Howard Marks on Liquidity

” When some investors in “non-traded BDCs” wanted to withdraw their money and weren’t able to do so in full, questions began to be raised regarding liquidity. Likewise, there were questions about how these vehicles valued their private debt holdings, and thus about the accuracy of reported carrying values and the process of withdrawing from the vehicles. Perhaps as a result, the shares of “publicly traded BDCs,” which can be sold but not redeemed, came to be priced at wider discounts from their net asset values. The preceding events were mostly treated as idiosyncratic, meaning there was no broad disillusionment or loss of confidence at the time. But it’s usually the case that if a confluence of troubling events builds up, a critical mass can eventually be reached, rendering investors no longer able to overlook the newly exposed flaws in the new thing. And that brings us to software debt. Direct Lending and Software Prior to the mid-2000s, investors in high yield bonds and leveraged loans were generally unwilling to lend money to technology companies, which were considered too fundamentally risky to be creditworthy. And since they couldn’t be levered, they weren’t candidates for purchase by private equity funds. But when investment in private equity funds grew strongly, their managers needed companies to buy, and that caused them to expand the range of what they would consider.

Now the analysis errs in the opposite direction, with excessive pessimism and skepticism replacing eagerness and gullibility, and with sheer terror replacing the blind faith that enabled investment when everything was going well. The implications of AI for the software industry, limitations on liquidity in private assets, and uncertainty regarding the accuracy of direct lending funds’ pricing have been there for years. But, simply put, people may not have asked enough questions or paid enough attention in the good times . . . as usual. This has led to the current discomfort of investors in direct lending vehicles. Individual investors in a new phenomenon like direct lending are unlikely to fully grasp its potential complications, especially if it has never been seen in action during tough times. The inclusion of leverage in the vehicles may have been touted as profit-enhancing, and now investors are seeing it at work in the opposite direction. And the investment vehicles’ limitations on liquidity – which may have been glossed over with a representation that “most of the time, you’ll probably be okay” – has come into play with surprising effect. True believers make the most money in manias, and skeptics lose the least when they crash. But the key to the investment success we aim for lies in always maintaining a healthy balance between belief and doubt.

The tariff announcement of April 2025 produced immediate pressure on leveraged positions and on assets whose value depended on the prior globalization regime. Some investors were forced to sell at exactly the moment when patient capital could buy at dislocations. This is the recurring pattern of crises: forced sellers provide liquidity to patient buyers, and the buyers who have the capital and the conviction to act during the panic capture returns that are unavailable in any other environment. The patience required to act in such moments is harder than it sounds. To deploy capital aggressively when the news is worst and the prices are falling requires a tolerance for being wrong in the short run and a confidence in the underlying mathematics of the assets being purchased. The mathematics of distressed credit — buying senior secured claims at deep discounts to par, with coupons that recover cost basis quickly — typically work even when the macro path is uncertain. What I have learned across three Nobody Knows memos is that the most important preparation for crisis is structural. The capital must be raised and committed before the crisis, the team must be in place, the underwriting muscles must be exercised, and the mandate must be clear. When the crisis arrives, there is no time to assemble the apparatus; there is only time to deploy it. The firms that have done the preparation in advance are the ones able to act, and the firms that act are the ones that capture the returns.

In most cases, the inventory was required to be sold back to First Brands, so while this served as a source of temporary liquidity, it left First Brands with layered, complex obligations that ballooned to several billion dollars. The scale of off-balance-sheet financing was striking; we’ve learned through bankruptcy filings that First Brands’s total obligations are $11.6 billion (inclusive of $9.3 billion of debt) versus the debt level of $5.9 billion that had been disclosed during a financing process undertaken in July. The complexity and opaqueness of these factoring and financing arrangements caused a creditor’s lawyer to say $2.3 billion had “simply vanished.” Byzantine corporate structures and extensive off-balance-sheet financing have been present in many corporate frauds we’ve witnessed, exemplified by Enron Corporation. But even in advance of First Brands’s bankruptcy filing in late September, Oaktree’s research turned up the following red flags: • only six years of operating history but already $5 billion of annual sales • controlled by an individual with almost no media references or online profile • a significant litigation history, including allegations of misconduct • reported profit margins above the industry average • a large number of M&A transactions creating a web of corporate entities • other aspects of weak controls You might wonder how a company as described above could attract financing.

My responses generally go like this: • Like anything else, there are pros and cons. The most obvious pro is that, to compensate for the lack of liquidity, private credit offers higher yields than public credit. The second is that private credit managers are able to offer funds (and thus returns) that are levered, which isn’t true of most public credit funds. The main negative stems from the absence of a market for the loans, and thus their illiquidity and the difficulty of actively managing holdings. Further, because there’s no market, private credit can’t actually mark to market. A final negative is that the fees are higher on private credit investing than on public credit, often including an incentive fee. • What about the lack of marking to market, and the resulting low level of volatility? It’s obviously unrealistic to think the value of private loans doesn’t fluctuate.hand,

My belief is that the risk in private credit isn’t systemic, since (a) private loan portfolios and their owners aren’t levered nearly as much as banks were in 2007-08 and (b) there isn’t the same level of interconnectedness, or “counterparty risk,” since the holders haven’t sold each other default protection and other forms of hedging, like banks did before the GFC. There are those who believe some holders of private credit have multiple layers of leverage, which could increase the risk in a downside scenario, but I have no way of knowing. The bottom line for me is that the return premium on private credit relative to public credit seems roughly fair given the merits. Extra return is a good thing, but the downside related to the lack of liquidity and resulting difficulty in actively managing holdings is a real consideration. All else equal, I would suggest employing a combination of the two. Credit Versus Equities I’ve written about equity valuations – primarily referencing the Standard & Poor’s 500 – as recently as this January in my memo On Bubble Watch.year,

© 2025 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Debt is neither a good thing nor a bad thing per se. Likewise, the use of leverage in the AI industry shouldn’t be applauded or feared. It all comes down to the proportion of debt in the capital structure; the quality of the assets or cash flows you’re lending against; the borrowers’ alternative sources of liquidity for repayment; and the adequacy of the safety margin obtained by lenders. We’ll see which lenders maintain discipline in today’s heady environment. It’s worth noting in this connection that Oaktree has made a few investments in data centers, and our parent, Brookfield, is raising a $10 billion fund for investment in AI infrastructure. Brookfield is putting up its own money and has equity commitments from sovereign wealth funds and Nvidia, to which it intends to apply “prudent” debt. Brookfield’s investments seem likely to go largely into geographies that are less saturated with data centers and for infrastructure to supply the vast amounts of electric power that data centers will require. Of course, we’re both doing these things on the basis of what we think are prudent decisions. I know I don’t know enough to opine on AI. But I do know something about debt, and it’s this: • It’s okay to supply debt financing for a venture where the outcome is uncertain. • It’s not okay where the outcome is purely a matter of conjecture.

© 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.

© 2024 Oaktree Capital Management, L.P. All Rights Reserved Follow us: There’s more recent experience with price controls, in Venezuela. Here’s what I said about it in Economic Reality: A case in point is the price controls, which have expanded to apply to more and more goods: food and vital medicines, yes, but also car batteries, essential medical services, deodorant, diapers, and, of course, toilet paper. The ostensible goal was to check inflation and keep goods affordable for the poor, but anyone with a basic grasp of economics could have foreseen the consequences: When prices are set below production costs, sellers can’t afford to keep the shelves stocked. Official prices are low, but it’s a mirage: The products have disappeared. (Atlantic Monthly, May 12, 2016, emphasis added) Here’s a shocker: you can set prices for goods, but you can’t make people produce them. That sounds a lot like economic reality. This is an example of the fact that officials may believe they can control economic developments with a stroke of the pen, but they’ll be thwarted by second-order consequences that complicate the effort. There’s nothing wrong with trying to bring down the cost of necessities. However, the best way to do this is to encourage additions to supply. Another way is to not overstimulate demand by injecting excessive liquidity into the economy. Mandating lower prices is generally the least effective way to get them.

© 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.

(TPOT) In my view we haven’t had a free market in money since the late 1990s, when I believe the Fed became “activist,” eager to head off problems real and imagined by injecting liquidity. Given that activism, investors have become preoccupied with central bank actions and their consequences. For years, that’s all investors have talked about. If I ran the Fed (to be clear, I don’t expect to be offered the job), I think I would (a) lower rates to stimulate the economy when it’s growing too slowly to produce needed jobs; (b) raise rates to cool off the economy when it’s overheating, to head off rising inflation; and (c) keep my hands off rates the rest of time, allowing market forces to determine their level. Under this construct, we certainly wouldn’t see rates perpetually near zero, as we did much of the time from 2009 to 2021. (I estimate the fed funds rate averaged roughly 0.5% over that stretch). © 2024 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

So, while most depositors can demand their money back at any time, (a) no banks keep enough cash on hand to pay back all their depositors, (b) their main assets don’t pay down in a short timeframe, and (c) if they need cash, it can take them a long time to sell loans – especially if they want a price close to par. Maintaining solvency requires bank managements to be aware of the riskiness of the assets they acquire, among other things. But liquidity is a more transient quality. By definition, no bank can have enough liquidity to meet its needs if enough depositors ask for their money all at once. Managing these issues is a serious task, since it’s a bank’s job to borrow short (from its depositors) and lend long. This mismatch, like most other mismatches, is encouraged by the upward slope of the typical yield curve. If you want to borrow, you’ll find the lowest interest rates at the “short end” of the curve. Thus, you minimize your costs by borrowing for a day or a month . . . but you expose yourself to the risk of rising interest expense, since you haven’t fixed your rate for long. Similarly, if you want to lend (or invest in bonds), you maximize your interest income by lending long . . . but that subjects you to the risk of capital losses if interest rates rise. If you follow the yield curve’s dictates, you’ll always borrow short and lend long, exposing you to the possibility of an SVB-type mismatch. • High leverage – Banks operate with skinny returns on assets.

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Reliance on trust – Since depositors put money in banks in pursuit of safety and liquidity and, in exchange, accept a low return, faith in banks’ ability to meet withdrawals is obviously paramount. Depositors ostensibly can get liquidity, safekeeping, and low interest from any bank – that is, one bank’s offering is essentially undifferentiated from those of others. Thus, most depositors are perfectly willing to change banks if given the slightest reason, and there’s no offsetting reason for them to leave their money on deposit if a bank’s safety is questioned. You may be familiar with one of my favorite sayings: “Never forget the six-foot-tall person who drowned crossing the stream that was five feet deep on average.” Surviving on average is a useless concept; you have to be able to survive all the time, including – no, especially – in bad times. Borrowing short to invest long powerfully threatens that ability. Being highly levered is another reason why, metaphorically, tall people sometimes drown in streams that are shallow on average. And for financial institutions, customers’ loss of confidence is a third. The bottom line is that banks are, essentially, highly levered fixed income investors. Any long-term, fixed-rate loans or bonds they own (which for most banks aren’t a large percentage of total assets) are subject to declines in economic value in a rising-interest-rate environment.

Banks don’t have to recognize price declines on assets they intend to hold to maturity, but any bank that is forced to sell those assets to meet withdrawals would have to show the declines on its financial statements. Looked at this way, retaining depositors’ trust is an absolutely essential ingredient in a bank’s activities, and that means assets, liabilities, liquidity, and capital have to be skillfully managed. In SVB’s case, its equity went up in smoke when rising interest rates reduced the value of a good part of its assets. In that vein, I’m going to share a personal anecdote. When our son, Andrew, went off to college in 2005, Nancy and I concluded it would be great to live outside the United States for a while, something neither of us had ever done. We chose to live in the UK for four months of the year, during which I worked in Oaktree’s London office. To generate income to cover our living expenses, we moved cash to a UK bank and asked that it be deposited in CDs at several building societies (what we in the U.S. call savings & loans). One of those was Northern Rock. In September 2007, as the financial crisis was brewing, Northern Rock had trouble securing the financing it needed in the wholesale funding market on which it traditionally had depended. That prompted depositors to queue up to close their accounts. I called my banker on a Friday afternoon to ask whether I could move my funds elsewhere, and he told me there would be a 2% penalty for early withdrawal.

I doubt our financial system was highly reliant on promises made by SVB and thus subject to extensive counterparty risk. The GFC affected some truly large banks – household names – and most people believed it was on the way to jeopardizing even bigger ones before the government stepped in. There’s no reason to think the failure of SVB poses the same risk. Finally, it should be borne in mind that even though huge banks appeared to be endangered in 2008, the Fed and other economic policymakers were able to come up with rescue plans (for the institutions and for the economy), and they worked! In that vein, it’s worth noting that the Fed’s response to SVB’s problems included (a) guaranteeing all SVB deposits, (b) making additional liquidity available to banks, (c) injecting extensive liquidity into the economy, and (d) letting its balance sheet grow, even though it’s been in the process of winding it down from its post-pandemic high. Thus, I find it hard to believe that SVB or the like can set off a chain reaction sufficient to trigger an irreversible financial crisis. On the subject of the problem’s scale, I want to mention a new pet peeve of mine. Increasingly, we hear the media say things like, “this was the best month in the stock market since 2020” or “we saw more new © 2023 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

© 2023 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The performance of the equity indices is often dominated by a few stocks or groups of stocks. • The gains of the leaders can make them seem expensive, arguing for profit-taking. • Human nature – especially the desire to avoid regret – adds to the motivation to sell. • By definition, if you reduce your holdings of the winners relative to their representation in the indices and these winners continue to outperform, you’ll have a tough time keeping up. In my memo Liquidity (March 2015), I included an insight from my son Andrew. To paraphrase, he said, “If you look at the chart of a stock that’s been up for 25 years and say, ‘Man, I wish I’d owned that stock,’ think about all the days you would have had to talk yourself out of selling.” I doubt many people watched Apple go from $0.37 to $180 without selling any. How many active investors would allow Apple shares to constitute nearly 8% of their portfolios, which was its weight in the S&P 500 at the recent peak? But – to oversimplify – if they sold Apple, they’ve lagged. The bottom line is that winners aren’t entirely dispensable. If you hope to at least keep up with the indices, you probably have to have an average representation in them. (This isn’t entirely inescapable. You might also achieve that goal by holding fewer of the losers.) The Role of Risk Bearing I’m going to conclude this memo using my favorite graph.

banks today are well capitalized and have significant liquidity and healthy balance sheets. This makes it less likely that we’ll see a GFC-type round of bank failures. I’ve heard it argued that current regulations and the resultant financial condition of banks aren’t robust enough, but I believe most banks – and especially the majors – are much stronger than they were before and during the GFC and typically much stronger than SVB. Interestingly, Canada, Australia, and Britain function very well with far fewer banks than the U.S. Canada, for example, has $2 trillion of GDP and just 34 domestic banks (17 per $1 trillion of GDP), and it seems to get by. In contrast, in 2021, the U.S. had 4,236 FDIC-insured commercial banks for its $20 trillion of GDP, or 212 banks per $1 trillion. Could regulators do a better job if there were fewer banks to monitor? We’ll see what happens to the number of U.S. banks if big ones absorb smaller ones and deposits become concentrated in the bigger ones. But given the role of private parties and their money in our system of government, I don’t expect to see a major change. © 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.

” Non-investment grade bonds – those rated double-B and below – were off-limits to fiduciaries, since proper financial behavior mandated the avoidance of risk. For this reason, what soon became known as high yield bonds couldn’t be sold as new issues. But in the mid-1970s, Michael Milken and a few others had the idea that it should be possible to issue non-investment grade bonds – and to invest in them prudently – if the bonds offered enough interest to compensate for the risk of default. In 1978, I started investing in these securities – the bonds of perhaps America’s riskiest public companies – and I was making money steadily and safely. In other words, whereas prudent bond investing had previously consisted of buying only presumedly safe investment grade bonds, investment managers could now prudently buy bonds of almost any quality as long as they were adequately compensated for the attendant risk. The U.S. high yield bond universe amounted to about $2 billion when I first got involved, and today it stands at roughly $1.2 trillion. This clearly represented a major change in direction for the business of investing. But that’s not the end of it. Prior to the inception of high yield bond issuance, companies could only be acquired by larger firms – those that were able to pay with cash on hand or borrow large amounts of money and still retain their investment grade ratings.

The illogicality of his advice makes clear how simplistic this adage – like many others – really is. However, regardless of the details, people may unquestioningly accept that they should sell appreciated investments. But how helpful is that basic concept? Origins Much of what I’ll write here got its start in a 2015 memo called Liquidity. The hot topic in the investment world at that moment was the concern about a perceived decline in the liquidity provided by the market (when I say “the market,” I’m talking specifically about the U.S. stock market, but the statement has broad applicability). This was commonly attributed to a combination of (a) the licking investment banks had taken in the Global Financial Crisis of 2008-09 and (b) the Volcker Rule, which prohibited risky activities such as proprietary trading on the part of systemically important financial institutions. The latter constrained banks’ ability to “position” securities, or buy them, when clients wanted to sell. Maybe liquidity in 2015 was less than it had previously been, and maybe it wasn’t. However, looking beyond the events of the day, I closed that memo by stating my conviction that (a) most investors trade too much, to their own detriment, and (b) the best solution for illiquidity is to build portfolios for the long term that don’t rely on liquidity for success.

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: investors are able to ignore short-term performance, hold for the long run, and avoid excessive trading costs, while everyone else worries about what’s going to happen in the next month or quarter and therefore trades excessively. In addition, long-term investors can take advantage if illiquid assets become available for purchase at bargain prices. Like so many things in investing, however, just holding is easier said than done. Too many people equate activity with adding value. Here’s how I summed up this idea in Liquidity, inspired by something Andrew had said: When you find an investment with the potential to compound over a long period, one of the hardest things is to be patient and maintain your position as long as doing so is warranted based on the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. Everyone wishes they’d bought Amazon at $5 on the first day of 1998, since it’s now up 660x at $3,304. • But who would have continued to hold when the stock hit $85 in 1999 – up 17x in less than two years?

• Who among those who held on would have been able to avoid panicking in 2001, as the price fell 93%, to $6? • And who wouldn’t have sold by late 2015 when it hit $600 – up 100x from the 2001 low? Yet anyone who sold at $600 captured only the first 18% of the overall rise from that low. This reminds me of the time I once visited Malibu with a friend and mentioned that the Rindge family is said to have bought the entire area – all 13,330 acres – in 1892 for $300,000, or $22.50 per acre. (It’s clearly worth many billions today.) My friend said, “I’d like to have bought all of Malibu for $300,000.” My response was simple: “you would have sold it when it got to $600,000.” The more I’ve thought about it since writing Liquidity, the more convinced I’ve become that there are two main reasons why people sell investments: because they’re up and because they’re down. You may say that sounds nutty, but what’s really nutty is many investors’ behavior. Selling Because It’s Up “Profit-taking” is the intelligent-sounding term in our business for selling things that have appreciated. To understand why people engage in it, you need insight into human behavior, because a lot of investors’ selling is motivated by psychology. In short, a good deal of selling takes place because people like the fact that their assets show gains, and they’re afraid the profits will go away. Most people invest a lot of time and effort trying to avoid unpleasant feelings like regret and embarrassment.

© 2022 Oaktree Capital Management, L.P. All Rights Reserved Follow us: That’s what I think happened to investors over the last 40 years. They enjoyed the growth of the economy and the companies they invested in, as well as the resulting increase in the value of their ownership stakes. But in addition, they were on a moving walkway, carried along by declining interest rates. The results have been great, but I doubt many people fully understand where they came from. It seems to me that a significant portion of all the money investors made over this period resulted from the tailwind generated by the massive drop in interest rates. I consider it nearly impossible to overstate the influence of declining rates over the last four decades. The Recent Experience The period between the end of the Global Financial Crisis in late 2009 and the onset of the pandemic in early 2020 was marked by ultra-low interest rates, and the macroeconomic environment – and its effects – were highly unusual. An all-time low in interest rates was reached when the Fed cut the fed funds rate to approximately zero in late 2008 in an effort to pull the economy out of the GFC. The low rates were accompanied by quantitative easing: purchases of bonds undertaken by the Fed to inject liquidity into the economy (and perhaps to keep investors from panicking). The effects were dramatic: • The low rates and vast amounts of liquidity stimulated the economy and triggered explosive gains in the markets.

• Strong economic growth and lower interest costs added to corporate profits. • Valuation parameters rose, as described above, lifting asset prices. Stocks increased non-stop for more than ten years, except for a handful of downdrafts that each lasted a few months. From a low of 667 in March 2009, the S&P 500 reached a high of 3,386 in February 2020, for a compound return of 16% per year. • The markets’ strength encouraged investors to drop their crisis-inspired risk aversion and return to risk taking much sooner than expected. It also made FOMO – the fear of missing out – the prevalent emotion among investors. Buyers were eager to buy, and holders weren’t motivated to sell. • Investors’ revived desire to buy caused the capital markets to reopen, making it cheap and easy for companies to obtain financing. Lenders’ eagerness to put money to work enabled borrowers to pay low interest rates under less-restrictive documentation that reduced lender protections. • The paltry yields on safe investments drove investors to buy riskier assets. • Thanks to economic growth and plentiful liquidity, there were few defaults and bankruptcies. • The main exogenous influences were increasing globalization and the limited extent of armed conflict around the world. Both influences were clearly salutary. As a result, in this period, the U.S. enjoyed its longest economic recovery in history (albeit also one of its slowest) and its longest bull market, exceeding ten years in both cases.

