BUGreed or Fear When I was a rookie analyst, we heard all the time that “the stock market is driven by greed and fear.” When the market environment is in healthy balance, a tug-of-war takes place between optimists intent on making money and pessimists seeking to avoid losses. The former want to buy stocks, even if they have to pay a price a bit above yesterday’s close, and the latter want to sell them, even if it’s on a downtick.

As in any inefficient, alpha-based market niche, the performance gap between superior and inferior managers can be substantial. Thus you’d better find superior managers, and that’s not easy. Also, since many of the best and most disciplined managers have closed their funds, you’d better hope the available funds will be able to replicate the returns that attracted you to the area in the first place.  With thousands of hedge funds all using computers to screen investment opportunities, there’s a tendency for lots of them to move in the same direction at the same time. This can shrink purchase opportunities, eat into prospective returns and reduce liquidity. The Wall Street Journal described the situation on June 30: “Increasingly, the growing group of hedge funds pile into the same trades. With so much money chasing similar strategies, good investment returns become more elusive. Moreover, when an attractive idea turns sour, the rush to the exits gets crowded, exacerbating an already tense investment environment.”  We read often about the migration to the hedge fund world of people from elsewhere in the investment industry. This is the same phenomenon as we saw in the dot-coms in 1998-99. When people flood an area because of the easy money to be made there, the results are usually predictable.  I’m particularly skeptical of the movement of people from traditional portfolio management to hedge funds.

And clearly, both selling panics and buying panics have more to do with extreme swings in emotion and urgency than they do with fundamental corporate and economic developments. The Credit Cycle I couldn’t leave the subject of cycles without touching on one of the most pronounced, the credit cycle. From time to time, providers of capital simply turn the spigot on or off – as in so many things, to excess. There are times when anyone can get any amount of capital for any purpose, and times when even the most deserving borrowers can’t access reasonable amounts for worthwhile projects. The behavior of the capital markets is a great indicator of where we stand in terms of psychology and a great contributor to the supply of investment bargains. The level of security issuance varies over time in a wave-like pattern, and the swing from high years to low years can be great. I don’t believe a high level of issuance says much about the desire of companies to raise money; usually they’ll take all that’s available. Rather, a high level of issuance indicates a willingness on the part of investors to buy increased amounts of securities, something that varies greatly depending on their mood. But equally important is the trend in the quality of new issue securities. It is my belief that a willingness to buy new securities in greater quantity invariably is accompanied by a willingness to buy securities of lower quality. Thus lower standards go hand in hand with higher amounts of issuance.

But at minimum the proceeds, or assets bought with the proceeds, should stay within the company. When debt is raised and the proceeds go out the door without enhancing the value of the company, a transaction should be viewed with a particularly critical eye. The fact that a substantial number of bonds-for-dividends deals could be done in recent months says a lot about where we stand in the credit cycle . . . and about the likelihood that some of these deals will be grist for distressed debt investment in the future. Looking for the cause of a market extreme usually requires rewinding the videotape of the credit cycle a few months or years. Most raging bull markets are abetted by an upsurge in the willingness to provide capital, usually imprudently. Likewise, most collapses are preceded by a wholesale refusal to finance certain companies, industries, or the entire gamut of would-be financers. The capital market oscillates between wide open and slammed shut. It creates the potential for eventual bargain investments when it provides capital to companies that shouldn’t get it, and it turns that potential into reality when it pulls the rug out from under those companies by refusing them further financing. It always has, and it always will. UJust Give Me My 10% Putting it all together, the fluctuations in attitudes and behavior described above combine to make the stock market the ultimate pendulum.

© Oaktree Capital Management, L.P. All Rights Reserved adjusted returns, it’s not likely to be by doing the same things everyone else is doing. The best and most safely earned profits are apt to be found outside the mainstream, not inside. The most important thing is being leery of leverage. The key elements in Oaktree’s investment approach include focusing on what’s out of favor; ascertaining intrinsic value and trying to buy for less; and adding value by working with assets once we own them. If done well, these things can simultaneously increase prospective return and reduce risk. Leverage, on the other hand, increases prospective return and UincreasesU risk. There’s nothing magic about leverage. It increases upside potential, but it also reduces or eliminates the margin of safety. Leverage is just an application of the Las Vegas maxim, “The more you bet, the more you win when you win.” But I think people tend to omit “. . . and the more you lose when you lose.” As Warren Buffett puts it, “It’s a very sad thing. You can have somebody whose aggregate performance is terrific, but they have a weakness – maybe it’s alcohol, maybe it’s susceptibility to taking a little easy money – it’s the weak link that snaps you. And frequently, in the financial markets, the weak link is borrowed money” (emphasis added).

