MALE VOICE 1: …Head of Investment Grade Corporate Credit and Tom Lottie, the former Vice Chairman of J.P. Morgan Asset Management. Please give them a warm welcome. Thank you.
SAM: Alright. Good morning everyone. Really excited to be doing the first session of the day. Important moments in market history. It has a really long acronym that we have been using internally, IMMMH, but you know we’ll keep it simple. So, just to kind of dovetail a little bit on level setting what we’re doing, right? All these things happen and we read about them, maybe we read about them on Wikipedia for example, and we can kind of get like the tactical details you know, after the fact, but I think there’s something very fruitful in talking to people who lived through them, worked through them, managed teams and managed money throughout these events. So, that is the purpose of this session. We’re going to leave lots of time for Q & A. We have 2 fantastic experienced portfolio managers up on the stage right now, and to kind of kick it off, I’m going to sort of turn it to Tom to set a few of the crises and how he saw them unfold.
MR. TOM LOTTIE: Thanks, Sam. This grey hair came from living through those crises. Actually, managing money through all of them actually. So, I am going to highlight 3 real quick. The first is the 1987 crash which the market went down 22 percent in one day. So, think about you come in tomorrow morning and the SMP is down 150 points or the DOW is down 5,900 points you know that’s the impact, and why was that? There was a new strategy at the time called portfolio insurance which used derivatives, which convinced clients, as well as the firms purveying it that you could actually reduce the risk of equities by using a derivative strategy to get you out when the decline started, and as a result, the market actually went up 37 percent in 1987 prior to that 22 percent decline, because people increased their allocation to equities from mods, but then what happened was, once the market cracked, and it cracked because bonds went from 7 percent to 10 percent, nearly 10 percent, and there was a dollar crisis. When it cracked, there was so much money in that strategy it overwhelmed the derivative markets and it became a self-perpetuating decline. And so, that was 1987 crash, and we’ll come back to these with stories. And then we had the ’98 and 2002 which to me was a 4 year period. It started with long term capital management we basically went belly up. The Fed provided liquidity during that event, that started the liquidity phase, and they basically what I call foam the runway in ’99 for what was perceived to be a major risk which is laughable at this point, which is Y2K. People did not actually want to get in airplanes in 2000 because they were afraid that when they swung to 2000 it might be 1900, nobody knew what would happen when the year turned. And so, there was real fear that there could be an economic disaster there fed from that runway. Then we had the technology boom, then you had a recession in 2001, then just as you were coming out you had 9/11, then you had Enron WorldCom so you went from greed to fear, it had everything and the market went own down over 49 percent at that time. So, that’s like the market going from 2,950 to 1,600. Again, it went up 40 percent going into it. And then we had the one that most of you probably lived through which is the 2007, 2008 crisis, which is really a real estate lead, the perception that real estate prices don’t go down on a national basis lead to a lot of fixed income vehicles, which was highly rated by the credit agencies and owned by the entire financial system world-wide. When that proved to be wrong, the financial needs to because our capital was being squeezed they needed to liquidate, that became a self-perpetuating decline in financials and the system which lead to an over 50 percent decline in the equity market. And so, those are the 3 crisis we’re going to talk about today.
SAM: Thanks, Tom. So, Lisa, when we were doing the prep call there were some very interesting, very clear examples of you in this, things happening, so talk us through some of that.
