Moderator: Stephen Renna

Stephen Renna:  Welcome Howard.  On behalf of everyone at the CRE Finance Council, thank you for participating in this feature interview.  The first question I have is what is your view on the major economies around the world?  The United States economy is growing modestly while Europe and Asia seem to be slipping towards recession.  What is the investment environment that each economy presents?

Howard Marks:  Well, as you say, all of the economies of the world are behaving quite sluggishly.  And the US, which looks like the best house on the bad block, of course is probably the envy of the world in terms of returning to hoped-for levels.  I don’t think we are going to get back to where we used to run, and I don’t know if anybody is.  I think we are going into a slower period than the decades we are used to, but I’m not an economist, this is just my leaning.

I think the superior recovery of the US is attributable to the measures coming out of the crisis that were taken by our leaders; Paulson, Geithner, and Bernanke, and  the provision of more stimulus early, whereas Europe tried austerity to reduce debt and deficits.  In short, the wealthier countries of Europe imposed more of a stringent approach than we followed.

It is interesting that they are declaring stimulus measures, as is Japan, just as we are taking ours off.

I don’t get into the precise question of whether or not Europe or other countries are going to see a recession, I consider it sufficient to say that their economies are functioning in a sluggish manner.

Stephen Renna:  As you mentioned, there is a lot of stimulus in all the economies around the world from central banks pumping liquidity into the markets.  They don’t appear to be backing off even in the United States.  So from a value investor perspective, is all of this stimulus ultimately more of an opportunity or more of a challenge?

Howard Marks:  In theory, you have opportunity while companies and assets benefit from the stimulus.  But that assumes, number one, that it works and, number two, a certain agility in selecting the ones that will experience gains and getting out.  In general, I think this stimulus poses risk, because to the extent that stimulus is kind of artificial — not natural –then you have to wonder about what happens when it stops.

So I think that it is one of the things to be cautious about.  And of course, the other is that stimulus is like medicine.  It’s good to get medicine, but it’s bad to need medicine. So the fact that Europe is stimulating is not a good sign, it’s a bad sign, it means that they have a malady.

Stephen Renna:  One of the tools of stimulus is interest rates.  The Federal Reserve is holding benchmark interest rates at near-historic lows.  What is your view on the Fed’s interest rate strategy?  And when rates eventually rise, do you think this is going to have a negative effect on bonds such as long-term treasuries?

Howard Marks:  Well, rates up/bonds down is not a matter of opinion.  If rates go up, bond prices will go down, period.  On the other hand, if you want to find unanimous sentiment, ask investors in the summer of 2013 whether or not interest rates would go up. 100 percent would have said yes.  And they went down.  So much for unanimity and so much for forecasting.  We don’t know what is going to happen with rates, period.

Having said that, it is reasonable, to think rates will go up primarily because it is reasonable to think that rates have been held artificially low.  So my best guess is that rates will go up a little –but only a little, because I don’t think either the economy or inflation is strong enough to call for a very large increase.  I don’t think we are going to see hyper-inflation or sky rocketing interest rates anytime soon, but I also don’t believe I can see the future.

Stephen Renna:  As part of the stimulus, you hear a lot of people talking about the asset bubbles.  What is your view on asset bubbles?  Do you see a bubble in any particular asset class?

Howard Marks:  Bubble is a troublesome word.  The term “bubble” has — to some people — specific connotations such that I would rather not use it.  One of the reasons I don’t like to use it is that I don’t think there is a broad agreement on what a bubble is.  To me, a bubble is extreme over confident psychology.  And I don’t think we have that.  I could be wrong, of course.  But what I think is that due to the central banks’ low interest-rate policies, people have been forced to move into risky asset classes in order to get the kinds of returns they seek.  So, people who are not satisfied with the piddling results on money market instruments, treasuries and high grades have had to go into other asset classes to get the returns they want.

The movement of that capital has lifted prices in those asset classes, and in some of them, very substantially.  So I don’t know; to me a bubble is something very specific: irrational optimism and I don’t find people who are that optimistic.  As I said in one of my memos, I don’t think people are thinking that bullish, they are just acting bullish.  And they are acting bullish because they have to in order to get the returns they want.  I described them at the time as handcuffed volunteers.

Stephen Renna:  Well, speaking of returns, what is your view of real estate debt investment in a relative value sense?

