Marathon Asset Management

CPI: Well Behaved, Fed Will Ease Next Week CPI was +3.0% year-over-year, both headline and core inflation number. The government shutdown delayed this September report, but here we are just days before the next Fed meeting and the administration pushed to get the CPI number released so that the Fed would have this important data point to be better informed when making important decisions with respect to monetary policy -> well done! Although inflation is firm at 3.0%, the Fed will find this number tolerable and will most likely ease next week. On the housing front, positive news for Owners’ Equivalent Rent (OER), which represents 26% of CPI-weighting, it rose only 13 bps last month, the slowest pace since November 2020. The biggest uptick was Energy prices which rose 1.5% for the month. The cost of energy will be a critical issue as the U.S. has entered the age of AI. Nuclear power is the cleanest, most reliable and largest potential generator for power, which is now fully recognized, however, it will take some time to build the plants that are necessary to power the next phase of the information/compute age. Markets stable. Good news for inflation is good news for credit markets.

Used Prices Up, New Prices Down Over the past three years, new home prices are down ~10% while existing home prices are up ~11%. Despite homebuilders cutting prices, offering concessions, and even buying down (subsidizing) mortgage rates, buyers aren’t biting. Inventory tells the story: - New homes: 9 months of supply, double the historical average and the highest (outside the GFC). - Existing homes: just 4.5 months of supply, right at the 30-year average (Bloomberg chart below) Why the gap? Used homes are easier to sell. They often come with furniture, more established neighborhoods, and sometimes even an assumable mortgage (government loans are!). Homebuilders are doing their best to cut costs by building smaller homes with fewer amenities, trying to meet an affordability challenge that’s worse than ever. Affordability is now at record lows, a concern in Washington regardless of political affiliation. Higher input costs (labor and materials) haven’t stopped new home prices from dropping, but demand remains weak. I expect the Administration, and the Fed will focus on lowering mortgage rates in the coming year: - Rate cuts at the front end of the yield curve are an absolute certain. - A new Fed Chair might potentially use QE to bring down long-term rates which would lower federal funding costs, ease mortgage affordability (lower rates, narrow the 10Y UST vs. 30Y MBS spread), and support CapEx expansion (data centers, re-industrialization). Yes, the American Dream is still alive, just less affordable. From an investment perspective, mortgage credit remains a strong complement within a diversified ABL program; Marathon is as active as ever investing in first lien and second lien residential mortgages. Question of the day: Are homebuilders a buy? The Homebuilder ETF (XHB) is down 10% over the past year, while the S&P 500 is up 15% in the same period.

The next Fed Chair……survey says? Scott Bessent has narrowed the number of Fed candidates down to 5. The Treasury Secretary intends to narrow this list further to just 3 candidates for recommendation to the President for his consideration. The candidates that make the short list: 1. Michelle Bowman, Fed Vice Chair for Supervision 2. Christopher Waller, Fed Governor 3. Kevin Hassett, National Economic Council Director 4. Kevin Warsh, Former Fed Governor 5. Rick Rieder, BlackRock’s head of Fixed Income Polymarket has Kevin Hassett in the lead, followed Kevin Warsh, Chris Waller and Rick Reider (shown below). Whoever is chosen will likely lower rates since this: 1. reduces government debt service costs 2. stimulates the housing market 3. promotes development of infrastructure projects, which is core to the economic plan of the current administration: building energy plants, AI data centers, reindustrialization of America that incentives companies to bring back manufacturing to the U.S. The next Fed Chair will be dovish, accept a higher inflation rate, while reducing the Fed Funds rate. As for longer term rates, although it is not my base case assumption, I would not be surprised to see the next Fed Chair offer to use its balance sheet to buy long-term UST to bring down long-term rates if the rates market does not cooperate (QE). Despite an economy that is likely to surprise to the upside in 2026, and despite inflation stubbornly stuck ~3%, I expect the Fed to normalize its Fund Rate, bringing it to 3% by September of 2026. Note: When Jay Powell raised interest rates by 525bps in 2022-23, at the same time he was tightening, he was also easing financial conditions by conducting quantitate easing (buying treasuries to lower long-term rates, which intuitively does not make sense to do when you are raising interest rates!). Likewise, over the past year as Jay Powell began lowering rates 125bps from its peak rate, the Fed was conducting a passive form of quantitative tightening (by letting UST roll off its balance sheet), again a counterproductive move. I view both actions as sub-optimal from a monetary policy standpoint, since the one action is offset by the other. As for the next Fed Chair, I would expect he will coordinate his policy actions to achieve the desired outcome (e.g. signal QE to bring longer term lower, when lowering rates at the front end). Equity markets may be fully priced with respect to valuation metrics, but with a growing economy and strong earnings outlook the market will likely move higher once it has consolidated and shaken out leveraged players. Credit markets should also perform very well in the coming year, however, some of the levered credit investors who have made poor investment decisions will bring questions. As the economy grows in 2026 and the Fed continues to ease financial conditions in 2026, the outlook has turned promising for private equity and commercial real estate.

