Moody's Talks - Inside Economics - Klein on Threats to the Global Financial System

Episode Date: October 18, 2022

Mark, Ryan, and Cris welcome back Aaron Klein, Miriam K. Carliner Chair and Senior Fellow at the Brookings Institution, to discuss stress points in the global financial system, the conditions for a financial crisis, and whether central banks are going to break something. Full episode transcript.Follow  @aarondklein on twitterFollow Mark Zandi @MarkZandi, Ryan Sweet @RealTime_Econ and Cris deRitis @MiddleWayEcon for additional insight.  Questions or Comments, please email us at [e-mail]. We would love to hear from you.  To stay informed and follow the insights of Moody's Analytics economists, visit Economic View. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics, and I'm joined by my two co-host, Chris DeReedies. Chris is the Deputy Chief Economist and Ryan Sweet. Ryan is the Director of Real Time Economics. How goes it, guys? How's everyone doing? It's been all right. How are you? I'm not going to say I'm tired because I've heard from many of our listeners. Mark, I hear you're tired. So I'm not going to say that. But I am in Tokyo, and it is late in Tokyo. It's, what, 943 here in Tokyo, PM.

And I'll have to tell you guys, the world is not over with the pandemic. The pandemic is still a deal. You know, particularly here in Tokyo, it's a defecon one. Everyone's wearing masks. They're very nervous about, you know, any kind of contact. It feels like, you know, where we were over a year ago. So the world is not back to normal. So how does that compare with the other stop?

in your whirlwind tour. Your marathon. Yeah, and I can't wait to get home. I really can't Saturday. This is most locked down. In Dubai and Abu Dhabi, they're more relaxed, but they have restrictions. So if you go into a restaurant, you have to show your PCR test that you got tested within 72 hours saying. Oh, wow.

Yeah. And in London, they're like the U.S. I don't know that they even, I didn't see any masks or, you know, pandemic? What pandemic? It's like a flu. This is like a flu, you know, now. But Singapore, Singapore was, well, you know, now that one of our colleagues has gotten sick. I don't know.

And he got sick in Singapore. I'm not sure. I feel bad for what's going to happen to Singapore. I shouldn't laugh. I should have. I know. I really don't know. It's just like, you know, you couldn't make this stuff up.

All I'm saying is the world's still two and a half years later, we're still grappling with this thing. I definitely, so it's clear Asia is more locked out. It's reflected in the data. It's in the statistics and doing it as well, right? Well, actually, interestingly enough, it's the one part of the world where inflation isn't that big a deal. And the reason it's not that big a deal is because they're still locked down. You know, there's not going on here. It should pick up.

It's starting to pick up. Like today, interestingly enough, today, October 12th was the first day you could come into Japan without a visa because of COVID. And I'll tell you, I was very nervous coming in because it was very unclear what the requirements were to come in. You know, they had this app and my SOS and you had to fill it out. and it was red, you got to, you know, it wasn't clear what happened to you. If it was blue, you're okay.

Here's the other bizarre thing. I just throw it out there. You know, just an observation. I get off the plane in Tokyo from Singapore and there's like a thousand, I'm making this up, but, you know, felt like a thousand people workers, you know, Japanese workers that were responsible for making sure that, you know, you had all the things you needed to do. to go through immigration. In a country where the working age population is declining and labor shortages are a problem,

you look around and go, why do we, why do you need, you know, what I give you the exact number. It was probably 15 people that did the exact same thing. They looked at my app and see if I had the right color. You know, it was like really bizarre, really bizarre. Yes, it's Japan, right? We're expecting all the robots there, right? Yeah, really bizarre. Anyway, one thing I have learned on this trip, though, is, or one thing that has become obvious

on this trip is that the world is up in arms over what the Federal Reserve and other central banks are doing, the tightening and monetary policy. And the stresses that's putting on the global financial system, and there's a growing concern that the central banks are going to break something. That's something out there, you know, when you stress the system with high rates long enough, something is going to break. So, you know, the most obvious was when I was in the UK a couple of weeks ago was the British pound going south and the British interest rates, the yields on guilt,

the analog to U.S. Treasury is going north. Still a lot of Sturman dragging over that, but a lot of concern about that. And to discuss this issue, and this is really an issue, we got one of our most favorite former participants in the podcast, Aaron Klein from Brookings to join us. Hi, Aaron. Good to see you. Mark, Chris Ryan, it's a pleasure to be back.