Howard Marks:  Well, again, it depends on how you define real estate.  We are optimistic regarding real estate assets.  But we aren’t active in so-called core real estate: class “A” buildings in prime cities.  But in the things that we are active in, we are optimistic.  We think that prices are not bubblish in our assets.  In the non-A buildings and the non-prime cities, we think prices are not unreasonable, and so we have been active.  That includes real estate lending.  And I think real estate lending is a reasonable thing to do now.  Among other things, number one, real estate is not homogenous.  Retail money doesn’t flow there as readily; there aren’t as many readily accessed vehicles for the kind of thing we do and so their prices don’t get forced up by the flow of retail money to the same extent.

And then much of the lending we do is private.  And private debt, I think, today, is cheaper than public debt, in part for the same reason, and in part because people have developed something of an aversion to private assets because holders of private assets suffered greatly in the crisis.  And so it is not attractive just because it’s real estate debt, but it’s against assets that haven’t risen in price so much and it is private lending as opposed to public.

Stephen Renna:  I’ve had the privilege of reading some of your client memos.  In them you talk about the concept of risk and how investors should think about risk.  Please comment on that.  Also, what do you see as the top risks in your business and in investing today?

Howard Marks:  I define risk as the probability of permanent loss– that is to say, not fluctuation or volatility.  And I think risk comes primarily from two things.  Number one, the level of prices, and so you should look at valuation metrics relative to history, relative to alternatives and so forth.  And second, risk comes from investor behavior.  So when buyers are enthusiastic and optimistic and risk-oblivious, that is a dangerous time. That’s really how I think about risk.  You have to look at valuation metrics, which is quantitative, and you have to do what I call taking the temperature of the market, which is qualitative.

I think that in many asset classes, risk is elevated today.  It is not maximally elevated, but it is elevated because of the behavior I described before, which is the result of the need to invest in pro-risk asset classes to make money.

Stephen Renna:  Also in your memos, you commented that in order to perform better than the pack, you have to “be comfortable with being uncomfortable with your investment portfolio”.  Can you just comment on your thinking with respect to that?

Howard Marks:  The things that people are comfortable with and feel good about, they will buy into.  And the things that everybody has bought into are unlikely to be bargains.  Things are likely to be bargains only if there is some aversion on the investor’s part to buying them.  That is to say, bargains are usually found among the things that people are not comfortable with.

The word “uncomfortable” actually came from a quote from Dave Swensen’s book, “Pioneering Portfolio Management,” in which he describes the need to have portfolios that are “uncomfortably idiosyncratic”.  I think that is a great phrase.  And, I don’t think I put it in the memo that you are referring to, but there is that Yogi Berra quote, “nobody goes to that restaurant, it is too crowded.”  It is kind of equally oxymoronic to say there’s an investment that everyone knows about, understands, likes and feels good about, and agrees that it’s a bargain.  If everybody knows about it and likes it and feels it is a bargain, won’t they have bought it up to the point where it is not a bargain?

Stephen Renna:  Absolutely, right.  Sure.

Howard Marks:  I think I said in one of my memos, all great investments begin in discomfort.

Stephen Renna:  Yes.  Excellent.

Can we shift gears to talk a little bit about Washington, since I’m sitting here in DC, the epicenter of law and regulation?

Howard Marks:  If you must.

Stephen Renna:  Well, I don’t think we could escape our conversation without raising the concept of regulation.  As you know, the Dodd-Frank legislation spurred a wave of regulation on the financial services industry.  Most recently and most notably are the risk-retention regulations.  What is your view with respect to the impact of these regulations on the financial sector and investment?

Howard Marks:  I wrote a memo three or four years ago, in which I said regulation is a pendulum which swings from too little to too much.  And you know, when we have a crisis or a crash, everybody concludes that the financial industry was at fault and that we need more regulation.  And so we get more regulation and then, maybe because things are better for a while or maybe because the industry behaves better for a while, everything goes smoothly and everybody says, “well, I guess we don’t need regulation.”  So then we deregulate, and the pendulum swings toward deregulation.  Then, eventually, it reaches an extreme of deregulation, and things stop going as well, and eventually we get another crisis.  And then it swings back toward regulation.

It’s hard to say what the right level of regulation is.  I’m not a libertarian who says the best regulation is no regulation, because I think that people need laws to live by.  And so it is just a pendulum, and it is hard to say where the proper point is.  If you think about the pendulum, it never stops at the happy medium.  It is usually swinging from one extreme to the other and back toward the other.

Now, for example, take a look at the risk-retention rule.  That is certainly an example of something that shouldn’t be necessary.  But on the other hand, in the last go around, it probably would have been a good thing, because you had people making loans who did not have a stake in the long-term success of those loans.