An investment style that does best (or worst) in one period is unlikely to do so again in the next. That was really the problem with the technology bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability would bring imitation and competition, which would cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive – technological progress – could at some point render them obsolete. And they failed to consider that the investing fads in favor of these technologies, companies and stocks could reverse, with dire consequences. UFourthU, investors should bear in mind the role played by timeframe. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet heavily on your conviction that a given phenomenon can be depended on in the long run, think about the six-foot tall man who drowned crossing the stream that was five feet deep on average. One of the great delusions suffered in the 1990s was that "stocks always outperform." I agree that stocks can be counted on to beat bonds, cash and inflation, as Wharton's Prof. Jeremy Siegel demonstrated, but only with the qualification "in the long run."

© Oaktree Capital Management, L.P. All Rights Reserved The important thing is to recognize that cycles reverse, and to allow for it. I described in my last memo, "What Lies Ahead?," the manner in which a recession continues until, at the margin, a few participants stop cutting back and decide instead to act in anticipation of better times. I believe this process, and the reverse process that eventually causes growth to stall out, will go on forever. No one knows when the turn will occur, or how far the correcting leg will go, but the odds are against anyone who says, "the business cycle is dead." How can non-forecasters like Oaktree best cope with the ups and downs of the economic cycle? I think the answer lies in knowing where we are and leaning against the wind. For example, when the economy has fallen substantially, observers are depressed, capacity expansion has ceased and there begin to be signs of recovery, we are willing to invest in companies in cyclical industries. When growth is strong, capacity is being brought on stream to keep up with soaring demand and the market forgets these are cyclical companies whose peak earnings deserve trough valuations, we trim our holdings aggressively. We certainly might do so too early, but that beats the heck out of doing it too late. UThe Credit Cycle The longer I'm involved in investing, the more impressed I am by the power of the credit cycle.

It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself. The process is simple:  The economy moves into a period of prosperity.  Providers of capital thrive, increasing their capital base.  Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.  Risk averseness disappears.  Financial institutions move to expand their businesses – that is, to provide more capital.  They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants. At the extreme, providers of capital finance borrowers and projects that aren't worthy of being financed. As The Economist said earlier this year, "the worst loans are made at the best of times." This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return UonU capital, and eventually to cases where there is no return UofU capital.

© Oaktree Capital Management, L.P. All Rights Reserved When this point is reached, the up-leg described above is reversed.  Losses cause lenders to become discouraged and shy away.  Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.  Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers.  Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.  This process contributes to and reinforces the economic contraction. Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness. Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled. I stated earlier that cycles are self-correcting. The credit cycle corrects itself through the processes described above, and it represents one of the factors driving the fluctuations of the economic cycle. Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on. In "Genius Isn't Enough" on the subject of Long-Term Capital Management, I wrote "Look around the next time there's a crisis; you'll probably find a lender."

Overpermissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose credit contributed to booms that were followed by famous collapses: real estate in 1989-92; emerging markets in 1994-98; Long-Term Capital in 1998; the movie exhibition industry in 1999-2000; venture capital funds and telecommunications companies in 2000-01. In each case, lenders and investors provided too much cheap money and the result was over-expansion and dramatic losses. In "Fields of Dreams" Kevin Costner was told, "if you build it, they will come." In the financial world, if you offer cheap money, they will borrow, buy and build – often without discipline, and with very negative consequences. The credit cycle contributed tremendously to the tech bubble. Money from venture capital funds caused far too many companies to be created, often with little in terms of business justification or profit prospects. Wild demand for IPOs caused their hot stocks to rise meteorically, enabling venture funds to report triple-digit returns and attract still more capital requiring speedy deployment. The generosity of the capital markets let companies sign on for huge capital projects that were only partially financed, secure in the knowledge that more financing would be available later, at higher p/e's and lower interest rates as the projects were further along. This ease caused far more capacity to be built than was needed, a lot of which is sitting idle.

© Oaktree Capital Management, L.P. All Rights Reserved In making investments, it has become my habit to worry less about the economic future – which I'm sure I can't know much about – than I do about the supply/demand picture relating to capital. Being positioned to make investments in an uncrowded arena conveys vast advantages. Participating in a field that everyone's throwing money at is a formula for disaster. We have lived through a long period in which cash acted like ballast, retarding your progress. Now I think we're going into an environment where cash will be king. If you went to a leading venture capital fund in 1999 and said, "I'd like to invest $10 million with you," they'd say, "Lots of people want to give us their cash. What else can you offer? Do you have contacts? Strategic insights?" I think the answer today would be different. One of the critical elements in business or investment success is staying power. I often speak of the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Companies have to be able to get through the tough times, and cash is one of the things that can make the difference. Thus all of the investments we're making today assume we'll be going into the difficult part of the credit cycle, and we're looking for companies that will be able to stay the course. UThe Corporate Life Cycle As indicated above, business firms have to live through ups and downs.

