Mastering The Market Cycle: Getting the Odds on Your Side

by Howard Marks

The process is simple: The economy moves into a period of prosperity. Providers of capital thrive, increasing their capital base. Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk. Risk averseness disappears. Financial institutions move to expand their businesses—that is, to provide more capital. They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants. At the extreme, providers of capital finance borrowers and projects that aren’t worthy of being financed. As The Economist said earlier this year, “the worst loans are made at the best of times.” This leads to capital destruction—that is, to the investment of capital in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return of capital. When this point is reached, the up-leg is reversed. Losses cause lenders to become discouraged and shy away. Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements. Less capital is made available—and at the trough of the cycle, only to the most qualified of borrowers. Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies. This process contributes to and reinforces the economic contraction. Of course, at the extreme the process is ready to be reversed...