Credit is money creation and the worst credit decisions are always made at the end of the bubble.
Look around.
I will show that there is a dangerous global reliance on derivatives, collateral reuse, balance sheet manipulation, overnight funding and the general acceptance of dangerous assets (junkier junk bonds, stocks and sovereign bonds) as collateral. These dubious forms of [dollar denominated] collateral are relied upon to clear all global trade and to create maximum leverage in the system. However, one volatility event wiping out one major form of collateral could undo the entire chain of leverage.
In other words, for a large percentage of financial institutions, if their assets decline below a certain value, or if volatility spikes, then even overnight funding being interrupted for a single day could force immediate contagious bankrupting collateral calls throughout the system, like we faced with Lehman and AIG.
Therefore, my concern has been heightened by extreme behaviors in the EuroDollar (dollar denominated asset) markets: sudden mass central bank dollar reserve liquidations; continuing failure of Chinese real estate bonds; dollar shortages in many countries halting imports; sovereign debt issues; stock declining; increases in defaults on various consumer debt across the world, etc…
These collateral shortages have already shown up in the increasing imminence of the yield curve, unusual dollar asset spreads, the dollar index spiking, large margin requirements for many currency swaps and general global volatility.
Which is all to say, that I am concerned we are at a point where any further increase in volatility could trigger an enormous liquidation event.
GFC1 was NOT about mortgages
The most important thing to understand about the First Great Financial Crisis (GFC1) is that subprime mortgages were a symptom, not a cause. Greenspan and Bernanke said repeatedly in congressional hearings following the crisis that mortgages can not explain such a global financial crisis. Simply put, a 1% increase in defaults of mortgages in 2007 can not possibly explain what happened. Consider that China had 20% mortgage defaults in the early 2000s and it did not cause a crisis, and yet the narrative continues that a 1% increase caused a global recession.
It was a EuroDollar (dollar collateral) shortage (review BIS reports on the crisis).
Every financial crisis is a money shortage and when credit contracts there is too little money to clear trade (money is a “medium of exchange”). Commercial lending creates money, contraction decreases money. Thus, as a collateral shortage develops into a crisis, the dollar dealers of the system are incentivized with premium to issue bad loans and to provide much needed currency (or EuroDollars for the repo market today).
When people say the dollar is the global reserve currency, this is somewhat deceiving. Dollar bills issued by the US Federal Reserve are certainly not used to clear trade, nor does the Fed create any new notional dollars (they swap equal notional value of assets in QE), but dollar denominated debt (EuroDollars) is the global currency. Your mortgages, car loans, corporate loans and even stocks are used as “collateral” for a global financial system. That is, for Israel to clear trade with New Zealand, they need to acquire dollar bonds in the repo market.
Hopefully, you can see the implications of this already — for the majority of the last century Wall Street has been increasingly getting rich packaging up our debt to be used as clearing chips (and now sources of leverage) in the global monetary system. This of course has downstream effects of banks being incentivized to create more consumer and corporate debt.
GFC as part of a longer trend
However, the EuroDollar system grew too rapidly to keep up with global trade demand. Money creation in this system relies on being able to make productive [collateralizable] loans, and history is pretty clear that steep increases in the rates of lending are always unproductive.
Globalization and near sole reliance on the dollar as the unit of account has caused demand to outpace supply. Money is a unit of account of resources and resource production (real money) could not be created as quickly as there was demand for currency.
Paradoxically, easier credit and the bidding up of existing bonds are themselves a solution to a [real] money shortage. The nature of fast credit expansion is that the inevitable contraction is even faster than the expansion. This is why you often see spikes in yields and prices before large deflationary crashes.
Negative yields are a symptom of EuroDollar (dollar bond) shortages. Why do you think it is that financial institutions would be willing to pay to loan money? After all, that is what negative yields on bonds are. Yes, Apple bonds are safe, but why pay 110 for 100 of Apple bonds? Because they still make profit lending them out on an overnight basis in repo (often to multiple institutions at once due to lack of transparency). They have additional value as a currency and this incentivizes overlooking the actual value and productivity of loans.
Why have yields been declining since 1982 if there is “excess liquidity”? Do the laws of supply and demand not apply here? Are the rising prices of bonds going up for 40 years not a sign that there is more demand than supply?