• Thus, while the Fed appears likely to slow the pace of its interest rate increases, it’s unlikely to return to stimulative policies any time soon. • The Fed has to maintain credibility (or regain it after having claimed for too long that inflation was “transitory”). It can’t appear to be inconstant by becoming stimulative too soon after having turned restrictive. • The Fed faces the question of what to do about its balance sheet, which grew from $4 trillion to almost $9 trillion due to its purchases of bonds. Allowing its holdings of bonds to mature and roll off (or, somewhat less likely, making sales) would withdraw significant liquidity from the economy, restricting growth. • Rather than be in a stimulative posture on a perpetual basis, one might imagine the Fed would prefer to normally maintain a “neutral interest rate,” which is defined as neither stimulative nor restrictive. (I know I would.) Most recently – last summer – that rate was estimated at 2.5%. © 2022 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

• They injected trillions of dollars of liquidity into the economy in the form of benefit payments to individuals, loans and grants to businesses and governments, enhanced unemployment insurance and large-scale bond buying. In fact, I think of 2020 as the year the word “trillions” came into everyday use. • Many people made more money in 2020 than they did in 2019, thanks to the enhanced benefits. 2020’s above-trend incomes coincided with below-trend spending, as we couldn’t take vacations or spend money on dinners, concerts, weddings, etc. The combination of these developments is estimated to have added roughly $2 trillion to consumer balance sheets. © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

while there are enormous uncertainties, there is a chance that macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability. (Emphasis added) Normally one would expect such a flood of additional liquidity into the economy to cause inflation to accelerate, but the Fed says no. Of course, although central banks might like to see inflation increase (as it makes it cheaper to repay debt), they have to discourage such talk for fear of fueling inflationary expectations. On the other hand, we’ve had substantial deficits and accommodative monetary policy ever since 2008 and no serious inflation. We’ve seen a 50-year-low in the unemployment rate and yet not the inflation the Phillips Curve would have predicted. And Japan and Europe have been trying for 2% inflation for years without success. Is inflation a threat anytime soon? The answer’s clear: who knows? In addition to these major risks, there are others that – although perhaps smaller, less consequential or less imminent – should nevertheless be considered: © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

Rather, if an investor has studied a company, reached a deep understanding of it and concluded that it possesses great potential for growth and profitability, he’ll probably recognize that it’s impossible to accurately quantify that potential and know when it has been realized. He also may realize that ultimate potential is a moving target, as the company’s strengths may allow it to develop additional avenues of growth. Thus he might have to accept that the correct approach is to (a) hope he has the direction and quantum approximately right, (b) buy and (c) hold on as long as the evidence suggests the thesis is right and the trend is upward – in other words, as long as there’s still juice in the orange. My 2015 memo Liquidity included some observations from Andrew regarding point “c”: When you find an investment with the potential to compound over a long period of time, one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. He hasn’t changed his tune one bit over the last five years.

This has been achieved through the radical lowering of interest rates and the injection of massive amounts of liquidity into the economy. The Fed funds rate – the bellwether of short-term interest rates in the U.S. – was reduced to zero for the first time during the Global Financial Crisis of 2008-09. And it worked – what followed was the longest economic recovery in U.S. history. But rates weren’t raised when the recovery was at its strongest, and when they finally were raised in 2017-18, the markets threw a tantrum and the Fed backed down, cutting rates instead. Now the Fed funds rate is zero again, the markets are far higher than they were in the last decade, and we’re seeing serious inflation. The Fed has announced that it’s going to “taper” its stimulative program of bond buying, and it is widely expected that it will begin to raise interest rates next year. Will the © 2021 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

” Looking at the above, it’s important to note the degree to which people (and thus markets) seem to think long-term phenomena can change in the short run. It’s common knowledge that the coronavirus is still gaining ground in the U.S. and elsewhere; the economy is destined for a serious recession; leveraged entities have to worry about their sources of loans and liquidity; and the price of oil is among the very lowest since the 1973 OPEC embargo. But the prices of financial assets have moved down as well: appropriately, too much or too little? In other words, we have to consider the outlook and the appropriateness of value, in the context of unprecedented uncertainty and the total absence of guidance from analogies to the past. There’s no doubt about the ability of the government’s and the Fed’s massive cash injections to make things better in the short run, and certainly the market has treated them as sure winners. But I think it’s important to take time out for a serious discussion of possible scenarios. Are this past week’s remedies certain to work? Are the prior week’s negatives really erased? Which will win in the short and intermediate term: the disease, economic ramifications or Fed/Treasury actions? To try to think about these things in a responsible way, I’ve decided to try cataloging the optimistic and pessimistic elements. © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.RESERVED

The economy began to reopen in May, supported by a near-zero base interest rate and the Fed’s provision of abundant liquidity, and the initial response was positive. Retail sales moved up 17.7% in May (after a 22.3% decline in March/April), and the unemployment rate fell to 11.1% in June, from a peak suspected to have been near 20%. Case closed. Failure to Fix It If only it was that simple. Unfortunately, in some instances the reopening took place before the number of new cases had declined enough for the spread of Covid-19 to be brought under control, and people in areas that had been spared in the early days acted cavalierly, allowing the disease to regain a foothold in their regions. Borrowing from Churchill (who probably borrowed it from Machiavelli), people who regulate economies and manage businesses say “never let a good crisis go to waste.” But in the case of Covid-19, the U.S. did just that. The nations of Asia and Europe had the earliest outbreaks, but they took swift and stern action – some say Draconian – including enforcing isolation and fining violators. But they got the disease under control. Unfortunately, a number of elements combined to weaken the actions taken in the U.S. and permit a resurgence of the disease: • The absence of uniform national policies on shutdowns, social distancing, masking and re- opening. • Inadequate support for the recommendations of health professionals and scientists.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • The U.S.’s effective private sector will supplement the public health efforts of government, producing massive amounts of supplies and equipment, and developing testing, treatments and vaccines. • The price declines of securities will draw in buyers, and ample capital is available in the form of dry powder in funds. When I read the more positive views regarding the current episode, I can’t help but think back to my favorite newspaper headline, which included the phrase “Bankers Optimistic.” Usually the case, perhaps, but it’s worth noting that the story in question was published on October 30, 1929, reporting on the prior day’s stock market crash. On that day of optimism, the Great Depression still had eleven years to run. The Negative Case I always say we have to be aware of and open about our biases. I admit to mine: I’m more of a worrier than a dreamer. Maybe that’s what made me a better credit analyst than equity analyst. On average I may have been more defensive than was necessary (although somehow I was able to shift to aggressive action when crisis lows were reached during my career). Thus it shouldn’t come as a surprise today that my list of cons is longer than my pros (and I will elaborate on them at greater length). • I’m very worried about the outlook for the disease, especially in the U.S. For a long time, the response consisted of suggestions or advice, not orders and rules.

 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.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: the federal government, cities and states can’t engage in unlimited deficit spending since they can’t print money or issue seemingly unlimited amounts of debt. Like companies and individuals, they need significant aid. On September 24, The Wall Street Journal reported on Fed officials’ testimony to Congress: The recovery would move along faster “if there is support coming both from Congress and from the Fed,” Chairman Jerome Powell said during the second of three days of congressional testimony Wednesday. Chicago Fed President Charles Evans told reporters that his projection that the unemployment rate would fall below 6% by the end of next year had been premised on around $1 trillion in additional fiscal relief. “If that doesn’t happen, then I think it’s going to be a lot harder, and much more unlikely that we make that much progress,” he said. . . . “The power of fiscal policy is really unequaled by anything else,” Mr. Powell told lawmakers on a House panel overseeing the U.S. response to the coronavirus. (Emphasis added) The same day, Dennis DeBusschere of Evercore ISI wrote: On monetary policy, the Fed is not out of bullets and still has quasi-fiscal programs like the Main Street Lending Program (MLSP) and the Municipal Liquidity Facility (MLF). But as our friends at Macro Policy Partners pointed out, “Powell all but waved the white flag on those programs in his remarks, which is troubling.

In other words, we use a lot of pattern-driven guesswork as we go about our daily lives or to fill in the gaps in an incomplete narrative. This is especially true in times of stress, as many of the mental processes that govern our reactions are associated with an urgent search for patterns to determine our moves. That is our snap reaction in economic or financial crises and why we cling to our repertoire of charts of V, U or L-shapes of recovery, among many. But, in very dislocated environments, we find serious limitations to this approach. Looking at the current environment, with disruptions to supply, demand, health and liquidity tensions, we could build an ensemble of the Spanish flu, the Fukushima earthquake and components of the 2008 crisis, for example. But given the very specific contexts of each event, we may run into endless combinations of the lessons learnt from these events. As a matter of fact, in a side-by-side comparison of many economic forecasts, even similar assumptions drive very different outcomes on how this crisis will play out. This may be a case of the “Anna Karenina principle” coined by Professor Yossi Sheffi at Massachusetts Institute of Technology. Paraphrasing Tolstoy, while happy economies are all alike, every unhappy economy is unhappy in its own way. We can’t assume that the response to public health or financial interventions will be similar across vastly different contexts.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: become excessive at the top (and vice versa on the downside). But in the current case, a moderate recovery – marked by reasonable growth, realistic expectations, an absence of corporate overexpansion and a lack of investor euphoria – was struck down by an unexpected meteor strike. People also ask what’s different about this episode from those I’ve lived through in the past. • As described above, the normal cyclical progression of ups and downs – and the normal series of events, each of which causes the next – had nothing to do with it. The current downturn didn’t result from excessively optimistic business decisions or too-high growth expectations that were disappointed, but rather from an exogenous event that brought a sudden end to the expansion. Thus the factors that result in and normally characterize a cyclical recovery – most of all the recognition that negativism is excessive and stimulative measures are required to turn things around – are unlikely to do the trick this time. Since the root cause of the current problem is medical rather than economic, merely cutting interest rates and flooding the economy with liquidity may not kickstart a recovery as usual. Rather, the virus has to be brought under control.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: The Markets and the Fed The U.S. stock market continues its ascent, and as measured by the S&P 500, it’s just about back to where all this started: the all-time record of 3,386 attained on February 19. The market for corporate credit has been strong as well. Here’s the macro situation, hopefully reduced to the bare essentials: The positives: • The reduction of interest rates to near zero has increased the value of investment assets and spurred a global bidding war that has raised their prices. • The Fed has flooded the economy and the markets with liquidity and other forms of support for individuals, companies and institutions. • The Fed and the Treasury seem willing to provide support and stimulus well into the future. The negatives: • The economy has suffered the greatest quarterly setback in history. • Covid-19 still isn’t under control. • A second spike is complicating efforts to re-open the economy. In short, titanic forces are arrayed against each other: Fed and Treasury versus disease and recession. Which will win? No one knows about the long run, but it’s clear which has come out on top so far. Lower interest rates increase the discounted present value of future cash flows and reduce the a priori return demanded from every investment.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: As recounted above, the negative case encompasses rising numbers of infections and deaths, unbearable strain on the healthcare system, job losses in the many millions, widespread business losses and mounting defaults. If these things arise, investors are likely to shift from the optimism of last week to the pessimism that was prevalent in the rest of March. Contributing factors may include: o negative psychology surrounding the combination of threats to the economy and life itself, o fear of more, and o a very negative wealth effect that depresses spending and investing. The Government Programs Last week the government enacted the CARES (Coronavirus Aid, Relief, and Economic Security) Act, with roughly $2 trillion of rescue and support. At the same time, the Fed will spend several trillion more to provide liquidity and buttress the financial system, and it has “committed to using its full range of tools.” I will dispense with listing all the provisions of the CARES Act, and merely note that J.P. Morgan’s description runs to eight pages. And as mentioned above, the list of ingredients and their magnitude are likely to grow. I’ll share a useful description of the economic situation and the government response from Conrad DeQuadros of Brean Capital, an economist I’ve taken to quoting: The CARES Act should not be thought of as fiscal stimulus but as an economic stabilization package.

Further, we have to wonder about the desirability of using 50 bps of the 150 bps the Fed does have at its disposal. Will it be enough? And what will the Fed be able to do when the economic impact of the virus has been muted but we only have 100 bps or less left with which to fight any recession that appears? The facts regarding monetary and fiscal policy are these:  In 2009, to fight the Global Financial Crisis, the Fed cut short-term rates to zero for the first time.  Not wanting to derail the subsequent recovery, it hesitated to raise rates before Chair Yellen enacted a series of rate increases in 2015-18 that took the Fed funds rate to 2.25-2.50%.  When around the end of 2018 interest rates reached levels that investors feared would jeopardize the economic expansion, Chair Powell’s Fed reversed course and embarked on a series of three rate cuts.  Thus today we have the 150 bps I mentioned above – “limited ammunition.”  In addition to rate cuts, the Fed has the ability to pump liquidity into the economy by engaging in quantitative easing through purchases of government securities. But we can’t know the long-term impact of expansion of the Fed’s balance sheet.  Finally, looking away from the Fed, we can think about fiscal policy (i.e., increased deficit spending). But this will add even more to our national debt. Normally, fiscal and monetary stimulus is applied in times of economic weakness.

In layman’s terms, when the fed funds rate is zero, 6% bonds look like a giveaway, so buyers bid them up until they yield less (thus I believe 97% of outstanding bonds yield less than 5% today, and 80% yield less than 1%). And Fed buying drives up the price of financial assets and puts money into sellers’ hands with which they can buy other assets, further elevating prices. For all these reasons, monetary actions have come out on top so far, validating the old maxim that “you can’t fight the Fed.” But what does it mean if the prices of stocks and listed credit instruments are where they are not primarily for fundamental reasons – such as current earnings and the outlook for future gains – but rather in large part because of the Fed’s buying, its injection of liquidity, and the resultant low cost of capital and low demanded returns? If high asset prices are substantially the result of tailwinds from technical factors such as these, does it mean those actions have to be continued in order for asset prices to remain high, and that if the Fed reduces its activity, those prices will fall? And that leads to the ultimate question (as Bruce Karsh seems to ask daily): can the Fed keep it up forever? Are there any limits on its ability to create bank reserves, buy assets and expand its balance sheet? And are there limits on the Treasury’s willingness to run deficits, now that it has taken this year’s to $4 trillion and shown an inclination to go well beyond that?

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Reserve System and accordingly a voting member of the Federal Open Market Committee. Here’s his reply: There is no limit on the ability of a central bank to create reserves, as long as someone is willing – or through government edicts, forced – to take them. This was true in the extreme circumstances of Weimer Germany, Brazil in the 1970s/80s, and it is true Zimbabwe today, as well as in the much more benign current situation in Japan. The key question is the impact of that reserve creation on money supply and the demand for money. Treasury’s appetite for deficit financing will remain high as long as real and nominal interest rates remain low. In the last five months, the Fed has swollen its balance sheet by $3 trillion and the Treasury has added $3 trillion to the expected deficit, for a total increase of liquidity in the economy of $6 trillion, probably with more to come. It’s normal to assume that an increase in liquidity on that order will increase the demand for goods relative to the supply, bringing on increased inflation, as it already has for financial assets. (Note, however, that even with interest rates low for a decade and near zero today, inflation hasn’t come close to the Fed’s target of 2%. If growth remains weak and inflation stays low, the Fed is likely to believe it can continue an activist regime.)

Here’s Randy Kroszner’s view: I think this is the key point: whether it is Japan, where the BoJ’s balance sheet exceeds 100 percent of GDP and continues to grow rapidly, or the ECB with a balance sheet of more than 50 percent of Eurozone GDP and growing, or the Fed with a balance sheet of just over a third of US GDP and growing, inflation has been below the 2 percent target, and expectations of inflation over short and long horizons remain low. Even when the U.S. was growing 2-3 percent pre-Covid, we didn’t see an uptick in inflation or inflation expectations. As long as there continues to be a very large demand for super liquid safe assets like bank reserves and cash, the central banks can maintain large balance sheets – and even increase them – without a sharp increase in money supply that ignites inflation. The ongoing uncertainty over the course of the virus and the policy responses will undoubtedly keep the demand for safe liquid assets high for some time. It’s also normal to assume that monetary expansion like this can lead to a weaker dollar, downgrades of the U.S.’s creditworthiness by rating agencies, higher interest costs on national debt, and/or jeopardy to the dollar’s status as the world’s reserve currency. All these things could increase the difficulty of servicing the U.S.’s expanded national debt, feeding back into still-higher deficits.

” On the days those two spoke, both the plain vanilla forward-looking p/e ratio and the Shiller cyclically adjusted price-to-earnings ratio were well above normal levels, disregarding all the uncertainties present and the big declines that lie ahead for GDP and earnings. And yet, over the next four weeks leading up to the June 8 high, the S&P 500 rose an additional 13%. What this proves is that either (a) “overpriced” isn’t synonymous with “sure to decline soon” or (b) Druckenmiller and Tepper were wrong. I’ll go with (a). On June 8, Druckenmiller described himself as “humbled.” (In this line of work, if you never feel humbled, it just means you haven’t realistically appraised your performance.) All I know is that a lot of smart, experienced investors concluded that asset prices had become too high for the fundamentals. Time will tell. * * * There’s no way to determine for sure whether an advance has been appropriate or irrational, and whether markets are too high or too low. But there are questions to ask: • Are investors weighing both the positives and the negatives dispassionately? • What’s the probability the positive factors driving the market will prove valid (or that the negatives will gain in strength instead)? • Are the positives fundamental (value-based) or largely technical, relating to inflows of liquidity (i.e., cash-driven)? If the latter, is their salutary influence likely to prove temporary or permanent? • Is the market being lifted by rampant optimism?

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: • Is that optimism causing investors to ignore valid counter-arguments? • How do valuations based on things like earnings, sales and asset values stack up against historical norms? Questions like these can’t tell us for a fact whether an advance has been reasonable and current asset prices are justified. But they can assist in that assessment. They lead me to conclude that the powerful rally we’ve seen has been built on optimism; has incorporated positive expectations and overlooked potential negatives; and has been driven largely by the Fed’s injections of liquidity and the Treasury’s stimulus payments, which investors assume will bridge to a fundamental recovery and be free from highly negative second-order consequences. A bounce from the depressed levels of late March was warranted at some point, but it came surprisingly early and quickly went incredibly far. The S&P 500 closed last night at 3,113, down only 8% from an all-time high struck in trouble-free times. As such, it seems to me that the potential for further gains from things turning out better than expected or valuations continuing to expand doesn’t fully compensate for the risk of decline from events disappointing or multiples contracting. In other words, the fundamental outlook may be positive on balance, but with listed security prices where they are, the odds aren’t in investors’ favor. June 18, 2020 © 2020 OAKTREE CAPITAL MANAGEMENT, L.P.

2T $ in PE dry powder, low gas prices and 0% interest rates pour fuel onto on the economy. The roaring 20’s mean the 2020's now. Bear case: Unemployment goes to 20%+. Everything does NOT go back to normal before at least a year or two, and in the meantime, there is a huge demand shock. The effects of the lockdown on businesses as well as the oil shock create depression-like conditions. In the Global Financial Crisis, I worried about a downward cascade of financial news, and about the implications for the economy of serial bankruptcies among financial institutions. But everyday life was unchanged from what it had been, and there was no obvious threat to life and limb. Today the range of negative outcomes seems much wider, as described above. Social isolation, disease and death, economic contraction, enormous reliance on government action, and uncertainty about the long-term effects are all with us, and the main questions surround how far they will go. Nevertheless, the market prices of assets have responded to the events and outlook (in a very micro sense, I feel last week’s bounce reflected too much optimism, but that’s me). I would say assets were priced fairly on Friday for the optimistic case but didn’t give enough scope for the possibility of worsening news. Thus my reaction to all the above is to expect asset prices to decline. You may or may not feel there’s still time to increase defensiveness ahead of potentially negative developments.

But as everyone knows, the Treasury and Fed announced rescue programs in mid-March and an enlarged Fed program during the week of March 23: zero interest rates, bond buying, grants, loans and significantly enhanced unemployment payments. The total ran to multiple trillions of dollars. And the authorities made it clear that there was more behind that: that the available resources were unlimited. • People accepted that the recession would end and a recovery take its place in short order. • With short-term interest rates near zero, investors lined up to buy bonds in the quest for return. Thus rather than a credit crunch, there’s been record amounts of capital available. • Even though the rescue provided “liquidity but not solvency,” whole industries (like the airlines) were saved from sure bankruptcy. • There were none of the spectacular implosions that mark most crises. • Ditto for panic selling. • Pessimism was replaced by willingness to think about better times ahead. • With interest rates at zero, investors couldn’t afford to be risk averse. They had to embrace risk assets in order to have a shot at returns above the low single digits. • Thus asset prices recovered. To illustrate the effect, since April 1, investors in distressed debt have had opportunities to make large rescue loans to companies or entities needing a quick response to problems related to illiquidity or pending debt maturities, and there’s still a good pipeline.

© 2020 Oaktree Capital Management, L.P. All Rights Reserved Follow us: to the tantrum the stock market threw in the fourth quarter of 2018, when the yield on the ten-year Treasury got up to 3.25%. It was enough to end the program of interest rate increases that Janet Yellen had initiated and bring on a series of cuts instead.) If investors believe the Fed can always be counted on to keep the markets aloft, that will encourage dangerous behavior. And, anyway, it seems like an impossible task and, in my opinion, a questionable goal for the Fed. Third, the kneejerk reaction to trillions of dollars of deficit spending on the part of the Treasury and further trillions of dollars of bond buying by the Fed is worry about inflation. The injection into the economy of trillions in added liquidity would seem to have the potential to create too much money chasing too little in the way of goods, causing prices to rise (as it has done for assets). Further, as a result of the rescue measures, we’re running a multi-trillion-dollar deficit and adding trillions to the national debt, which as a percentage of GDP now approaches the high established after World War II. Printing large amounts of money has had severe consequences in the past. One wonders whether the 2020 version might bring about some of the things traditionally associated with currency debasement: • undesirably high inflation, • weakness of the U.S. dollar, • a downgrade of the U.S.

