Cockroaches in the Coal Mine

[Music]

This is the memo by Howard Marx.

Cockroaches in the coal mine.

[Music]

Pardon the mixed metaphor, but I

couldn't resist. Jamie Diamond, chairman

and chief executive officer of JP Morgan

Chase, whose comments are always

insightful and direct, said the

following last month with regard to the

bankruptcy filings from First Brands, an

auto parts supplier, and Triricolor, a

seller of and subprime lender against

used cars.

My antenna goes up when things like that

happen. And I probably shouldn't say

this, but when you see one cockroach

there are probably more. Everyone should

be forewarned on this one. And we all

know that coal miners used to bring

along a canary when they entered a mine

since its tiny body would succumb to any

gas that was present before the gas

could pose a threat to the miners. Both

the cockroach and the canary can be

precursors of problems ahead. We've

heard both sayings in use in the last

month, and we're likely to hear them

more. One of the most prominent

characteristics of the financial markets

that I've detected over the years is

their tendency to obsess over a single

topic at a given point in time. The

topic eventually changes to another, but

before it does, it's often the thing

people want to discuss to the near

exclusion of everything else. Today

it's the recent string of episodes in

subinvestment grade credit. current

events.

Given the suggestion that fraud may have

played a role in both the first brands

andricolor bankruptcies and given that

both companies had borrowed in the

private credit market, people saw a

connection. Is this the beginning of a

problem? As I mentioned in my memo, give

me credit in March. The thing people

have asked me about most often over the

last few years is private credit. The

sector took root around 2011 when banks

were limited in making loans following

the global financial crisis and money

managers stepped in to fill the void

primarily lending to leverage hungry

private equity sponsors. Because lenders

were few, those who would put out money

were able to demand high interest rates

and a high level of safety. These loans

looked good to investors in the low rate

environment that prevailed. Thus

private credit was anointed as a magic

investment solution with perhaps $2

trillion flowing into the sector in the

subsequent years. The arrival of new

entrance and a great deal of incremental

capital created more competition to lend

and inevitably reduced some of the

lenders advantages.

When asked about private credit, I

answered that the investment environment

had been mostly benign over the years

since 2011. meaning to echo Warren

Buffett, the tide had never gone out on

private credit. That is, it hadn't been

tested. Now, with two high-profile

bankruptcies in short order, people

thought they might be starting to see

cracks.

The tone turned more serious when it

became clear that not only were there

failures, but also there might be

something sinister behind them. There

are allegations that First Brands, which

had both public and private debt

outstanding, used the same receivables

as collateral for multiple loans.

Triricolor turns out to have made loans

to buyers lacking credit scores or

drivers licenses and had been previously

cited by regulators for practices such

as selling cars for which it lacked

titles.

And then last month, as Robert Armstrong

of the Financial Times noted in his

daily online column, Unhedged, which is

one of my favorites, on October 15th

Zion's Bank Corp disclosed in a

regulatory filing that it recently

became aware of apparent

misrepresentations and contractual

defaults by two corporate borrowers that

did not respond to the bank's subsequent

inquiries and would take a $50 million

write down on the loans.

And on October 16th, another midsized

bank, Western Alliance, disclosed that

back in August, it had initiated a fraud

lawsuit against one of its commercial

real estate borrowers.

Most recently, it's been revealed that

two small telecom firms under Common

Control, Broadband Telecom and Bridge

borrowed extensively on the basis of

fabricated receivables and have filed

for bankruptcy. If one is an isolated

instance and two hint at a pattern, are

six an ominous trend.

As I pointed out in my memo, what does

the market know in 2016? In real life

things fluctuate between pretty good and

not so hot. But in investors minds, they

go from flawless to hopeless. We saw a

very strong reaction in this case.

Notably, the stock prices of some

prominent alternative asset managers

were down 5 to 7% on October 16th, close

on the heels of the regional bank's

disclosures.

The truth is that there are always

defaults and not infrequently

defalcations.