In eras of paper currency redeemable for metals, the notes would often be more valuable than the market value of the metal you could redeem it for. This deflationary characteristic inherent in money supply shortages is itself a complex system’s way of self-healing. Since there is a shortage of currency to clear trade, the currency increases in value.
This is why our dollar denominated debt (and therefore its underlying assets) have surged in value. Via liquid arbitrage markets, the value of our homes have increased to match the value of the EuroDollar currency demand, while the trending rate of inflation over the last 40 years has fallen.
Each CPI spike in the last 40 years is associated with a then deflationary recession: 1981, 1990, 2000 and 2008. Each asset market crash associated with each recession has gotten worse with time, and this time with a much larger bubble and spike in CPI.
What is even more interesting, is that the yield curve “predicted” these recessions:
This is a chart of 10 year treasury bills minus 2 year bills. Why would anyone want a lower yield on a 10 year than a 2 year? Especially considering that these are also during times of CPI spikes?
Think about it — if inflation is compounding, the longer the bond, the more you would lose. Having a 10 year of the same yield is significantly more at risk of having value destroyed during inflation as it would compound losses for longer.
Yet, even during the inflation scare of 2008, the yield curve continued to invert. It inverted leading up to the recession of 1981, 1990, 2000, 2008 and again recently.
The answer as to why in the world a long bond would have a lower yield than a short bond, especially during a CPI spike, is simply explained by the special value of long bonds to the monetary system during a collateral shortage.
What is not shown by focusing solely on the 10y and 2y is just how incredibly inverted the yield curve is (provided by Jeff Snider):
It begins all the way at the one year, has a historically steep curve and inverts in multiple places. This is a dramatic statement about current liquidity.
The higher the CPI spike, and the greater the fear of inflation, and the odder it is that the yield curve would invert. I’m proposing that it is lack of liquidity which causes both the yield curve inversion and later ends up forcing the system to bid up remaining “safe” assets and partially causing CPI spikes (aside from supply chain issues from recessions). After all, the yield curve inversion precedes the CPI spikes / inflation scares, as it inverted in Feb 2006 and it inverted in Aug 2019.
Monetary shortages are why loans before crashes are always the worst loans made. Pre 2008, not only did the system move towards CDO mortgage derivatives (over leveraged in repo) as a collateral source and default swaps (which also hedged mortgage collateral, creating more balance sheet capacity, per Basel rules), but the very worst of subprime lending were loans made in the last two years.
Each monetary shortage has a bubble before a crash because the demand for currency is so great that lenders are incentivized and desperate to find borrowers.
Today we see easy credit result in SPACS, high use of margin debt, over leverage with hedge funds (i.e. Archegos), ubiquitous use of shadow derivatives, infinite rolling over of junk bonds for corporations (often using high interest to repurchase shares — i.e. GE, BA, HUBS, etc…), no income check auto loans, auto loans given at 160% LTV, (now) no income mortgages, etc…
Monetary shortages cause the system to over rate and overvalue bonds to increase balance sheet capacity (the real purpose of manipulating bad bonds to be AAA, as lending is constrained by the “riskiness” of the collateral (RWA & VAR)).
Is the spike in CPI and assets sustainable productive credit, or is it rapid expansion associated with easy/bad credit? I believe it is the canary in the coal mine.
Easy credit preceding deflationary busts is as old as credit. If you think Archegos and Gamestop blowups are unique to our recent stock frenzy, please read about 1929. 1929 even had “SPAC” like “trusts” that were also blank check vehicles trading on the stock market (the beginning of Goldman defrauding customers). It took us 91 years and the dollar shortage of March 2020 (see BIS report) to get these dangerous vehicles back. (We had also undone laws made in 1934 to prevent over leverage in the 80s to allow derivatives).
The EuroDollar system expansion took place rapidly in the 60s and 70s (hence two decades of increasing rate of inflation) and since then we have experienced disinflation filled in with increasingly desperate means of bad credit. LBO blow ups in the 80s, LTCM and various derivative blow ups in the 90s, the dot com bubble, the 2008 crisis, and now for the grand finale — a culmination of every dangerous financial instrument invented in the last 400 years used ubiquitously and globally.