© 2019 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Carlos: You know that means you’ll get less out on Monday than you put in today. HM: Okay, then don’t put it in the bank. Carlos: You have to put it in the bank. HM: So put it in the bank. That’s it in a nutshell. Money can’t be free-floating in space. It has to be someplace. And you can’t keep much of it in your wallet or under the mattress. Thus, in general, any substantial sum has to go into the bank. And in Europe – then and now – doing so means you’ll get out less than you put in. I have to admit that this didn’t come as a shock to me. Oaktree and I had turned very cautious in 2005-06, and as a result, all of my money that wasn’t in Oaktree funds was in a “laddered portfolio” of U.S. Treasurys. (In my case, equal amounts of 1, 2, 3, 4, 5 and 6-year maturities. When the closest-in note matures, you roll it to the end of the line. It’s the most mindless form of investing known to man.) At the time I put that portfolio together, I signed up for a yield in the range of 5-6%. And I was thrilled: the greatest safety, total liquidity and a meaningful yield. But then, in 2007, the Fed started cutting rates to rescue the economy from the sub-prime mortgage crisis. And one day in late 2008, my banker called to say, “The 6% note has matured. You can roll it over at five-eighths.” I asked, “What-and-five-eighths?” “No, that’s it,” he said, “just five-eighths.” The world had changed.

” Thus the imprudent deals that were getting done in 2005-06 were reason enough for us to increase our caution. The Current Environment What are the elements that have created the current investment environment? In my view, they’re these:  In order to counter the contractionary effects of the Crisis, the world’s central banks flooded their economies with liquidity and made credit available at artificially low interest rates.  This caused the yields on investments at the safer end of the risk/return continuum to range from historically low in the United States to negative (and near zero) in Europe and elsewhere. At least some of the money that in the past would have gone into low-risk investments, such as money market instruments, Treasurys and high grade bonds, turned elsewhere in search of more suitable returns. (In the U.S. today, most endowments and defined-benefit pension funds require annual returns in the range of 7½-8%. It’s interesting to note that the notion of required returns is much less prevalent among investing institutions outside the U.S., and where they do exist, the targets are much lower.)  Whereas I thought while it was raging that the pain of the Crisis would cause investors to remain highly risk-averse for years – and thus to refuse to provide risk capital – by injecting massive liquidity into the economy and lowering interest rates, the Fed limited the losses and forced the credit window back open, rekindling investors’ willingness to bear risk.

Here’s how he recently put it: “I tell my students real estate has ten-year cycles, but luckily bankers have five-year memories.”  Investors have had plenty of time to get used to monetary stimulus and reliance on the Fed to inject liquidity to support economic activity.  While there certainly is no hard-and-fast rule that limits economic recoveries to ten years, it seems reasonable to assume based on history that the odds are against a ten-year-old recovery continuing much longer. (On the other hand, since the current recovery has been the slowest since World War II, it’s reasonable to believe there haven’t been the usual excesses that require correcting, bringing the recovery to an end. And some observers feel that in the period ahead, a proactive or politicized Fed might well return to cutting interest rates – or at least stop raising them – if weakness materializes in the economy or the stock market.)  Finally, it’s worth noting that nobody who entered the market in nearly ten years has experienced a bear market or even a really bad year, or seen dips that didn’t correct quickly. Thus newly minted investment managers haven’t had a chance to learn firsthand about the importance of risk aversion, and they haven’t been tested in times of economic slowness, prolonged market declines, rising defaults or scarce capital.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Question number five: “Is there anything innately wrong with ETFs and their popularity?” ETFs are just another vehicle for buying stocks and bonds. They’re neither good nor bad per se. But there is a way in which I worry about ETFs’ impact, and it has to do with the expectations of the people who invest in them. My thinking goes back to the reason ETFs gained popularity in the first place: the ability to buy or sell them anytime the market is open. I’d bet a lot of the people who make use of ETFs do so for the simple reason that they think they’re “more liquid.” There are a couple of problems with this. First, as I wrote in “Liquidity” (March 2015), the fact that something is able to be sold legally, or the fact that there’s a market for it, can be very different from the fact that it can always be sold at a price that’s intrinsically fair or close to the last price at which it sold. If bad news or a downturn in investor psychology causes the market to drop, invariably there’ll be a price at which an ETF holder can sell, but it may not be a “good execution.” The price received may represent a discount from the value of the underlying assets, or it may be less than it would have been if the market were functioning on an even keel. If you withdraw from a mutual fund, you’ll get the price at which the underlying stocks or bonds closed that day, the net asset value or NAV.

But the price you get when you sell an ETF – like any security on an exchange – will only be what a buyer is willing to pay for it, and I suspect that in chaos, that price could be less than the NAV of the underlying securities. Mechanisms are in place that their designers say should prevent the ETF price from materially diverging from the underlying NAV. But we won’t know if “should” is the same as “will” until the mechanisms are tested in a serious market break. Some people may have invested in ETFs in the mistaken belief that they’re inherently more liquid than their underlying assets. For example, high yield bond ETFs have been very popular, probably because it’s far easier to buy an ETF than to assemble a portfolio of individual bonds. But what’s the probability that in a crisis, a high yield bond ETF will prove more liquid than the underlying bonds (which themselves are likely to become quite illiquid)? The weakness lies in the assumption that a vehicle can provide more liquidity than is provided by its underlying assets. There’s nothing wrong with the fact that ETFs may prove illiquid. The problem will arise if the people who invested in them did so with the expectation of liquidity that isn’t there when they need it.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Thus the best we can do is turn cautious when the situation becomes precarious. We never know for sure when – or even whether – “precarious” is going to turn into “collapse.” To close, I’m going to recycle two of the final paragraphs of The Race to the Bottom. Doing so permits me to provide an excellent example of history’s tendency to rhyme: Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. . . . This memo can be recapped simply: there’s a race to the bottom going on, reflecting a widespread reduction in the level of prudence on the part of investors and capital providers. No one can prove at this point that those who participate will be punished, or that their long-run performance won’t exceed that of the naysayers. But that is the usual pattern. It’s now eleven years later, but I can’t improve on that. I’m absolutely not saying people shouldn’t invest today, or shouldn’t invest in debt. Oaktree’s mantra recently has been, and continues to be, “move forward, but with caution.

© 2018 Oaktree Capital Management, L.P. All Rights Reserved Follow us: later, when the buying has stopped and the price has receded. It might be possible to sell stock today at $20.03 or $20.04 that can be bought back at $20.00 or 20.01 in a few days.  Thus the quant provides liquidity that otherwise wouldn’t exist and is willing to carry positions overnight. In exchange the quant gets a couple pennies more for the stock he supplies than he’ll have to pay to buy it back. We might say that for the most part, the stat arb computer responds to disequilibria between the price of one stock and the prices of other stocks or the market as a whole, and it acts on the assumption that the relationships will revert to normal. The pennies made aren’t a big deal (perhaps a 0.1% profit in the above example), and as Renaissance Technologies said in a statement to a Senate subcommittee in 2014 concerning its core Medallion fund, “The model developed by Renaissance . . . makes predictions that are profitable only slightly more often than not.” But if you do it often enough and on enough leverage, stat arb can produce meaningful returns on equity. This is like what Long-Term Capital Management did in the late 1990s, looking for statistical divergences that could be arbitraged. One of its executives described what it did as going around the world picking up nickels and dimes.

” 4. “There are stocks that are past my sell points, and I’m letting them continue to burble higher.” 5. “I appreciate Howard Marks’s message but I think now is no more a time to be cautious than at any other time. We should always invest as if the best is yet to come but the worst could be right around the corner. This means durable portfolios, hedges, cash reserves . . . etc. There is no better or worse time for any of these things that we can foresee in advance.” I take issue with all these statements, especially the last, and I want to respond – not just in the sense of “dispute,” but rather to clarify where I stand. In doing so, I’ll incorporate some of what I said during my appearances on TV following the memo’s publication. Numbers one and two are easy. As I explained on CNBC, there are two things I would never say when referring to the market: “get out” and “it’s time.” I’m not that smart, and I’m never that sure. The media like to hear people say “get in” or “get out,” but most of the time the correct action is somewhere in between. I told Bloomberg, “Investing is not black or white, in or out, risky or safe.” The key word is “calibrate.” The amount you have invested, your allocation of capital among the various possibilities, and the riskiness of the things you own all should be calibrated along a continuum that runs from aggressive to defensive. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: return. You want to take risk when others are fleeing from it, not when they’re competing with you to do so. Do you see any differences between then and now? Is there any need to redo this description? Not for me; I think “ditto” will suffice. I’ll simply go on to borrow the conclusion from “The Race to the Bottom” (February 2007): Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. The Seeds for a Boom My son Andrew worked extensively with me in preparing this memo. We particularly enjoyed making a list of the elements that typically form the foundation for a bull market, boom or bubble. We concluded that some or all of the following are necessary conditions. A few will give us a bull market.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Does that mean passive investing, index funds and ETFs are a no-lose proposition? Certainly not:  While passive investors protect against the risk of underperforming, they also surrender the possibility of outperforming.  The recent underperformance on the part of active investors may well prove to be cyclical rather than permanent.  As a product of the last several years, ETFs’ promise of liquidity has yet to be tested in a major bear market, particularly in less-liquid fields like high yield bonds. Here are a few more things worth thinking about: Remember, the wisdom of passive investing stems from the belief that the efforts of active investors cause assets to be fairly priced – that’s why there are no bargains to find. But what happens when the majority of equity investment comes to be managed passively? Then prices will be freer to diverge from “fair,” and bargains (and over-pricings) should become more commonplace. This won’t assure success for active managers, but certainly it will satisfy a necessary condition for their efforts to be effective. One of my clients, the chief investment officer of a pension fund, told me the treasurer had proposed dumping all active managers and putting the whole fund into index funds and ETFs. My response was simple: ask him how much of the fund he’s comfortable having in assets no one is analyzing.

It’s not clear where index funds and ETFs will find buyers for their over-weighted, highly appreciated holdings if they have to sell in a crunch. In this way, appreciation that was driven by passive buying is likely to eventually turn out to be rotational, not perpetual. Finally, the systemic risks to the stock market have to be considered. Bregman calls “the index universe a big, crowded momentum trade.” A handful of stocks – the FAANGs and a few more – are responsible for a rising percentage of the S&P’s gains, meaning the stock market’s health may be overstated. All the above factors raise questions about the likely effectiveness of passive vehicles – and especially smart-beta ETFs.  Is Apple a safe stock or a stock that has performed well of late? Is anyone thinking about the difference?  Are investors who invest in a number of passive vehicles described in different ways likely to achieve the diversification, liquidity and safety they expect?  And what should we think about the willingness of investors to turn over their capital to a process in which neither individual holdings nor portfolio construction is the subject of thoughtful analysis and decision-making, and in which buying takes place regardless of price? Credit Corporate debt instruments are good candidates for spotting bull-market behavior given that (unlike equities, for example), we can readily determine their prospective returns.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Private equity firms market double-digit return track records, and even their top-of-the-cycle 2005-07 funds now sport respectable gains. As a result, they’re attracting capital at all-time-high rates: Private equity is experiencing the best fundraising climate in years – perhaps ever. In the first half of the year, 224 North America-focused funds closed, raising $133 billion, while globally there have been 412 private equity funds closed, which raised a combined $221.4 billion, surpassing slightly the record $220.8 billion raised in 2008, according to Preqin. (Mergers & Acquisitions newsletter) Private equity funds have been raising total capital in the hundreds of billions for the last few years, and even before the latest spate of mega-funds, they already had several hundred billion of “dry powder.” Importantly, since private equity managers mostly engage in leveraged buyouts, these amounts have to be viewed in terms of the levered-up total capital they’ll produce. Thus the PE firms will probably add more than a trillion dollars to their buying power this year. Where will it be invested at a time when few assets can be bought at bargain prices? Sellers of private companies, too, tend to set asking prices for their firms based on what cash flows are worth in this low-return world. I’m not saying private equity isn’t a solution, or even that it’s not the best solution.

Can something that does that seriously be considered a “medium of exchange” or “store of value,” rather than the subject of a speculative mania? Maybe not, but Bitcoin looks staid in comparison to Ether, which has appreciated 4,500% so far this year. The outstanding Ether is now worth 82% as much as all the Bitcoin in the world, up from 5% at the beginning of the year. The New York Times notes that together, the outstanding Bitcoin and Ether are worth more than Paypal and almost as much as Goldman Sachs. Would you rather own all of the two digital currencies or one of those companies? In other words, are these currencies’ values real? They’re likely to keep working as long as optimism is present, but their performance in bad times is far from dependable. What will happen to Bitcoin’s price and liquidity in a crisis if people decide they’d rather hold dollars (or gold)? We Agree, But . . . Andrew told me about a conversation he had recently with some fund managers, in which he went over a lot of what I’m discussing here. Given today’s conditions, their response started predictably: “We agree, but . . .” We hear a lot of that these days:  We agree, but the things we’re doing offer higher returns than the rest.  We agree, but cash isn’t an option when it returns nearly nothing.  We agree, but we can’t take the risk of being out of the market.  We agree, but there’s no alternative. © 2017 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2017 Oaktree Capital Management, L.P. All Rights Reserved Follow us: Investors should choose their risk posture based on an assessment of what’s being offered in terms of absolute return, absolute risk, and thus absolute risk-adjusted return. But today – on that famous other hand – investors generally don’t have the luxury of holding out for absolute returns and safety like they enjoyed in the past. Many of the things I’ve highlighted above offer good returns and risk premiums relative to the returns on Treasurys and high grade debt. But (a) low rates may be – generally are expected to be – a temporary condition and (b) it might be wiser to gauge reward in absolute terms. The bottom line is that while the prices and prospective returns on many things are justifiable today relative to other things, you can’t eat (or spend) relative returns. Everyone’s investing on the basis of relatives these days; they see no alternative. But that reminds me of former Citigroup CEO Chuck Prince, who gained fame in the months leading up to the Global Financial Crisis for saying of the bank’s leveraged lending practices, “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. We’re still dancing.” Today I think most investors know the good times will end someday, as Prince did, but for now they feel they, too, have no choice but to dance.

 Finally, a number of issues internal to the markets – ranging from reduced liquidity to market- reporting glitches to the meltdown of high-risk credit funds – shook investors’ faith. © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

In 2014, while a $3½ billion fund, it had substantial holdings in particularly-high-risk, illiquid debt. Then it encountered snowballing capital withdrawals at a time of reduced market liquidity. Under circumstances like these, portfolio managers generally raise cash by liquidating their most salable holdings, causing the quality and liquidity of the remaining portfolio to decline. Continuing withdrawals took FCF’s assets below $800 million in December 2015, and I hear it was down to 20 or fewer holdings, all of extremely low quality. Further redemptions would have forced the manager to sell those, realizing extremely low prices, eliminating any liquidity that may have been present, and leaving investors who hadn’t redeemed holding the bag. The fault certainly lies with the fund’s managers. Risky, illiquid investments may be appropriate for closed-end funds whose capital is secure, but probably not for mutual funds or other vehicles subject to daily redemptions. It’s debatable whether a fund should be expected to be able to handle both an 80% © 2016 OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: loss of AUM and a substantial decline in liquidity. But, as I wrote in “Liquidity” (March 2015), “no investor should shoulder more illiquidity than its realities permit” and, in particular, “no investment vehicle should promise more liquidity than is afforded by its underlying assets.” Illiquid assets and the possibility of capital flight: there are few surer recipes for investment disaster. Investors lacking strong emotional and analytical foundations might have been scared into believing that FCF’s problems connoted – or presaged – widespread weakness among high yield bonds and other forms of risky debt. Those who were a bit less panicky might have understood that high yield bonds in general were probably secure but still feared that illiquidity would combine with cascading redemptions to cause a chain reaction of capital withdrawals from other funds, forced sales, and collapsing bond prices. But those with adequate emotional and analytical resources would have recognized that FCF’s problems were more endogenous and idiosyncratic than a function of high yield bonds broadly, and that adequate creditworthiness provides the debtholder’s ultimate protection against chaos in the market. Recent Developments Behavioral economics and its younger cousin, behavioral investing, aren’t theoretical.

The importance of psychology and its influence on markets must be recognized and dealt with.  The second key lies in controlling one’s emotions. An investor who is as subject as the crowd to emotional error is unlikely to do a superior job of surviving the markets’ swings. Thus it is absolutely essential to keep optimism and fear in the appropriate balance.  Emotional self-control isn’t enough. It’s also important to have control over one’s circumstances. For professionals, that primarily means structuring one’s environment so as to limit the impact on them of other people’s emotional swings. Examples include inflows to and outflows from funds, fluctuations in market liquidity, and pressure for short-term performance. At Oaktree we never fail to appreciate the benefit we enjoy from being able to reject “hot money” and limit our funds’ redemption provisions.  And finally there’s contrarianism, which can convert other investors’ emotional swings from a menace into a tool. Going beyond just fending off emotional fluctuation, it’s highly desirable to become more optimistic when others become more fearful, and vice versa. I’m lucky to have received many gifts of investment insight early in my career. Perhaps foremost among them is one I picked up in New York about 40 years ago, at a lunch meeting of what we called the Third Thursday Group.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Liquidity My wife Nancy’s accusations of repetitiveness notwithstanding, once in a while I think of something about which I haven’t written much. Liquidity is one of those things. I’m not sure it’s a profound topic, and perhaps my observations won’t be either. But I think it’s worth a memo. Liquidity Defined Sometimes people think of liquidity as the quality of something being readily saleable or marketable. For this, the key question is whether it’s registered, publicly listed and legal for sale to the public. “Marketable securities” are liquid in this sense; you can buy or sell them in the public markets. “Non- marketable” securities include things like private placements and interests in private partnerships, whose salability is restricted and can require the qualification of buyers, documentation, and perhaps a time delay. But the more important definition of liquidity is this one from Investopedia: “The degree to which an asset or security can be bought or sold in the market without affecting the asset's price.” (Emphasis added) Thus the key criterion isn’t “can you sell it?” It’s “can you sell it at a price equal or close to the last price?” Most liquid assets are registered and/or listed; that can be a necessary but not sufficient condition.

For them to be truly liquid in this latter sense, one has to be able to move them promptly and without the imposition of a material discount. Liquidity Characterized I often say many of the important things in investing are counter-intuitive. Liquidity is one of them. In particular, it’s probably more wrong than right to say without qualification that something is or isn’t “liquid.” If when people ask whether a given asset is liquid they mean “marketable” (in the sense of “listed” or “registered”), then that’s an entirely appropriate question, and answering it is straightforward. Either something can be sold freely to the public or it can’t. But if what they want to know is how hard it will be to get rid of it if they change their mind or want to take a profit or avoid a possible loss – how long it will take to sell it, or how much of a markdown they’ll have to take from the last price – that’s probably not an entirely legitimate question. It’s often a mistake to say a particular asset is either liquid or illiquid. Usually an asset isn’t “liquid” or “illiquid” by its nature. Liquidity is ephemeral: it can come and go. An asset’s liquidity can increase or decrease with what’s going on in the market. One day it can be easy to sell, and the next day hard. Or one day it can be easy to sell but hard to buy, and the next day easy to buy but hard to sell. In other words, the liquidity of an asset often depends on which way you want to go . . .

© Oaktree Capital Management, L.P. All Rights Reserved find your position is highly liquid: you can sell it quickly, and at a price equal to or above the last transaction. But if you want to sell when everyone else wants to sell, you may find your position is totally illiquid: selling may take a long time, or require accepting a big discount, or both. If that’s the case – and I’m sure it is – then the asset can’t be described as being either liquid or illiquid. It’s entirely situational. There’s usually plenty of liquidity for those who want to sell things that are rising in price or buy things that are falling. That’s great news, since much of the time those are the right actions to take. But why is the liquidity plentiful? For the simple reason that most investors want to do just the opposite. The crowd takes great pleasure from buying things whose prices are rising, and they often become highly motivated to sell things that are falling . . . notwithstanding that those may be exactly the wrong things to do. Further, the liquidity of an asset is very much a function of the quantity involved. At a given time, a stock may be liquid if you want to sell a thousand shares but highly illiquid if you want to sell a million. If so, it can’t be said categorically that the stock is either liquid or illiquid. But people do it all the time. Investment managers are often asked how long it would take to liquidate a given portfolio.

The answer usually takes the form of a schedule that says: “We could sell off x% of the portfolio in a day, y% in a week, and z% in a month, etc.” But that’s a terribly simplistic answer. It doesn’t say anything about how the price received would compare with the last trade or the price at which the assets were carried on the previous valuation date. Or about how changing market conditions might make the answer different a month from now. Bottom line: to the statement “we could sell off z% in a month” one should add “but who knows what the price will be, or what effect changing market conditions might have on that percentage?” Anything else requires an assumption that the assets’ liquidity is constant. That’s often far from the case. Usually, just as a holder’s desire to sell an asset increases (because he has become afraid to hold it), his ability to sell it decreases (because everyone else has also become afraid to hold it). Thus (a) things tend to be liquid when you don’t need liquidity, and (b) just when you need liquidity most, it tends not to be there. (In the 2014 Berkshire Hathaway Annual Letter, released early this month, Warren Buffett expresses his dislike for “substitutes for cash that are claimed to deliver liquidity and actually do so, except when it is truly needed.”) The truth is, things often seem more liquid when you buy than when you go to sell.

The bottom line is that it can be wrong to assume it’ll be easy and painless to get out of your holdings, and especially to exit a position after its price has begun to drop. Liquidity and Opportunities We watch TV, listen to radio or read newspapers. I’m always amused when the pundits say, “stocks went up today because several companies beat analysts’ earnings forecasts” or “the market dropped because of increased uncertainty regarding the price of oil.” How do they know? Where do buyers or sellers register their motivations, such that the media can discern them so definitively? There’s only one indisputable explanation for why the market went up on a given day: there were more buyers than sellers. When buyers have greater influence in the market than sellers – because would-be © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved buyers predominate relative to sellers; buyers feel more urgency than sellers; or buyers want to buy more shares than sellers want to sell – prices rise. Under those circumstances, sellers enjoy great liquidity, and buyers have to pay a premium over prior prices. So there’s the germ of a plan. Why not sell the things people are bidding for most strongly and buy the things they’re eager to dump? That sounds like a good idea. It is, and that’s why smart investors flock to it: it’s called contrarianism. One of the main reasons why opportunistic strategies like distressed debt investing can perform well is that investors are sometimes able to buy from sellers who outnumber them . . . who are in a hurry . . . who want to sell really badly . . . or who have to sell regardless of price. To achieve “immediacy” (a term for a quick exit coined by Richard Bookstaber), the sellers tend to sacrifice something else: price. And the price discount they accept makes an important contribution to the bargain hunter’s excess return. (See Investment Miscellany, November 2000, for a thorough discussion of immediacy). Random Thoughts on Liquidity Here are a number of truths about liquidity. Some are important, but they don’t fit into a coherent narrative.  It’s possible that liquidity can be relied on when sellers and buyers are balanced in number and degree of motivation.