© Oaktree Capital Management, L.P. All Rights Reserved How quickly views change, and how quickly the logical-sounding rationale for lofty or depressed prices is shown in retrospect to have been "silly." * * * The risks entailed in ignoring the inherently cyclical nature of things are manifold, and the various cycles interact, often in ways that surprise the optimists. On October 26 the beautifully written (but inaptly-titled) "Grant's Interest Rate Observer" described the situation at a fallen telecommunications giant as follows: In the New Economy, the front office seemed persuaded, there would be no recession (let alone a global recession) and no bear market (especially one concentrated in technology). There would be no pause in the growth of the demand for broadband, no collapse in the price of broadband access and no credit contraction. What we are looking at . . . is compressed cash flow at the trough in a cyclical business so new that its proponents have yet to discover that it is, in fact, cyclical. This example represents a four-bagger. It seems the company's management ignored the cyclicality of (l) the economy, (2) the stock market, (3) the availability of credit, and (4) the demand and price for its product. As in this case, the failure to prepare for cycles usually leads to what later are perceived as obvious, easily-avoided mistakes.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: We're Not In 1999 Anymore, Toto In "The Wizard of Oz," a tornado carried Dorothy and her dog, Toto, to a land ruled by a mysterious despot in whom people had vested extraordinary powers. In the investment world of 1999, similarly, the promise of easy money powered a wild ride into a world in thrall to high tech investing. Both of these seemingly omnipotent forces were eventually exposed as vulnerable, however, and the spells surrounding Oz and the stock market were broken. * * * In my favorite commercial of 1999, Stuart, the cyber-geek from the mailroom, exhorted his boss to make his first on-line stock purchase, saying, "Let's light this candle!" When Mr. P. protested that he didn't know anything about the stock, Stuart suggested, "Research it." Mr. P. pushed a button on his keyboard and a few seconds later, suddenly wiser, proceeded to buy his first hundred shares. Like many, he demonstrated how easy it is to feel smart in a bull market. In 2000, on the other hand, on-line brokerage commercials were different. When the little boy asked his father what he was doing at the computer, the father said he was investing for his college education. Looking over his dad's shoulder, the boy was curious about the on-screen data. "Five-year earnings, p/e ratio . . ." the father enumerated. "A p/e ratio of 23," the son asked, "is that good?"

Of course, the bottom line is that lots of things people considered eminently logical in 1999 – like low-risk triple-digit gains – are now being shown to have been far too good to be true. The headlines of 1999 look silly now, and the debunking in 2000 seems obvious (e.g., "What Are Tech Stocks Worth, Now That We Know It Isn't Infinity?" in the Wall Street Journal on April 17). But that's a juxtaposition that marks the end of every market boom. UHow'd We Get Here? In the 1990s, positive macro forces contributed to an extremely benign environment and steadily reinforced each other:  low inflation,  the shift of the federal budget from deficit to surplus,  easy money at low interest rates,  technological gains, and  a high degree of risk tolerance.productivity,

” Today, great results in venture capital are in the headlines, money is everywhere, investors are emboldened and the mantra is “of course!” In this context, it's very much worth noting that in 1994, someone looking at venture funds formed from 1981 to 1992 would have seen only one vintage year with an average net return above 12%, and nine out of twelve years with single digit average returns. Despite the lukewarm results as of that date, a few forward-looking investors were willing to commit $7.8 billion to venture capital funds, and it is they who are earning the returns we see. In 1998, on the other hand, the 200%+ results on the top funds formed in recent years egged investors on to commit more than three times that amount: $26.1 billion. Today one hears only that investors want to put more into venture capital but can't get access to the most desirable funds. I'll leave it to you to deduce the implications for future returns.  The role of the IPO: A “mania-within-a-mania” has taken flight in the high-tech investment world, and it surrounds Initial Public Offerings. In years past, new issues had to be priced to sell, and companies accessing the public equity market for the first time had to hope they could get investors to pay a fair price. Now, investors are sure that buying stock on a new issue - at the price the founders are willing to sell at - is the ticket to easy money. And to date it has been.

