Marks' Memos

I am a big believer in studying people that are a whole lot more smarter and more successful than I am. I vainly believe that if I study people who are smarter and more successful than I am, I may one day be as smart and successful as they are.

One of the individuals I have been studying for the past two years is Howard Marks. Mr. Marks is the Chairman of California-based Oaktree Capital Managment.

Every couple of months, Mr. Marks puts out a memo on whatever subject he happens to be thinking about at the time. The memos are always amazingly insightful, entertaining, and thought provoking. The lastest memo, So Much That's False and Nutty, is absolutely briliant.

Marks' latest installment takes a look at the various causes of the current economic crisis and makes some recommendations for how we can potentially avoid another crisis like this one in the future.

From Marks' memo:

The truth is, risk tolerance is antithetical to successful investing. When people aren’t afraid of risk, they’ll accept risk without being compensated for doing so . . . and risk compensation will disappear. This is a simple and inevitable relationship. When investors are unworried and risk-tolerant, they buy stocks at high p/e ratios and private companies at high EBITDA multiples, and they pile into bonds despite narrow yield spreads and into real estate at minimal “cap rates.”

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. For example, as of the middle of 2008, the average $1 billion-plus endowment is said to have had investments in and undrawn commitments to the main illiquid asset classes (private equity, real estate and natural resources) equal to half its net worth. Some had close to 90%.

Investors’ desire to earn money makes them willing to do things they haven’t done before, especially if those things seem modern and sophisticated. Technological complexity and higher math can be seductive in and of themselves. And good times and rising markets encourage experimentation and erase skepticism. These factors allow Wall Street to sell innovative products in bull markets (and only in bull markets). But these innovations can be tested only in bear markets . . . and invariably they are.

When considering a course of action, we should ask, “Is it right?” Not necessarily the cleverest practice or the most profitable, but the right thing? The people I think of perverting the mortgage securitization process never wondered whether they were getting an appropriate rating, but whether it was the highest possible. Not whether they were doing the right thing for clients or society, but whether they were wringing maximum proceeds out of a pile of mortgage collateral and thus maximizing profits for their employers and bonuses for themselves.