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.


 

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

  1. Another thoughtful and timely article Many thanks.
    (Your comments on eating foie gras, given the intense cruelty of the industry are abominable)

  2. A Brave new World H……….. and Howard both describe…but Howard is out on the Limb further.. As in the last sentence ….nobody knows how it will turn out or for that matter if a system resembling anything we currently have will emerge at all…

    1. Marks may be out on a limb, but he is right about the system. It simply cannot stay the same. Adjustments will be made, if for no other reason than the huge amount of outside interference taking place. The kind of market participants H talks about the most will find new ways to make more money and leave us with a system we know even less about that the current one.

  3. That’s interesting take as I when originally read H. Mark’s memo I actually thought it wasn’t his writing. It had an off tone from so many of his past year’s earlier memos and the memo from only a week before. Maybe that Fed President asked him to put a little positive color out there to the readership.

  4. The only ‘leverage’ I’ve ever used in my whole life has had to do with moving an object that had more mass than me. I’ve never applied ‘leverage’ in any other way. Once, I got cold-cocked by the handle of a Handyman jack while changing a tire. It slipped a cog – important to the leverage – much to my unleveraged chin’s chagrin. Leverage is wonderful, too bad it has this tension against it!

  5. Howard is upset because it will be harder for him to be a predator now. He is upset that the fed backstopped some if his targets. I usually like his articles but when I read this one, I realized right away he had a major axe to grind.

  6. Yes, like large corporates, many main street businesses are also over-leveraged, but this does not imply an equivalent level of moral hazard, primarily because of the large differences around recourse. Banks, and even the SBA as a lender of last resort, force most mainstreet businesses to provide personal guarantees to get meaningful business credit, except for rare small businesses with sizeable hard assets they can collateralize. Inventory is generally not even accepted as collateral. Corporate investors and managers do not bear equivalent levels of personal risk in their business activities, and will not suffer similar personal consequences in the unfolding catastrophe, as the rules of the game stand today.

    1. A timely and correct comment. Even when they set up as LLPs most small firm owners must put just about everything they own on the line. Limited liability doesn’t exist for these folks. Remember, SMEs, on average, only have six total employees, almost no assets except real estate, and almost no cash.

  7. if $330 trillion is “cartoonish”, but $10 trillion or whatever we are at is “not even close” then the Fed has explaining to do why we aren’t getting stimulus checks more in the neighborhood of $120,000

    1. I think that would be Congress, not the Fed.

      Your larger point still stands. What is that number that would spark a true inflationary impulse? I feel most economists, and pretend economists on TV, have continuously and vastly underestimated that number.

  8. Implicit in the Fed behavior over the last 10 years is that we can never have a rainy day again. And now that it is pouring, the promise of an umbrella big enough seems a bit dubious. The Fed’s power to eliminate the business cycle, insure that we never have a recession again by becoming an insurance company that doesn’t collect premiums, which was always a dodgy proposition became more than suspect when the repo market began flashing red last fall. The moral hazard problem is a problem whether Fed chooses to ignore it or not. And that is something of a misnomer –the Fed actively encouraged investors to seek out risk in all the wrong places. The recovery from this very exogenous shock will be the real indicator of the wisdom of what was “unconventional” in 2009 become the norm in 2019 as what will be revealed is that there is a very real difference between making a marginal deal a good deal with free money and trying to make a bad deal into a good deal with free money. At the end of the day paying to build a bridge to nowhere is nothing more than a series of transfer payments whose benefit depreciates along with the currency printed to pay them.

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