But more often, given the herd mentality in markets, “everyone” wants to either sell or buy at once. There’s an old saying to the effect that “In times of crisis all correlations go to one.” The prices of everything move in unison during crises because investors are driven by mob psychology, not fundamentals. Thus – and for the same reason – in times of crisis liquidity often goes to zero.  Usually, as described above, it’s either hard to buy but easy to sell, or hard to sell but easy to buy. Sometimes, however, when everyone’s confused and intimidated, the market freezes up and it can be hard to do both. For example, after securities backed by sub-prime mortgages were thoroughly impugned in the crisis of 2007-08, there was a total lack of trading. The fact that the “last trade” occurred months ago made it hard for potential buyers and sellers to feel confident regarding what a fair price might be. I believe it was for this reason that the U.S. Treasury organized the Public Private Investment Partnership program, under which nine investment managers raised equity capital from clients for investment in mortgage backed securities, with the Treasury matching the equity and then supplying an equal amount of zero-cost leverage. The goal was to cause trading to occur, and with it “price discovery.” After transactions resumed, buyers and sellers had a better idea what a fair price was, so trading and liquidity increased.

This was one of the ways in which the government coaxed the capital markets to reopen. Yet this program is little known and its brilliance is unrecognized.  It’s one of my standing rules that “No investment vehicle should promise greater liquidity than is afforded by its underlying assets.” If one were to do so, what would be the source of the increase in liquidity? Because there is no such source, the incremental liquidity is usually © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved illusory, fleeting and unreliable, and it works (like a Ponzi scheme) until markets freeze up and the promise of liquidity is tested in tough times. Some hedge funds provided an example in the last crisis. They raised capital with which to buy assets of uncertain liquidity, sometimes using leverage, and they promised investors the ability to withdraw their money quarterly or annually. But when the end of 2008 rolled around, the desire of LPs for liquidity overwhelmed the capacity of the marketplace to absorb the assets that were for sale (or perhaps the GPs wisely refused to sell because a fair price couldn’t be obtained). When that occurred, the funds told LPs they couldn’t have the liquidity they’d been promised. Illiquid assets went into locked-up “side pockets,” and “gates” came down delaying the effective dates of withdrawals. These little-known provisions gave LPs an unpleasant surprise, demonstrating that in a crisis, the promise of withdrawal from a vehicle holding illiquid assets can easily turn out to be too good to be true.  People often think about liquidity constraints as relating to specific assets; they don’t necessarily think about the knock-on effects of illiquidity from asset to asset and market to market.

For example, in the crisis, institutional investors had to sell liquid assets at steep discounts and redeem from the most liquid hedge funds because of the heavy allocations to illiquid strategies and gated funds elsewhere in their portfolios. The resulting elevated supply of assets for sale from these funds reduced the liquidity for sellers in those markets and put downward pressure on assets that shouldn’t have been so affected.  Specific investor actions can have a dramatic impact in illiquid markets. For example, the price of an illiquid asset can rise simply because one buyer is buying, in which case selling the asset becomes very easy. When that buyer stops buying, however, the market can quickly reset to much lower levels in terms of both price and the liquidity enjoyed by sellers (and it can overshoot in the other direction if the buyer decides to sell what he’s bought).  In assessing an asset’s liquidity, one should think about the other people who hold it. Are they all the same type of investor, and thus likely to react the same to a given story on Bloomberg? Do many of them own it in funds whose investors have the right to make quick withdrawals? And, in particular, are they highly levered and subject to potential margin calls? The more ownership is concentrated in the hands of investors who could become motivated to sell en masse, the faster liquidity can disappear.  Taking on large amounts of illiquidity is neither a winning nor a losing strategy per se.

Like any other form of risk, it’s advantageous to bear illiquidity when the incremental return for doing so is high, but a bad idea when it’s not. And, needless to say, the liquidity premium is neither always there nor always generous. In my view, some endowments emulated Yale to excess in the years before the crisis, taking on too much illiquidity in the belief that (a) as ultra-long-term investors they could bear it and (b) they were sure to be well paid for doing so. But risk premiums arise from risk aversion, meaning they may not exist when investors are risk-tolerant. The willing acceptance of illiquidity in the early to mid-2000s caused the premium for bearing it to be inadequate, and investors who did so were penalized, not rewarded.  On the other hand, at the right time, investors can make tremendous amounts of money simply by being willing to supply liquidity (or accept illiquidity). When everyone else is selling in panic or © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved sitting frozen on the sideline, refusing to buy, cash can be king. Often when a crash follows a bubble-driven run-up, most people are short of cash (and/or the willingness to spend it). But it may not be a good idea to always sit with a large amount of cash so as to be able to provide liquidity and scoop up bargains in a once-a-decade crash. This may equate to sub-optimizing. It would have paid off in 1990-91, 2001-02 and 2008-09, but what about the other 19 years in the last 25?  A high degree of concern over illiquidity can push investors to avoid it to excess. For example, institutions whose realities could permit a long-term investment approach sometimes decide to invest only in things they can get out of quickly. Is this prudence, or merely sub- optimizing? Is it done in response to a threat that has a reasonable likelihood of materializing, or to a crisis while it is fresh in memory (“fighting the last war”)? Is it realistic, or the result of an irrational desire to be able to turn the whole portfolio into cash in short order? Or is it done in order to always be able to comply with a sell order from the boss or the investment committee? Liquidity is a good thing (everything else being equal). But is it smart to require that a portfolio be able to provide more liquidity than is ever likely to be called on? Let’s remember that liquidity isn’t free. There’s usually a cost, and it comes in the form of return forgone.

 I think the best way to deal with the issue of liquidity is to think of the portfolio in terms of layers ranging from highly liquid to totally illiquid. The appropriate size for each layer at a given point in time is a function of each investor’s specific situation, as well as the position of the market in its cycle. In sizing those layers, it’s clear that no investor should shoulder more illiquidity than its realities permit, as happened in 2008 with serious consequences for some endowments. Portfolios may be required to (a) meet their owners’ needs for current cash with which to operate, (b) fund capital drawdowns at a time when lock-up funds aren’t making distributions, or (c) enable the owners to avoid having to sell assets at depressed prices. Thus portfolio liquidity should be set so these needs can be met in bad times. But how bad is bad? Should the portfolio have to respond to the last bad year, the average of the last five bad years, the worst year ever . . . or something worse? These decisions require judgment.  Finally, excessive liquidity can do more harm than good, and investors can be better off if they’re able to trade less rather than more. My son Andrew makes a number of excellent points on the theme that liquidity is a good thing, but not necessarily all good: o The siren song of liquidity can convince investors to try their hand as traders.

The result can be increases in (a) emphasis on short-term considerations relative to long-term ones, (b) transaction costs and taxes, and (c) exposure to negative surprises when the liquidity they’ve been enjoying and counting on disappears. o Liquidity can cause you to lower the bar for investments. If you’re thinking about making an investment you know you won’t be able to exit for years, you’ll probably do thorough due diligence, make conservative assumptions and apply skepticism, etc. But when you have something that appears very liquid, you may take a position casually, with little work or © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved conviction, under the assumption that it would be easy and cheap to get out. Here’s a great quote on the subject from Warren Buffett: If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes. Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio’s market value. o Certainly owners of companies wouldn’t (and couldn’t) trade in and out of them every day. If you intend to invest in businesses based on their fundamentals – rather than trading based on short-term market dynamics – it’s critical to think and act like a long-term owner. o When you find an investment with the potential to compound over a long period of time, one of the hardest things is to be patient and maintain your position as long as doing so is warranted on the basis of the prospective return and risk. Investors can easily be moved to sell by news, emotion, the fact that they’ve made a lot of money to date, or the excitement of a new, seemingly more promising idea. When you look at the chart for something that’s gone up and to the right for 20 years, think about all the times a holder would have had to convince himself not to sell. An abundance of liquidity can be a handicap in this regard. Here’s some more good advice from Warren: “If you can enjoy Saturdays and Sundays without looking at stock prices, give it a try on weekdays.

” Looking less often would improve most investors’ results. I have particularly strong feelings about the insistence that 401(k) retirement accounts include only investment choices that provide daily pricing and liquidity. I’ve heard from Oaktree pension clients about employees who frequently trade their 401(k) accounts. It can’t be a good thing for these portfolios to be constantly rejiggered. It’s hard enough to make an occasional well- reasoned long-term decision, but much harder to make a large number of correct short- term decisions. Rather than ensuring daily liquidity, the people in charge could help plan participants by limiting them to annual changes at most. So liquidity – like most other things in the investment world – is multi-faceted and complex, not simple. There are a lot of considerations to be taken into account, and certainly no simple formula for doing so. Like everything else in investing, there’s no surefire way to manage the issue of liquidity in the absence of superior insight. Influences on Liquidity Today Many factors cause the availability of liquidity to change over time. The biggest factor lately in some of our credit markets has been the growth of demand through mutual funds and ETFs, or Exchange-Traded Funds. While there’s been no real mania for stocks, the ultra-low level of interest rates has driven many retail investors (who in the past may have invested in Treasurys and money market funds) to credit vehicles instead.

ETF-like vehicles, sometimes known as “tracking shares,” began to appear in the early 1990s, and they proliferated significantly after 2000. According to Wikipedia, “As of January 2014, there were over 1,500 ETFs traded in the U.S., with over $1.7 trillion in assets.” (Several years ago I cited Wikipedia in a memo, and Oaktree co-founder Richard Masson – a stickler for correctness – told me in no uncertain terms that it wasn’t a respectable source. I think things have changed enough since then, Richard: I’m citing it!) ETF’s have become popular because they’re generally believed to be “better than mutual funds,” in that they’re traded all day. Thus an ETF investor can get in or out anytime during trading hours, whereas with mutual funds he has to wait for a pricing at the close of business. “If you’re considering investing,” the pitch goes, “why do so through a vehicle that can require you to wait hours to cash out?” But do the investors in ETFs wonder about the source of their liquidity? Here’s what Wikipedia has to say about the liquidity of ETFs: An ETF combines the valuation feature of a mutual fund or unit investment trust, which can be bought or sold at the end of each trading day for its net asset value, with the tradability feature of a closed-end fund, which trades throughout the trading day at prices that may be more or less than its net asset value. . . . Consider the possibility that many of the holders of an ETF become highly motivated to either buy or sell.

© Oaktree Capital Management, L.P. All Rights Reserved If there is strong investor demand for an ETF, its share price will temporarily rise above its net asset value per share, giving arbitrageurs an incentive to purchase additional creation units from the ETF and sell the component ETF shares in the open market. The additional supply of ETF shares reduces the market price per share, generally eliminating the premium over net asset value. A similar process applies when there is weak demand for an ETF: its shares trade at a discount from net asset value. What would happen, for example, if a large number of holders decided to sell a high yield bond ETF all at once? In theory, the ETF can always be sold. Buyers may be scarce, but there should be some price at which one will materialize. Of course, the price that buyer will pay might represent a discount from the NAV of the underlying bonds. In that case, a bank should be willing to buy the creation units at that discount from NAV and short the underlying bonds at the prices used to calculate the NAV, earning an arbitrage profit and causing the gap to close. But then we’re back to wondering about whether there will be a buyer for the bonds the bank wants to short, and at what price. Thus we can’t get away from depending on the liquidity of the underlying high yield bonds. The ETF can’t be more liquid than the underlying, and we know the underlying can become highly illiquid.

 The earning of a profit proves the investor made a good decision.  A low price makes for an attractive investment.  Assets that are appreciating deserve your attention.  Contrarianism will bring consistent success.  It’s important to do what feels right.  Assets with greater liquidity are safer.  The level of risk in a portfolio can be kept low by applying a simple formulaic process. My answer is that all sixteen reflect potential misconceptions, and they have to be (a) understood at the second level, not the first, and (b) dismissed as always holding the keys to success. Here’s why:  The market is “efficient,” meaning asset prices reflect all available information and thus provide accurate estimates of intrinsic value – The efficient market hypothesis assumes people are rational and objective. But since emotion so often rules in place of reason, the market doesn’t necessarily reflect what’s true, but rather what investors think is true. Thus prices can range all over the place. Sometimes they’re fair, but sometimes they’re way too high or low. It’s a big mistake to impute rationality to the market and believe its message.  Because people are risk-averse, risky deals are discouraged and the market awards appropriate risk premiums as compensation for incremental risk – The truth is that investors’ risk-averseness fluctuates between too much and too little.

This whole discussion calls to mind a Wall Street Wonder called “auction rate securities.” They were popular ten years ago, but today they’re only a footnote to financial history. In brief, auction rate securities were developed to satisfy the desire of borrowers for long-term financing at the lower interest rates on short-term debt. The securities were described as safe and liquid because Dutch auctions would be held every week or month, resetting the yield on the securities to contemporary levels and thereby ensuring a price near par, as well as plentiful liquidity. Certainly there would always be some yield capable of enticing investors to buy at par. Thus the securities would be free from the risks associated with long-term debt. That’s what should have happened. Here’s what Wikipedia says did happen: Beginning on Thursday, February 7, 2008, auctions for these securities began to fail when investors declined to bid on the securities. The four largest investment banks who make a market in these securities (Citigroup, UBS AG, Morgan Stanley and Merrill Lynch) declined to act as bidders of last resort, as they had in the past. This was a result of the scope and size of the market failure, combined with the firms’ needs to protect their capital during the 2008 financial crisis. (Emphasis added) On February 13, 2008, 80% of auctions failed. On February 20, 62% failed (395 out of 641 auctions) . . . . When the auctions failed, auction rate securities became frozen.

Holders saw large markdowns and for years were unable to obtain liquidity. Eventually, the investment banks that had issued the securities bought many of them back at par, under threat of investigation by U.S. attorneys general. And one more “miracle” disappeared from the scene. Lastly on the subject of ETFs, a senior loan ETF can be sold for settlement in three days, whereas if there are tenders of creation units, sales of loans to raise the funds with which to pay for those units may require a week or considerably more to settle. What are the implications of such a mismatch? So-called “liquid alternatives” or “liquid alts” are another recent innovation. They’re supposed to deliver performance comparable to other alternative investments without the illiquidity they entail. To me it sounds like just one more promise of something for nothing. How many portfolio managers are smart enough, for example, to deliver the alpha of a well-managed hedge fund without accepting the illiquidity that the clever manager of that hedge fund feels he has no choice but to bear? © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved Financial innovations created in good times often fool people into thinking a silver bullet has been invented that offers a better deal than traditional investments. (By “traditional” I mean investments that are acknowledged to entail increased risk as the price for targeting increased return . . . not the “miracles” where increased return comes gratis.) Many recent innovations have promised high liquidity from low-liquidity assets. As I said on page three, however, no investment vehicle should promise more liquidity than is afforded by its underlying assets. Do these recent promises represent real improvements, or merely the seeds for subsequent disappointment? Auction rate securities were a way to buy long-term debt securities without interest-rate risk and illiquidity. Likewise, ETFs offer a liquid way to invest in potentially illiquid markets. But these instruments rely for their desirable outcomes on the assumption that other parties will do what they “should” do. Over the course of my career I’ve seen many instances when market participants failed to do what they were supposed to do. The related financial innovations often remind me of my father’s story about the habitual gambler who finally found a sure thing: a race with only one horse. He bet all his money, but halfway around the track the horse jumped over the fence and ran away. Will ETFs prove liquid in the next crisis?

And what impact will mass sales of ETFs have on the prices of underlying assets? We’ll find out. Finally under the heading of recent developments, I want to mention the Volcker Rule, which arose from a suggestion from former Fed chairman Paul Volcker. The main reason for the 2008 government bailouts of systemically important banks was the losses the banks had suffered thanks to unsuccessful investments made with their proprietary capital in mortgage backed securities and other levered assets. When these collapsed, the banks lost a great deal of their capital, such that they required capital injections only the government could or would make. In response to that experience, legislators decided to incorporate the Volcker Rule into the Dodd–Frank Wall Street Reform and Consumer Protection Act, the main piece of regulation to emerge after the crisis. Although there has been much back-and-forth regarding its modification and enactment, the main thrust of the Volcker Rule is to prevent banks from making speculative investments that aren’t related to their activities on behalf of clients; in other words, to impose a general ban on proprietary trading. Often during crises, investors take to the sidelines, such that there are no buyers for the assets that come up for sale. Liquidity dries up, and prices plummet. In the past, banks have stepped forward, risking their proprietary capital in pursuit of profit.

Many times in our experience, banks have competed strongly against us to buy distressed debt, thereby supplying liquidity to the market. Although the eventual impact of the Volcker Rule is unknown, any diminution of the banks’ likelihood of engaging in proprietary buying during crises suggests a significant reduction in liquidity just when it may be needed most. For the last few years I’ve been expressing my view that (a) investors – driven by central bank-mandated interest rates near zero – have been moving into riskier investments in pursuit of higher returns and (b) in taking that step they’ve often ignored the need for caution or been ignorant as to how to achieve it. I believe that as an important part of this behavior, those investors have extrapolated the high level of liquidity they’ve witnessed in the last five years, failing to understand its transitory nature. The impact on liquidity of ETFs, liquid alternatives and the Volcker Rule has yet to be tested in tough times. We’ll see what happens in the next serious downturn. * * * © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved The bottom line is unambiguous. Liquidity can be transient and paradoxical. It’s plentiful when you don’t care about it and scarce when you need it most. Given the way it waxes and wanes, it’s dangerous to assume the liquidity that’s available in good times will be there when the tide goes out. What can an investor do about this unreliability? The best preparation for bouts of illiquidity is:  buying assets, hopefully at prices below durable intrinsic values, that can be held for a long time – in the case of debt, to its maturity – even if prices fall or price discovery ceases to take place, and  making sure that investment vehicle structures, leverage arrangements (if any), manager/client relationships and performance expectations will permit a long-term approach to investing. These are the things we try to do. And the worst defenses against illiquidity – or, better said, the approaches that make you most dependent on the availability of liquidity – are (a) employing trading strategies under which you buy things because of how you think they’ll perform in the short run, not what they’ll be worth in the long run, (b) being focused on what the market says your assets are worth, not what your analysis shows them to be worth, and (c) buying with leverage that exposes you to the risk of a margin call in a declining market.

One of the great advantages of investing in performing debt is that if our credit judgments are correct, the return will come from our contractual relationship with the issuers – from the interest and principal they’ve promised to pay us – not the operation of the market. At Oaktree, trading is what we do to implement portfolio managers’ long-term investment decisions. We generally consider it a cost of doing business, not something we engage in to make money. There are two benefits to this approach:  we aren’t highly reliant on liquidity for success, and  rather than be weakened in times of illiquidity, we can profit from crises by investing more – at lower prices – when liquidity is scarce. We’re not immune to occasional periods of illiquidity; our holdings become just as hard to sell as anyone else’s. But with the proper structure and approach, it’s possible to turn such periods to our advantage rather than just endure them. * * * I started this memo by saying liquidity might not be a profound topic. But when I ran a draft by our CEO Jay Wintrob, who came to us in November from AIG, he took issue. I’ll give him the last word: In September 2008, AIG experienced serious liquidity issues (despite its $1 trillion balance sheet) when it couldn’t post $20-25 billion of liquid collateral related to credit default swap contracts written by one of its subsidiaries. The U.S. government stepped in © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved as a result, lending support that eventually reached $182.3 billion, massively diluting AIG shareholders in the process. When you can’t meet a margin call because you have insufficient liquidity, that’s profound. March 25, 2015 © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved  Assets with greater liquidity are safer – Greater liquidity generally means you can get out of an asset easier and closer to the price of the last trade. But first, liquidity can dry up when other investors change their mind about the asset. And second, the theoretical ability to get out when you want says nothing about fundamental safety and relatively little about investment safety in the long run. It’s much safer to be in well-analyzed assets with good fundamentals and attractive prices, in which case you can hold for a long time without needing to exit. The best defense against a lack of liquidity is arranging your affairs so there’s little need for it.  The level of risk in a portfolio can be kept low by applying a simple formulaic process – Rather, risk comes in many forms and they can be overlapping, contrasting and hard to manage. For example, as I said in “Risk Revisited,” efforts to reduce the risk of losing money invariably increase the risk of missing out on gains, and efforts to reduce fundamental risk by buying higher- quality assets often increase valuation risk, given that higher-quality assets often sell at elevated valuation metrics. What does the above consist of? It’s a collection of time-honored bromides that range from (a) only effective part of the time to (b) just plain wrong. These investment myths are pervasive but of little help.

But my point is that transactions merely adjust what you own, and engaging in them doesn’t necessarily increase potential profit. Sticking with what you own may be enough – although it may not be easy in tough times.  In my memo on liquidity in March, I borrowed an idea from my son Andrew: If you look longingly at the chart for a stock that has risen for twenty years, think about how many days there were when you would’ve had to talk yourself out of selling. That’s not always easy. Two of the main reasons people sell stocks are because they go up and because they go down. When they go up, people who hold them become afraid that if they don’t sell, they’ll give back their profit, kick themselves, and be second-guessed by their bosses and clients. And when they go down, they worry that they’ll fall further. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

© Oaktree Capital Management, L.P. All Rights Reserved There may be absolutely no intellectual justification for that feeling. If you liked it a month ago at $80, should you sell it now just because it’s at $60? The best way to get through a downdraft is to verify your thesis, tighten your seatbelt and hang on. If you sell just because there’s a downdraft (or an updraft), you’ll never get that twenty-year winner. When you look closely, you’ll see that every twenty-year rise included a lot of ups and downs. To enjoy long-term success, you have to hold through them.  A lot has been written of late about reduced liquidity in the current investment environment, in part a result of restrictions under the Volcker rule. This may have contributed to last month’s volatility, but it should be viewed as having exacerbated the short-term pain, not as altering the long-term fundamentals. Coping with a declining market seems easy ahead of time, since emotions aren’t in play and investors know what they should do. It’s only when prices start falling in earnest, as they have recently, that it turns out to be harder than expected. So What Will Work? Superior investing isn’t easy. I’ve set forth a number of examples of its complexity, and a long list of simplistic rules that can’t be depended on. Among the many things that keep investing from being easy is the fact that no tactic works every time. Almost every tool an investor might employ is a two-edged sword.