Now, you shouldn’t need a law to tell someone that if you are buying a loan from a bank, that is going to stop being on the hook and probably knew it was going to get off the hook — and as a consequence might not have been concerned with long-term credit worthiness — you should pay less for it or maybe not consider buying it.  Thus buyers’ behavior should police the market, and we shouldn’t need regulation.

It’s easy to say that.  And that is the way the world should be.  But the world is not often the way it should be, and in the last go around, certainly people did not take enough cognizance of the fact that mortgage generators were making loans and packaging and selling them onward in a way that introduced moral hazard.

It would be nice not to need regulation.  I went to the University of Chicago which talks about the wisdom of the free market, and sometimes that proves to be an oxymoron, and the market does not function as wisely as it should.  Do we need laws to protect people from themselves, and do we want them?  That is an interesting philosophical question.  I believe that in the long run, the free market is the best allocator of capital and resources.  And we should leave it alone.  But the interesting thing about the world we live in is that there is always another hand.  And on the other hand, if you let the free market operate freely and achieve that great long-term allocation of resources, you are going to have some chaotic periods in the short run.  And you are going to have bubbles and crashes.  Some part of us says we don’t want to endure that.

So in order to avoid bubbles and crashes, you probably need regulation to moderate behavior.  And you know, I’m in the financial industry, but that doesn’t make me say zero regulation is always the right thing.  At the bottom line, I don’t think the entire financial industry covered itself with distinction in the years leading up the crisis.

Stephen Renna:

So going back to my question, do you think that the level of regulation that has resulted, whether it is the Basel rules or Volcker or risk retention, is the pendulum swinging too far?

Howard Marks:  Personally, I probably don’t.  I’m not familiar enough with the details to say that it has or hasn’t gone too far, but I think the idea of risk retention is not a bad thing.  And given people’s naiveté, it does seem to be required.  And the idea that banks, which are systemically important and would have to be bailed out if they got into trouble, should not engage in adventurous proprietary activities doesn’t seem silly to me.

Stephen Renna:  Okay, fair enough.

And just a couple more questions, Howard, and thank you again for your time.  One of the things we are doing right now is surveying our members with respect to the market outlook for 2015.  Do you care to discuss what you have experienced in 2014 from an investor’s perspective and what you anticipate 2015 to bring?

Howard Marks:  Well, first of all, I want to point out that I don’t believe in forecasts, including my own.  Secondly, while we might talk about what should happen or might happen, we never know what will happen and we absolutely never know when it will happen.  So when you say next year as opposed to this year or 2016, I get a little squeamish.

But right now, we see a high level of liquidity, and we have a wide-open capital market in which it is easy for people to access money.  And this has an appearance, as it always does, of a virtuous circle in which business conditions are good, which makes the capital markets generous, which contributes to the good business conditions, et cetera.

And right now, you can’t think of anything that is going to make defaults rise or capital become in short supply.  Historically, however, that has always been the case.  Eventually, someday, defaults go up, capital markets become tighter, and people who have to refinance have more trouble doing it, and it gets harder to start new businesses and finance new projects and so forth.

It’s hard for me to sign off on what is going to happen in 2015.  It is hard to imagine what is going to make things turn negative in 2015, which is very different from saying it’s not going to happen.
But eventually, business conditions will get less good, and eventually people who are holding assets will probably say “I should have sold six months ago.”  Unless they are real estate dynasties.  But I certainly wouldn’t say it is going to happen in 2015.

Stephen Renna:  Well, this next question might be something that you can predict with a little more certainty.  Have you decided on the topic of your next client memo?

Howard Marks:  I have not.  If I had a good idea, I probably would have written it by now.

Stephen Renna:  Howard, we also wanted to give you an opportunity to raise a topic that you would like to speak to that we haven’t addressed.  Certainly, we haven’t covered all issues of investing.  Is there anything that you would like to comment on at this point?

Howard Marks:  No, I don’t have anything in mind, Steve, I think your questions have covered a lot. Very few trees grow to the sky and I think people already are cognizant that most things are cyclical.  And with that in mind, I think people will do the right thing.

Stephen Renna: Okay, well, Howard, this has been terrific.  Thank you very much for your time.

Howard Marks:  Sure.

Stephen Renna:  I have just one little side question and that is, does your wife really think your client memos are all the same?

Howard Marks:  She sure does.  And I’m starting to think she’s right.

Stephen Renna:  Well, thank you, again, Howard.  This has been terrific.

Howard Marks:  My pleasure.

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