Howard Marks Has Lots To Say About Bailouts And Moral Hazard. So, I’ll Bite.

It was only – checks notes – seven days ago, when Howard Marks declared it was time for investors to at least consider going on offense.

“Conditions have changed such that caution is no longer as imperative”, Marks wrote, in his fifth memo in five weeks. “With part of the crisis-related losses having already taken place, I’m somewhat less worried about losing money and somewhat more interested in making sure our clients participate in gains”, he added.

That represented something of a reversal for Marks who, just a week previous, said that due to a “wider range of negative outcomes” compared to the conditions which persisted during the GFC, he “expects asset prices to decline”.

---

Through Tuesday, the S&P was up nearly 29% from the March lows. The bounce (which skeptics including myself are still keen to describe as a “bear market rally”) has been helped along by trillions in fiscal stimulus and what amounts to a promise from the Fed to make everyone “whole”.

That implicit promise from the Fed rests on the notion that the pandemic isn’t anyone’s “fault”, and therefore shouldn’t be “allowed” to trigger outcomes which many market participants have long warned would accompany the next recession – outcomes like, for example, lots of downgrades from the swelling universe of BBBs.

The Fed’s decision to backstop fallen angels, buy credit ETFs and venture into spread products has been met with incredulity from some corners, even as it was wholly predictable not just based on the severity of the situation, but also because the Europeans and the Japanese have been doing it for years.

And yet, as predicable as it was, the move is wholly unpalatable for many market participants. Howard Marks is one of those market participants.

After a lengthy discussion of rampant economic uncertainty and following another pass at answering the unanswerable (i.e., “How will society and its leaders make the trade-off between minimizing deaths from the virus and restarting the economy?”), Marks says the conversation has pivoted from depression obsession (if you will) to a debate about “the propriety and long-term impact of the various government actions”.

To be frank (because I don’t know any other way to be), Marks is beginning to demonstrate a disconcerting propensity for trafficking in bad logic (see the first linked post above, where I attempt to answer some of his “questions” about the ramifications of recent policy actions on the dollar), far-fetched hypotheticals and straw men. Take the following passage, from his Tuesday memo:

[Are] the program[s] really limitless? And is that okay? The stimulus, loans, bailouts, benefits and bond buying that have been announced thus far add up to several trillion dollars. What are the implications of the resultant additions to the federal deficit and the Fed’s balance sheet?  To be facetious, the government could send every American a check for $1 million, at a cost of $330 trillion. Would there be negative consequences from doing this, such as burgeoning inflation, a downgrade of U.S. creditworthiness or the dollar losing its status as the world’s reserve currency? If the answer is yes, is there a point below $330 trillion at which those ramifications might kick in? And if so, where? Could we be there already?

As should be immediately apparent to all readers, there is no utility whatsoever in positing a cartoonish example of overkill and then asking if it’s possible that something short of that might be perilous too. The answer is obviously yes. That is, “Yes, Howard, of course there is an amount of stimulus somewhere between the combined ~$4 trillion we’re spending now across various programs and $330 trillion in direct checks, that would drive up inflation expectations and cause consternation in the market”.

But what is the point of asking that question if you don’t intend to quantify the threshold or even to posit a range? You could argue that this is completely unknowable, and that’s fine, but then why bother?

As for Marks’s query “Could we be there already?” the answer is no. We’re not even close.

And I can virtually guarantee that while inflation expectations may bounce for a spell (especially if oil prices manage to sustain anything that looks like “stability” in the wake of the OPEC+ deal), they will not accelerate meaningfully in an environment characterized by acute demand destruction no matter how quickly the Fed’s balance sheet grows (and it won’t be growing as quickly going forward, by the way).

Marks reserves his harshest criticism for the Fed’s foray into risk assets and the multi-pronged effort to keep credit flowing to all borrowers, irrespective of creditworthiness.

“Just two months ago, I attended a dinner with the president of one of the 12 Federal Reserve Banks”, Marks writes. “I asked him whether the Fed might adopt the tactic of buying corporate bonds, given the limited room for rate cuts”.

“No”, this official told Marks. The Fed would only buy government and agency obligations.

(It’s nice to know that Howard is at dinner with regional Fed bosses asking about the likely evolution of policy, by the way. If there’s a “plus one” option, I’ll gladly go along next time, especially if there’s foie gras involved.)

Of course, the Fed ultimately did decide to buy corporate bonds, both IG and some high yield, along with credit ETFs. Marks mentions that, along with regulatory relief for BDCs, on the way to saying the following:

I was particularly surprised by these latter actions.  What’s the Fed’s purpose in buying non-investment grade debt?  Does it want to make sure all companies are able to borrow, regardless of their fundamentals?  Does it want to protect bondholders from losses, and even mark-to-market declines?  Who’ll do the buying for the government and make sure the purchase prices aren’t too high and defaulting issuers are avoided (or doesn’t anyone care)?

