50 cents dollar

Peter Lettman

Everyone knows about the anticipation leading up to Warren Buffett’s annual shareholder letters. But for a certain Wall Street set, there are equally high expectations for the writings of Howard Marks.

Marks is the chairman of Oaktree, the low-profile but powerful L.A-based firm that manages more than $50 billion in alternative investments, mostly in fixed-income strategies. He’s been writing memos to clients since 1990, but a cult following developed after a missive he penned on Jan. 1, 2000 titled “bubble.com.” A few months before tech stocks imploded, Marks sounded a warning. “To say technology, Internet and telecommunications stocks are too high and about to decline is comparable today to standing in front of a freight train,” he wrote. “To say they have benefited from a boom of colossal proportions and should be examined skeptically is something I feel I owe you.”

Now that we have your attention, you might want to check out Marks’s latest, a 13-page memo that has filled up financier’s in-boxes since it was emailed to clients on Tuesday. Marks borrows from Buffett in titling his memo “The Tide Goes Out.” It opens:

For every period, there’s a quotation which serves perfectly to explain what’s going on, and I often find myself borrowing it. Warren Buffett provides more than his share; not only is his insight unmatched, but so is his ability to express it. [Since July], I’ve found frequent use for this one: ‘When the tide goes out, we find out who’s been swimming without a bathing suit.’”

The memo is wide ranging, with sections on “Leveraging and Inflating,” “Deleveraging and Deflating,” “Financial Self-Destruction” and “Where Will It End.” Arguably the most provocative riff is on mark-to-market accounting, an issue the WSJ’s David Reilly homed in on earlier this month. “The current capital market cycle has been accelerated by an element that was added to the capital market equation in the 1990s: mark-to-market accounting,” writes Marks. He then provides a firsthand historical overview of the mark-to-market evolution:

In the simpler but still not totally stable financial world I entered forty years ago, stability was desired in financial institutions. So, for example, banks and insurance companies were allowed to carry a loan or a bond at cost on their balance sheets as long as it was (a) fundamentally unimpaired and (b) intended to be held to maturity. Even if its market value fell temporarily, it was assumed that a creditworthy claim would be repaid in full at maturity. Thus, price fluctuations were ignored as long as fundamentals were sound.

More recently, “transparency,” “accountability” and “market signals” became more highly prized. A lot of this had to do with skullduggery unearthed at companies like Enron. As a result, accounting increasingly came to require that assets be valued at actual or estimated market prices. I’d had a preview of this in 1990 when, as part of efforts to “get” the high yield bond industry (and Drexel and Milken), S&Ls were required to market price their holdings of high yield bonds – dooming many of them in a time of price weakness. . . .

In 1990, when high yield bonds had the brush with difficulty described above (meaning spreads widened to 1,100 basis points, and a law was passed that required S&Ls to reflect price declines on their balance sheets), I was asked to brief the board of TCW on the risks. I presented a parable about a regulated financial institution that went bankrupt under the weight of mark-to-market accounting. I joked with Bill Spencer, who was president of Citibank when I worked there, that in the 1980s, that could have been Citibank if it was required to recognize mark-to-market losses on real estate loans. Guess what: today that’s the rule. [Emphasis his.]