In all these ways, lower prices either increase the demand for oil or reduce the supply, causing the price of oil to rise (all else being equal). In other words, lower oil prices – in and of themselves – eventually make for higher oil prices. This illustrates the dynamic nature of economics.  Finally, in addition to the logical but often hard-to-anticipate second-order consequences or knock-on effects, negative developments often morph in illogical ways. Thus, in response to cascading oil prices, “I’m going to sell out of emerging markets that rely on oil exports” can turn into “I’m going to sell out of all emerging markets,” even oil importers that are aided by cheaper oil. In part the emotional reaction to negative developments is the product of surprise and disillusionment. Part of this may stem from investors’ inability to understand the “fault lines” that run through their portfolios. Investors knew changes in oil prices would affect oil companies, oil services companies, airlines and autos. But they may not have anticipated the effects on currencies, emerging markets and below-investment grade credit broadly. Among other things, they rarely understand that capital withdrawals and the resulting need for liquidity can lead to urgent selling of assets that are completely unrelated to oil. People often fail to perceive that these fault lines exist, and that contagion can reach as far as it does.

[Bernstein demonstrated considerable foresight in writing this paragraph and the next four in the lead-up to the global financial crisis.] Can we sustain the low-risk character of the environment when it leads many investors to take high risks and to overvalue risky assets in search for higher returns? . . . The more risk we take because we believe the environment is low-risk in character, the less the environment continues to be low-risk in character. . . . The more we emphasize the low risks in the environment, the more we point out and explain its features, and the more we believe we understand what is going on – unique as this environment may be – the weaker our normal and rational inclination to risk aversion becomes and the more our actions alter the character of the environment. The economist Hyman Minsky has reminded us, “Each state nurtures forces that lead to its own destruction.” All of history testifies to the truth of this observation. Greater liquidity [by which Bernstein meant greater availability of funds] leads firms to borrow more than before. But higher levels of debt mean increasing vulnerability to adversity and negative shocks in an ever-changing world. For these reasons, as Minsky put it, stability leads inevitably to instability. . . . Even places that were once banana-republics, like Argentina and Brazil, are issuing long-term bonds and even issuing bonds denominated in foreign currencies.

Parsing them allows investors to choose among the strategies and accept the risks they’re more comfortable with. The process can be quite informative. Our oldest “new strategy” is Enhanced Income, where we use leverage to magnify the return from a portfolio of senior loans. We think senior loans have the lowest credit risk of anything Oaktree deals with, since they’re senior-most among their issuer’s debt and historically have produced very few credit losses. Further, they’re among our most liquid assets, meaning we face relatively little illiquidity risk, and being active in a broad public market permits us to diversify, reducing concentration risk. Given the relatively high degree of safety stemming from these loans’ seniority, returns aren’t overly dependent on the presence of alpha, meaning Enhanced Income entails less manager risk than some other strategies. But to have a chance at the healthy return we’re pursuing in Enhanced Income requires us to take some risk, and what we’re left with is leverage risk. The 3-to-1 leverage in Enhanced Income Fund II will magnify the negative impact of any credit losses (of course we hope there won’t be many). However, we’re not worried about a meltdown, since the current environment allows us to avoid funding risk; we © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

I touched above on concentration risk, but we should also think about the flip side: the risk of over- diversification. If you have just a few holdings in a portfolio, or if an institution employs just a few managers, one bad decision can do significant damage to results. But if you have a very large number of holdings or managers, no one of them can have much of a positive impact on performance. Nobody invests in just the one stock or manager they expect to perform best, but as the number of positions is expanded, the standards for inclusion may decline. Peter Lynch coined the term “diworstification” to describe the process through which lesser investments are added to portfolios, making the potential risk- adjusted return worse. While I don’t think volatility and risk are synonymous, there’s no doubt that volatility does present risk. If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing. And in the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often this can really be done only in retrospect. Thus it’s clear that a professional investor may have to bear consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss.

Some or all of the above risks are potentially entailed in our new credit strategies. Parsing them allows investors to choose among the strategies and accept the risks they’re more comfortable with. The process can be quite informative. Our oldest “new strategy” is Enhanced Income, where we use leverage to magnify the return from a portfolio of senior loans. We think senior loans have the lowest credit risk of anything Oaktree deals with, since they’re senior-most among their issuer’s debt and historically have produced very few credit losses. Further, they’re among our most liquid assets, meaning we face relatively little illiquidity risk, and being active in a broad public market permits us to diversify, reducing concentration risk. Given the relatively high degree of safety stemming from these loans’ seniority, returns aren’t overly dependent on the presence of alpha, meaning Enhanced Income entails less manager risk than some other strategies. But to have a chance at the healthy return we’re pursuing in Enhanced Income requires us to take some risk, and what we’re left with is leverage risk. The 3-to-1 leverage in Enhanced Income Fund II will magnify the negative impact of any credit losses (of course we hope there won’t be many).

If circumstances cause you to sell a volatile investment at the wrong time, you might turn a downward fluctuation into a permanent loss. Moreover, even in the absence of a need for liquidity, volatility can prey on investors’ emotions, reducing the probability they’ll do the right thing. And in the short run, it can be very hard to differentiate between a downward fluctuation and a permanent loss. Often this can really be done only in retrospect. Thus it’s clear that a professional investor may have to bear consequences for a temporary downward fluctuation simply because of its resemblance to a permanent loss. When you’re under pressure, the distinction between “volatility” and “loss” can seem only semantic. Volatility is not “the” definition of investment risk, as I said earlier, but it isn’t irrelevant. One example of a risk connected with volatility – or the deviation of price from what might be intrinsic value – is basis risk. Arbitrageurs customarily set up positions where they’re long one asset and short a related asset. The two assets are expected to move roughly in parallel, except that the one that’s slightly cheaper should make more money for the investor in the long run than the other loses, producing a small net gain with little risk. Because these trades are considered so low in risk, they’re often levered up to the sky. But sometimes the prices of the two assets diverge to an unexpected extent, and the equity invested in the trade evaporates.

The investments that are part of such strategies could require substantial workout negotiations or restructuring in the event of a bankruptcy, which could entail significant risks, time commitments and costs. The investments targeted by such strategies may be thinly traded, may be subject to restrictions on resale or may be private securities. In such cases, the primary resale opportunities for such investments are privately negotiated transactions with a limited number of purchasers. This may restrict the disposition of investments in a timely fashion and at a favorable price. In addition, real estate-related investments can be seriously affected by interest rate fluctuations, bank liquidity, the availability of financing, and by regulatory or governmentally imposed factors such as © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

With corporate balance sheets in relatively good shape (thanks in large part to all of the refinancing activity over the past two years), the capital markets awash in liquidity, and economies (at least in the U.S.) showing some © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Further, the development of derivatives, in particular, vastly increased the ease with which risk could be shouldered (often without a complete understanding) as well as the amount of risk that could be garnered per dollar of capital committed.  While not a novel development, there was an enormous upsurge in buyouts. These included the biggest deals ever; higher enterprise values as a multiple of cash flow; increased leverage ratios; and riskier, more cyclical target companies, such as semiconductor manufacturers.  There was widespread structural deterioration. Examples included covenant-lite loans carrying few or none of the protective terms prudent lenders look for, and PIK-toggle debt on which the obligors could elect to pay interest “in kind” with additional securities rather than cash.  Finally, there was simply a willingness to buy riskier securities. Examples here included large quantities of CCC-rated debt, as well as debt issued to finance dividend payments and stock buybacks. The last two increase a company’s leverage without adding any productive assets that can help service the new debt. Toward the end, my 2007 memo included the following paragraph: Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere.

It’s highly informative to assess how the other characteristics of 2007 enumerated above compare with conditions today:  global glut of liquidity – check  minimal interest in traditional investments – check (relatively little is expected today from Treasurys, high grade bonds or equities, encouraging investors to shift toward alternatives)  little apparent concern about risk – check  skimpy prospective returns everywhere – check Risk tolerance and leverage haven’t returned to their pre-crisis highs in quantitative terms, but there’s no doubt in my mind that risk bearing is back in vogue. Examples from the Media My preparation for writing these memos often includes amassing media citations around a central theme. Here are some from the last few weeks:  Now, eight years since the PIK-toggle entered the market, companies are again using the esoteric structures, along with a host of riskier borrowing practices associated with the buyout boom that helped inflate the 2006-07 credit bubble. (Financial Times, October 22)  At the same time, more than $200bn of “cov-lite” loans have been sold so far this year, eclipsing the $100bn issued in 2007. That means 56 per cent of new leveraged loans now come with fewer protections for lenders than normal loans. (Ibid.)  Bankers say much of that issuance has been a result of the return of another pre-crisis market vehicle – the collateralised [sic] loan obligation. . . . Like the rest of the leveraged © OAKTREE CAPITAL MANAGEMENT, L.P.

© Oaktree Capital Management, L.P. All Rights Reserved. such securities. The limited liquidity of the market may also adversely affect the ability of investors to arrive at a fair value for certain lower-rated securities at certain times and could make it difficult to sell certain securities. It should be recognized that an economic downturn or increase in interest rates is likely to have a negative effect on the lower-rated bond market and on the value of the lower-rated securities as well as on the ability of the securities' issuers, especially highly leveraged issuers, to service principal and interest payment obligations to meet their projected business goals or to obtain additional financing. Moreover, the prices of lower-rated securities have been found to be less sensitive to changes in prevailing interest rates than higher-rated investments. If the issuer of a fixed-income security defaults, the holder may incur additional expenses to seek recovery and the possibility of any recovery can be subject to the expense and uncertainty of insolvency proceedings. This memorandum, including the information contained herein, may not be copied, reproduced, republished, posted, transmitted, distributed, disseminated or disclosed, in whole or in part, to any other person in any way without the prior written consent of Oaktree. © OAKTREE CAPITAL MANAGEMENT, L.P. ALL RIGHTS RESERVED.

Returns on risky assets were running high, and a number of factors were cited as having eliminated risk:  The Fed was considered capable of restoring growth come what may.  A global “wall of liquidity” was coming toward us, derived from China’s and the oil producers’ excess reserves; it could be counted on to keep asset prices aloft.  The Wall Street miracles of securitization, tranching, selling onward and derivatives creation had “sliced and diced” risk so finely – and directed it where it could most readily be borne – that risk really didn’t require much thought. In short, in those days, most people couldn’t imagine a way to lose money. I believe most strongly that the riskiest thing in the investment world is the belief that there’s no risk. When that kind of sentiment prevails, investors will engage in otherwise-risky behavior. By doing so, they make the world a risky place. And that’s what happened in those pre-crisis years. When The New York Times asked a dozen people for articles about the cause of the crisis, I wrote one titled “Too Much Trust; Too Little Worry.” Certainly a dearth of fear and a resulting high degree of risk taking accurately characterize the pre-crisis environment. But that was then. It’s different today. Today, unlike 2006-07, uncertainty is everywhere:  Will the rate of economic growth in the U.S. get back to its prior norm? Will unemployment fall to the old “structural” level?

© Oaktree Capital Management, L.P. All Rights Reserved. had come not from the value added by a dependable process, but from the fact that in essence the futures had allowed people to be more than 100% invested in a rising market.  And more recently, “risk parity investing” worked through volatile times because it gave its followers greater strategic diversification, defensiveness and bond exposure than most other investors had. But it, like most other things, failed to prevent losses when Ben Bernanke spooked the market by threatening to ease off bond buying and let interest rates rise. This year’s results for risk parity show that nothing works all the time. The point is that no mechanical tools can enable investors to prosper under all circumstances. They can provide tilts or reduce exposures, but the tool that promises a mix of good results and great results without the possibility of bad results is too good to be true. And when excessive confidence develops in such things, investors are heading for trouble. The same is true for the Greenspan put and its successor, the Bernanke put. Alan Greenspan’s tenure as Fed chairman was marked by efforts to avoid problems by injecting liquidity and lowering interest rates. Investors put great stock in his ability to keep things moving ever upward. His policies prevented occasional corrections along the way, but the price paid was a big one: the financial crisis of 2008.

CONFIDENTIAL © Oaktree Capital Management, L.P. All Rights Reserved. The Realities of Risk and Return In late 2008 and early 2009 (in other words, for universities, fiscal year 2009), the global financial crisis presented the greatest sinkhole in eighty years. Those caught mid-stream without life jackets were penalized. Many of Penn’s leading peer institutions lost 25-28% that year, while Penn’s loss was “only” 15½%. I described Penn’s results, loosely speaking, as “the least worst.” Going from the investment arena to the real world of university operations makes it clear that investment risk isn’t an abstraction. No, risk isn’t just volatility. It’s what happens to owners of capital when downward fluctuations occur and principal losses are experienced. Many of Penn’s peers were forced to curtail some of their spending, ranging from hot breakfasts to student aid. Some had to suspend construction projects. There were freezes on hiring and wages. Some put illiquid partnership interests up for sale to raise cash and/or escape continuing funding obligations. And some had to borrow in the taxable bond market to meet cash needs. Penn, on the other hand, had lots of liquidity and faced little in the way of capital calls. Thus it didn’t have to go on the defensive operationally. Instead, it was able to keep hiring faculty, keep giving grants instead of loans, and take advantage of an attractive opportunity to purchase adjacent acreage. The benefits of risk control were made concrete.

For example, Ford goes down, giving you a loss, but rather than go down in sympathy (which would give you an offsetting gain on the short position), a favorable development at GM makes it go up, compounding your loss as the hedge goes against you.  Hedging in the wrong amount. You hold 1,000 Ford shares, and you think that – given their likely relative performance – you should short 500 GM shares to hedge your risk. But it turns out that while they move in opposite directions, their relative movements aren’t what you expected. Thus you either hedged too much (and thus you lose more on the hedge than you make on the underlying position) or you hedged too little (so the protection you sought doesn’t materialize). There’s no sure way to choose the right “hedge ratio.”  Time risk. The two sides of the position may work as you expect, but not when you expect. Thus the hedge may fail to work in the short run, meaning the loss on one side of the hedge may occur before the gain on the other, in which case you’ll look flat-out wrong for a while. And if you’re required (by regulation, margin call, capital withdrawals, etc.) to close out the position at that point, the result could be quite negative.  Insufficient liquidity. If conditions or goals change, you might want to adjust or remove your hedge. But market developments in terms of liquidity might make it impossible to alter one or both sides of the position.

They believed that the markets had been rendered safe by the combination of (a) an omniscient, omnipotent Fed providing a “Greenspan put,” (b) the wonders of securitization, tranching and selling onward and (c) the “wall of liquidity” coming toward our markets, composed of excess reserves being recycled by China and the oil-producing nations. They accepted the alchemy under which financial engineering could turn sub- prime mortgages into triple-A debt. And they viewed leverage as sure to have a salutary effect on returns. There’s nothing more risky than a widespread belief that there’s no risk . . . but that’s what characterized the investment world. It was possible to conclude in 2005- 07 that investors were applying insufficient risk aversion and thus engaging in risky behavior, elevating asset prices, reducing prospective returns, and raising risk levels. What were the signs?  The issuance of non-investment grade debt was at record levels.  An unusually high percentage of the issuance was rated triple-C, something that’s not possible when attitudes toward risk are sober.  “Dividend recaps” went unquestioned, with buyout companies borrowing money with which to pay dividends, vastly increasing their leverage and reducing their ability to get through tough times.

They further complain that actions inherent in market-making can be hard to distinguish from Volcker Rule violations. Where do positions held for trading and hedging stop and prop trading start? Think about Goldman Sachs’s bets against subprime mortgages:  Did they hedge Goldman’s long positions in mortgages?  Did they lessen the risk in Goldman’s overall portfolio?  Were they bets against Goldman’s clients?  Or did they enable Goldman to take positions that served its clients and otherwise engage in client facilitation? I’d guess the answer is “all of the above.” Clearly, however, a market maker can do far more to provide liquidity if it is allowed to hedge through offsetting positions. Mortgage shorts also shored up Goldman’s finances and made it one of the least needy financial institutions. Which would we like to have more of, Goldman Sachs or Lehman Brothers, which plunged into mortgages and derivatives without significant risk control and consequently went bankrupt? And yet Goldman’s actions have been vilified and proprietary investing has been outlawed. On February 6, a front-page New York Times story indicated how difficult it is to rein in free- market forces and self-interest.

And yet markets began a dramatic recovery in early 2009, investors have returned to bearing risk, and many indices are back in the vicinity of their pre-crisis peaks. What’s behind this turn of events? In 2007 and 2008, governments around the world rushed to support financial institutions and stimulate economies. They did this by making liquidity readily available and cutting interest rates to near zero. Everyone knew the rate cuts would stimulate the economy by encouraging borrowing and reducing the cost of doing business, and that they would increase the profit margin in lending, buttressing financial institutions. But I don’t think anyone fully appreciated the impact they would have on reviving pro-risk behavior. In short, the rate cuts made it unrewarding to hold cash, T-bills and high grade bonds. Investors looking for returns in line with their needs – or income on which to live – were literally forced to move into riskier asset classes in pursuit of returns in excess of a few percent. © Oaktree Capital Management, L.P.Reserved

© Oaktree Capital Management, L.P. All Rights Reserved the general welfare, consumer spending or GDP growth if the level of business activity, as seen in revenues, isn’t rising; GDP doesn’t benefit from profit margin expansion. Reliance on Government Stimulus A year or so ago, the government came to the rescue of the economy with massive stimulus. With the Great Depression as a reference point, Bernanke et al. were determined to limit the contraction in liquidity, support financial institutions and encourage economic activity. Some say too much has been spent, the resulting deficits are worrisome, and the program’s a flop, since the economy’s still languishing and unemployment remains high. But the fact that growth is sluggish doesn’t mean the stimulus has failed. The relevant question isn’t how the economy is doing, but how growth compares against what it would have been without the stimulus. “What if” questions like that are largely unanswerable, but I’m sure we’re much better off than we would have been without the government’s help. Home sales are weak, but what would they be if the federal government wasn’t directly or indirectly backing 80-85% of all new mortgages and providing $8,000 tax credits to first-time home buyers? What would 2009 auto sales have been without the “cash for clunkers” program? GDP growth is insubstantial, but what would it be if government spending hadn’t risen by double digits?

In the low- return climate of the time, much of the appeal of these asset classes came from the fact that they promised higher returns thanks to their use of leverage, whether through borrowing, tranching or derivatives. Given the high promised returns, investors forgot about (or chose to ignore) the ability of leverage to magnify losses as well as gains. Contributing to investors’ rosy view of leverage’s likely impact was their belief that risk had been banished by (a) the efficacy of the Fed and its “Greenspan put,” (b) the combination of securitization, disintermediation, tranching, decoupling and financial engineering, and (c) the “wall of liquidity” coming toward us from China and the oil producing nations. For these reasons, few market participants were afraid of losing money. Most just worried about missing opportunity. The unattractive outlook for stocks and bonds meant investors would have to be aggressive and innovative if they were going to earn significant returns in the low-return environment. Thus risk aversion (a) was unnecessary and (b) would be counter-productive. “You’d better invest in this new financial product,” people were told. “If you don’t, you’ll miss out. And if you don’t and your competitor does – and it works – you’ll look out-of-step and fall behind.” When contemplating a virtuous circle without end, investors usually think of only one word: “buy.

about losing money. Fear of missed opportunity drove most investors, and Citibank’s Chuck Prince famously said, “. . . as long as the music is playing, you've got to get up and dance. We're still dancing.” Although he worried about a possible decline in liquidity, he worried more about falling behind in the manic race to provide capital. Recent History – on the Downside The events from mid-2007 through late 2008 or early 2009 demonstrate the reverse in operation. The upward trend in home prices ground to a halt and subprime mortgages began to default in large numbers. Leveraged vehicles melted down. Credit became unavailable, and financial institutions needed rescuing. Recession caused spending to contract, and corporate profits declined. Bear Stearns, Merrill Lynch, AIG, Fannie Mae, Freddie Mac, Wachovia and Washington Mutual all required rescues. Bank capital, commercial paper and money market funds needed federal guarantees. After the bankruptcy of Lehman Brothers, people began to ponder the collapse of the financial system. As often happens in scary times, “possible” morphed into “probable,” or at least something very much worth worrying about. Now a vicious circle replaced the virtuous one of just a few months earlier. And with its arrival, the fear of losing money replaced the fear of missing opportunity. As I’ve said before, I imagine most investors’ cry was, “I don’t care if I ever make a penny in the market again; I just don’t want to lose any more. Get me out!

Why These Developments? As with any economic event, there are numerous explanations for these things. But the one I want to concentrate on is government stimulus. In the depths of the credit crisis, governments around the world took steps to deal with the liquidity contraction, economic slowdown and banks’ depleted capital accounts. These included reductions of interest rates to record lows. The motivations and effects are many and varied. First, everyone knows it’s the primary goal of rate cuts to stimulate economic activity by making it cheaper and thus more attractive for businesses to borrow money with which to invest in factories, capital good and inventories. Retail credit should be cheaper, too, encouraging consumers to borrow and buy. Second, providing low cost borrowings is a way to rebuild the health of financial institutions. If a bank can borrow $100 million from the central bank at 1% and lend it out at 6%, it’s as though the government gave it $5 million per year (assuming the loans turn out to be money-good). Thus, in addition to enhancing banks’ profitability and equity, in principle this should lead to increased lending. To date, the results in these areas have been mixed. Economic activity is still muted and lending is slow. But another by-product has become particularly pronounced: encouragement to take risk.