Beware of the Cockroach: This comment was in respect to JP Morgan’s $170M hit on Tricolor when Jamie said, “it’s not our finest moment." Jamie, always the perfectionist and CEO extraordinaire who transformed JP Morgan into a global powerhouse/most profitable bank the world has ever known is on pace to book in excess of $60B in profits in 2025 despite this loss to the sub-prime auto loan company. Jamie’s comment that “when you see one cockroach, there are probably more” is a reminder to everyone managing risk in the $3T private credit market, as he notes further risks that may be lurking, especially if economy were to falter. The number of bad PIK loans, amendments with debt extensions, loans classified as non-accrual loans collectively represents the “at-risk” category that capital allocators should focus on when evaluating private credit investment managers and an allocation to private credit funds. When businesses are too highly levered (6x or more Debt-to-EBITDA or LTV in excess of 50%), the loan is too risky for bank lending standards, and the high standard set by a conservative private credit manager. A seasoned private credit portfolio with attributes of low leverage and tight covenants to profitable non-cyclical businesses is what banks, loan officers and conservative credit managers should strive to achieve, which is complete contrast to the cockroach comparison. Significant alpha is generated when a Direct Lending investment manager can achieve an outcome of zero losses. Credit managers in the Private Credit market with experienced and disciplined investment processes to source, underwrite, structure and asset manage a diverse portfolio of loans should perform well throughout the business cycle, especially when positioned with robust businesses with strong PE sponsorship, tight covenants, low leverage with ability to pay down debt. We appreciate the concern Jamie has expressed, particularly with respect to the $1T+ of private credit loans some of which were aggressively underwritten in an era of near-zero rates as many of these companies have inadequate equity cushion as they contend with debt payments that are 2x vs. the initial model. JP Morgan’s fortress balance sheet is similar to the large money center banks. The new concern that the Fed and markets is focused on is NBFI, the non-bank lenders as banks have large exposure to these counterparts. This came to light more clearly last week when a couple select regional banks also reported counterparty losses; the KBW Regional Bank Index fell 6% in a single day. It is noteworthy to observe NDFI as shown in this chart below.