Yeah, and it looks like your pajamas there, Aaron. I'm just saying. You know, the beauty of remote work? I have a face for radio. I used to do a radio show. I would do the 6 to 10 a.m. show on a. commercial station as a job when I was in college because it came with a free breakfast. So it was minimum wage plus free breakfast.

And I used to do a little stint where I breathe heavily into the microphone and say, did I brush my teeth? You're making this up. It's where 99 rocks. Rock in the Upper Valley. You can't make this up. 991, 99 rocks. Where's the upper valley?

Lebanon, Hanover, New Hampshire. So I went to Dartmouth College. Ah, very good. Well, Aaron, you now have a new title, I understand. This is like you have an endowed chair, which is a huge deal because obviously it takes some of the financial pressure off. And you're the Merriam-K. Carliner chair of economic studies at Brookings. Is that right?

It is. It is. The Carlinner family was very generous in their endowment, and it's a great honor to represent that work. but my portfolio remains the same. I'm doing a lot of financial regulation, financial technology, thinking about the macro economy, trying to figure out what's going on here.

A little bit excited about the infrastructure bill that we have in society and the U.S. And also intrigued to hear about your tidbits about Tokyo since I'm heading there in a couple weeks myself. Yeah, I heard. We had a big event was it Numerra? The Numerra Foundation. I'm presenting a paper there on the use of payments

as a tool of foreign policy. Subject for another day, Russia invades Ukraine, and America's response is you're off the swift payment network. Yeah. Right. We're increasingly fighting with bonds, not bombs, and with the access to the U.S. dollar and payment settlement as a weapon in our national defense portfolio, not as a method of extracting exchange or settlement.

Yeah. Well, I mean, that is definitely a topic that I'd love to explore, but perhaps we put that to the side over here. In fact, one quick question about that, just personal interest, we're doing some work around cyber risk, and one of the scenarios we're considering is an attack on the Swiss system. Do you think that's a reasonable thing to consider? Well, North Korea has already done it. That's right. Yeah, that's right.

Korea through the Bank of Bangladesh and the New York Federal Reserve attacked. And in point of fact, I believe the story goes, it kind of had a random person not been on a random weekend to see something, even more money would have been stolen. So I think that's a very realistic scenario. There are lots of horrible, scary cyber scenarios to think about. But the world lacks a global central bank. And the swift payment system provides many of those services. in payment interoperability and connection that a global that a central bank provides,

but it by definition is not a governmental entity. Yeah, that was at the New York Fed, right? It was like one Saturday or something. It was like diehard. Remember, diehard was right at the New York Fed? Yeah, Ryan knows all those movies. He could recite the entire script of diehard. No, I don't know how I could go that far, but I remember the movie.

Yeah, right. There's three of them. Yeah, no, I'm not going to get into whether or not it was a Christmas movie or not, which I know it's a raging debate. I'm not qualified. Yeah, that's not something I have any qualification to discuss as a holiday that perplexes me. Nonetheless, you know, the idea that they would steal the hard gold bars, there's more gold in the Federal Reserve Bank in New York than anywhere else in the world. But really, the way to steal money is electronically. Because most money is electronic.

Yeah. Yeah. Well, it's good to have you. And just to refresh people's memories, you know, way back when you were, would it be fair to say the chief economists of the Senate Banking Committee? Is that correct? Yeah. Correct. I served as chief economist at Senate banking for both Chairman Paul S. Sarbanes of my beloved state of Maryland and Christopher J. Dodd of Connecticut. And then after my time as chief economist on the Senate Banking Committee, I was Deputy Assistant Secretary for Economic Policy at the U.S. Treasury Department. essentially the first term of the Obama administration. Got it. And that's a good segue into, I guess, kind of the first thing I'd like to tackle in the context of financial market stresses.

And that is, do you think the system, the financial system, is in a much better spot? And I guess the answer is probably yes. But how much better spot is it today compared to, let's say, prior to the financial crisis a little over a decade ago? Oh, I think it's apples to oranges in the U.S. context. In the U.S. context, the state of bank capital of regulation of leverage is totally different than it was in 2007.

