Howard Marks on Insurance Economics

They could reasonably have been expected to deliver high volatility-adjusted returns (that’s what Sharpe ratios are), but I insist strenuously that risk and volatility aren’t the same thing. Direct loans embody no less credit risk than liquid credit instruments such as high yield bonds and broadly syndicated loans. It just isn’t reflected as readily in prices. • Hundreds of investment firms offered their services in direct lending, the vast majority of which entered the private credit market after the end of the Global Financial Crisis, meaning they’d never been tested in rough times. Regardless, they were given plenty of money to manage. • The arrival of many new managers and a great deal of incremental capital caused lenders to compete to make direct loans by accepting lower yields, narrower yield spreads, and reduced safety. Some managers were doubtless motivated to lower their standards in order to put a lot of capital to work.underwriting

And just like the support for rent control – there’s a lot of that in California, too – the government sought to help out homeowners by limiting the premiums companies could charge for fire insurance. In a sign of the times, I’ll let my new (and AI-powered) editorial assistant, Perplexity, fill you in on the background. I’ve simplified the format and added emphasis, but I haven’t changed a word. What follows below is pretty close to what I would have produced in an hour or two: Before the devastating fires of 2025, California’s fire insurance market was already in a state of crisis, shaped by a combination of regulatory constraints, insurer withdrawals, and mounting wildfire risk. Insurers were prohibited from using forward-looking catastrophe models to set rates for wildfire risk. Instead, they were required by law to base their rates on historical average losses over the previous 20 years. This approach became increasingly problematic as wildfires grew more frequent and severe, making historical data a poor predictor of future risk. Regulations also prevented insurers from raising premiums to reflect increased reinsurance costs, further limiting their ability to price policies according to actual risk. Major insurers began withdrawing from the California market or ceasing to write new policies in fire-prone areas.

The flow of pension fund money into any asset that promises to beat zero-rate bonds has been so dramatic that equities, junk bonds, property, private equity and a host of other more abstruse areas of investment have spiraled in value – and to such an extent that they look highly vulnerable to any shock . . .” (Financial Times, August 5) Proof? What about the fact that in early July, a €3 billion offering of Italian sovereign bonds maturing in 2067(!) was almost six times oversubscribed thanks to its lavish 2.877% yield? What a bonanza Italy was at the time, with a 10-year bond out-yielding Germany’s 10-year by 215 basis points, 1.78% to -0.37%.  There’s no longer any reason to pay slowly in order to make money on “float.” o In the old days, people paid their bills on the last possible day, preferring to keep the money in the bank and earn interest as long as possible. Under negative rates they may prefer to pay sooner. o Many insurers traditionally have made money primarily because they paid claims years after they collected the premiums on the policies they issued. What happens if it costs them money to hold float until claims are paid?  Likewise, there’s no impetus to collect receivables quickly. In the past, wholesale customers were offered discounts for paying bills early. Now the seller might say, “No, you keep it. I’d rather you paid me in six months.”  Negative rates put pressure on people, such as retirees, who live on the income from their investments.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: A Case in Point – Senior Loans in the Financial Crisis While on the subject of 2008, I want to review the performance of senior loans. In the old days, banks made corporate loans, sometimes sharing part with a syndicate of a few friendly banks but retaining the rest. More recently the custom changed, with banks syndicating their loans widely to buyers of all types and retaining rather little. This process has more in common with investment banks’ underwriting of securities than with the commercial banks’ prior lending process. Senior loans became a significant area of activity for credit investors like us. They’re typically their issuers’ senior-most debt, so they’re perceived to carry little credit risk. And since they pay interest at floating rates, there is no interest rate risk. (Of course, with so little risk, they offer low yields.) They’re the highest-quality instruments I’ve ever dealt in. Because they were considered so safe, loans were widely deemed appropriate for levered investment, and prior to the financial crisis large numbers of highly levered Collateralized Loan Obligations, or CLOs, were formed to hold them. Borrowing at low floating rates to buy senior debt paying high floating rates was very enticing, and the CLO business mushroomed. Senior loans were affected dramatically by the events of 2008.

That can’t be it either; distressed debt may have been little-known and under-appreciated when we raised our first fund in 1988. But there can’t be many institutional investors who haven’t heard of distressed debt by now; certainly the secret’s out.  Can it be because people are unwilling to venture into the sordid world of default and bankruptcy? That might have been the case in the 1980s, but today most investors will do anything to make a buck. So, then, why? I think it’s largely a matter of mistakes. At our London client conference in April, I listened as Bob O’Leary, a co-portfolio manager of our distressed debt funds, described his group’s work as follows: “Our business is often an examination of flawed underwriting assumptions.” In other words, it’s their raison d’être to profit from the mistakes of others. Hearing Bob put it that way gave me the immediate inspiration for this memo. The active investor only achieves above average performance to the extent that he can identify and act on mistakes others make. The opportunities invested in by our distressed debt funds are a glaring example. What’s the process through which the mistakes arise?subjected

© OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED. CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. and/or overstates its ability to withstand them. Using Bob’s terminology, they employ overly optimistic underwriting assumptions, particularly in good times.  As a result, debt is piled on that turns out to be more than the company can service when things turn down.  Just as companies and acquirers are often too optimistic in good times, debt holders tend to become too pessimistic in bad times. As a result, they become willing to sell the debt of financially distressed companies at prices that overstate the negatives and thus are too low, giving us the potential for superior returns with less-than-commensurate risk. All three of these are foundational elements for success in distressed debt investing.  The first two contribute to the creation of high-potential-return situations. If no one underestimated risk and thus overloaded capital structures with debt, there wouldn’t be many defaults and bankruptcies. We call these lending decisions “the unwise extension of credit” or, alternatively, “stacking wood for the bonfire.”  And if no one panicked in response to negative developments and scary prospects, and thus sold out too cheaply, there would be no reason to expect higher risk- adjusted returns from distressed debt than from anything else. Many of the biggest mistakes made in the business and investment worlds have to do with cycles.