Buy the Dip Lou Hanover, Marathon’s brilliant CIO, loves to “buy the dip.” When others are feeling pain as panic spreads through the market, Lou stays calm, carefully evaluating opportunities, aware that many are selling at the lows, and patiently waiting for the deleveraging process to unfold. That’s what buying the dip is all about. There’s another kind of dip that Lou loves to buy! Lou loves to “Buy the DIP” or Debtor-in-Possession loans to finance a “good company with a bad balance sheet” that must undergo Chapter 11 bankruptcy restructuring. The DIP loan provides liquidity to a company for it to sustain operations during the restructuring process. Despite the apparent risk of lending to a distressed entity, DIP loans to ongoing business with concerns provide investment managers like Marathon with a strong investment opportunity. DIP loans carry a “super-priority” status whereby when the company is operating under the U.S. Bankruptcy Code, the DIP lender ranks ahead of all pre-existing debts, equity claims, and even administrative expenses in repayment. This ensures lenders are paid first when the company emerges from BK; or in the downside scenario if a company liquidates or forced to sells assets, the DIP lender is repaid first. DIP loans carry interest rates usually several hundred basis points higher than typical private credit loans with additional economics associated with upfront fees, call protection and exit fees; in total, DIP loans can deliver 15-25% IRRs. Marathon Asset Management has provided DIP loans to ~50 companies over the years and has never incurred a loss given the discerning way in, which we evaluate a company and the low leverage of this super-senior BK loan. Lou’s preference is to be the lead DIP lender. Over the past couple of years, Marathon has led 8 such DIP loans for companies (listed below), all of which have (or will) emerge from BK with strong operating businesses and assets. The intent is always to invest when our capital can help the company emerge from bankruptcy in a strong position to create a win-win. 1. First Brands 2. Marelli Automotive 3. Hearthside Foods 4. Mallinckrodt 5. Talen Energy 6. Cineworld 7. LATAM Airlines 8. Avianca Airlines Takeaway: Buy the dip when the market is finding its bottom and buy the DIP when a strong company stumbles. In both cases, conviction comes from careful analysis and the confidence to act from a position of strength; it’s when uncertainty creates opportunity.

Is There a Bubble Forming? To answer that, let’s first clarify what a bubble is: In financial markets, a bubble arises when asset prices surge dramatically beyond their intrinsic value. This is typically fueled by investor exuberance, rampant speculation, and often, heavy leverage. Such growth becomes unsustainable, detaching from economic fundamentals. Eventually, as confidence wanes, demand collapses and the bubble bursts, triggering sharp market declines, widespread losses, forced liquidations, and economic reverberations. Andrew Ross Sorkin’s newly released and fascinating book, 1929: Inside The Greatest Crash In Wall Street History, chronicles one of the most dramatic bubbles ever. The infamous 1929 stock market crash wiped out 89% of the Dow Jones Industrial Average. In more recent history, we’ve seen two other catastrophic bubbles (shown in two graphs below): The Dot-Com Crash (2000): - The NASDAQ Composite peaked at 5,048.62 on March 10, 2000. - It plummeted 78% by 2002, bottoming at 1,139. - Recovery took nearly 15 years, with the index finally closing above its 2000 high in April 2015. Japan’s Real Estate and Market Collapse (1990s): - The Nikkei 225 hit a record 38,915.87 on December 29, 1989. - It then fell into a prolonged slump, bottoming near 7,000 in 2009—a drop of about 80%. - The index didn’t surpass its 1989 peak until February 2024—34 years later. What About AI? Unlike those previous bubbles, the current excitement around artificial intelligence is grounded in real, transformative potential. While revenue models are still emerging, AI investment is accelerating across nearly every sector, from software and finance to healthcare, manufacturing, transportation, and more. I anticipate U.S. capital expenditures on AI alone will total around $3 trillion over the next four years. This excludes the ongoing operational spending (OpEx) needed to maintain and scale these systems. The productivity gains AI promises are likely greater than currently estimated. Bubble or Boom? Yes, the momentum in AI markets is enormous. The opportunity is real, but so are the risks and challenges. Still, it’s unlikely that this will evolve into a full-blown bubble. A market correction? Yes, it’s possible, even likely. But a speculative frenzy detached from economic reality? That seems doubtful. Takeaway: Perhaps the biggest bubble is in people speculating AI is a bubble.