There are some similarities, which I'll get into that may make folk wonder. But the level of safety and soundness within the financial system, we just had a very sharp recession as it related to COVID, completely unforeseen. Now, you know, the reasons why the recession and the response help mitigate some potential problems from the banking system, but I think the system is in much, much better shape than it was in 2007, you know, as a result of deep structural changes in regulation and also as a result of the human cycle. I think there's something to the three generations argument. right, which is there's a crisis in one generation. They're never going to repeat it. The second

generation is scarred by it. The third generation looks back and goes, wait a second, why do we have all these rules and regs in place? Our grandfathers and grandmothers lived in a very different world. We can do better. They loosen things up and then oops, there it is again. You know, Aaron, to that point, there's been a recession almost every 10 years, 1950, 1960, 1980, 1990. I'm not making this up. 2000. The financial crisis messes me up. Messes this simple. You know, then 2020. And, you know, I don't know that that's an accident, right? It almost goes to your point. It takes about 10 years for that memory to fade or for the people who were running the show, you know, they were running financial

institutions and the regulatory bodies when the last crisis, occurred. They leave and the guys that are left don't have that experience in that memory. And they go, you know, I got better data. I got better models. Those guys were idiots. And then we're off and running again. See, Chris, this is why Mark's probability recession is so low. He's waiting until 2030. That's his model. Exactly right. That's exactly. It's too early. It's too early. I suspect if you took a model that said, you know, is the year recession in years the end with the number zero and ran that against the official central bank forecasts of probabilities of growth, you would win with just a dummy.

Is it if zero, then recession, otherwise predict. Yeah, that sounds like Ryan's models. That's how it sounds pretty good. I mean, it sounded like how he took his models. And I joke, Aaron. He's like a savant when it comes to the. this model. He's like, you know how Bloomberg rates people in terms of their accuracy for CPI, which is like everyone wants to know CPI. He is number one. And they also have

some, what's that measure they use? I didn't look and see, but you're like, what is it? What is it? It's an accuracy score? How do they measure that? That's a good question. I don't know. Anyway, you're like 70. I'm making a step. You're like 77 and the next person is like 59 or something. It's like a big different. That's impressive. In the political world in Washington, everybody focuses on Nate Silver, who got a lot of elections right, including 08, but there's actually a guy who's out of Emory,

now runs his own polling from Drew Linzer, who's consistently beat Nate Silver. Yeah, really? I didn't know you. In the political forecasting of it, he runs a firm civics. But yeah, no, no, no. The ranking of the forecasters is a big, that's a big thing. I hope you get a trophy. at the end of the back

and then I rib them every once in a while yeah Mark just makes fun of me that's my my prize so Ryan you want to reveal your CPI forecast for tomorrow even though this will be heard by our listeners oh that's interesting what do you got

month every month is going to be point two headline and then core which strips out food and energy is 0.3 month or a month So what does that make year over year? Do you know? I forget it. I think it's about eight.

E1. The headline. 8.1. That sounds better. You know where core, the concept of core came from? I do not. From the wind campaign, which is whip inflation now, it was a Nixonian concept that to reduce headline inflation to reduce inflation expectations, we should take out the things that are high, which at the time were food and energy. a series of economists have published a lot of papers justifying that, that somehow, you know,

we should be studying the inflation for people who don't eat or consume energy because that's a very useful subset of humanity. But the actual idea to strip it out to core was Nixonian in every sense of the word. Oh, yeah, it fits. That definitely fits. We need to bring back the buttons. Bring back white, Chris? buttons, the wind buttons. But that wasn't Nixonian. That was Carter, wasn't it? The wind button?

No, or Ford, maybe. It was Ford. I think it's Ford. It was Ford. Yeah, I don't think it was Nixon. Anyway, enough for the history lesson, although it's quite impressive the amount of history we do know. Of all the things that were done, Aaron, after the crisis to try to improve the system's resilience because of what happened. The system collapsed and needed a government bailout. What would you put at the top of the list in terms of the response? Higher capital. At higher capital. Higher capital. I mean, when you look, a lot of people get the history of the financial crisis wrong, right? The crisis, you know, metastasizes in a series of situations in which you have extreme leverage, right? Lehman, bear,

Fannie and Freddie, right? You have, you know, AIG, you have these things that are incredibly highly leveraged. And the solution, one solution to leverage is increased capital, right? You had regulators like the Federal Reserve pushing, you know, changes to the Basel capital structure that would have used fancier models. They thought their models were better than Ryan's that would have reduced the amount of bank capital. Can you believe that in 2005 and six, the Fed and some other regulators were arguing that the banks were opunitively capitalized?