And why should the SEC provide relief to leveraged investment vehicles?  If such an entity proves to be over-leveraged and sees its collateral marked down such that it’s constricted or even liquidated, what’s the loss to society?  Why should leveraged investors — ostensibly not systemically important — be protected from pain? 

[…]

Most of us believe in the free-market system as the best allocator of resources.  Now it seems the government is happy to step in and take the place of private actors.  We have a buyer and lender of last resort, cushioning pain but taking over the role of the free market.  When people get the feeling that the government will protect them from unpleasant financial consequences of their actions, it’s called “moral hazard.”

What surprises me is the lack of profundity. There is nothing new about these questions. They are good questions. But we’ve been asking them for years both directly and indirectly.

Directly, vis-à-vis the ECB and BoJ’s sponsorship of corporate credit and equities, for instance.

Indirectly, because is not what the Fed is doing simply making what was tacit explicit? After all, what does engineering a “hunt for yield” mean if not, as Marks puts it, “ensuring that all companies are able to borrow regardless of their fundamentals”.

Think about the myriad distortions which have shown up across credit markets over the past five years. At one point late last summer, there were 100 companies in the € debt market whose entire curve was negative. In a sense, debt had become an asset for those corporates. And don’t forget about negative-yielding “high” yield debt, the ultimate oxymoron. Marks himself addressed those issues in an October note.

My point isn’t to say that Howard is wrong. Rather, it’s simply to say that policymakers have been deliberately suppressing volatility, compressing risk premia, tamping down spreads and keeping the market wide-open for borrowers for the better part of a decade.

Also, regular readers will hopefully recall that I cautioned on blindly accepting moral hazard arguments a few weeks back. Here is what I said on the subject in “March Madness: How The Treasury Market Blew Up“:

Some of these measures [will be] met with predictable lines of criticism. The charges will vary, but generally involve some combination of generalized shouting about moral hazard and more specific accusations tied to purported “bailouts” of hedge funds and other market participants.

To be sure, there’s always a moral hazard argument. And that goes for markets and life in general. Just pick a vexing scenario where some higher power (usually governments or officials) is compelled to intervene and you can conjure a moral hazard counter-narrative.

That doesn’t mean moral hazard arguments aren’t good or that they don’t often prove prescient when something goes wrong down the road. It’s just to say that you should be wary of blindly assuming that everyone who screams “moral hazard” is saying something profound. Moral hazard arguments are a dime a dozen — and not just in markets.

Since I penned those lines, moral hazard arguments have come out of the woodwork. Again, many of those arguments are good ones, and emanate from people who I respect a great deal. But my warning stands.

Howard also takes issue with the notion that the pandemic is so anomalous an event that everyone should be made whole. Here’s his short critique of that notion:

Some people argue these days that there’s no way those who took on leverage that turned out to be excessive could have been expected to anticipate a pandemic and the resultant damage to the economy. Thus, the argument goes, the jam the government is rescuing them from “isn’t their fault,” meaning the bailout isn’t unreasonable. As I wrote in Which Way Now?, I understand they aren’t guilty of having ignored a likely risk. But unlikely (and even unforeseeable) things happen from time to time, and investors and businesspeople have to allow for that possibility and expect to bear the consequences. In other words, they have to think like the six-foot-tall man hoping to get across the stream that’s five feet deep on average. I see no reason why financiers should be bailed out simply because the event they’re being harmed by was unpredictable.

His points are good ones superficially, and they resonate because Howard is adept at making intuitive-sounding arguments that appeal to readers’ sense of fairness. But note how he slips in “financiers” at the end of the passage. It’s missing from the preceding sentences. That’s important. And I’ll explain why.

Are small business owners not “businesspeople”? Are many Main Street businesses not also over-leveraged? Yes and yes. In other words, Marks’s argument applies to all businesses, large, medium and small. If you accept the line of reasoning in that excerpted passage, everyone who counts as a “businessperson” (from sandwich shop owner to Delta executive) must “bear the consequences”.

Of course, that isn’t a very reader-friendly position to take, and instead of address the implications of his argument head on, Marks slips in “financiers” in the last sentence to elicit support for the position which, as written, by no means applies strictly to “financiers”.

Ultimately, the best part of Howard’s April 7 memo comes just a few paragraphs in. To wit:

What does the U.S. see today?

• one of the greatest pandemics to reach us since the Spanish Flu of 102 years ago,
• the greatest economic contraction since the Great Depression, which ended 80 years ago,
• the greatest oil-price decline in the OPEC era (and, probably, ever), and
• the greatest central bank/government intervention of all time.

The future for all these things is clearly unknowable.  We have no reason to think we know how they’ll operate in the period ahead, how they’ll interact with each other, and what the consequences will be for everything else.  In short, it’s my view that if you’re experiencing something that has never been seen before, you simply can’t say you know how it’ll turn out.

No argument there, Howard. None at all.

---