Rock and a Hard Place 80% publicly listed BDCs are currently trading at a discount to their NAV. BDCs are required to distribute at least 90% of their taxable income as dividends, which limits their ability to retain earnings for growth. If the share price is below NAV, issuing new shares becomes dilutive to existing shareholders, so funding new loans is limited. For sub-scale BDCs, this creates a difficult dilemma: they face limited ability to grow and participate in new lending opportunities. In such cases, managers often find themselves caught between a rock and a hard place. Including the large quarterly dividends (average payout rate is 11.7%) y-t-d performance is negative for 2/3rds of BDCs as shown in the chart below: negative 7.99% return y-t-d (high dividend payouts are more than offset by the decline in price). BDC share prices ~15% lower when the S&P 500 is up 14% y-t-d. BDCs with “bad PIK” (loans accruing, but not paying interest due to deterioration in cash flow), loan amendment to avoid impairment (kicking the can), increase in non-accruals, 2x leverage, 2nd Lien loans exposure, and poor liquidity have led to poor share price. Within the Top 10 publicly listed BDCs, two are trading at a discount to NAV of 32% and 58%, respectively. Hats off to the 20% club, those BDCs that are growing, originating new loans, and performing well (Ares leads the pact as the largest BDC manager, while Main Street has the highest price-to-book value) - these BDCs are well positioned to grow. BDC managers (REITs too) disdain when shares trade below NAV, since markets view their company in negative light; growth and higher fee income is important, if shares trade below NAV any share that is sold below NAV is dilutive for existing shareholders. Under the Investment Company Act of 1940, BDCs are generally prohibited from issuing shares below NAV without explicit annual shareholder approval. When loan performance is poor, incentive fees and moral obviously suffer. Takeaways: 1. Invest with top quartile managers should always be the goal, it is true for private and public markets. 2. The variance of realized outcomes is greatly magnified in the public markets for private credit managers (BDCs) vs closed end funds à closed-end funds have ~25 lower volatility vs. BDCs. 3. Alpha is derived from mitigating loan losses; the goal is zero default while the average manager experiences roughly ~100bps annual loss rate.

Mr. Big, Big Numbers: - 3.8% GDP for the past 6 months (3.8% in Q2 & 3.8% Q3 estimate--GDPNow) is stunning. - 3% Inflation is high relative to Fed expectations and its core goal, but Fed still on a path to easing rates to 3%. - 3% inflation and 3% growth are beautiful stats for Scott Bessent as it put the government on an improved path to grow and inflate its way out of our massive debt load. Big Growth Coming in ‘26 - OBBBA signed into law in July ’25 allows for bonus depreciation that permits a company or asset owner to purchase physical assets and depreciate 100% of the cost of the asset on Day 1; 100% CapEx write-off creates huge incentives/reduces tax payments, but it takes time to order plant and equipment-- it’s coming! - Tariffs create a large incentive to onshore, bring manufacturing and production back to the U.S., from pharma to autos, companies are planning to expand domestic production. Under OBBBA, the company can write off the investment to reduce taxes Day 1 of the investment! - AI and compute trajectory is higher; more data centers, more power, more chips are necessary. Nearly every industry sectors will imbed AI into their business to remain competitive. The AI spend is estimated to be $3T- $5T in the next 5 years, a massive boon to the economy. The companies making these investments get to take advantage of bonus depreciation and write off the investment Day 1 thanks to OBBBA! - Federal Reserve will have a new Chairman in May ’26, who will likely provide monetary stimulus to support growth policies. Takeaways: 1. the surprise is to the upside for growth in next two years, recession risk has been greatly reduced. 2. Much of this sentiment is already priced into equities already, however the path of least resistance is higher as earnings surpass $300 per share for S&P500. 3. Growth is great for credit, spreads to remain tight for public credit while the need for private credit continues to expand to support growth. 4. Peak uncertainty is behind us.

Marathon is pleased to announce the closing of a senior financing for Owl Cyber Defense, a leading defense technology company providing Cross Domain Solutions (CDS) and Data Diode technology. https://lnkd.in/eAEA4yG4