England went ahead of us and reduced capital ratios going right into the teeth of the crisis. Luckily, Sheila Baer and the FDIC and some others, Sarah's Sarbanes and Shelby actually bipartisanly on the hill push back against early adoption of these Basel capital models. So the number one change has been capital. The number two is essentially the standalone investment bank kind of doesn't really exist anymore. I mean, that part of the shadow, quote unquote, shadow banking system are regulated bank holding companies. Yeah. Right. And so you don't, you know, you don't really have the same type of financial structure where you had high leverage in non-prudentially regulated, non-capital regulated entities.

That would be like a Lehman Brothers or a Bear Straser. Goldman Sachs is now a bank. Yeah. Everyone's a bank. Yeah. Now, that wasn't by regulation per se. That just happened because they had to be in a bank, right? Because if they didn't become a bank, they couldn't get the fed's support.

And they couldn't get the fed's support. They were toast. They were out. They were history. Correct. But they were also a little bit Hotel California. Once they came in, they couldn't turn around. Go out.

Go back out. No, American Express became up. There were a lot of companies, not even once it didn't fail, right? but that through that stress period that went into the prudential bank regulatory system like Chris you probably know this what was fanny and Freddie's capitalization prior to the crisis do you recall regulatory cap I think was 0.45 yeah that's what it was it was 45 basis points point five can you imagine we would run economic capital models yeah because oh the ice prices never fall or maybe they fall on a market but

They never fall across the country. You know, they're negatively correlated, you know, right? Well, we would actually make more realistic assumptions, but the regulatory capital always was the binding constraint, right? You would never have an economic capital calculation that was lower than that. By my calculation, the loss in, you know, if you add up all the realized losses on their mortgage securities and holdings was about 300 basis points all in, you know, during the, so just 45 basis points of capital

against 300 basis points of loss, and that's why they're still in government conservatorship. Okay, so, you know, it's interesting, Aaron, once I was on CNBC, and it was a guest host, and Barney Frank, you know, he was the bear of the House Financial Services Committee. That's Dodd Frank. You know, you're the senator you work for, and Barney Frank, a real character, and I asked him the same exact question. And you know what he said to me, which I found very surprising. It was the risk retention in mortgage securities.

Remember the skin? Yeah. He had a whole 5%, I think it was 5% risk. He later called the exemption that ate the rule. Yeah. Yeah. It set the way that that retention was expanded regulatorily. within the Obama administration, I might add, and got very upset, qualified mortgage, QM.

Yeah. Yeah. But look, you know, the history of financial crises is that it's never the same asset twice, right? Dutch tulips, South China Sea, Japanese real estate, where you are, Mark. I think that's a mark to market in the 80. Remember 1990, circa 1990? Yeah, absolutely. And they've never recovered from that, actually.

And so, you know, I don't know what will cause the next financial crisis, but I'm absolutely certain it will not be U.S. subprime mortgages. Yeah, there is no such thing, is there at this point? Oh, yeah. Well, I mean, it's a shadow of what it was. If there's so prime, it's shadow. Correct. But there's a way to do economically sound subprime lending, right? I mean, there's a risk return, right?

Yeah, capital. You can give mortgages capital. but also, you know, stronger underwriting. Yeah. Shockingly, why their loans don't tend to perform as well as the model because I've never met a model that, you know, takes the data and says, well, assume this is false, right? All the models.

And so they're responsible products out there just at a much smaller scale. The other thing that I found in my research is that all financial crises, not recession, there's a big difference between the two, But all financial crises involve two things. The fundamental mispricing of an asset and leverage. You have bubbles, but not crises if you have one of the two. So example, what is the value of a click, right? This was in the, in circa 2000, one of your recession years, this caused a recession.

