Cockroaches in the Coal Mine

THE ARGUMENT

A run of sub-investment grade failures — First Brands, Tricolor, two small telecom firms, plus disclosures at Zions and Western Alliance — raised the question of whether private credit was cracking. Marks answers that there is nothing wrong with the plumbing: clustered defaults and the occasional fraud are what sixteen years of good times and falling standards reliably produce, which makes them systematic rather than systemic. The memo then turns into a worked example of the credit analysis that flagged First Brands before it filed.

What it actually claims

1. His central distinction is between something hardwired into the financial system, as counterparty risk was in the Global Financial Crisis, and a recurring behavioral failure — these clusters are the second, systematic rather than systemic.

2. He reads the sell-off as the usual overshoot from flawless to hopeless, and says he does not think it is necessarily the beginning of a trend, and sets it against the base rate of default he has watched for decades.

   • •the stock prices of some prominent alternative asset managers were down 5-7% on October 16
   • •more than 2% of all high yield bonds by value default in a typical year, across 47 years in the market

3. He dates private credit to the post-crisis gap left by bank retrenchment, when the few lenders willing to put money out could demand both high rates and high safety, and argues that the new entrants and incremental capital that followed reduced those advantages — while the sector has still never been tested.

   • •the sector took root around 2011
   • •perhaps $2 trillion flowing into the sector in the subsequent years

4. He returns to the chapter of his own book he had not planned to write: prices move far more than intrinsic values because attitudes toward risk are so volatile, so standards fall in good times and are raised only after the losses arrive.

5. He revives Galbraith’s "bezzle" to explain why fraud is cyclical — plentiful money and relaxed diligence raise the rate of embezzlement while lowering the rate of discovery — and says it should not surprise anyone if the years just past turn out to have produced a crop of frauds not yet discovered.

   • •the last sixteen years of largely uninterrupted economic growth, rising markets, and profitable risk taking

6. The First Brands numbers are the memo’s hardest evidence: what the bankruptcy filing revealed bore little relation to what lenders had been shown months earlier.

   • •total obligations of $11.6 billion, inclusive of $9.3 billion of debt
   • •versus the $5.9 billion of debt disclosed during a financing process undertaken in July
   • •a creditor’s lawyer said $2.3 billion had "simply vanished"

7. He lists the red flags Oaktree found before the filing — none conclusive on its own — to argue that credit work is the assembly of a mosaic rather than a single discovery, and that scale is what pays for it.

   • •only six years of operating history but already $5 billion of annual sales
   • •a thorough job of credit research costs the same whether you are investing $50 million or $500 million

Figures are the author's own, as cited in the memo.

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