MS. LISA: They did. Vivid to this day they still linger with me. So, I’m going to talk a little bit about that ’01, ’02 period, because it was particularly challenging stretch of time for investment grade credit where I spent most of my career, and just to give you a bit of perspective, in 2002, I believe it was, about 50 percent of the weakest run of investment grade, so triple B minus got downgraded into high yield, so there was a lot of distress and Enron as Tom had mentioned was a company that I felt like I lived that first hand, so maybe I’ll just share my impressions of that a little bit. Around October of 2001 the company came out and announced a very large loss and at the time you know, the company seemed to be ticking along just fine. There was a little bit of volatility in the equity, but still the ratings agencies had them high triple B, and I remember going to my colleagues and the analyst who was covering the company at the time, and we said we really don’t understand what’s going on here, you know what’s going on with this big loss, and the more we started to delve into this we realized, we really didn’t understand the company you know, it was a very complex company. They had a lot of balance sheet transactions in these you know, funny little special purpose vehicles that had names like raptor and osprey alike, and we just couldn’t get our heads around it so we made a decision to sell and I remember it vividly. It was a Friday and we went into the market with our dollar bonds and we were able to sell our bonds nearly at par, so that was a great outcome but I remember we had Euro bonds as well, and I was working on London at the time and there were only 2 dealers that really traded these bonds, and the one that was really good was out of the office, and the other dealer had a quote that was actually really low, it was either 90 or 92. So, I got indignant and I said we’ll wait ‘til Monday and I didn’t sleep all weekend thinking oh my god this is going to be awful. We got in on Monday and sold the bonds. Make a long story short, the ratings agency started to catch up as more and more people began to delve into the real workings of Enron. The ratings agencies downgraded them to high yield I want to say in November, and then in early December they filed for bankruptcy, because you know we realized the accounting fraud and everything else that was going on.
SAM: Lisa, as a quick follow up and maybe bringing it to the here and now. Do you think lack of transparency or special purpose vehicles or the things you just mentioned, is that still an issue?
MS. LISA: Not so much today, I mean we had Sarbanes Oxley come into place, we have you know, I think a little bit more disclosure and protection from investors, but I think complexity is always an issue and that’s one of the things that I learned through these crises, you think you get paid for complexity in a structure or transaction, until you get a bill of volatility, and whatever you think you are getting paid for the complexity, it’s not enough.
SAM: Not worth it?
MS. LISA: It’s not worth it.
SAM: Okay, maybe let’s talk about overarching lessons then or any direction you want to take it in, let’s turn it to Tom first, the Lisa.
MR. TOM: Sure. I’m going to use the ’98 to 2002 as well because I think it covers a lot of things, but one of the lessons is how extreme things can get in both directions, right? And so, in ’98 to 2000, because of Y2K you had a lot of liquidity, but because of Y2K most of corporate America realized they had to redo their entire technology infrastructure to avoid the risk that something would go wrong when the year turned to 2000. So, you had a massive increase in technology spending leading into 2000. So, you had liquidity, this massive increase, and then you had which goes to complexity a little bit or sort of an unknown, you had the internet, right? Which created this ability to envision the future as having you know, unbridled opportunities in the technology sector. So, you had everything to create a bubble, liquidity, year term numbers, and this open-ended opportunity which lead the bubble in technology. And then, Y2K hit, so the market went up 40 percent into that and technology stocks went up 100 percent and got to multiples of 100 times basically. Then Y2K hits, and absolutely nothing happens. Alright? and so, what happened then was everybody had already spent all this money on technology and there was a complete stop in technology spending because it had all been spent. So, all of these stocks that were very high multiples all of a sudden started missing numbers, and that ultimately lead to a recession, the bubble burst and we went down. So, that was greed, and it takes a lot for greed to get to an excess and it did in that case, and then it morphed into fear which is more normal. Fear is the worst thing. The analogy I always give is you are on the plains of Africa early people, and they’re getting attacked by the lion and the first stops to think and the one runs. The one who ran away survived, the one who stopped to think got eaten. The gene and the one who ran is in all of us, and if you get fear people don’t think, and the combination of a recession, 9/11, Enron WorldCom created absolute fear on the downside. So, we went from a bubble on the upside to real fear on the downside, and one of the things, a process usually will get you out of a bubble early which is something to remember. Sometimes your best future investors are going to look the worst at the end of a cycle because they’re starting to get out, but it also helps you get it, and it was one of the few times in my career that there was a bell that went off which was October of 2002 when the high yield bond market bottomed. That to us was a message that you can take risk, because the epicenter had started to improve, and so that one had everything, greed, fear, etcetera.
SAM: So, really quickly Lisa would you agree is the high yield market, I don’t want to make too many broad sweeping generalizations, what do we think is our leading indicator because I don’t think it’s stocks, to be very honest.