Japan allowed similarly dangerous balance sheet deregulation and it resulted in the great Japanese bubble that collapsed in 1991. For example, in Japan mortgages were deemed safe and did not count against balance sheet capacity, and therefore allowed financial institutions to create unlimited mortgage loans. As a result, they had one of the greatest housing bubbles ever.
History is repeating. Japan had an incredible spike in CPI followed by decades of deflation. They are in the midst of a 3 decade depression that is possibly going to get worse.
Keep in mind the US has adopted the same “stimulus” (monetary) policies as Japan. Japan had a monetary shortage issue and they bailed out their financial system, keeping the dysfunctional system in place (which is what QE does). Furthermore they used unproductive debt, which — if anything at all — makes deflation worse. The result has been decades of deflation.
Entering GFC2: The Great Dollar Shortage
For me, the scariest part is that never has a single currency been the sole medium of exchange for the globe, not even gold, and never has there been so much leverage upon it.
This is why Taleb doesn’t like Monsanto — if the entire world is using one type of seed, say for wheat, then if it has some kind of weakness, the entire world could experience that weakness at once. Similarly, having a single currency means that we all have one synchronized large recession.
Over leverage up until now has been circular and self fulfilling. The use of derivatives, shadow banking, unquestioning rollover of corporate bonds to unprofitable companies, the reintroduction of collateralized debt obligations (CDO) with commercial real estate (CLO), and the ubiquitous use of consumer and government debt has been incentivized by this dollar shortage. Risky behavior has been rewarded because the risky behavior provided liquidity during a collateral shortage.
Ironically, the risky assets have met their dollar obligations provided by additional liquidity from further risky lending. As long as debt can rapidly expand, dollar bond payments can be met and their value can stay afloat. But credit is no longer expanding and the decline in value of these dollar assets becomes circular and rapid in its contraction.
I understand it doesn’t look like a liquidity shortage with asset prices going up and various supply chain issues, but this is the very nature of financial crises — they begin with asset bubbles.
As one EuroDollar asset goes down, another increases its premium. Evergrande and Chinese real estate declining is an opportunity for expansion of our auto loans to provide market liquidity. Right now we are hopping from one source of easy credit expansion to another (like 2007) until we run out of new sources of EuroDollars.
Economies are complex systems and increases in complexity (population, resources, globalization, etc…) have nonlinear increases in demand for money to clear trade. The only way collateralized lending creates sustainable money is if that lending results in more resources. However, our complexity increases and our GDP growth rates are declining. If money doesn’t increase then the network of trading has to decrease.
If gold’s inelasticity (gold simply not being able to expand fast enough to keep up with economic growth, which has nonlinear demand for currency) could cause depressions from ancient Rome to Europe’s Great Bullion Famine to the Long Depression in the US, imagine how much worse it would be if debt, not only doesn’t increase fast enough, but if it were to rapidly contract at a much larger scale than 2008.
In 1933 we could require that you not store gold (our reserve currency) under your bed in order for it to recirculate. In 2022, the money never existed. Ubiquitous collateral reuse and rehypothecation means that the banks are clearing trade without underlying assets. Same with derivatives.
Shadow banking is the true source of “money printing”, albeit with temperamental forms of dangerous debt. Trade is being cleared without any underlying assets. The Prime Dealer banks have solved collateral shortages by clearing the trade on a ledger and without any collateral. However, this behavior can not exist in times of volatility, and the possible evaporation of a major source of currency is what makes the possibility of volatility that much more dangerous.
Repo also provides “collateral transformation”, as a financial institution can swap its junk collateral for AAA collateral on an overnight basis. Because of this simple “repurchase agreement” (repo) an institution can go back into the market and get more leverage.
However, what happens when an institution, like Bear Stearns, has tons of leverage (or balance sheet capacity) because of this collateral transformation, but then suddenly can’t roll over its overnight loans? Mass liquidation.
This constant maximum leverage hidden in the system can result in a rapid withdrawal from the lending markets, making collateral scarcity (like 2008 and briefly in March 2020) much worse. Every institution has maximized its balance sheet capacity via these precarious (albeit Fed sanctioned) methods and the scariest part is that general volatility can trigger large margin calls.
How much collateral an institution is required to post is determined by the volatility and liquidity of the asset used. All these institutions are trading and leveraging up on margin itself and volatility causes margin calls. If suddenly a type of asset is deemed unsafe (i.e. MBS or CDO) then there is a sudden requirement to use good collateral (usually treasuries), which causes a chain of liquidations.