The loans are senior-most in the capital structure, meaning they should provide some protection in a sluggish economy, and the fact that their interest rates float with LIBOR should insulate them against interest rate increases. Oaktree manages half a dozen large “multi-strategy fixed income” accounts, in which we are responsible for allocating capital to our various marketable securities strategies. Recently, in recognition of the developments described above, we made a modest initial shift away from high yield bonds and into convertibles, with their sensitivity to equity market trends. Here’s what I wrote to our multi-strategy clients a month ago: Certainly by the onset of 2000, people believed too much in stocks and thought too little of bonds. Now, a decade later, these things are reversing. As we enjoy our portfolios’ performance, we should be alert for a day when bonds will have become too popular and stocks’ outcast status will have rendered them too cheap. We can pat ourselves on the back for being in the right asset classes today, but we shouldn’t fail to consider what these diverging performance trends can do to tomorrow’s returns. Since few investment trends continue forever, it’s usually smarter to expect ultimate regression to the mean rather than growth to the sky. No one should view the great popularity of bonds relative to stocks without reservation. September 10, 2010 © Oaktree Capital Management, L.P.Reserved

© Oaktree Capital Management, L.P. All Rights Reserved  For as long as bonds have been rated, there’ve been low-rated bonds. But prior to the late 1970s, non-investment grade bonds couldn’t be issued as such. Rather, they were “fallen angels”: bonds issued with investment-grade ratings that were subsequently downgraded due to deterioration on the part of their issuers.  At Wharton, Mike read a 1958 study by W. Braddock Hickman which showed that over the period 1900 to 1949, lower-rated bonds had produced higher realized returns on average than higher-rated bonds. Sure some low-rated bonds defaulted, but higher yields and lower purchase prices on the many that didn’t default more than made up for the ones that did.  Mike concluded that low-rated bonds were an overlooked asset class; even for a weak credit, there had to be some yield that would compensate for the credit risk; thus it should be possible to issue bonds with speculative ratings; and he could make it happen.  Thus Mike’s contribution consisted of raising the profile of the asset class and proselytizing for it, making a market in high yield bonds and underwriting new issues. He wasn’t the only one, just the most prominent figure by far. And the expansion of the universe of new issue high yield bonds from $2 billion to $200 billion that Mike presided over between 1978 and 1990 provided early impetus for the growth of buyout investing into the major activity it is today.

© Oaktree Capital Management, L.P. All Rights Reserved beneath a portfolio of bonds averaging single-A, leveraged up 15-to1, gets a triple-A rating. Huh? Second, as the Financial Times wrote on November 13, “if there are losses and the CPDO’s net asset value begins to fall from its target, the leverage is increased to try to earn more at a faster rate.” In other words, if you did a little of something and it didn’t work, try to recoup your losses by doing a lot.  U What Due Diligence?U – The other day, Orin Kramer (see “Pigweed”) observed skeptically that “the most profitable way to be a lender today is to have no underwriting department.” In other words, default rates are too low, and the market is too competitive, for credit analysis to be worth paying for. In December, Reuters described a takeover bid whose competitiveness was enhanced by a reduced due diligence period and a short list of information requirements. And most interestingly, one of the major investment banks told us recently that on most syndicated loans, about 70% of the buyers never visit the data rooms set up to facilitate due diligence.  UPut the Pedal DownU – FT.com pointed out on January 21 that, “One-tenth of the capital committed [to private equity funds] in 2002 was . . . put to work within one year. For funds invested in 2005, the corresponding proportion was almost 30 percent.

It has brought in gross revenues of $180 million worldwide since May against its production budget of $160 million, meaning that after the deduction of at least half the revenues for distribution charges, advertising costs and exhibitors’ fees, it’s still a big loser.  If there’s one thing I’ve never claimed to understand, it’s how you put a price on a highly improbable disaster. Thus I have a lot of respect for anyone who can do a consistently superior job of underwriting catastrophe insurance against earthquakes, hurricanes and terrorist events. Is the right premium for insuring a Caribbean hotel against hurricanes $1 million or $5 million, given that the loss may be zero or $100 million? The difficulty of setting these premiums isn’t keeping hedge funds from filling the gap in the “cat insurance” market.  Along similar lines as catastrophe insurance, hedge funds are among the leading writers of Credit Default Swaps, the equivalent of issuing insurance against bond defaults. Hedge funds find it attractive to write this coverage for multi-year periods, perhaps in part because the premiums are taken into earnings each year, adding to returns and giving rise to incentive fees, while the defaults are likely to come later. As in any form of risk transfer, the ultimate profitability of this proposition will depend on how well the insurers know the risks and on what they’re able to charge in terms of premiums.

I feel at any given point in time it runs on fear UorU greed. As 1991 began, everyone was petrified of high yield bonds. Only the very best bonds could be issued, and thus buyers at that time didn't have to do any credit analysis -- the market did it for them. Its collective fear caused high standards to be imposed. But when investors are unafraid, they'll buy anything. Thus the intelligent investor's workload is much increased. 7. Gresham's Law says "bad money drives out good." When paper money appeared, gold disappeared. It works in investing too: bad investors drive out good. When undemanding investors appear, they'll buy anything. Underwriting standards fall, and it gets hard for demanding investors to find opportunities offering the return and risk balance they require, so they're forced to the sidelines. Demanding investors must be willing to be inactive at times.