How's that for a good old-fashioned

word? Over my 47 years in the high yield

bond market, more than 2% of all bonds

by value have defaulted in a typical

year and many more during crisis. If you

apply that percentage to the number of

subinvestment grade issuers, which runs

in the thousands, it shouldn't come as a

surprise if there are a few dozen

defaults in a normal year. So no, I

don't think this is necessarily the

beginning of a trend. It's not an

indictment of the whole subinvestment

grade debt market or the whole private

credit market. Rather, it's just a

reminder that the yield spreads people

care about so much are there for a

reason. Because subinvestment grade debt

entails credit risk and thus a reminder

that credit skills are always a

necessity for debt investors, even if

the need for those skills isn't apparent

in good times.

The cycle in attitudes toward risk.

In 2016, when I first sat down to write

my book, Mastering the Market Cycle:

Getting the Odds on Your Side, I had an

idea what topics I would cover. The

economic cycle, the profit cycle, the

cycle in investor psychology, the credit

cycle, the distressed debt cycle, and

the real estate cycle. The chapter I

didn't plan to write and the one that

became the most important chapter in the

book and one of the longest was the one

titled the cycle in attitudes toward

risk.

Security prices fluctuate much more than

do the intrinsic value and prospects of

the underlying companies and the main

reason for this is the extreme

volatility in the way people feel about

risk.

When the economy is humming, companies

are reporting growing earnings. Security

prices are rising and profits are piling

up. People say things like, "Risk is my

friend. The more risk I take, the more

money I make." And anyway, I don't see

anything to worry about. In good times

ambiguous developments are interpreted

positively and negative ones are easily

brushed aside. And when times have been

good for a while, the possibility of

loss recedes from consciousness. Rather

missing out on potential gains and

falling behind one's competitors becomes

the dominant concern. Investors risk

tolerance grows and they tend to focus

less on due diligence and more on

bidding aggressively for deals. See my

memo, The Race to the Bottom, February

2007.

In all these ways, the result is a

lowering of standards. Eventually

the economy turns down, corporate

profits decline, the markets slump, and

people lose money. Now, the refrain is

bearing risk is just a way to lose

money. I'll never do it again. Get me

out at any price. Now, it's the

negatives that are exaggerated and the

positives that are ignored. People

regret the due diligence they didn't

perform and the iffy deals they didn't

reject and they're reminded that there's

something worse than missing out on

gains. The pendulum has swung in the

other direction and risk aversion takes

over from risk tolerance. As a result

the standard for investing and lending

becomes elevated.

One of the quotations I have the most

use for is said to come from Mark Twain.

History does not repeat itself, but it

does rhyme. This is particularly

relevant in the world of finance, where

certain themes reappear in cycle after

cycle. The recurring roller coaster of

psychology and the resulting behavior is

the most important of them. The key

observation is that good times lead to

complacency, risk tolerance, and

carelessness as people bid aggressively

for assets and compete to make loans.

And then bad times expose the results of

that carelessness as investments that

were entered into without an adequate

investigation and margin for error

failed to hold up in a hostile

environment.

This is nothing new. As financial

historian Edward Chancellor wrote in his

2022 book, The Price of Time, the

Manchester banker John Mills commented

perceptively in 1865 that as a rule

panics do not destroy capital. They

merely revealed the extent to which it

has previously been destroyed by its

betrayal into hopelessly unproductive

works. In other words, many flawed

decisions which the economist Friedrich

Hayek aptly described as malinvestment

are made in booms and exposed in busts.

It will ever be so. This is summed up

most concisely in a great banking adage

the worst of loans are made in the best

of times.

a good bezel.

Charlie Munger and I used to enjoy

talking about the economist John Kenneth

Galbrath. Galbrath was the source of

many of my favorite expressions with

regard to the financial markets. One I

haven't mentioned since my memo the long

view in 2009 is the bezel. A concept

Galbrath introduced in his book the

great crash 1929.

What's a bezel? In short, according to

Galbrath, it's the wealth financial

fraudsters or embezzlers appear to have

created which lifts the spirits of the

beneficiaries up until the time they're

found out. Charlie used to say, "The

good times just described in giving rise

to a low level of prudence create the

necessary conditions for a good bezel."

Here's how economist Michael Pettis

described the cyclicality of this

phenomenon in his newsletter.