© Oaktree Capital Management, L.P. All Rights Reserved Anyone who bought in those declines benefited from the rallies that surely followed. Of course, that didn't work quite so well in 2000. The dips in March-April, May and July were all followed by rallies, but they were traps for unsuspecting buyers. Only "sell the rallies" proved correct. URespect cyclesU – There's little I'm certain of, but these things are true: Cycles always prevail eventually. Nothing goes in one direction forever. Trees don't grow to the sky. Few things go to zero. That was really the problem with the bubble. Investors were willing to pay prices that assumed success forever. They ignored the economic cycle, the credit cycle and, most importantly, the corporate life cycle. They forgot that profitability will bring imitation and competition, which will cut into – or eliminate – profitability. They overlooked the fact that the same powerful force that made their companies attractive, technological progress, could at some point render them obsolete. U Worry about timeU – Another element that investors ignore in their optimism is time. It seems obvious, but long-term trends need time in order to work out, and time can be limited. Or as John Maynard Keynes put it, "Markets can remain irrational longer than you can remain solvent." Whenever you're tempted to bet everything on a long-run phenomenon, remember the six-foot tall man who drowned crossing the stream that was five feet deep on average.

© Oaktree Capital Management, L.P. All Rights Reserved day at $100 and be at $200 in six months.” Would you play? Could you stand the risk of saying no and being wrong? The pressure to buy can be immense. There have always been ideas, stocks and IPOs that produced great profits. Yet the pressure to participate wasn't as great as it is today because in the past the winners made millions, not billions, and it took years, not months. The upside in the deals that've worked so far has been 100-to-l (give or take a zero). With that kind of potential, (a) the upside becomes irresistible and (b) it doesn't take a very high probability of success to justify the investment. I have said in the past that while the market is usually driven by fear and greed, sometimes the strongest motivator is the fear of missing out. Never was that as true as today. This only intensifies the pressure to join in and crawl further out on that limb of risk. With broader relevance than just the dot-com stocks, the relative performance chart below from Barron's of September 27 (already quite outdated) shows two things: 1. over the last two decades, technology stocks have had periods of both underperformance and overperformance relative to the large-cap universe, and 2. the recent outperformance is unparalleled even in this bullish period. Nothing in this chart suggests that it'll be easy money in technology from here.

In my opinion, (a) the three ingredients behind success are timing, aggressiveness and skill, and (b) if you have enough aggressiveness at the right time, you don't need that much skill. But those who have attained their success primarily through well-timed aggressiveness can't be depended on to repeat it -- especially in tough times. When an investment track record is considered, it's essential that the relative roles of these three factors be assessed. 6) Change in the availability of credit is a powerful force, and the longer I'm in the investment business, the more I respect the role of the credit cycle. For example, although we hope we added value through our implementation, our 1990 distressed debt funds earned their 50% gross returns largely because (a) fear and the government's actions closed the credit window, (b) the LBOs of the 1980s couldn't refinance their debt and defaulted in droves, and (c) that debt could therefore be bought for a song. A significant recession contributed to the conflagration, but whereas a generous capital market would have let companies finance their way out of trouble (as they did from 1993 through mid-1998), a tight one brought them down in 1990-92. The product of lenders is money, and it's their job to move it off the shelves. Because money is the ultimate undifferentiable commodity, lenders can compete for market share in boom times only by taking on bigger risks than the next guy, charging less interest or accepting looser terms.

© Oaktree Capital Management, L.P. All Rights Reserved In times of easy money, companies prosper that should not, just as deserving companies fail when money's tight. Easy money was key in Long-Term's early success and later collapse. The bankers and brokers let the General Partners lever up their equity capital and take on far out-sized positions. They loaned amounts of money that were unsafe both for Long-Term Capital and for themselves. I assume that, seduced by Long-Term's brilliance, they did so without knowing how much it had borrowed in total or what its portfolio looked like. The violent swings of the credit cycle -- usually far more volatile than the underlying economy -- are behind many of the extreme occurrences in the business and investment world. Excessive lending contributed greatly to booms preceding the collapses in real estate in 1989-92 and emerging markets in 1997-98, just as tight lending added to the bankruptcies of 1990-92. Look around the next time there's a crisis; you'll probably find a lender. 7) “How Quickly They Forget.” While it would be great (and very profitable) to be able to see the future, the truth is that few of us can. But you don't have to be prescient to be able to invest intelligently while avoiding the most dangerous hazards. Knowledge of the past will get you a good part of the way there. The relevance of the lessons of Long-Term has nothing to do with knowledge of the future. Leverage is always dangerous.

