Hopefully all of us are PREPARED now. These are the quotes about Credit Cycles.
The longer I'm involved in investing, the more impressed I am by the power of the credit cycle. It takes only a small fluctuation in the economy to produce a large fluctuation in the availability of credit, with great impact on asset prices and back on the economy itself.
The process is simple:
The economy moves into a period of prosperity.
Providers of capital thrive, increasing their capital base.
Because bad news is scarce, the risks entailed in lending and investing seem to have shrunk.
Risk averseness disappears.
Financial institutions move to expand their businesses – that is, to provide more capital.
They compete for market share by lowering demanded returns (e.g., cutting interest rates), lowering credit standards, providing more capital for a given transaction, and easing covenants.
At the extreme, providers of capital finance borrowers and projects that aren't worthy of being financed. As The Economist said earlier this year, "the worst loans are made at the best of times." This leads to capital destruction – that is, to investment of capital in projects where the cost of capital exceeds the return UonU capital, and eventually to cases where there is no return UofU capital.
When this point is reached, the up-leg described above is reversed.
Losses cause lenders to become discouraged and shy away.
Risk averseness rises, and along with it, interest rates, credit restrictions and covenant requirements.
Less capital is made available – and at the trough of the cycle, only to the most qualified of borrowers.
Companies become starved for capital. Borrowers are unable to roll over their debts, leading to defaults and bankruptcies.
This process contributes to and reinforces the economic contraction.
Of course, at the extreme the process is ready to be reversed again. Because the competition to make loans or investments is low, high returns can be demanded along with high creditworthiness.
Contrarians who commit capital at this point have a shot at high returns, and those tempting potential returns begin to draw in capital. In this way, a recovery begins to be fueled.
I stated earlier that cycles are self-correcting. The credit cycle corrects itself through the processes described above, and it represents one of the factors driving the fluctuations of the economic cycle.
Prosperity brings expanded lending, which leads to unwise lending, which produces large losses, which makes lenders stop lending, which ends prosperity, and on and on.
Read Howard Marks’ compete memo “You Can't Predict. You Can Prepare.” Written in Nov. 2001.