Certain periods, Galbrath further noted

are conducive to the creation of bezel

and at particular times, this inflated

sense of value is more likely to be

unleashed, giving it a systematic

quality.

This inventory of fraudulently inflated

wealth varies in size with the business

cycle. In good times, people are

relaxed, trusting, and money is

plentiful. But even though money is

plentiful, there are always many people

who need more. Under these

circumstances, the rate of embezzlement

grows. The rate of discovery falls off

and the bezel increases rapidly. In

depression, all this is reversed. Money

is watched with a narrow, suspicious

eye. The man who handles it is assumed

to be dishonest until he proves himself

otherwise. Audits are penetrating and

meticulous. Commercial morality is

enormously improved. The bezel shrinks.

China financial markets August 23rd

2021.

The overconfidence, incaution, and

inattentiveness that lead to unwise

investments in good times also present

the perfect conditions for fraudulent

schemes. Risk tolerance, FOMO, fear of

missing out, inadequate due diligence

and fevered buying provide fertile soil

for financial scams. In heady times

rather than say, "That's too good to be

true," people are more likely to ask

"How can I get in on that?"

The markets aren't crooked, per se. But

they're full of money, and thus, they

tend to attract crooks, and

intelligently, the crooks are most

active in times when conducting due

diligence is in retreat, and loose

change becomes more readily accessible.

It shouldn't come as a surprise in the

years ahead if the last 16 years of

largely uninterrupted economic growth

rising markets, and profitable

risktaking are shown to have produced a

bumper crop of frauds.

Nowadays, I'm often asked whether the

issues just described are systemic. In

other words, are they pertaining to the

system or affecting the system as

opposed to idiosyncratic occurrences

that don't say anything about the

system? For an example of something

systemic, consider the counterparty risk

that arose during the global financial

crisis. Because financial institutions

had entered into hedging transactions

with each other, one bank's weakness

weakened the others, impacting the

system overall. I think hardwired into

the system is a good way to describe

something that's systemic.

I don't think today's issues are

systemic in the sense that there's

something wrong with the lending system

or that they will trigger other defaults

and lead to a breakdown of the system.

In simpler words, there's nothing wrong

with the plumbing. But imprudent loans

and business frauds often occur in

clusters for the simple reason that

people who make investments and loans

are highly prone to error in good times.

Investors and lenders are supposed to be

risk averse and thus exercise discipline

and vigilance, but sometimes they fail

in this regard. This isn't part of the

plumbing of the financial system, but

rather a regularly recurring behavioral

phenomenon. So, it isn't systemic, but

it is systematic.

A case in point, First Brands.

In September, First Brands, a

non-household name auto parts supplier

rocketed into the news with a bankruptcy

filing. While possibly an isolated

instance, this attracted significant

attention as the first high-profile

bankruptcy involving a borrower in the

adolescent private credit market. The

problem at first brands appears to stem

primarily from its borrowings against

receivables. In many fields, it's normal

for manufacturers and wholesalers to

ship goods to their retailer customers

on credit and to make efficient use of

their capital, sell the resulting

receivables to financial institutions at

discounts that give those institutions

their return. This process is called

factoring. and it's been a very normal

practice in various industries for as

long as I've been in the business world.

In the case of first brands, however

one part of the practice was different.

Rather than payments being made by

retailers directly to the financial

institutions that bought the

receivables, some went to First Brands

for forwarding to the institutions.

This allegedly permitted first brands to

sell receivables more than once and

perhaps to retain some payments rather

than forward them to the factoring

firms. In an analysis we conducted last

summer, we found that in addition to

these factoring arrangements, the

company made aggressive use of other

forms of offbalance sheet financing. For

example, first brands sold inventory to

related specialurpose vehicles which

then used the purchased inventory as

borrowing base assets to obtain loans.

In most cases, the inventory was

required to be sold back to First

Brands. So, while this served as a

source of temporary liquidity, it left

First Brands with layered complex

obligations that ballooned to several

billion dollars.

The scale of offbalance sheet financing

was striking. We've learned through

bankruptcy filings that First Brand's

total obligations are 11.6 billion

inclusive of $9.3 billion of debt versus

the debt level of $5.9 billion that had

been disclosed during a financing

process undertaken in July. The

complexity and opaqueness of these

factoring and financing arrangements

caused a creditor's lawyer to say $2.3

billion had simply vanished.

