In the book “The Most Important Thing”, Howard Marks cites the credit cycle as his favorite cycle for generating investment opportunities. The credit cycle is the author’s favorite for its inevitability, extreme volatility, and ability to create opportunities for investors in tune with it.
As he puts it, the longer he is involved in investing, the more impressed he is with the power of the credit cycle.
“It only takes a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with a big impact on asset prices and back to the economy itself.”
The process is simple:
- The economy moves into a period of prosperity.
- Capital providers thrive, increasing their capital base.
- As bad news is scarce, the risks involved in borrowing and investing appear to have lessened.
- Risk aversion disappears.
- Financial institutions act to expand their business – that is, to provide more capital.
- They compete for market share by lowering required returns (e.g., by cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing contract requirements.
At the extreme, loan providers finance loans and projects that are not worth funding.
As the old banking saying goes, “the worst of loans are made in the best of times.”
This leads to capital destruction – that is, capital investment in projects where the cost of capital exceeds the return on capital, and eventually to cases where there is no return on capital.
When this point is reached, the ascending part of the cycle is reversed.
- Losses discourage lenders, who stop providing loans.
- Risk aversion increases and along with it, interest rates, credit restrictions and contract requirements increase.
- Less capital is made available – and at the beginning of the cycle, only to the most qualified borrowers, if any.
- Companies are starving for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
- This process contributes to and reinforces the economic contraction.
Obviously, at the extreme, the process is ready to be reversed again.
As competition for granting loans or investments is low, it is possible to demand high returns as well as high creditworthiness. Contrarians committing capital at this point have a chance of earning high returns, and those tempting potential returns begin to attract capital. In this way, a recovery begins to be fueled.
The credit cycle corrects itself through the processes described above and represents one of the factors that drive fluctuations in the economic cycle.
Prosperity breeds expanded borrowing, which leads to reckless borrowing, which produces large losses, which causes lenders to stop lending, which ends prosperity, and so on.
Happy investing!