We fundamentally did not price this new asset, an eyeball on a website and a click. And we had a giant bubble. right and some things the the dot-com bubble popped it was large enough to cause a recession people lost money right but we didn't have a crisis why didn't we have a crisis there wasn't leverage you couldn't really buy and trade the nasdaq with much leverage in that era what in large part because we had regulations from the Great Depression where they had a stock market panic on leverage so the So you can also have tremendous amount of leverage with if you don't have a fundamental mispricing of the asset, you can lose money, but not trigger a financial crisis.

What's an example of that? Right? So leverage loans would be an example of that. Oh, I see. Yep. You need both as a prerequisite for a crisis. So when I'm asked the question, kind of what could be the cause of the next financial crisis or where are you looking at?

The threshold analysis I take is, is there a fundamental mispricing of an asset, and is there leverage? Right. You also need scale, right? You could have a... It has to be big enough, right? So, crypto, for example, may not...

It may have... I don't know how much leverage there is in the crypto markets, but it's possible that they're levered, but it's not large enough to really do a lot of fundamental damage. That's right. That's right. But the size has to be built upon leverage. It can't just be that there's a lot of money in it. Okay. The money has to be levered. Yeah. So before we get to the stress points in the system, Chris, let me go back to you in the question I posed to Aaron. Of all the things that were done in the wake of the financial crisis to try to make the system more resilient, it was certainly capital number one top of the list. what else would you put on that list that you think is important? Yeah, my number two, this might be controversial, is actually stress testing. The institutionalization of a more formal process, forcing institutions to run stress testing exercises,

examine the results report on the results. I think that was, I think in the midst of the crisis, that was very therapeutic, right? kind of shed light on the risk, it calmed some nerves. And I think the power, we've continued that process, I think that is beneficial. Yeah.

I mean, sounds a little self-serring because we do a lot of that for a living, right? The help the financial institutions with their stress testing, from capital stress testing to climb it, but I agree with you. Did you see that recent speech

from former Fed Governor Tarillo on stress testing? Did you catch that, I saw that you sent it to me early this morning. I haven't read it. I did. Brookings non-resident fellow Dan Terullo. Yeah.

I mean, look, you know, I'm a little less sold on stress testing. I think Chris's comment is spot on. I think that's my former guy's boss, Tim Geithner, would have put that to, if not number one, with capital. That was his name of his book, wasn't it? Stress stress test or something. Yeah. You know, I've, the way that banks are. regulated is twofold. One is risk-weighted capital, and the other is simple leverage ratio.

And simple leverage ratio has a series of faults, right? Just says you have to have 10% capital, pick a number, whatever that number is. You can't go below it, right? And so banks naturally try to maximize their return on assets, which should drive them to riskier positions because that creates higher ROA on a simple leverage ratio. On the other hand, with the simple leverage ratio, you can't gain it. There's no way you can move stuff around and hide risk or this or that, right? 10% is 10%.

The other one is the risk-weighted system, right? Where we're going to sit there and say, well, we know that this type of debt is riskier than this type of debt, which is riskier than this. So we're going to differentiate your capital charge, and we're going to have a really sophisticated model. you know, maybe it'll be, you know, not quite as good as Ryan's because it's run by the government, but like, you know, really super smart people.

And this is going to be more accurate. And so banks are going to have to, you know, have a less risky portfolio relative to their money to happen. The problem, so in that way, it solves for the problems. The problem is, what if your risk weights are wrong, which we've seen repeatedly, right, in large part because of financial crisis involves the fundamental mispricing of an asset, and there's no reason to think the Federal Reserve or government is going to fundamentally correctly price an asset better than the market. There are many reasons to think it might be worse, but there's, you know, and some to think it might be better, but structurally speaking,

we misprice assets all the time. That's part of evolution and innovation. So, you know, I've always, I found in my travels that you get people who get, who adhere to one of, of the two models. Institutionally, the Fed loves risk weights, right? The FDIC tends to prefer simple leverage ratio. And people fall into different camps. I've put myself in the camp of chopsticks, which I can eat a lot of food with two chopsticks.

