'It's not a judgment': why Howard Marks isn't afraid of 'cockroaches' in the debt market

A series of bankruptcies in the auto industry and problems at regional banks could signal broader problems in the lending market, Jamie Dimon, head of JPMorgan, the largest U.S. bank, warned in October. "I immediately set off alarm bells when these things happen. I probably shouldn't say this, but when you see one cockroach, there are probably more ... everyone should be wary," he expressed.

Cockroaches, like canaries in a mine, can indeed be harbingers of disaster, Oaktree Capital Management co-founder Howard Marks agrees. In his new note Cockroaches in the Coal Mine, he explains what's happening in the private credit market, how risk affects price fluctuations and why long years without losses leave investors vulnerable.

The September bankruptcies of auto parts supplier First Brands and auto lender Tricolor were the first "cockroaches" in the private lending market. Signs of potential fraud were uncovered: First Brands, bankruptcy lawyers say, may have used the same receivables as collateral for multiple loans, while Tricolor lent to customers without credit scores or documentation.

More signals followed in October: regional bank holding company Zions Bancorp reported misconduct by corporate borrowers and wrote off about $50 million, and another bank, Western Alliance, said it had filed a fraud lawsuit against a commercial real estate borrower. It was later revealed that two telecommunications companies, Broadband Telecom and Bridgevoice, borrowed against fictitious receivables and went bankrupt.

"If one case is an isolated incident and two hint at a pattern, are six cases an ominous trend?" - Marks writes. Investors were wary, and the market reacted nervously: after the bad news from the banks, shares in some large alternative asset managers fell 5-7%.

But Marks believes the panic is premature. "Defaults happen all the time, and it's not that uncommon for there to be waste," he reminds us. In his years in the high-yield bond market, Marks has observed that in a normal year, about 2% of securities default, and more during crises.

"Default is not an indictment of all below-investment-grade rated debt or the private credit market," the investor writes. - Rather, it is simply a reminder that the credit spreads that get so much attention exist for a reason, and that below-investment-grade debt carries risk."

In addition, Marks reminds us that the private lending market emerged in the aftermath of the global financial crisis, when banks cut back on corporate lending and foundations took their place. "Because there were few lenders, those who were willing to lend money could demand high interest rates and high levels of guarantees," he writes. In an era of low rates, such loans seemed almost risk-free, and some $2 trillion flowed into the sector over the following years. But the growth in capital and the number of players increased competition and gradually lowered standards.

Howard Marks believes that price fluctuations in the market often reflect not so much changes in the real value of companies as changes in investors' attitudes to risk.

"When the economy is growing, companies are posting record profits, and markets are rising, people begin to think: risk is my friend, the more I risk, the more I earn," Marks writes. - In good times, ambiguous events are interpreted positively, and negative events are easily dismissed." Over time, the fear of losing money gives way to the fear of "missing an opportunity." Asset research becomes a formality, and competition for returns lowers standards.

In this phase, not only carelessness but also the illusion of prosperity takes hold. Economist John Kenneth Galbraith called it bezzle (short for embezzlement) - imaginary wealth created by fraud and credulity. Until the fraud is uncovered, both sides win: the fraudster spends the stolen money, feeling rich, and the victim is assured that the money is still there.

But the pendulum inevitably swings the other way. "Profits go down, quotes go down, and people decide that taking risks is just a way to lose money. They say, 'I'm never going to take risk again. Get me out of this at any price.'" Now the negative is exaggerated and the positive is ignored," Marks writes. Optimism is replaced by fear, and investment standards are sharply raised. Scams perpetrated during the boom years are exposed.

This cycle repeats itself over and over again: prosperity breeds carelessness, and crises breed excessive caution. Many erroneous decisions, which economist Friedrich Hayek describes as "misinvestment," are also made during booms and revealed during recessions. "This will always be the case," Marks is certain. - One might describe it with the great banking aphorism: 'The worst loans are made in the best of times.'"

In the final letter, Marks summarizes: issuer default is not a failure of the system, but a natural part of life when investing in below-investment grade rated debt. When optimism and liquidity reign in the market for long periods of time, credit standards inevitably weaken, and with it, errors and fraud increase. Such times, Marks writes, bring back a sense of proportion to investors - reminding them that the desire to make money cannot replace due diligence and analysis.

This balance is most difficult to strike in segments with limited transparency. Marks notes that in the private credit market, investors are often dependent on data from intermediaries and auditors. The real risks become apparent after they have been realized - when the price of the asset has adjusted.

Qualitative analysis is especially important here. Oaktree's team investigated First Brands and, long before the bankruptcy, identified confusing factoring and off-balance sheet financing schemes - signs of weak controls. These observations allowed the fund to adjust its position and avoid losses.

After 15 quiet years, Marks says the market is entering a "more interesting" phase: mistakes accumulated during the growth years are starting to show and investors are returning to caution. "On the other hand, instances of fraud have likely sobered lenders and investors and put them on alert," he writes. - In the coming months, and perhaps even years, they are likely to return to a heightened level of prudence in their decisions. That would be a good development."

This article was AI-translated and verified by a human editor