MS. LISA: I think it’s the credit markets. I like to look at treasuries because I think treasuries are one part of the market that actually does tend it move, it’s very liquid, I think it’s the best expressions of people’s fears about what is going on, both as a flight quality but also you know, in times when economies are overheating. And we laughed now, we don’t really see inflation like inflation is gone, but there are times when the treasury market can be a good indicator of that. I find sometimes with credit markets we can have distortions that can sometimes make them maybe a little but less of a pure indicator than treasury or rates would be.
SAM: So, turning it to you thinking back to the .com or to 2008, any of the lessons learned?
MS. LISA: I’m going to pick up on something Tom said which is a lot of liquidity, and drawing on the tail end of that period that we’re talking about, you know that ’01 ’02 period, with that being said, coming out of that recession was really accommodating and brought rates down to different leaves and in kind of a funny way I think that sort of set us up for a period that kind of brought upon the great financial crisis, because you know as you start to get into 2004, 2005, 2006 even though the Fed was raising rates, rates were still very low and we saw a lot of behavior in which people were looking for some kind of a greater yield, and we had the creation, I was working in Europe at the time, these things calls SIVS and they were you know in short entities that you could give them money, you buy into this little fund, it was supposed to be short term, and what they were doing on the other side was buying longer term assets, so it could have been things like asset backs and remember that period of time, some of the collateral for asset back security or structured product was mortgages, sometimes sub-prime sometimes others or you had a lot of bank paper, subordinated bank paper that was going into these vehicles and you know, while they were great as long as these short term investments were maturing, people were putting money in, where things really started going off as we got later into the cycle which was ’07, where people didn’t want to roll over these short term funds that were going to SIFS and SIVS, and then they had assets on the other side that were losing value. So again, I think that was really an outgrowth of a period of time where we had too much liquidity going into the crisis and people just looking for yield, and in a way it feels similar to the environment that we’re in now with a lot of extra liquidity in the markets.
MR. TOM: Can I give one piece of advice on-
MR. TOM: Hopefully you will find helpful if I was in your shoes what I would be doing. One of the things that you know, it’s hard to understand how stupid we all are when you get these emotional behavioral extremes. I mean, we’re all, I don’t care who you are whether it’s a central banker, whether it’s management, there’s going to, you’re going to react in a way that in retrospect you’re going to say what was I thinking, alright? and so, believe that, okay, it’s going to happen. And so, what you want to do is to try to minimize the likelihood of that occurring, and one of the ways to do that is whether it’s your plan, whether it’s a manager you’re looking at, look at history, try to model at least game out what environment, a really bad environment might look like for your asset allocation, for your manager and talk about it, not only with yourselves but with your boards so that, because one of the things is that I found is if you think about it, it buys you time. If it’s a complete surprise, the behavioral is going to dominate, so the more you think about it and talk about it with your boards and management and etcetera, the more you can remind people that you know, we talked about this at a time when it was more irrational and we decided we’re going to live through it as opposed to if it was something that nobody ever expected you know, the behavioral dominates. So, that’s just something to, history is there to be understood. History is there to model it, it’s not, as mentioned earlier, it’s not going to repeat but it will rhyme, and it’s a very worthwhile thing to do both for yourselves and for boards.
SAM: And I think just to jump off of Tom’s point, I have been reading a lot about this particular like psychological theory, it’s called the Gunning during Effect. Basically, we overestimate our capabilities. Even emerging leaders’ young titans, right? Everybody kind of tends to do this and the thing is you think that you’re not, and the way to kind of deal with these blind spots in thinking that the research backs up is to test your assumptions, keep going back to where you could be wrong, testing where you could be wrong, and I think investment committees try to do that, but building that in is a way to be more resistant to the behavioral aspects that Lisa and Tom are alluding to. So, I want to get into that a little bit deeper, talking to clients, managing teams, all of these things that I think are hard even in the best of times, I can imagine become excruciatingly difficult when there’s turmoil and market chaos, so Lisa were you managing a team or did you have to talk to clients in some of these during these chaotic periods? Advice, thoughts?
