Good Times Foster Complacency, Exposing Malinvestment and Fraud

Deep Dive

Jamie Dimon's observation regarding bankruptcies from First Brands and Tricolor served as an initial warning, prompting a comparison to the historical use of canaries in coal mines to detect dangerous gases. This incident highlights a tendency in financial markets to focus intensely on a single topic, which at present is sub-investment grade credit. The discussion then shifts to private credit, a sector that emerged around 2011 when banks faced limitations on lending after the global financial crisis, leading money managers to fill the void. Initially, private credit lenders could demand high interest rates and safety due to limited competition, making it an attractive investment in a low-rate environment, with approximately two trillion dollars flowing into the sector.

The narrative moves to the increasing competition within private credit due to new entrants and substantial capital, which has diminished some of the lenders' advantages. The source notes that the private credit sector had not been truly tested until recently, with two high-profile bankruptcies in quick succession suggesting potential cracks. The tone became more serious with allegations of fraud in these cases. Specifically, First Brands is accused of using the same receivables as collateral for multiple loans, while Tricolor allegedly made loans to buyers lacking credit scores or driver's licenses and had prior regulatory citations for practices like selling cars without titles.

Further instances of apparent misconduct are presented, including Zion's Bancorp disclosing awareness of misrepresentations and contractual defaults by two corporate borrowers, leading to a $50 million write-down. Additionally, Western Alliance disclosed initiating a fraud lawsuit against a commercial real estate borrower. More recently, two small telecom firms, Broadband Telecom and Bridgevoice, were revealed to have borrowed extensively based on fabricated receivables and subsequently filed for bankruptcy. The source questions whether these isolated instances hint at a pattern or an ominous trend.

The text then addresses the market's reaction, noting a strong response with stock prices of prominent alternative asset managers declining following these disclosures. The source asserts that defaults are a normal occurrence, with over 2% of all high-yield bonds defaulting in a typical year, and many more during crises. Applying this percentage to the thousands of sub-investment grade issuers suggests that dozens of defaults in a normal year should not be surprising. Therefore, the source concludes that these events are not necessarily the beginning of a trend or an indictment of the entire sub-investment grade or private credit markets, but rather a reminder that yield spreads exist for a reason, compensating for credit risk, and that credit skills remain essential for debt investors, even if not apparent in good times.

The discussion then broadens to the cycle in attitudes toward risk, contrasting investor psychology in good times versus bad times. In good times, when economies are strong and profits are rising, investors tend to view risk positively, believing more risk leads to more money, and they interpret ambiguous developments favorably, with the possibility of loss receding from consciousness. This leads to increased risk tolerance and a focus on aggressive bidding rather than due diligence, a phenomenon the source refers to as a "race to the bottom." Conversely, in bad times, when economies falter and markets slump, the refrain becomes that bearing risk leads to losses, and negatives are exaggerated while positives are ignored, with investors regretting insufficient due diligence.

The source introduces the adage, often attributed to Mark Twain, that "history does not repeat itself but it does rhyme," applying this to finance where themes reappear cyclically. Good times foster complacency, risk tolerance, and carelessness, leading to aggressive asset bidding and lending. Bad times, in turn, expose the results of this carelessness when investments made without adequate investigation and margin for error fail. This is further illustrated by financial historian Edward Chancellor's observation that panics reveal previously destroyed capital through "hopelessly unproductive works," reflecting malinvestment made during booms and exposed during busts. A concise banking adage summarizes this: "the worst of loans are made in the best of times."

The concept of "bezzle," introduced by John Kenneth Galbraith, is discussed as a phenomenon where financial fraudsters or embezzlers appear to create wealth that lifts spirits until they are discovered. The source posits that good times, characterized by a low level of prudence, create the necessary conditions for a "good bezzle." Economist Michael Pettis is cited for describing the cyclicality of this phenomenon, noting that certain periods are conducive to bezzle creation, with an inflated sense of value being unleashed systematically. The size of this inventory of fraudulently inflated wealth fluctuates with the business cycle; in good times, money is plentiful and people are relaxed and trusting, leading to an increased rate of embezzlement and a decreased rate of discovery. This reverses in depressions when money is scrutinized, audits are penetrating, and commercial morality improves, causing the bezzle to shrink.

The text then links overconfidence, inaction, and inattentiveness in good times to unwise investments and fraudulent schemes. Fear of missing out (FOMO), inadequate due diligence, and fevered buying create fertile ground for financial scams. In heady times, rather than questioning overly attractive opportunities, people are more inclined to seek participation, with markets attracting crooks who are most active when due diligence is in retreat and money is readily accessible. The source anticipates that the past 16 years of economic growth and profitable risk-taking may have produced a significant number of frauds.

The question of whether these issues are systemic, affecting the entire system, or idiosyncratic, affecting only specific occurrences, is raised. Systemic issues are exemplified by the counterparty risk during the global financial crisis. The source argues that current issues are not systemic in the sense that there is something fundamentally wrong with the lending system that would trigger a breakdown. Instead, imprudent loans and business frauds often occur in clusters due to human error, particularly in good times when investors and lenders are expected to be risk-averse but sometimes fail to exercise discipline and vigilance. This is described not as a flaw in the financial system's "plumbing" but as a recurring behavioral phenomenon, making it systematic rather than systemic.

The case of First Brands is presented as an example. While possibly isolated, its bankruptcy filing attracted significant attention as the first high-profile case involving a borrower in the private credit market. The problem at First Brands appears to stem from its borrowings against receivables, a practice called factoring. In this case, payments from retailers were allegedly sent to First Brands for forwarding to financial institutions, which allegedly permitted First Brands to sell receivables multiple times and potentially retain some payments. The company also allegedly used aggressive off-balance-sheet financing, selling inventory to special purpose vehicles that then used it as collateral for loans, creating complex obligations that ballooned to several billion dollars. The complexity and opacity of these arrangements led one creditor's lawyer to state that $2-3 billion had "simply vanished."

The text notes that byzantine corporate structures and extensive off-balance-sheet financing have been present in many corporate frauds, citing Enron as an example. Even before First Brands' bankruptcy, OakTree's research identified red flags, including a short operating history with significant sales, a controlled individual with minimal public profile, a substantial litigation history with allegations of misconduct, profit margins above industry average, and numerous mergers and acquisitions creating a web of entities. Weak controls were also observed. The source questions how such a company attracted financing, explaining that private credit often involves companies not filing SEC disclosure documents, making initial investment decisions heavily reliant on information from