I’ve read a lot of notes and articles about the current financial crisis. This one, forwarded to me by First Republic, is among the best I’ve read. Entitled simply, Nobody Knows, it’s written by Howard Marks of Oaktree Capital. A few excerpts:
This is a great time for my favorite quote from John Kenneth Galbraith: “There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
On the causes of the crisis:
- 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.
- Unquestioning acceptance of financial platitudes without wondering whether altered circumstances and elevated asset prices had rendered them irrelevant: (1) houses and condos are good investments and can be counted on to appreciate, (2) mortgages rarely go into default, (3) there can never be a nation-wide decline in home prices, (4) it’s okay to grossly lever a balance sheet if you’ve hedged enough through derivatives, and (5) it’s safe to borrow and invest funds equal to a huge multiple of your equity capital if the probabilistic expected value is positive, because “disasters rarely happen.”
- Individuals such as mortgage brokers and mortgage borrowers who were given incentives to do the wrong thing.
- Newly minted financial “masters of the universe” encouraged to maximize returns for themselves and their employers without concern for whether they were adding value to the financial system or endangering it.
On what to do:
My answer is simple: we have no choice but to assume that this isn’t the end, but just another cycle to take advantage of. I must admit it: I say that primarily because it is the only viable position. Here are my reasons:
- It’s impossible to assign a high enough probability to the meltdown scenario to justify acting on it.
- Even if you did, there isn’t much you could do about it.*
- The things you might do if convinced of a meltdown would turn out to be disastrous if the meltdown didn’t occur.
Then I went on to create the converse of the above, the three stages of a bear market:
- the first, when just a few prudent investors recognize that, despite the prevailing bullishness, things won’t always be rosy,
- the second, when most investors recognize things are deteriorating, and
- the third, when everyone’s convinced things can only get worse.
In the final stage, you can buy assets at prices that reflect little or no optimism. There can be no doubt that we are in the third stage with regard to many financial institutions. Not necessarily at the bottom, but in a serious period of unremitting pessimism.