MS. LISA: Actually, it’s kind of ironic. So, some of you most of you don’t know me, but I joined J.P. Morgan in December of 2008 and I had left my former employer in September of 2008, so I had a 3-month gardening leave. My colleagues were able to start at J.P. Morgan at the same time, but I was the credit person. So, I was not there in the thick of things to be able to talk to clients and the like, so I think for better or worse missed that very challenging quarter. But what I did have to grapple with was you know when I did start my role, is looking at portfolios and thinking about you know, what we had in them and what we wanted to do, and you know the one thing and Tom alluded to that too, is having a process is really important. So, if you have an investment process you stick with it, and I learned the same process now for 20 years between being here and at a prior firm, and that got us through a lot of cycles, so I knew if I had a process in place that would take us through, but I think it was also important to look at things that we go wrong and that was more of an idiosyncratic basis where there were individual companies we were working with that weren’t behaving the way we think they should and being able to go back and think what was the thesis for making an investment in the company, what’s changed in the thesis, and then did evaluations reflect the new changed environment or the original thesis that we had in place, and then we can make a decision, because as Tom said earlier, if you’re in panic mode you’re not necessarily making rational decisions. So, I think it’s good to think about that, particularly when you’re managing a team. And then I think the other lesson that I learned, and this really goes back to this ’01 ’02 period that was really challenging for credit, is you know when you have a problem name or situation in your portfolio, it helps to get your best thinkers and get people around that to decide what you should be doing, but at the end of the day if you’re leading a team, you have to be the one who makes that final call and make that right or wrong. Sometimes you’re going to get it right and sometimes you’re going to get it wrong, but you’ve got to own the decision in the end.
MR. TOM: Just building off that. Behavioral is a big one, and if you haven’t read the book Conman’s book Thinking Fast or Slow, it’s a very good book, it’s a good synopsis of, and what a process does is allow you to think slow you know, when you think fast you react emotionally and it’s like speed bumps on a road, right? it makes you slow down and think, which is a very valuable thing during those periods but one of the things to realize is when all these examples we went through were typically in the beginning there was an upshot on all these. And what happens there, and this is again one of the challenges of this business like people will have a process, we had a process back in ’99, we started selling technology in ’99. We had risk controls or we didn’t totally kill ourselves and our clients in ’99, but usually if you have a discipline process, you probably starting to get our early and one of the reasons is people who don’t have a discipline process begin to cave, right? There is something that drove it and people start to cave, whether it’s managers and they are the next and final leg. I remember early 2000 you can see it in the market, people were being fired who were value managers, and a lot of them went out of business in 2000, and you could see it in the market a lot of the money was going to this group and they were selling this group, right? and so, a lot of times the best managers forward looking might have the roughest period during that last phase and it’s a real challenge to know if they are really stupid, or is it just the process that’s going to kick it. And so, you know having a north star and having a discipline whether it’s your managers or your own processes as a firm that you really believe in is absolutely critical to get you through this.
SAM: And that is something I wasn’t really aware of before we did all the prep for this but in 2000 people knew things were out of whack but evaluations kept going up, and you would have been wrong if you left early from that tech call.
MR. TOM: Right.
SAM: I just want to go back to talking to clients because I know client facing is a piece that can be really challenging. Was there ever a time for both of you, where you had to say to clients I don’t know? Right and you really had to say we’re not sure, and did you have to do that, how did that feel?
