In an investor memo now ricocheting throughout the alternative asset industry, Oaktree Capital Management chairman Howard Marks has blamed the spreading financial crisis in part on mark-to-market accounting.
Offering a wide-ranging analysis of the recent turbulence in financial markets that has rocked Wall Street and alternative investments since late last summer, Marks wrote that mark-to-market accounting was the “accelerant” that “turned out to be one of the main contributors to the boom/bust cycle”.
Marks argued that since regulators have mandated mark-to-market accounting in the wake of Enron and other corporate accounting scandals of the early 2000’s, bank portfolios have grown increasingly volatile.
Prior to Sarbanes-Oxley and other post-Enron regulatory changes, US banks were allowed to carry their assets, such as loans or bonds, at cost on their balance sheets. In contrast, under the new accounting rules banks value their assets based on fair value, or what they could get for them on the open market—however that was defined, given the illiquid and hard-to-value nature of many of these assets.
Marks wrote that banks were therefore able to expand their balance sheets as their assets appreciated, resulting in a higher willingness to extend leverage. But when asset prices started to drop in the wake of the subprime mortgage fiasco, “contracting asset values now meant the bank’s portfolio is worth less, and that its equity is smaller and can support less debt and thus less lending.”
Private equity GPs are currently pondering how best to apply new fair value accounting rules to their portfolios of private investments.
Marks, who co-founded Los-Angeles based Oaktree in 1995 after spending ten years at The TCW Group, also touched on several other aspects of the crisis, including its unique multi-sector nature, government attempts to stem its effects, and the pivotal role overleveraging played leading up to the current debacle.
Although cautioning against overblown fears, Marks wrote that “this [crisis] is different in both degree and kind. We’ve had collapses in the past, but never so broad-gauged and systemic”.
The memo also recommended that government intervention focus on halting the epidemic of “deleveraging” that is crippling the nation’s credit markets, although Marks cautioned that such intervention can only go so far.
“I’m no expert, but it makes sense to me that the quantum of pain on the way down has to at least approach the pleasure everyone felt during the boom,” he wrote.
Oaktree, which manages more than $50 billion (€32 billion) in alternative assets, prides itself on pursuing investments immune from business cycle volatility. The company’s Principal Opportunities Funds oversees some $8 billion in assets. Its OCM European Principal Opportunities Fund, currently in the market, has a target of roughly $1.95 billion.