Byzantine corporate structures and

extensive offbalance sheet financing

have been present in many corporate

frauds we've witnessed, exemplified by

Enron Corporation. But even in advance

of First Brand's bankruptcy filing in

late September, Oak Tre's research

turned up the following red flags. Only

six years of operating history, but

already $5 billion of annual sales.

controlled by an individual with almost

no media references or online profile, a

significant litigation history

including allegations of misconduct

reported profit margins above the

industry average, a large number of M&A

transactions creating a web of corporate

entities, other aspects of weak

controls.

You might wonder how a company, as just

described, could attract financing.

First, private credit often involves

companies that don't file disclosure

documents with the SEC. Thus, initial

investment decisions are usually based

heavily on information provided by

bankers and auditors.

Investors have little choice but to rely

on these sources, and usually they can

do so safely. Only after they've made an

initial commitment and are considering

increasing it, do most investors gain

access to a company's data room and

engage in extensive research. Second

while the truth is often clear after the

fact and especially after a bankruptcy

filing, the picture can be more nuanced

beforehand. After all, these are

companies that have passed muster with

underwriters, auditors, and investors.

If the negatives surrounding the company

were totally evident, either it wouldn't

have been able to obtain financing in

the first place, or its debt would be

selling at bankruptcy prices by the time

a holder catches on, making it too late

to benefit from analysis.

In investment research, conclusions

usually aren't compellingly obvious, but

instead built up from inferences and

probabilities. It's not a matter of one

decisive discovery at an aha moment, but

rather the assembly of individual

snippets of information into a mosaic

that leans toward a conclusion based on

what in law is called a preponderance of

the evidence. In the case of first

brands, having taken a small position

we dug deeper early last summer. The red

flags just listed weren't conclusive

especially given that we didn't have the

full picture that became clear through

the bankruptcy filing. Rather, these

observations hinted at weaknesses and

suggested problems.

Importantly, Oak Tree's span and scale

provided multiple points of contact with

First Brands through a number of our

strategies, helping us to assemble the

necessary mosaic.

Further, a thorough job of credit

research costs the same whether you're

considering investing $50 million or

$500 million.

Greater scale allows an investor to

spread the cost of in-depth research

over larger holdings. In investing, size

has both pros and cons, but here we're

talking about one of the former.

This is how analysis should be done. And

in this case, I'm glad to say it was. Of

course, I am writing about our

experience with first brands because we

reached the correct conclusion. We don't

always do this as well as we did in this

case. And I want to say right here that

over our 47 years of investing in

subinvestment grade debt, we've

experienced plenty of defaults and even

a few frauds. That's an inevitable part

of life when your business consists of

knowingly bearing credit risk for

profit. But these caveats don't keep the

first brand's case from proving a

valuable opportunity for learning.

What are the key takeaways?

Defaults are a normal part of life in

subinvestment grade investing. However

bullish conditions in good times usually

lead to a lowering of lending standards

giving rise to elevated defaults and an

occasional fraud.

It's absolutely essential to always

balance the desire to put money to work

with the need for prudence.

Superior credit analysis is a matter of

second level thinking. Thinking that's

different from that of others and better

based on a mosaic of information and

inferences.

In detecting credit defects, the big

payoff is for being early. If you reach

a negative conclusion at the same time

as everyone else, the price you'll get

for your holdings is likely to be marked

down to fully reflect the negatives.

That's market efficiency. It's important

to note that whereas private credit has

been the rage of late, all else being

equal, it's great to hold public debt

that can be exited more readily if you

sour on the credit.

We've lived through generally good times

in the last 16 years. The coming period

is likely to be more interesting as

errors that were made in those good

times come to light. On the other hand

the frauds just described have probably

chasened lenders and investors, putting

them on alert. Thus, they're likely to

incorporate a re-elevated level of

prudence in their decisions in the

coming months and perhaps years. This

would be a positive development.

November 6th, 2025.

Thank you for listening to The Memo by

Howard Marx. To hear more episodes, be

sure to subscribe wherever you listen to

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