This is a quick chain of liquidations both because the volatile asset is widely used, as well as derivatives layered upon it, and because there is a long succession of lenders — “collateral chains”. Because Lehman can’t make CDO payments the value goes down, because the value is down AIG owes collateral on every CDS sold. Because Goldman bought default swaps from AIG to offset its mortgage assets (an offsetting hedge allows maximum balance sheet capacity) it can no longer lend in repo, and because Goldman can’t lend in repo it means someone else can’t roll over their overnight repo loans, and so on and so on…
GFC2 is more severe
Financial crises are often proportional to debt levels. Private debt to GDP is significantly higher than it has ever been in history in nearly every major economy in the world. What is scarier is that the majority of debt is not known or disclosed (it is inferred and estimated via footnotes). Derivatives and rehypothecation are also forms of debt that are not accounted for because they remain in the shadows and largely undisclosed and certainly unaccounted for on any debt metric.
In other words, we have the largest levels of debt relative to GDP, as a nation and globally, in the history of man and that’s not even including most of our debt that is hidden in the shadows.
Once lack of repayment has rippled through the system and good quality collateral is demanded, we will all learn just how little real notional dollar value there is. We will have the greatest deflationary event in the history of finance. Never has private debt rapidly increased and not rapidly decreased. This time, we have far too many economies reliant on what is already too few EuroDollars and about to be a lot less.
While all the pieces of this bubble have existed hundreds of years before (even repo has a previous history in 17th century call loans), these instruments that Buffett declares “financial weapons of mass destruction” have only been used lightly prior to this shadow banking monetary system. (Note that Buffett stated that we have more systemic risks today than in 2008 and he described the behind the scenes of 2008 as “looking into the abyss”).
While price discovery is taking decades in some cases, once liquidation begins, assets will drop quickly as repo financing will freeze with fear of what is truly the underlying collateral, and who is credit worthy, spreads.
It is my belief that it is precisely because commercial lending and trade is hidden that debt has been able to build so high. It is because of the shadows that price discovery and the laws of arbitrage have been suspended for an usually long period. That it is not a coincidence that private debt today (relative to GDP) is multiple times higher than the debt crisis of 1929 and the ones prior.
I also theorize that the more complex debt is — both in terms of length of collateral chains and characteristics of the instrument (like “complex derivatives”) — the longer it takes for price discovery and arbitrage to unfold. That is, the larger and more complex our global economy and its instruments, the longer and further we can deviate from “intrinsic value” (or productive value) of underlying assets. Yet, it is the nature of financial engineering to become more complex and leveraged over time.
Conclusion
Please allow me over the next months’ posts to defend my positions that high [private] debt (often in the form of financial engineering) causes financial crises and that shadow banking today is a playground of often unlimited debt.
Unfortunately, there is a void of study of economic history and the current monetary system in academia today. I will do my best to give detailed research and to point to others who, after 2008, have dedicated a lot of their life to studying the complexities of repo and collateral chains — like Jeff Snider of EuroDollar University and Manmohan Singh of the IMF (despite working at the IMF, he has to use limited footnote disclosures of the bank’s annual reports or literally call to put together any sort of data).
I believe that money is to the economy what CO2 and oxygen are to the environment. Monetary history is not only incredibly interesting and pertinent to all things financial, the fact that it is no longer studied in academia means that those who are self-motivated to learn will have a significant advantage in understanding future markets.
Buffett, for example, learned from the last crisis and is prepared for the next. He said that when there is fear in the lending markets only one type of dollar collateral is accepted: treasury bills.
Money “is like oxygen”, and the global currency is EuroDollars. Money is created via lending. When there is a contraction in lending, there is a shortage of money to clear trade. This is a financial crisis.
Fragility in various major dollar bond markets, from sovereign bonds to Chinese real estate, are looming triggers of volatility. Record levels of financial engineering, debt and globalization mean that the globe’s ups and downs will be synchronized. And as the father of fractal geometry (nonlinear math of the real world) Beniot Mandlebrott wrote in his book on financial markets, the downsides move at a nonlinearly increasing pace.
The crashes are a lot faster than the bubbles, and that was a historic bubble.