However, a program such as QE that increases liquidity has additional consequences. For example, other countries are complaining that (a) excess capital from the low-rate U.S. will flood their markets, inflating asset and commodity prices, and (b) increasing the supply of money in the U.S. will weaken the dollar, unfairly strengthening the appeal of U.S. exports and reducing U.S. demand for imports. The Ramifications In 2003, my memo “What’s Going On?” included a tortured metaphor called “The Cat, the Tree, the Carrot and the Stick.” In low-return environments, I said, investors are forced to move further out on the risk curve because of the paltry returns available on safe investments, and lured to riskier investments by the higher returns promised there. Conscious risk bearing can be done responsibly and perhaps even profitably. But low- return environments often lead investors to unconsciously reach for return, with results that are painful. One of our greatest imperatives is to be alert to the emergence of such behavior. A final reference to past memos: you might want to look back to 2004’s “Risk and Return Today.” It describes an investment environment in which rates on short-term Treasurys, reduced by the Fed, had brought down returns in the safe part of the capital market. As a result, I said, the capital market line was “low and flat,” with inflated asset prices, low returns, skimpy risk premiums and high risk.

This problem is particularly severe at financial institutions (and what is a national economy today other than a financial system, hopefully with a manufacturing sector tacked on?) Financial institutions are, by definition, marked by high leverage, and if confidence declines, the providers of credit tend to ask for their money back. Since these institutions never have enough cash on hand to satisfy the demands of the would-be withdrawers, they can fall prey to a run on the bank. The first task, then, is to restore confidence and keep capital available. Thus, at the beginning of May, the E.U. put together a rescue package for Greece worth €110 billion. And then, when the possibility of contagion to Spain, Italy and Portugal began to be recognized, that was increased on May 10 to €750 billion (or $900 billion, a figure remarkably similar to the U.S.’s program). In addition, the European Central Bank established a program to buy government bonds of the affected nations, along the lines of our “quantitative easing.” Many European governments have announced plans to reduce deficits. Their tactics include reduced spending, freezes or cuts in public sector employment and wages, and higher retirement ages. Some have enacted tax increases to augment revenues. Greece even says it’s going to start collecting more of the taxes that are owed. Austerity is all the talk in Europe, and some leaders are predicting periods of substantial suffering.

What explains that? For one thing, the crisis – as painful as it was – was surprisingly brief. The worst of it began in the third quarter of 2008 with the disclosure of weakness at financial institutions. The onset of the most intense part of the crisis can be dated to Lehman Brothers’ September 15 bankruptcy filing. Remarkably, high yield bonds began to recover just three months later, with most of the indices showing gains of roughly 5% for the month of December. So in the credit markets, the worst pain lasted only about three months and quickly gave way to recovery. And what kicked off the recovery? Fear of missing opportunity was resurrected by the Fed and other central banks which forced interest rates on short-term government debt to near zero. It might have been the banks’ intent, or it might have been an unintended consequence, but those low rates pushed investors to engage in riskier behavior. The returns on T-bills and money market funds went to a fraction of a percent, meaning investors had to crawl out on the limb in pursuit of returns they could live with. Further, governments flooded the system with liquidity and produced the opposite of crowding out. When governments are big issuers of debt, it can be hard for non- © Oaktree Capital Management, L.P.Reserved

As an indication of the intra-European differences, The Wall Street Journal said the following on June 15: Germany views the crisis on the euro zone’s Southern fringe as a symptom of other countries’ failure to copy Germany’s fiscal discipline and structural overhauls to its economy. Its proposed remedies focus mainly on pushing other countries to cut budget deficits. France, however, believes Germany’s large trade surplus and weak domestic demand are part of the euro zone’s problem, since they force weaker economies to pay for their imports with debt, rather than through exports to the German market, Europe’s biggest. In addition to political complexity, efforts to solve the problem will run into two important issues:  Austerity measures and tax increases are anti-stimulative, and they are being applied at a time when the economies in question are weak and need stimulus. Economic historians such as Ben Bernanke recognize that adding liquidity is the best way to deal with a slowdown, and that the withdrawal of liquidity exacerbated the Great Depression.  In the long run, reducing deficits and debt will not be enough. The countries in question have to increase their productivity and competitiveness. In “Will It Work?

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: The Long View Many of my memos over the last year and a half have touched on the developments in 2003-07 that brought on the current financial crisis. By now, everyone understands the role of innovation, risk tolerance and leverage in the boom that led to the bust, so I think it’s now time to look back considerably further. The Importance of Cycles In my opinion, there are two key concepts that investors must master: value and cycles. For each asset you’re considering, you must have a strongly held view of its intrinsic value. When its price is below that value, it’s generally a buy. When its price is higher, it’s a sell. In a nutshell, that’s value investing. But values aren’t fixed; they move in response to changes in the economic environment. Thus, cyclical considerations influence an asset’s current value. Value depends on earnings, for example, and earnings are shaped by the economic cycle and the price being charged for liquidity. Further, security prices are greatly affected by investor behavior; thus we can be aided in investing safely by understanding where we stand in terms of the market cycle. What’s going on in terms of investor psychology, and how does it tell us to act in the short run? We want to buy when prices seem attractive.

© Oaktree Capital Management, L.P. All Rights Reserved but also quite painful. If the world is unwilling to live with such lessons from time to time – and if some institutions are considered to be “too big to fail” for society’s purposes – then free markets and self-interest have to be restrained. Greed may be good, but it can be permitted to run free only up to a point. Nothing’s More Risky Than a Widespread Belief That There’s No Risk The recent crisis came about primarily because investors partook of novel, complex and dangerous things, in greater amounts than ever before. They took on too much leverage and committed too much capital to illiquid investments. Why did they do these things? It all happened because investors believed too much, worried too little, and thus took too much risk. In short, they believed they were living in a low-risk world. In 2006 and early 2007, for instance, we heard a lot about the “wall of liquidity” that was coming toward us from China and the oil producing countries, a flow that could be counted on to provide capital and raise asset prices non-stop. Likewise, we were told (a) the Fed had tamed the business cycle through its adroit management, (b) securitization, tranching and disintermediation had reduced risk by putting it where it could best be handled, and (c) the “Greenspan put” could always be counted on to bail out investors who made mistakes. These and other things were said to have lowered the risk level worldwide.

© 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.

© Oaktree Capital Management, L.P. All Rights Reserved Embracing Illiquidity Among the risks faced by the holder of an investment is the chance that if liquidity has dried up at a time when it has to be sold, he’ll end up getting paid less than it’s worth. Illiquidity is nothing but another source of risk, and it should be treated no differently:  All else being equal, investors should prefer liquid investments and dislike illiquidity.  Thus, before making illiquid investments, investors should ascertain that they’re being rewarded for bearing that risk with a sufficient return premium.  Finally, out of basic prudence, investors should limit the proportion of their portfolios committed to illiquid investments. There are some risks investors shouldn’t take regardless of the return offered. But just as people can think of risk as a plus, so can they be attracted to illiquidity, and for basically the same reason. There is something called an illiquidity premium. It’s the return increment investors should receive in exchange for accepting illiquidity. But it’ll only exist if investors prefer liquidity. If they’re indifferent, the premium won’t be there. Part of the accepted wisdom of the pre-crisis years was that long-term institutional investors should load up on illiquid investments, capitalizing on their ability to be patient by garnering illiquidity premiums. In 2003-07, so many investors adopted this approach that illiquidity premiums became endangered.

© Oaktree Capital Management, L.P. All Rights Reserved of fundamental difficulty, falling asset prices, reduced market liquidity, collateral value tests and margin calls can be the ruination of investors employing leverage. That’s what befell many in the fourth quarter of 2008. In 2003-07, interest rates brought low by the Fed, modest demands for risk premiums on the part of unworried investors, and financial institutions’ competition to lend conspired to make low- cost leverage readily available. That cheap financing (a) convinced people that high leverage was the route to increased returns (even from low-yielding underlying investments), (b) armed all parties for a bidding war for assets, and (c) made people rush to borrow and buy before the river of financing ran dry. The result was a buying spree of massive proportions, the bill for which – in terms of debt maturities, often unpayable – will come due in the next few years. Like just about everything else in investing, leverage is neither good nor bad per se. Used at the right time, in judicious amounts, to purchase low-priced assets, it’s a good thing. But that’s not the story of the pre-crisis years. And that’s a big reason for the trouble we’ve had since. “Risk Means More Things Can Happen Than Will Happen” The above quote from Elroy Dimson of the London Business School helps bring risk into focus.

© Oaktree Capital Management, L.P. All Rights Reserved technical reasons. Loan investors who were able to hold on recovered, but many who had bought with leverage couldn’t do so. They drowned in the deep part of the stream. Chuck Prince on Dancing A quotation from the former CEO of Citigroup contains just 30 words, but it could serve as a case study regarding the events leading up to the crash: 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. We’re still dancing. (Charles Prince, July 9, 2007) I suspected in mid-2007 that this quotation would end up being emblematic of the cycle. It’s been replayed many times, but usually without the first dozen words. Prince seems to have been more aware of what was going on than people give him credit for. He may have sensed the bank was on thin ice in lending and levering, like the rest. The problem wasn’t that he overlooked the danger; the problem was that he felt he had to participate anyway. One of the dilemmas faced by businesses is that they can conclude that they have no choice but to take part in dangerous behavior. Usually this is because they’re unwilling to cede market share. On October 5, Leo Strine, Vice Chancellor of the Delaware Court of Chancery, wrote as follows in The New York Times Dealbook: . . .

© Oaktree Capital Management, L.P. All Rights Reserved Here’s another way to put it, from The Wall Street Journal of November 24, When it comes to booms gone bust, “over-investment and over- speculation are often important; but they would have far less serious results were they not conducted with borrowed money.” That statement wasn’t made in reference to current events; that was Irving Fisher writing 76 years ago (“The Debt-Inflation Theory of Great Depressions,” Econometrica, March 1933). Borrowed money lets economic units expand the scale of their activity. But it doesn’t add value or make things better; it just makes gains bigger and losses more painful. There’s an old saying in Las Vegas: “The more you bet, the more you win when you win.” But they always forget to add “. . . and the more you lose when you lose.” In one of those beautiful phrasings that demonstrate his mastery of language, Jim Grant of Grant’s Interest Rate Observer has described liquidity and leverage as “money of the mind.” By this he means they’re intangible and ephemeral, not dependable like assets or equity capital. Someone may lend you money one day but refuse to renew your loan when it comes due. Thus, leverage is purely a function of the lender’s mood. The free-and-easy lending of 2003-07 has turned into an extreme credit crunch, and the unavailability of credit is both the root and the hallmark of today’s biggest problems.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients From: Howard Marks Re: Doesn’t Make Sense Academics have their theories about market efficiency. Because market participants are well-informed and rational, they say, markets make correct decisions and smoothly assign the right price to each asset. It’s for this reason that investors can’t routinely find the mispricings they need in order to be able to beat the market. But investors – and most of the people living on this planet, for that matter – are far from the unemotional computing machines the academics assume them to be. They make faulty decisions, fall for scams and swing from one irrational position to another all the time. In fact, I marvel at how many things take place in the worlds of business, investments and politics that stem from irrationality and just don’t make sense. It’s my purpose here to write about a few. ULetting the Market Call the Tune In “Whodunit,” I talked about Chuck Prince, the ex-CEO of Citigroup. Early in July of 2007, he astutely observed, “When the music stops, in terms of liquidity, things will get complicated.” However, he went on to add, “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Because Citigroup danced as much as the other banks or more – and lost as much or more on subprime-related write-downs – Prince lost his job in November 2007.

equities having fallen for three consecutive years for the first time since the Great Depression – many investors concluded that their return aspirations couldn’t be met in traditional investments. Pressure for higher returns had the effect of increasing the acceptance of alternative investments, hedge funds, emerging market securities, leverage and financial innovation . . . in the process, suppressing customary risk aversion.  Leverage and risk taking became the dominant features of the financial landscape, facilitated by a “global wall of liquidity.” The low promised return on most investments, the pressure for more and the availability of low-cost capital all combined to make leveraged structures the flavor of the day.  Importantly, much of the growth in leverage took place free of regulatory oversight. In the past, the creation of debt was limited by margin requirements, Fed regulations, bank capital requirements and bankers’ prudence.an

The crisis revealed how thin the layer of true liquidity actually was. Instruments that had traded daily in normal markets became untradeable. The bid-ask spread that had been a rounding error became a chasm. Capital that had been committed on the assumption of roll-over financing had to be redeployed at any price the market would bear. The lesson is that liquidity is a regime-dependent asset, and the regime that produces abundant liquidity is not the regime in which you need it most. What we did at Oaktree during that period was deploy capital into the dislocations. The opportunity set was the widest I had seen in my career — distressed debt trading at prices that implied default rates several times any reasonable estimate, structured credit that had been marked down mechanically, and senior secured loans trading at deep discounts to par. None of these would have been available at those prices in any other market environment. The decision to buy aggressively required capital, conviction, and a tolerance for being wrong in the short run. We had raised a meaningful distressed debt fund in 2007 and 2008 that gave us the dry powder to act. Without that capital pre-arranged, we would have been unable to participate. The lesson of 2008, as of every prior crisis, is that the time to raise capital for distress is before the distress arrives.

© Oaktree Capital Management, L.P. All Rights Reserved UHow Things Got This Way Much of the current problem can be attributed to a decades-long bubble in the financial sector that made it the employer of obvious choice; attracted employees who were “the best and the brightest” (although often untrammeled by experience); contributed to greed and risk taking; drove out fear and skepticism; and carried institutions, behavior, expectations and asset prices to unsustainable levels. What are the factors that got us in the current mess?  Excess liquidity, which had to find a home.  Interest rates that had been reduced to stimulate the economy.  Dissatisfaction with the resulting prospective returns on low-risk investments.  Inadequate risk aversion, and thus a willingness to step out on the risk curve in search of higher returns.  A broad-scale willingness to try new things, such as structured products and derivatives, and to employ massive leverage.  A desire on the part of financial institutions to supplement operating income with profits from proprietary risk taking – that is, to be “more like Goldman.”  A system of disintermediation, selling onward, and slicing and dicing that caused many participants to overlook risk in the belief that it had been engineered away.  Excessive reliance on rating agencies which were far from competent to cope with the new instruments, and on black-box financial models that extrapolated recent history.

© Oaktree Capital Management, L.P. All Rights Reserved For forty years I’ve seen the manic-depressive cycle of investor psychology swing crazily: between fear and greed – we all know the refrain – but also between optimism and pessimism, and between credulity and skepticism. In general, following the beliefs of the herd – and swinging with the pendulum – will give you average performance in the long run and can get you killed at the extremes. Two or three years ago, the world was so different as to be almost beyond remembering. It was ruled by greed, optimism and credulity. In short, it was the opposite of the last few weeks: no story was too positive to be believed.  “There’s a worldwide ‘wall of liquidity’ that can never dry up.”  “Triple-A CDOs are as safe as triple-A corporate debt but will deliver higher returns.”  “Leverage holds the key to better investment results.”  “Tranching and selling onward are spreading the risk, thereby eliminating it.”  “Decoupling has reduced nations’ economic reliance on the U.S.” Boy, what a good time that was for a dose of skepticism! What benefits it could have provided (in terms of losses avoided). But when conventional wisdom is rosy, few can stand against it. People who do so too early look woefully wrong and are swept aside. That discourages others from trying the same thing, even as the cycle swings further to the positive extreme.

© Oaktree Capital Management, L.P. All Rights Reserved UCompulsory Short-Termism But is it right to say Prince and Citi could have avoided trouble by refusing to go along? Let’s do what some DVDs let you do nowadays: go back and consider an alternative ending. It’s July 2005 instead of July 2007. Presciently, Chuck Prince says, “When the music stops, in terms of liquidity, things will get complicated. We’re not going to get caught in that trap. As of today, we’re adopting a conservative stance toward loans, mortgages, subprime, CDOs and SIVs. The others can dance all they want; we’re sitting this one out.” What would’ve happened? Rather than lose his job in late 2007, he probably would have lost it sooner. Why? Because from whenever he made that statement until July 2007, Prince would have looked dumb. While other banks were gaining market share, Citi’s share would have been shrinking. And while other banks were borrowing on the cheap to make mortgage-related investments at seemingly attractive spreads, Citi would have been on the sidelines, forgoing easy profits. Shareholders would have been yelling for Prince’s scalp. The bottom line is one of my three favorite adages: Being too far ahead of your time is indistinguishable from being wrong. Of the two things I think are most wrong about American business, the worst is short-termism. (The other is the ability of executives to thrive while their companies do poorly.)

© Oaktree Capital Management, L.P. All Rights Reserved Democrats who controlled the White House for 28 of the 36 years from 1933 to 1969, and the Senate for 44 of the 48 years from 1933 to 1981. (In America, regulation is generally associated with Democrats and liberalism, and deregulation with Republicans and conservatism.) The last 28 years have been very different, however, thanks primarily to Ronald Reagan and Margaret Thatcher, bolstered by centrist Clinton and Blair administrations, and helped along by Bush, Bush and Brown. For much of that time, the Fed was under the leadership of Alan Greenspan, who is philosophically indebted to Ayn Rand, a strong believer in free markets. Free-market solutions were deemed certain to yield optimal economic decisions. Deregulation, privatization and market pricing went into full swing. Government involvement in policy making and control was disrespected. In short, it was assumed that the profit motive – Adam Smith’s “invisible hand” – would maximize capital efficiency and, therefore, societal welfare. This trend reached its apogee in the last ten years. The Glass-Steagall Act was nullified; this allowed, for example, the combination of Citibank and Salomon Brothers. Other than lowering interest rates and providing liquidity to fend off weakness, the Fed employed a hands-off approach. Investment managers and investment bankers gained fame and huge fees for performance that showed which of them were the most talented.

© Oaktree Capital Management, L.P. All Rights Reserved consumer incomes, propelling the economy ahead but rendering households increasingly leveraged. As this process moved onward, it depended on a continued supply of the underlying ingredients: confidence, liquidity, leverage, risk tolerance and acceptance of untested structures. The resulting “virtuous circle” was described in glowing terms just as its perpetuation was growing increasingly unlikely. Bust It took five years or so for the bullish background described above to be established in full. As usual, far less time was required for the excesses to be exposed and the process of their unwinding to begin. The air always goes out of the balloon a lot faster than it went in. Regular readers know that if there’s one thing I believe in, perhaps more strongly than anything else, it’s the fact that cycles will prevail and excesses will correct. For the bullish phase described above to hold sway, the environment had to be characterized by greed, optimism, exuberance, confidence, credulity, daring, risk tolerance and aggressiveness. But these traits will not govern a market forever. Eventually they will give way to fear, pessimism, prudence, uncertainty, skepticism, caution, risk aversion and reticence. A lot of this has happened. Busts are the product of booms, and I’m convinced it’s usually more correct to attribute a bust to the excesses of the preceding boom than to the specific event that sets off the correction.

© Oaktree Capital Management, L.P. All Rights Reserved mentioned in “Now What?” in January. We still have to see money begin to circulate throughout the system. Jim Grant, the creator of Grant’s Interest Rate Observer, uses a great phrase to describe liquidity and credit: “money of the mind.” Unlike actual currency, it grows and shrinks depending on people’s moods – we’ve just seen a great demonstration. So it’s not enough for the Fed to give money to financial institutions; they have to be convinced to provide liquidity and credit. In recent times, the Fed has provided a lot of capital to banks, but it has also taken in a lot of deposits from banks. We want to see the Fed’s advance reloaned, not put on deposit. That’s what it’ll take to restart the credit machine. Even when credit starts flowing again, however, I doubt things will return immediately to their old pace. Losses have been taken and capital destroyed, and more losses may still be incoming (ask yourself if home prices are finished going down). More importantly, psyches have been damaged: consumer psychology, lenders’ willingness, even investor confidence – all have taken a beating. I doubt if things will bounce right back. There just won’t be the same expansiveness. I’ll stick with what I said in “Now What?” Undoubtedly, credit will be harder to obtain. Economic growth will slow: the question is whether it will remain slightly positive or go negative, satisfying the requirement for the label “recession.

© Oaktree Capital Management, L.P. All Rights Reserved Even understanding Lehman’s current trading positions was tough. Lehman’s roster of interest-rate swaps (a type of derivative investment) ran about two million strong . . . What kind of effort would it require to understand the significance of two million derivatives positions: are they thoroughly hedged, or bullish or bearish on balance? And what about Lehman’s millions of other derivatives and complex securities? This opacity, combined with heavy leverage, reliance on short-term funds, liquidity and conscious risk taking, is the reason why a loss of confidence is conceivable at any financial institution in times of panic. What will the Wall Street of the future look like? We read – and I don’t doubt – that for at least a while it will be smaller, less leveraged, less profitable, and more highly regulated. But I also think it will be less competitive and less risky. In the course of my career, Wall Street went from being (1) brokers handling riskless trades for commission to (2) dealers buying and selling inventory for a spread to (3) block traders purchasing large amounts of stock when market liquidity was inadequate to (4) proprietary traders risking their own capital in pursuit of profit for the house. Backing down this progression wouldn’t be the worst thing in the world. U What Will Start the Recovery? Eventually, someone will walk out of the crowd and take advantage of the lows.

© Oaktree Capital Management, L.P. All Rights Reserved Depression by withdrawing liquidity when they should have been increasing it. Let’s not tighten again. In “Doesn’t Make Sense” in July, I listed four things that have to happen in order for the trends in mortgages and financial institutions to turn positive:  Home prices have to stop going down.  Home mortgages have to be made available.  Financial institutions have to stop experiencing incremental write-offs.  Financial institutions have to be able to raise additional capital with which to rebuild their balance sheets. I also pointed to the complication: that each of these four things is dependent on the occurrence of another. The good news is that the Treasury plan has the potential to break into the cycle of negativity, directly address the third and fourth of these, and thus contribute to the first and second. That’s why I’m all for it. In the Depression, the engine of capital provision went into a long-term stall, and we know the consequences. The attempt now is to jump-start processes that have stalled and prevent the rest from doing so. I’m sure this is the right thing to do, and I hope for its success. September 24, 2008 P.s., In “You Can’t Predict. You Can Prepare.” (November 2001), I described the process through which stock markets pull out of declines and turn upward: Stocks are cheapest when everything looks grim.