MR. TOM: I’ll hit that one, because not only did we have to tell clients but we had to tell ourselves which was in 2008, right? I mean, 200, anybody who told you they knew what was happening in 2008 was lying, right? it was as close certainly in my career you know, we could have totally imploded, because you had a self-perpetuating liquidation that was just going to feed on itself and feed on itself as the had to banks de-leverage. They all had the same stuff and they all had to sell, and they were the center of this system right, that’s what made it so dangerous. And I remember saying Susan Bowel and I were managing, came from a meeting, it was actually a fixed incoming meeting somewhere, not here, but a dinner and I said you know, either the world is going to end tomorrow or this is an incredible buying opportunity and I actually couldn’t tell you 100 percent for sure that the world wasn’t going to end tomorrow, but if it ended nobody was going to blame us at that point, right? You were basically at the point where every negative was built in, and Tarp was a catalyst because it was a buyer, despite all of the issues with Tarp, you needed a buyer of these assets, if you didn’t have a buyer, it was going to keep liquidating. One of the things to remember at bottoms is it is always going to feel horrible, that’s not the level, it’s the change in the level, right? and so, what happens is at the bottom it’s obvious everything is horrible, you’re not going to think there is any good news. The question is have we hit a change on the margin, less bad? A lot of times people wait for good and by the time you wait for good, it’s all over. The money is made when it goes from horrible to just a little less horrible.
SAM: That’s the mantra, less bad.
MR. TOM: Yeah.
SAM: That’s what we’re looking for.
MR. TOM: Exactly, but that’s a really important one. Investing is all about change and people get caught up in level and that’s just something to remember around those periods.
MS. LISA: I’m going to pick up on that because I think you’re absolutely right. I find it’s even a bit more challenging particularly in credit, because we are just by definition a less liquid market than equities. So, it really does take a strong stomach to feel as if you are trying to get yourself into a position after you have just come off this period that feels so horrible and there’s been such destruction and you know, it doesn’t have to do with this period of time, but more recently if you think back to the energy volatility that we had back in 2015 and ’16 that was an interesting part of the market because you know, everyone was watching oil prices collapse and people were fearful about getting back in and particularly investing in corporate bonds from energy companies, and I can remember you know, we were beginning to feel more comfortable with things as we began to cross into 2016 but there was no liquidity because nobody was issuing new debt, you were trying to all chase after the same secondary debt, and prices just shot through the roof before people could really get invested. So, to Tom’s point you’ve got to be early, and probably more so when you start to think about credit investing.
MR. TOM: Can I take it back to something Lisa said earlier which I think is important which is the intellectual honestly. You know, where this is a business where the longer you’re in it the more you make mistakes, and if you actually intellectually go back and try to learn from your mistakes as Lisa, you actually get better and better, because you experience things that you internalize and potentially make yourself better for the next time, and it’s one of the things that’s really, really important, and intellectual honesty also means being able to say you don’t know, and what’s important about that is one of the things that is important during these crisis is because you’re going to be early, you’re going to, things are going to, is risk management, because this is a business it’s not black or white, It’s never black or white, I can’t use shades of grey anymore, but it’s basically you know, it’s probabilities, it’s probabilities that you’re dealing with, and being honest about that means okay, you think like the thing that saved us in ’99 is we controlled our sector bets. So, we never got out of technology, we just had a negative bet in technology. Firms that went out in technology, they were right, but they went out of business because the bet was too big, they and the clients couldn’t withstand it. So, managing risk is an admittance that it is not a perfect science and there is probabilities you’re dealing with and the more you bring that into the process, I think the better you’re going to be able to survive these highly volatile emotional periods.
SAM: I want to ask about and we’re going to turn to questions. I want to ask about 2 factors that I think are big. One is leverage because I feel like it’s this broad boogie man that we often point to, so I want to get Lisa’s view on leverage, leverage’s role on certain instances that happened in the past, maybe how you see leverage now, and then Fed because any panel is not complete without talking about the Fed.