Something always goes wrong eventually. Those who see high returns often mistake risk bearing for genius. The swings of the credit cycle can overwhelm all other factors. Every boom carries within itself the seeds of decline (just as every bust lays the groundwork for recovery). Forget forecasting -- you'll be well ahead if you simply bear in mind the lessons of the past. We've all heard George Santayana's famous observation that "Those who cannot remember the past are condemned to repeat it." And yet, how many of today's mistakes are just replays of the past? Thirty years ago, the stocks of "the best companies" reached P/Es of fifty and more from which they eventually collapsed. Ten years ago, highly leveraged investments were financed with bridge loans which investment bankers were stuck with when the financing window closed. Five years ago, banks got into big trouble with derivatives. All of these are causing problems again in 1998 for those who forgot history or rationalized its irrelevance in the "new paradigm." I've previously recommended John Kenneth Galbraith's excellent little book, A Short History of Financial Euphoria. Although I don't appreciate its swipes at high yield bonds, I consider it must reading for anyone who wants to think and invest against the grain. Galbraith says: Contributing to ... euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory.

easy money has been made, and the improvement in these parameters is bound to subside. Anyone who thinks equity returns over the next fifteen years will look anything like the last fifteen is certainly bucking the odds. It is still important to look for what's relatively cheap. For example, the fact that big stocks have recently been beating small stocks by the widest margins in history means small stocks are likely to have their day in relative terms. This was shown in August, when the Dow was down 7% and small stocks rose. The possibility of a market decline certainly exists, and while "everyone" says a 5%, 10% or 15% dip would just be a buying opportunity, we wonder how investors would feel about a rerun of the 1973-74 experience, in which stocks declined an average of 2% a month for 24 months. At 8,200, we heard people say a 25% decline would only take the market back to the level of a year earlier -- implying that it wouldn't hurt. We doubt many investors who've never seen even a 10% "correction" would come through such a period with their equanimity unscathed. What could cause a market decline? A drop in investor confidence -- perhaps the commodity that's most freely available today -- would likely be the key, but the reason is hard to foresee. "We're not expecting any surprises," people say, and that has become our new favorite oxymoron. Surprises are never expected -- by definition -- and yet they're what move the market.

In distressed debt, real estate and control equity, we continue to buy things that are found outside the mainstream sources of supply, that are as depressed in price as can be found in this environment, and that protect against losses through a call on strong asset values. We have been privileged to read a recent letter from Julian Robertson to his investors. In it, Robertson compares today's fund managers to the Phoenician sea captains of thousands of years ago who were paid a percentage of the value of the goods they transported and thus were incentivized to design boats which emphasized speed over safety. This worked as long as the weather was good, but the storms that eventually came consigned the less safe ships to the bottom of the sea. He goes on as follows: The last several years have been a great period for the audacious captains with their fleets of fair-weather ships. There has not been a storm for years; perhaps climatic conditions have changed and there will never be another storm. In this scenario the audacious crew with its fleet of swift but flimsy ships is the cargo carrier of choice. [Robertson's ship] will continue to be run as it has in the past; conservatively, making sure its crew and merchandise are safe. This metaphor suits Oaktree exactly; we couldn't say it better. Being prepared for stormy weather, even if it could cost us some of the easy money in good times, is certainly the course for us. September 3, 1997 © 1997 OAKTREE CAPITAL MANAGEMENT, L.P.

It is my view that, first, few of the trends being pursued are at their beginnings; money has been flowing to today's popular sectors for at least a year or two. Second, while some may argue that prices are not forbiddingly high, it's almost impossible to argue that they're very low (or that the easy money hasn't already been made). Third, it seems to me that investors are accepting higher levels of risk throughout the system. Here's one illustration: Our cautious high yield investing saved clients a lot of money and heartache in 1989 and 1990. Because we apply in-depth, downside-conscious credit analysis to the high yield segment of the bond market, and define it narrowly, investors who were chastened by the last decline and don't want to bear the full brunt of the next one have hired us repeatedly in the years since. Now, however, we detect increased interest in more "eclectic" managers who will buy cash-paying or non-cash-paying bonds, going concerns or bankruptcies, convertible or straight bonds, and U.S. or foreign debt. This is just one example, near to us, of the new acceptability of risk -- at what just might be the wrong time. Too-low interest rates and too-high prices may prove at some point to have set the stage for a correction. If so, many of the riskier tactics to which recent trends are pushing investors will increase the extent to which that correction is felt. What course of action, then, would we argue for? We do not preach risk-avoidance.