© Oaktree Capital Management, L.P. All Rights Reserved advances and no one – except bargain hunters and investors in distress – relishes pullbacks. But I wonder if that stance makes sense. How can we have gains but not losses? How can a free-market economy allocate capital effectively if capital creation is abetted and capital destruction is prevented? The fact is, excesses like we’ve just seen have to be corrected – painfully – and if they aren’t, they’ll just grow bigger and bigger as the cycles wear on. “Moral hazard” will arise, convincing people that risk takers will always be bailed out, something that’s bound to encourage greater risk taking. The Fed’s actions in the current situation have been dramatic:  an unexpectedly large half-point cut in the discount rate in September,  strong steps to inject liquidity and encourage borrowing by banks, and  an unusual ¾-point rate cut on January 21, followed by another ½ point a week later. In two decades as Fed Chairman, Alan Greenspan was required to deal with the emerging market crisis and meltdown of Long Term Capital Management in 1998; the possibility of a Y2K glitch; the tech stock and broader bear market in 2000-02; the ramifications of the 9/11 attack; and concern over the possibility of deflation. And yet he never cut rates by ¾ point in one step or by 1-¼ points in just eight days. Thus Bernanke’s actions seem extreme. Is the Fed attempting to prevent a normal recession?

© Oaktree Capital Management, L.P. All Rights Reserved time uncertainty have rarely, if ever, been able to achieve the level of future clarity required to act pre-emptively. Most regulatory activity focuses on activities that precipitated previous crises. Aside from far greater efforts to ferret out fraud (a long-time concern of mine), would a material tightening of regulation improve financial performance? I doubt it. The problem is not the lack of regulation but unrealistic expectations about what regulators are able to prevent. How can we otherwise explain how the UK’s Financial Services Authority, whose effectiveness is held in such high regard, fumbled Northern Rock? Or in the US, our best examiners have repeatedly failed over the years. These are not aberrations. The core of the subprime problem lies with the misjudgments of the investment community. . . . Even with full authority to intervene, it is not credible that regulators would have been able to prevent the subprime debacle. (Emphasis added) Martin Wolf sized the challenge in the FT of April 16: If regulation is to be effective, it must cover all relevant institutions and the entire balance sheet, in all significant countries; it must focus on capital, liquidity and transparency; and, not least, it must make finance less pro-cyclical. That’s a tall order. The results are unlikely to stack up well against the goals.

you end up with something that has a higher expected return but isn’t riskier? That’s too good to be true.  Finally, in addition to magnifying losses as well as gains, leverage carries an extra risk on the downside that isn’t offset by accompanying upside: the risk of ruin. Leverage, when added to losses, can lead to margin calls and meltdowns. There is no corresponding benefit. This lesson is being well learned today. Second, every investment or portfolio entails a variety of risks, and its overall risk is the sum of those. Every investment embodies both the specific risk related to the individual company or asset and the systematic risk that is a function of its membership in a market – its beta. There also can be liquidity risk, legal risk, currency risk and political risk. Finally, risk is introduced by the structure in which an asset is held. Here I’m referring to the risk that comes with leverage. To simplify for my current purpose, risk comes from the combination of what you buy and how you finance it. You can buy very risky assets, but if you don’t lever up to do so, you’ll never lose them to a margin call. Or you can buy fundamentally safe assets, but the combination of enough leverage and a sufficiently hostile environment can cause a meltdown. In other words, investing in “safe” assets isn’t necessarily safe, particularly if you’ve borrowed to buy them. We’ve seen this at work in recent days, as entities that invested in top-quality assets have run into trouble.

But any misdeeds are likely to be symptomatic of a lax environment, not causes of the problem, and punishing them is unlikely to be an effective part of the solution. UEliminating the Fear of Loss A couple of weeks ago, I had a great talk with Tom Petruno, an insightful business reporter for the Los Angeles Times. Calling on our shared experience as Californians, he presented what I consider a very apt analogy. It went like this: We’ve all heard about the connection between the Fed’s actions and moral hazard. There’ve been many incidents and scares over the last couple of decades: Black Monday, the meltdown of Long-Term Capital Management, Y2K, the bursting of the tech bubble, 9/11, and a recession here and there. Each time, the Fed rushed in with interest rate cuts and increases in liquidity designed to prevent or offset their depressing effects. A few times, it was said, these actions averted a collapse of the world financial system. But the cost was moral hazard: a growing expectation that the Fed would bail out imprudent risk takers. By behaving in ways that cause people to think they’ll always come to the rescue, authorities encourage risky behavior. And we all share the cost of rescuing the risk takers, whether we participated or not. In this way, the risk taking encouraged by the Fed’s policy of protecting participants caused the risks to grow ever- higher.

In the distressed debt funds that we organized in 1990 and 2002, both times of chaos in financial markets, we earned net IRRs in the 30s and 40s. If you think about it, those IRRs have to be described as aberrant. No one should be able to earn returns like those without significant leverage. And yet we did. Like all active investors, we try to buy things for less than they’re worth. The above results suggest we were aided in those funds by people who were willing to sell things far below their worth. Why would they do so? Often because of the fire sale process described above. Not surprisingly, our financial leaders are attempting to short-circuit this process. Mortgage defaults are real and widespread and will produce losses for holders of related securities. Eventually those losses will have to be recognized and dealt with. But I think several of the actions we’re seeing are aimed at avoiding exaggerated, panicked fire sales:  injections of liquidity,  mortgage reset holiday,  taking SIVs (and their debt) onto balance sheets, and  proposing a Super-SIV (which now seems to be history).

Does it foresee an unusually serious one, perhaps driven by unprecedented weakness in home prices? Or is it concerned about profound financial system weakness, centered at banks and the monoline insurers? UKudos and Brickbats I hesitate to single out an individual for criticism, especially after he’s been punished through loss of his job, but CEO Chuck Prince of Citigroup contributed the unfortunate quote that just has to stand as the symbol of the last few years’ excesses. In early July, he showed foresight by saying “when the music stops, in terms of liquidity, things will get complicated.” Unfortunately, he added, “as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” What I think Prince was saying is that even if the market’s overheated, a financial institution has to participate or risk losing market share to those who will. But that’s my point. Is there any business a company won’t do? Is there any profit a company won’t pursue? Might there be something worse than losing market share? What a wonderful thing it would have been to lose market share in the crazy period leading up to last summer. Doing so held the key to avoiding the CDO carnage. Short-termism is one of the greatest problems in U.S. business today, and it makes it tough to go left when all your competitors are going right. But our business leaders should dare to be great.

Frankly, there is so much liquidity in the world financial system, that lenders (even “our” lenders) are making very risky credit decisions. . . . I know that this liquidity environment cannot go on forever. . . . I know that the longer it lasts, the greater the pressures will be on all of us to take advantage of this liquidity. And I know that the longer it lasts, the worse it will be when it ends.  John Paulson won well-deserved fame for generating returns up to 590% in his hedge funds last year. He did three things well: He recognized the excesses in the residential real estate arena. He figured out how to profit from their inevitable reversal. And he was lucky enough to get the timing right; rather than reach his conclusion earlier, look wrong for a long time and give up – as others did – he turned bearish in 2005 and was able to hold on until events began to prove him right in 2006.  I’m glad to say our clients’ sectors of the investment world – such as pension and endowment funds and insurance companies – generally haven’t reported much participation in the most highly leveraged entities.  Goldman Sachs has distinguished itself thus far by avoiding subprime and CDO losses, being short mortgage paper and skating through the crisis. Lehman Brothers, Credit Suisse, Deutsche Bank and JP Morgan Chase are other institutions that seem to have signed on for less subprime pain than their competitors.

from addressing localized fundamental problems. Instead, the problem is hydra-headed, affecting a large number of areas due to contagion. Larry Summers put it this way: You have three vicious cycles going on simultaneously. A liquidity vicious cycle -- in which asset prices fall, people sell and therefore prices fall more; a Keynesian vicious cycle -- where people's incomes go down, so they spend less, so other people's income falls and they spend less; and a credit accelerator, where economic losses cause financial problems that cause more real economy problems. There is no schematic diagram for the workings of the economy and the markets, as in “if we do A, the result will be B.” That’s particularly true for the current crisis, since some of the financial techniques that gave rise to it are new; others haven’t been used to the same extent; and they’ve never been combined as they were in the last few years. In particular, the workings of economies and markets depend heavily on psychology, which can’t be treated as if it’s hard-wired. Thus the people trying to address this bust can only work from hypotheses and try possibilities. The Fed and the administration are determined to solve the problem, but we’re unlikely to have the unwind we need without pain. As I wrote in “Whodunit,” in order for efficient capital allocation decisions to be made, an economic system that aims to create capital has to witness capital destruction from time to time.

© Oaktree Capital Management, L.P. All Rights Reserved bank lending, weaker loan standards and rising risk tolerance. The risk embodied in these things came home to roost in residential mortgages first because it’s there that they were applied to the greatest extent and to the weakest underlying collateral. Too many triple-A securities were created from each pool of non-investment grade mortgages, and they collapsed as soon as default rates surpassed the models’ assumptions.  The credit crunch was an obvious next step. A number of more generalized developments resulted from the mess in residential mortgages: o rising risk aversion, o higher demanded risk premiums, and thus lower prices for risky assets, o the withdrawal of leverage and liquidity, o leveraged fund meltdowns and frightening headlines, o losses at banks and thus endangerment of their capital adequacy, and o hoarding of capital and the unavailability of new loans.  This resulted in problems at financial institutions. Losses on highly leveraged investments were sure to lead to a crisis mentality, which could morph easily into a plain old crisis. What are the characteristics of financial institutions? o high leverage, o near-total reliance on short-term deposits and borrowings to fund illiquid, longer- term assets, o risk bearing – that’s what their business consists of, and it’s by doing so that they earn lending spreads (if they borrowed safe and lent safe, where would the spread come from?)

© Oaktree Capital Management, L.P. All Rights Reserved Finally, underperforming companies will crop up in private equity portfolios, and the need for turnarounds and restructurings will take up time and pull down returns. In many ways, the private equity industry may have to operate as it did in an earlier era, when funds were smaller, the volume of transactions was more moderate, both purchase and sale prices were lower, holding periods were longer, and IRRs were lower (but perhaps more meaningful in terms of times-capital-returned). Funds will have to make money the way they used to, with more emphasis on buying cheap and adding value and less on financial engineering and quick flips. Large funds formed within the last 12-18 months may find themselves uninvested for a while, and thus in high-fee limbo. * * * It’s worth remembering that the boom of the last few years arose in the financial sector, not the “real world.” Economies grew around the world – as did corporate profits – but there was no economic boom other than in developing nations. It was optimism, risk tolerance, innovation, liquidity, leverage, credulity and the race to compete that reached multi-generational highs. Thus the ramifications will be (actually, have been) felt first and most strongly in the financial sector. The question is how far they’ll spread from there. Undoubtedly, credit will be harder to obtain.

 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.

© Oaktree Capital Management, L.P. All Rights Reserved  Suddenly, market participants realized how hard it can be to value obscure, infrequently-traded assets and how much the prices of such assets can diverge from their value. In fact, “value” can be an empty concept in times of crisis, when it becomes painfully clear that an asset is only worth what it can be sold for. Thus people came to question the prices funds were using to value subprime-related holdings, as well as the model-derived prices their investment bank creators had charged for them.  Worried about both subprime fundamentals and pricing, and suddenly under increased scrutiny, many lenders stopped providing financing. Short-term commercial paper, which many investors had used to leverage their subprime-related asset investments, became largely impossible to roll over.  Funds that had promised liquidity to their investors – even some money market funds – became worried about their ability to accurately value subprime holdings and sell them at fair prices. Thus they suspended withdrawals. What could have a more traumatic effect on investor confidence?  Where leverage was withdrawn, margin calls arrived, or funds had to meet actual or feared withdrawals, holders of subprime assets became forced sellers. Few things have a more devastating effect on investment performance.

UThe L Word Revisited Most explanations of the financial dynamism of the last few years have centered on something called “excess liquidity.” Vast amounts of liquidity in the hands of investors, it’s been said, caused them to avidly pursue investments, neglect due diligence, accept low prospective returns, and therefore bid up asset prices. But where does excess liquidity come from? Not from more currency. The amount of currency in the world is somewhat fixed, and each person’s receipt is another person’s expenditure. The fact that China has massive reserves to invest merely means those sums came out of someone else’s account. I think the “L word” that should be focused on isn’t liquidity, but leverage. This is the one I discussed in “It’s All Good,” and the element behind many of the excesses of late. High levels of lending and borrowing relative to capital balances can increase buying power and fire up economies and markets. The question is whether that expansion will be maintained and increased. If not, this source of growth will peter out . . . as has been the case in the last few weeks. A decade or so back, the ability of parties other than the Fed to increase the leverage in the system was limited. Margin debt for purchases of stock couldn’t exceed 100% of an investor’s equity, and bank loans likewise were restricted to a multiple of capital.

© Oaktree Capital Management, L.P. All Rights Reserved been looking for new ways to make money.” But when the market has been moving down and people are tallying their losses, they tend to be much less open to new ideas. In the financial world, the mother of invention isn’t necessity, its salability. In the roaring 1960s we saw Nifty-Fifty investing, dual shares from mutual funds and discounted shares issued through unregistered private placements without any mechanism for subsequent liquidity. In the ’80s we saw portfolio insurance – a surefire way to enjoy the appreciation potential that comes with large commitments to equities, but with much less risk. And in the ’90s, no one could think of a reason why every dot-com, e-tailer, media aggregation and venture capital fund wouldn’t be successful. Of course, all of these things failed to function as promised and either disappeared forever or experienced severe corrections. And what have we seen in the last few years? CDOs, CLOs, CPDOs, SPACs and securitizations of every type. In the current environment – marked by decent returns; disinterest in conventional, safe assets; and openness to risky investments – few people seem to dwell on the reasons why something new might not work. No one asks why, if a $2 billion fund was successful, a $20 billion fund shouldn’t be as well. Derivatives deserve particular attention in this regard.

© Oaktree Capital Management, L.P. All Rights Reserved This pattern of contagion exemplifies the hidden fault lines that I say can run through portfolios and – like construction flaws in California homes – become apparent only during infrequent catastrophes. But their invisibility most of the time doesn’t mean they’re not there. The existence of these common threads is one of the things that make it difficult to predict the correlation between assets, one of the key ingredients in intelligent portfolio construction. And it’s a good reason to attach a significant premium to managers with alpha, or superior investment insight and skill. ULeverage and Liquidity It’s clear that when the story of 2002-07 is written, leverage and liquidity will be among the main players. For much of the last few years, we saw a vast appetite for securities. It created enormous demand for – and pushed up prices of – real estate- and asset-backed paper, CLO and CDO debt, buyout funds, hedge funds, high yield bonds and leveraged loans. In fact, there seemed to be unlimited demand for non-mainstream investments. With all that money to put to work, few potential buyers refrained from participating in an upswing that some observers thought lacked a sufficient raison d’être, reasonable limits and adequate risk compensation. One of the factors contributing most strongly to that demand was an ability to borrow excessive amounts, for questionable purposes, on loose terms and at a low cost.

Long-Term Capital Management, the Granite Fund, Amaranth Advisors, the two Bear Stearns funds, Sowood Alpha Fund and Basis Yield Alpha Fund were all marked by “safe” positions leveraged to the sky. And they all melted down. In a number of ways, perpetuation of the market conditions of the last few years was dependent on several assumptions about liquidity:  that investors with liquidity would be eager to put it to work,  that providers of capital would make liquidity available, meaning that leveraged investors would be able to maintain their portfolio holdings and buy more,  that securities markets would remain liquid, such that holdings could always be sold at prices close to their intrinsic value, and  that funds would therefore be able to keep the promise of liquidity that they’d made to their investors. In short, it was assumed that liquidity would continue to flow in the direction of leveraged investment funds (in the form of financing and incremental capital commitments) rather than away (in the form of margin calls and investor withdrawals). Two or three months ago the world was described daily as “awash in liquidity.” Where is it now? Investments requiring nothing more than the perpetuation of favorable market conditions can be very seductive. And they work most of the time . . . until the pit has been dug deep enough, the branches have been spread, and everyone has forgotten about the existence of risk.

© Oaktree Capital Management, L.P. All Rights Reserved The investment environment of the last few years could have been negatively impacted by the removal of any one of the elements of liquidity listed above. But if you look at the list, it becomes clear that they’re highly interrelated. Weakening one assumption could render the others less reliable. And, in truth, a single exogenous development – such as a major decline in psychology – could simultaneously harm them all. That’s the main story of the last few weeks. Investments costing many times the investor’s equity. Dependence on unreliable short-term financing. Susceptibility to margin calls or capital withdrawals. Assets that can become unsalable at a moment’s notice. Prices that can collapse because the markets are thin and everyone wants out at the same time. The formula is simple and the results are predictable. Not every fund that’s so disposed collapses, but the potential’s always there – with borrowing to buy at its core. Fundamental problems are present in most investment conflagrations, but exposure to excessive leverage and disappearing liquidity is often the accelerant. As breakingviews.com (my new favorite) put it in The Wall Street Journal of August 2, “The markets may hurt you, but your lenders will finish you off.” URisk Reduction Of the many fairy tales told over the last few years, one of the most seductive – and thus dangerous – was the one about global risk reduction.

Thus, everything else being equal, the bigger the boom – the greater the excesses of the capital markets in the upward direction – the greater the bust. Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable. And usually, the air goes out of the balloon a lot faster than it goes in. * * * Today’s financial market conditions are easily summed up: There’s a global glut of liquidity, minimal interest in traditional investments, little apparent concern about risk, and skimpy prospective returns everywhere. Thus, as the price for accessing returns that are potentially adequate (but lower than those promised in the past), investors are readily accepting significant risk in the form of heightened leverage, untested derivatives and weak deal structures. The current cycle isn’t unusual in its form, only its extent. There’s little mystery about the ultimate outcome, in my opinion, but at this point in the cycle it’s the optimists who look best. As is often the case, I could have made this a shorter memo by simply invoking my two favorite quotations, both of which have a place here. The first is from John Kenneth Galbraith, who passed away last year. I was fortunate to be able to spend a few hours with Mr.the

Thus I found it novel – even surprising – to read a January memo on this subject from Carlyle founder William Conway to his colleagues, with thoughts echoing mine: As you all know (I hope), the fabulous profits that we have been able to generate for our limited partners are not solely a function of our investment genius, but have resulted in large part from a great market and the availability of enormous amounts of cheap debt. This cheap debt has been available for almost all maturities, most industries, infrastructure, real estate, and at all levels of the capital structure. Frankly, there is so much liquidity in the world financial system, that lenders (even “our” lenders) are making very risky credit decisions. . . .

© Oaktree Capital Management, L.P. All Rights Reserved I know that this liquidity environment cannot go on forever. I know that the longer it lasts the more money our investors (and we) will make. I know that the longer it lasts, the greater the pressures will be on all of us to take advantage of this liquidity. And I know that the longer it lasts, the worse it will be when it ends. And of course when it ends the buying opportunity will be a once in a lifetime chance. But, I do not know when it will end. . . . Last year, I asked you to be humble, ethical and optimistic. This year I am asking you to be careful as well. In 1990-91, our distressed debt funds made a fortune buying the obligations of companies that had been loaded up with too much debt in LBOs in the late ’80s. Chastened by that experience, lenders in the ’90s didn’t provide enough leverage to make buyout companies much of a factor in the debt collapse of 2002. But with the memory of having 1990-91 faded, leverage became freely available in the last few years, and thus we have little doubt we’ll be buying a great deal of distressed LBO debt the next time around. When all the above is taken together, it seems likely that a few years out, we’ll see a landscape littered with companies that were crippled with excessive debt loads and lenders who weren’t repaid.

(The Financial Times reported on September 11 that according to JPMorgan, the alternative investment world amounts to $3 trillion, while the size of the mainstream bond and equity world is estimated at $60 trillion.) Thus the amounts people are trying to invest can overwhelm these markets. For this reason, investors may attach more importance to the ability to put large sums to work than to being able to attain historic returns and risk premiums, clear high due diligence hurdles, or structure fee arrangements that channel managers’ energies for the benefit of clients.  For now, the high level of liquidity is creating a “virtuous cycle.” The inflows have (1) given rise to asset appreciation, high returns and further demand, and (2) made it easy for weak companies to finance their way out of trouble, thus contributing to the impression that the level of risk is low.  The business model for managers in these areas has been completely altered by these developments. Because the amounts under management are so large (and the ability to charge high management fees is so great), managers can get rich off management fees and deal fees alone. For managers, then, high returns may be a nice-to-have, not a need-to- have, and avoiding endangering the fee machine can become a greater preoccupation.that:

Establishing and maintaining an unconventional investment profile requires acceptance of uncomfortably idiosyncratic portfolios, which frequently appear downright imprudent in the eyes of conventional wisdom. Concern over this risk keeps many people from superior results, but it also creates opportunities in unorthodox investments for those who dare to be different.  Illiquidity – If an investor needs money with which to pay for surgery in three months or buy a home in a year, he may be unable to make an investment that can’t be counted on for liquidity that meets his schedule. Thus, for him, risk isn’t just losing money or volatility, or any of the above. It’s being unable when needed to turn an investment into cash at a reasonable price. This, too, is a personal risk. Theoretically, a fund whose life is perpetual and whose liquidity needs are predictable shouldn’t be sensitive to this risk and thus should be able to bear it for profit. The bottom line is that investment risk comes in many forms. Many risks matter to some investors but not to others, and they may make a given investment seem safe for some investors but risky for others. Rejecting risk as synonymous with volatility, as I do, eliminates the one measure of risk that’s entirely quantifiable, objective and absolute. This, in turn, makes it hard to argue that the market’s an efficient machine that precisely assesses the risk of each investment and allocates prospective return proportionately.