MS. LISA: Okay, so maybe I’ll take leverage first then. So, as a credit investor, the simplest type of leverage that I look at is leverage on a corporate balance sheet, and the one thing that still strikes me and you all read about this in the paper and the work that you do, you’re aware of this, we have a lot of leverage in our investment grade universe right now, and there’s a record amount of triple B issuance and people are more acutely aware of that. When you look at leverage today, it’s just about at the same level at we saw I 2001 and 2002 on corporate balance sheets and arrogant, and I think that’s an interesting point because leverage went up materialistically in that ’01 ’02 period, really because we had a recession, and we’re in a period of growth where yeah, it’s not stellar by historical standards, but companies have very willingly put leverage on their balance sheet, and Tom and I were talking about this earlier before the panel and I understand why companies are doing it. It’s very cheap to put leverage on your balance sheet right now, and I was giving him an example of a US company that issued this week in the Euro market. They actually have a negative yield, they issued in the negative yield, so they have a zero coupon on their bond and an investor would pay them over par to get bond that returns you zero in terms of coupon income. So, you know, I understand why companies are doing it, but I think we just need to be acutely aware you know, when that downturn comes whenever it may be, we’re going into that period of time with more leverage than we have in previous periods. But leverage can also take on other forms, so Tom mentioned before long term capital. I think at it’s peak when things were really unwinding, I was doing a little bit of work on this in prep, I think they were at a 50 to 1 leverage ratio at one point, so again leverage can take on different forms, and I don’t think we have these forms in the system today, but I am kind of acutely aware of is do people try to put leverage on their portfolios because they need to enhance their returns when you got leveraging investments across the world and you’re getting little returns, are you maybe willing to put a little more leverage into your portfolio to try and enhance your return? So, I’m aware of that in the back of my mind although I don’t see a lot of that. Should I comment on the Fed quickly?
SAM: I think everyone needs to comment on the Fed.
MS. LISA: Okay, I’ll comment on the Fed. So, we were talking in prep you know, has the Fed change, and I thought about the Fed over these periods of time that we’re discussing today going back to you know, Black Monday, the .com bubble etc. it seems like as we got more into the 90’s and even into the 2000’s, we had more frequency of crises, because if you take that period from Black Monday, beyond that you had the tequila crisis, you had the Asian financial crisis, you had Russia default, you had long term capital. So, you had a lot of different things and the way I look at things is they have been a little more global and a little more centered in financial markets. So, I think you know from when Greenspan came in we have now adopted a philosophy that seems to deal more with controlling asset crises than maybe pure economic crises, and I think that there’s also this focus on financial conditions which might explain this a little bit better. So, I think it was William Dudley that was talking about financial conditions and you know, how do financial conditions matter to the Fed? Well it’s thinking about you know the dollar and what is a dollar’s impact on trade and what does that mean to the economy, what is the impact of corporate bond spreads? What does that mean for borrowing and what does that impact on the economy? Equity evaluations, what does that mean for a wealth effect? So, I think that the Fed is now trying to take these factors into consideration and looks very carefully at markets when they’re starting to think about policy, hence why we’re seeing this shift in the feds focus so quickly that we’ve seen over the course of this year.
SAM: Interesting, Tom?
MR. TOM: I just have 2 quick things on the leverage. The one thing I would say on the leverage because I think Lisa covered a lot of it, leverage is usually not the catalyst. I view leverage as the accelerant. I use crowding in equities, it’s usually not the thing that causes the crack, but it can accelerate and worsen the damage, that’s just on the side on the leverage. On the Fed, you know, each of these crises I think highlight the good and the bad of the Fed, right? if you look at 1987, the Fed didn’t really have anything to do with causing that cycle, it was really a financial market, but they provided liquidity the day of the crash in ’02 that assured the plumbing still worked because firms owed incredible amounts of money on the other side of these derivatives trades, and there was a real question of whether or not that money would actually get paid and the Fed provided liquidity to make sure the plumbing worked. That’s a classic reason for having a central bank, and always good to remember that there are reasons to have a central bank, and I think Tarp and Bernanke in ’08 ’09 was absolutely critical. You would not have survived that without someone like a Bernanke and the Fed and what they did with Tarp. At the other hand, you could say they semi-caused it with the real estate and the liquidity, the assimilate with the Y2K. you know, they’re human beings like all of us, they’re going to make mistakes, they’re going to be prone to the same excesses that all investors, clients, they’re not immune to this, corporations, et cetera, but there’s a reason for central banks that you need, and there are times that they are the only ones that can provide that, and I think these crises are the only way to show them.
SAM: I feel like the way we put our parents on a pedestal for a long time and then it all comes crashing down we do that with central bankers. So, we have run out of time, I want to thank everyone, hopefully this was informative, helpful, useful, and a kickoff for what’s going to be a really great day.
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