This demonstrates that when a company increases its debt, the impact of subsequent developments is magnified. That’s why borrowing is also called leverage . . . and why borrowing makes companies riskier. But what if it borrows money and gives it to the shareholders? Take the same company with $200 of debt and $200 of equity. Assume again that it borrows $100, but this time, rather than buy assets, it distributes the cash to its equity investors. Now it has $300 of debt and $100 of equity supporting the same $400 of assets, and it takes just a 25% decline in the value of its assets to erase its equity. So whereas all borrowing makes companies riskier, borrowing for dividends greatly amplifies the effect, as the assumption of debt doesn’t lead to either the acquisition of productive assets UorU an increase in cash reserves, but merely a decrease in shareholders’ equity. For this reason, lenders should view borrowing for dividend distributions with extreme skepticism. But it is a feature of the current capital market environment – with its excess of enthusiasm and shortage of caution – that transactions designed to replace equity with debt have become commonplace. According to CSFB, in the 36 months that began April 1, 2003, $68 billion was borrowed through high yield bond issuance or bank loans with the stated purpose of paying dividends or repurchasing stock, whereas deals of this sort were largely unheard of prior to that date.

TU Classic Investment Mistakes THemlines go up and down. Ties go from wide to narrow and back again. There are only so many ways in which things can vary. Likewise, there are only a few mistakes one can make in investing, and people repeat them over and over. It seems Amaranth made several.  TBorrowing short to buy long (and illiquid). This cardinal sin is at the root of most great investment debacles. A fund’s capital should be as long-lived as its commitments. And no fund should promise more liquidity than is provided by its underlying assets. You can successfully invest in volatile assets if you’re sure of being able to ride out a storm. But if you lack that certainty and face the possibility of withdrawals or margin calls, a little volatility can mean the end. In the case of Amaranth, just as had been true of Long-Term Capital Management and the big junk bond holders that were forced to sell out at the 1990 lows, many of the losses would have turned back into profits if they had just been able to hold on through the crisis. That’s why I always caution, “Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average.” It’s not enough to be able to get through on average; you have to be able to survive life’s low points.  TConfusing paper profits with real gains.

© Oaktree Capital Management, L.P. All Rights Reserved dependent on it for their continued existence, he clearly had no way to realize them. My father used to tell a joke about the guy who insisted that his hamster was worth thousands more than he had paid for it. “Then you should sell it,” his friend urged. “Yeah,” he responded, “but to whom?”  Being seduced by loss limitation. Hunter is said to have liked buying deep-out-of-the- money options, and everyone knows that one great thing about buying options is that in exchange for a small option premium you receive the right to benefit from price movements on lots of assets. You can only lose 100% of the amount you put up . . . and in deep-out-of- the-money options people do just that all the time.  Misjudging liquidity. People often ask me whether a given market is liquid or not. My answer is usually, “that depends on which side you’re on.” Markets are usually liquid in one direction or the other but not necessarily both. When everyone is selling, a buyer’s liquidity is great, but a seller will find the going difficult. When sellers’ urgency increases, they’re likely to have to give on price in order to achieve the “immediacy” they crave (see my memo “Investment Miscellany,” November 16, 2000). If their desire for immediacy is extreme, the bids they see might be absurdly low. Thus markets can’t be counted on to accommodate a seller’s need to realize fair value.  Ignoring the impact of others.

© Oaktree Capital Management, L.P. All Rights Reserved As usual, James Grant supplies a trenchant analysis, this time in the April 25 issue of Forbes. His summary of what’s going on in real estate highlights time-honored mistakes that are being repeated: Markets look forward, except when they look backward. At this moment the real estate market is looking backward. . . . Mistaking the past for the future, people are pouring money into houses, shopping centers, office buildings, hotels, anything with a front door and a roof. They are paying some of the fanciest prices on record. Property bulls come in all sizes, shapes and net worths. “We are living with the greatest liquidity ever,” an eminent REIT promoter was quoted as saying in March in the New York Sun. “We’re not going to have a crash in the real estate market, there is too much liquidity.” Liquidity is a term of art. It means lots of money. It can also mean – and, in 2005, does mean – “low interest rates,” “E-Z financing terms,” “low dollar exchange rate” and “value investors go away.” In an evident state of liquidity-induced euphoria, a Miami Realtor recently proclaimed to The New York Times, “South Florida is working off a totally new economic model than any of us has ever experienced in the past.” Not true. The “South Florida economic model” is the oldest in the book. An excess of dollars leads to a drop in interest rates. And a drop in interest rates to a rise in real estate prices.

© Oaktree Capital Management, L.P. All Rights Reserved necessarily-representative period. In addition, it’s weakened by post-selection bias (low-return funds are unlikely to volunteer their performance) and survivorship bias (the estimated 25% of funds that go out of business each year are even less apt to do so). Importantly, holdings of illiquid or infrequently marked securities can cause betas and risk to be understated and thus Sharpe ratios to be overstated (Pensions & Investments, August 19, 2002).  It is obvious that some of the tactics employed by hedge funds entail considerable volatility and illiquidity. And yet, hedge funds give their investors the periodic right to withdraw. Thus, it’s possible for a hedge fund to offer more liquidity than does its underlying investment portfolio. This can be a formula for disaster. Given that a lot of the capital now in hedge funds is “hot money” prone to exit given a period of underperformance, it’s not hard to envision (and in fact the community has seen) rapid-fire withdrawals that lead to downward spirals and penalize the last investors out the door, who can find themselves owning disproportionate amounts of hard-to-value and hard-to-sell securities.  In most hedge funds, it’s hoped that the managers’ actions will neutralize the effect of market fluctuations. In other words, you’re betting on the managers’ skill, not the market direction.

In November 2000, I wrote about “A Framework for Understanding Market Crisis,” an insightful article by Richard Bookstaber, then of Moore Capital Management, that analyzed the behavior of panic sellers. Rather than reinvent the wheel, I’ll excerpt from my earlier memo:  Most people think security price movements result primarily from the market’s discounting of information about corporate, economic or geopolitical events – so-called “fundamentals.” If you sit with a trader, however, it’s easy to observe that prices are always moving in response to things other than fundamental information.  Bookstaber says, “the principal reason for intraday price movement is the demand for liquidity . . . . In place of the conventional academic perspective of the role of the market, in which the market is efficient and exists solely for informational purposes, this view is that the role of the market is to provide immediacy for liquidity demanders . . . . By accepting the notion that markets exist to satisfy liquidity demand and liquidity supply, the framework is in place for understanding what causes market crises, which are the times when liquidity and immediacy matter most.”  “Liquidity demanders are demanders of immediacy.” I would describe them as holders of assets in due course, such as investors and hedgers, who from time to time have a strong need to adjust their positions. When there’s urgency, “the defining characteristic is that time is more important than price . . . .

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.

© Oaktree Capital Management, L.P. All Rights Reserved falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they just get scared). The liquidity demanders increase in number, and they become more highly motivated.  In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market’s increased volatility and decreased liquidity have reduced the price they’re willing to pay. And maybe they’re scared, too. “Information did not cause the dramatic price volatility. It was caused by the crisis- induced demand for liquidity at a time that liquidity suppliers were shrinking from the market.” Speaking of panics, we all recognize the carnage that occurs when the desire to sell far exceeds the willingness to buy. But I think Bookstaber’s analysis applies equally to the opposite – times when the desire to buy outstrips the willingness to sell. It amounts to a “buying panic” and represents no less of a crisis, even though – because the immediate result is profit rather than loss – it is discussed in different terms. Certainly 1999 was just as much a year of irrational, liquidity-driven crisis as was 1987.

Hit a homer and he’s rich; strike out and he goes back to his old job.  We know incentive fees can serve to align interests between investors and their managers when profits are in the offing. But what happens when there are losses? When a fund has run up some serious losses and needs to recover to the “high-water mark” before it can generate incentive fees again, its personnel don’t stand to share in gains for a while. So what is there to make them stay around to engineer the recovery, rather than move to a new fund where they can profit from dollar one? On July 15 The Wall Street Journal described one such situation: “Rather than try to dig out of the deep hole, while at the same time not getting paid as much as they could earn elsewhere, Mr. James and his team began to contemplate starting out on their own.”  Finally, I’ll list a few other topics that may make hedge funds the subject of negative headlines in the future: o the risk implicit in the combination of leveraged hedge funds, leveraged funds of funds, and leveraged fund investors; o the absence of registration and regulation; o the lack of transparency; o the potential conflicts that arise when hedge funds are run within an organization that also manages non-hedge fund money in the same markets; o hedge funds’ involvement in buyouts (do they have the needed skills? will it reduce their liquidity and ability to value the portfolio for subscriptions/redemptions?)

Already companies are scrambling to show they're clean in terms of accounting, governance, and executive compensation.)  Certainly the belief in the inevitability of stock market profits has been dispelled. Who still believes that "stocks can be counted on to beat bonds and cash"? (Okay, nothing has changed regarding the long run, but investors have learned that living through a negative short run isn't that much fun.) And who still believes that the "efficient market" can be relied on to price stocks right? For these reasons, I think millions who were suckered into investing without the necessary expertise or awareness of risk will drop out for a while.  Likewise, the 1999 mantra of buying on dips has been laid to rest. Those who tried it in the last 28 months have paid a high price for investing on autopilot, and they are unlikely to rise up and counter the bears' selling any time soon. Sure, stocks will rise again, but few of the burned investors are worried about missing the first ten percent.  The leaders that people counted on to make them rich in 1998-99 are gone from the scene, and no one's likely to win investors' confidence anytime soon. Alan Greenspan's words no longer have the same soothing effect; now he's blamed for fostering too much liquidity, too great a market bubble, and then too-high interest rates. Likewise, investors have learned painfully that bullish statements from analysts and strategists precede up markets UandU down markets alike.

Remember what Lord Keynes said about the ability of markets to remain irrational for long periods of time. And remember that it's possible for you to be forced to sell at the bottom – by emotions, competitive pressure or the need for liquidity – turning temporary volatility (the theoretical definition of risk) into very real permanent loss. In order to get more out of the ups of stocks and try to lessen the pain of the downs, most people turn to active management via market timing, group rotation, industry emphasis and stock selection. But it's just not that easy. The American Way – earnestly applying elbow grease – doesn't often payoff. For a model, don't think about the diligent paperboy on his route; think about trying to profit from flipping a coin. I say that because I believe most markets are relatively "efficient," and that certainly includes the mainstream stock market. Where large numbers of investors are aware of an asset's existence, have roughly equal access to information and are diligently working to evaluate it, the market operates to incorporate their collective interpretation of the information into a market price. While that price is often wrong, very few investors are capable of consistently knowing when it is, and by how much, and in which direction. The evidence is clear: most investors underperform the market.

© Oaktree Capital Management, L.P. All Rights Reserved intrude into our regular existence? Are chemical and biological weapons a real threat? 2. About our response. Can we find bin Laden? Can we capture him and his henchmen? Will our military actions be successful, and can they be undertaken without extensive collateral damage? Can we pursue justice without alienating people and nations? Will terrorists move to punish our actions? Will their doing so shake our resolve, or that of our allies? 3. About the economy. How deep a recession are we in for? How long will it last? What will prompt a recovery, and what shape will it take? Will industries like airlines and hotels be permanently depressed, or will they return to pre-9/11 normalcy? When will liquidity and a desire to buy things return? Can we rely on normal cyclical patterns in these things? Will these elements be set back again if there is further terrorism? Who among us can say he knows the answers to these questions? And who can say the future is foreseeable without those answers? Many of these questions take us into uncharted territory where no one can say what will happen. The possible answers include some that could profoundly affect the economy and the markets, and they worry me. Some of the greatest dilemmas in investing surround highly unlikely events with highly negative implications. It's hard to know what to do about them, but we should at least be aware of their existence.

© Oaktree Capital Management, L.P. All Rights Reserved Who would say that confidence wasn't shaken by the events of September 11? Words we would have applied to our domestic security before, like insulated, invulnerable and impregnable, now seem to be out the window. Who doesn't feel at least a little less safe than a month ago? Thus most people are less full of the positive feelings that are required for a purchasing or investing decision, and on average they may "hunker down." Many economic units have concluded that in this more uncertain world, greater cash reserves are in order – for rational as well as emotional reasons. Individuals fear that jobs will be lost, hiring will be slow, and bonuses and raises will be less generous – and they know they've saved too little and tapped their home equity to keep spending. Home and car purchases will be deferred. Business investment will be slow, especially given that capacity utilization was low and falling even prior to September 11. Each of these decisions will take away a potential source of growth from the economy and contribute to a slowdown. That's what makes for the down-leg of the economic cycle (and we believe one has been well under way for several months). And when every expenditure that can be delayed has been delayed, the decline will slow and then stop. Then one person will conclude it's not going to get any worse, or prices any lower.

One potential buyer will come off the sidelines and place an order; one worker will be hired to fill that order; and one manufacturer will buy a new machine in anticipation of increased business. And one person will decide to buy a share in a business, or even try to start one. And that's what gets the up-leg going. It's all based on the ebb and flow of psychology. In my opinion, the key question is "How long will it take to restore confidence?" I don't claim to have the answer, but I think it may be a while. UStimulative ActionsU – The federal government has acted boldly to combat economic weakness, as it has been doing all year. All economic trends start at the margin, and that's where the government's actions can help. They can keep things from getting as bad as they otherwise would have gotten – but they cannot call the tune. Immediately providing a record amount of liquidity to the financial system prevented some problems that otherwise would have arisen given the damage to our infrastructure. Difficulties in the movement of funds and settlement of securities transactions were avoided, enabling the system to work and Americans to maintain faith in it. Prompt monetary action worked again to avert a potential crisis, as it did in 1987 and 1998. Fiscal policy, which relates to taxing and spending, also will have an impact. Government spending is stimulative, in that it uses money to purchase goods or to pay people who may turn around and spend it.

© Oaktree Capital Management, L.P. All Rights Reserved . . . but there's something of an oxymoron afoot. Even though thousands of people expect to make a living from active investment management, much of traditional investment thinking is built on the realization that alpha is severely limited (even though the practitioners don't state it that way). Why do I say that? Most investors claim they can outperform the market – that is, can see, assess and understand better than the average investor – because of superior intelligence and hard work. Doesn't everyone think he can beat the market? But much of what's actually practiced, even by Oaktree, subtly acknowledges that the ability to know more – and if you think of it, that's a lot of what alpha really is – is quite limited. It's a common assumption that if an investor's portfolios are highly concentrated, they're risky. But that assumes he can't see the future. If he could, it would be perfectly safe to have a low level of diversification. In fact, if his foresight were perfect, then the safest portfolio would hold only one asset, because that's the one he would think of most highly (and, since he could see the future, he would of course be right). Thus diversification, which is widely practiced even in the "I know" school of investing, represents a tacit acknowledgement that there's a lot that investors don't know. Investors' strong preference for liquidity is another indicator that this limitation is accepted.

I think one of the elements that roped in so many people and convinced them they could invest safely despite their lack of expertise was the media's repeated message that these things were knowable. Some of the confidence of these personalities has evaporated of late. UThe FedU – The trend of personalizing described above reached its apogee in the deification of Alan Greenspan. For almost fourteen years, Greenspan has done an excellent job at the Fed. He kept a weather eye out for signs of inflation and took steps to avert it when needed. He wisely injected liquidity into the financial system in times of crisis. And he made every effort to keep a steady hand on the economy, trying to avoid sudden moves that could unsettle the participants. He has presided over a terrific economy; I can't imagine a better one. I phrase that carefully, because it will be debated whether he made it great or it made him great. People who know things I don't will decide the question. In January, the markets demonstrated their great faith in Greenspan by leaping forward when the first interest rate cut was announced. "Surely Greenspan will be able to avoid a cessation of growth." Investors were highly confident that he would be able to save them. Yet in 1998-9, when he as good as said "I’m going to slow the economy and rein in this irrational exuberance," no one acted as if he could, and the market continued to roar.

Even the "I know" investors, who buy on the assumption they're right, insist on liquidity – because they know there's a good chance they'll be wrong and need to beat a retreat. But the more you can see the future, the less likely you'll be wrong, and the less risk there is that exiting could be difficult. In reality, then, not just investment theory, but also a great deal of everyday practice, is built around the acknowledgement that alpha – skill and foresight – is a scarce commodity. URiskU – It's essential that investors consider risk. In the time since I entered the investment field, return has increasingly come to be evaluated in risk-adjusted terms. Everyone knows that if two portfolios return 8% a year for five years, the two managers didn't necessarily do an equally good job of investing. If one did it with T-bills and the other with emerging market stocks, the first manager almost certainly did a better job – since he earned the same return with far less risk. That's real added value, just like earning more return with the same or less risk. To know how good a job a manager did, then, you have to have a good idea how much risk he took. Yet I think risk may be the area where both theory and many aspects of practice are furthest from right. The first thing you learn in investment theory, and one of the most widely agreed-on assumptions in practice, is that "volatility equals risk."

© Oaktree Capital Management, L.P. All Rights Reserved  Bookstaber says “the principal reason for intraday price movement is the demand for liquidity .... In place of the conventional academic perspective of the role of the market, in which the market is efficient and exists solely for informational purposes, this view is that the role of the market is to provide immediacy for liquidity demanders.....By accepting the notion that markets exist to satisfy liquidity demand and liquidity supply, the framework is in place for understanding what causes market crises, which are the times when liquidity and immediacy matter most.”  “Liquidity demanders are demanders of immediacy.” I would describe them as holders of assets in due course, such as investors and hedgers, who from time to time have a strong need to adjust their positions: When there's urgency, “the defining characteristic is that time is more important than price .... they need to get the trade done immediately and are willing to pay to do so.”  “Liquidity suppliers meet the liquidity demand.” They may be block traders, hedge fund managers or speculators with ready cash and a strong view of an asset's value who “wait for an opportunity when the liquidity demander's need for liquidity creates a divergence in price [from the asset's true value]. Liquidity suppliers then provide the liquidity at that price.

” What they offer is liquidity; providing liquidity entails risk to them (which increases as the market's volatility increases and as its liquidity decreases); and the profit they expect to make is their price for accepting this risk. “To liquidity suppliers, price matters much more than time.”  Usually when the price of something falls, fewer people want to sell it and more want to buy it. But in a crisis, “market prices become countereconomic,” and the reverse becomes true. “A falling price, instead of deterring people from selling, triggers a growing flood of selling, and instead of attracting buyers, a falling price drives potential buyers from the market (or, even worse, turns potential buyers into sellers.)” This phenomenon can occur for reasons ranging from transactional (they receive margin calls) to emotional (they get scared). The number of liquidity demanders increases, and they become more highly motivated. “Liquidity demanders use price to attract liquidity suppliers, which sometimes works and sometimes does not. In a high-risk or crisis market, the drop in prices actually reduces supply [of liquidity] and increases demand.”  In times of crisis, liquidity suppliers become scarce. Maybe they spent their capital in the first 10% decline and are out of powder. Maybe the market's increased volatility and decreased liquidity have reduced the price they're willing to pay. And maybe they're scared, too. Bookstaber recalls the Crash of 1987.

After the first leg down, liquidity suppliers “had already ‘made their move,’ risking their capital at much lower levels of volatility, and now were stopped out of their positions by management or, worse still, had lost their jobs. Even those who still had their jobs kept their capital on the sidelines. Entering the market in the face of widespread destruction was considered imprudent ... Information did not cause the dramatic price volatility. It was caused by the crisis-induced demand for liquidity at a time that liquidity suppliers were shrinking from the market.”

© Oaktree Capital Management, L.P. All Rights Reserved  “One of the most troubling aspects of a market crisis is that diversification strategies fail. Assets that are uncorrelated suddenly become highly correlated, and all positions go down together. The reason for the lack of diversification is that in a [volatile] market, all assets in fact are the same. The factors that differentiate them in normal times are no longer relevant. What matters is no longer the economic or financial relationship between assets but the degree to which they share habitat. What matters is who holds the assets.” In recent years, the “habitat” in which most investors feel comfortable has expanded. Barriers to entry have fallen, access to information has increased and, perhaps most importantly, most investors' forays abroad have been rewarded. Thus “market participants become more like one another, which means that liquidity demanders all [hold] pretty much the same assets and grab whatever sources of liquidity are available.” If they are held by the same-traders, “two types of unrelated-assets will become highly correlated because a loss in the one asset will force the traders to liquidate the other.” That's not a bad explanation for the fact that when Long-Term Capital and the emerging markets crashed in September 1998, high yield bonds and other unrelated asset classes fell with them.

I hope you'll recognize in the above some of the elements behind the Oaktree approach, as exemplified by our work with distressed debt.  We look for Bookstaber's “liquidity demanders,” with their exogenous motivations. We call them forced sellers, and they provide our best bargains.  We take advantage when “noneconomic” market conditions increase the pressure to sell even as asset prices move lower.  And we rarely approach holders to buy, preferring to wait until they call us. In that way we are “liquidity suppliers” rather than eager buyers. Take it from me, the latter pay more. Many of us may have had thoughts like Bookstaber's, and in my 30+ years in money management I've had plenty of chances to watch liquidity demand soar, liquidity supply dry up, prices collapse and diversification fail. But I respect someone who can put into a rigorous framework that which “everybody knows.” Speaking of panics, we all recognize the carnage that occurs when the desire to sell far exceeds the willingness to buy. But I think Bookstaber's analysis applies equally to the opposite - times when the desire to buy outstrips the willingness to sell. It's called a buying panic and represents no less of a crisis, even though - because the immediate result is profit rather than loss - it is discussed in different terms. Certainly 1999 was just as much of an irrational, liquidity-driven crisis as 1987.