I can eat somewhat with some level of class. With one, you're just spearing. And I think you need to be comfortable using either as the binding constraint. And what I found is that regulators and often academics and bankers, et cetera, fall in love with one or the other, and they get nervous when the other one's the binding. There's either enough capital or there's too much capital

because their preferred metric isn't binding. And so I'm more skeptical of some of these models, stress tests. I mean, what was the stress test for COVID? How did the stress test work during COVID? Well, they actually ran a set of scenarios during COVID, I recall. I don't know if it changed anything in terms of their capitalization, but I think it was helpful for identifying things, but you're right. They couldn't do that ex ante for sure, right? So, you know, I'll do something I'm not supposed to do on a podcast, which is admit that I was wrong.

So when COVID started, people are like, what's going to be the first problem on institutions balance sheets? And I looked it up and what did I look for, right? I looked for leverage and, mispricing of an asset. And I found used cars. There is a huge amount of used cars, particularly subprime, which a lot of used cars, I think only 30% of Americans buy their car new. Yeah. And used cars were rolling off car lots with 140% loan to value, right? Because, you know, shady practices by used car dealers, shock art, they may not be the most reputable business people on earth in terms of adding things to the loan, warranties, etc. They were financing these things very high. And, you know, the, so these things were negatively collateralized. They were

sometimes leveraged in somewhat, you know, collateralized loan obligations, a bunch of the acronyms you recall from the financial crisis. There were a few credit unions in particular, who I thought were not well capitalized and deep into this market. And there used to be an old adage, well, used cars are safer than houses because you can sleep in your car, but you can't drive your house. So there's a group of people that will preference their car over defaulting on their apartment or their home. But COVID changed that, right? You know, in COVID, there's nowhere to drive to. Yep.

Now, what happened? Used cars, which are definitionally a depreciating asset. We have the entire history of the used car market available to us by data, and it is only ever depreciated. And so my middle will assume that, you know, a 10-year-old civic is worth less every month. First time in human history, the price of a 10-year-old car rose sharply, sharply. Yeah. And there wasn't a problem in the market. If I walked up to any of you in 2019 and said, I have a model.

And in my model, the value of used cars goes up 30% year over year. Yeah. I mean, we have a whole business modeling that, actually. I don't know. Mike Briston is our colleague who does that. I'm not sure how, whether you got that right or wrong. I just want to go back to your chopstick analogy, which is a very good one. But it's important that you have chopsticks that are finally tailored and tuned, right?

because if you set the leverage ratio too high, you really incent these institutions to do things you really don't want them to do. So you got to get that exactly right. And it's a bit of a calibration. Yeah. That's right. And they have to work together. What I've been most concerned about in looking at regulators is they buy into one or the two approaches and then don't like the others so they don't try to make them actually work together instead they try to say. That's a great point. That's a great point. Okay, so I think we've established that the system today, and this replies to the U.S., but similar things happened in much of the rest of the world in the wake of the financial crisis, at least the developed world.

So the global financial system probably feels like sitting on a much more solid foundation than it did 15 years ago. So with that as a backdrop, let's come forward to the current point in time and this growing concern that because central banks, the Fed and other central banks are jacking up interest rates so fast and so high. And prospects are that they're going to go higher and stay high for an extended period of time that this is going to create stressors in the financial system, expose problems. system will break again? Or, you know, I mean, taking the extreme case here in the scenario, but some flavor of that is what's kind of pervading, you know, the conventional thinking out there in the marketplace. Aaron, do you think that that's a reasonable concern at this point? How are you handicapping that threat at this point? So, I mean, a couple things, right?

Getting back to one theme we have, right? Nobody modeled the Fed using 75 basis point height. this point. That's the norm. Yeah. Right? Because we hadn't seen that for 30 years and the model never thought about that. To the global ripples of what of the rise in the value of the dollar associated with that with dollar denominated debts.

So I think other countries, particularly in the developing world, are going to have problems and the problems are going to cause recessions. And there may well be a recession caused in the United States. by this. So you're going to have double or triple whammies where the U.S. as a net importer of goods sees a domestic slowdown. There's a global debt overhang, particularly in countries with dollar-denominated debts, and they've seen the changes in the value of the currency. And you have a problem there. Those are problems of economic growth, recessions, expansions. Those are not financial crises. And I think there's a big distinction between the two. When it gets to the question

of a financial crisis, returning to Japan, where you are, I believe this is what yesterday was the third day that the Japanese treasury tenure didn't trade. Oh, you know, I didn't know that. Is that right? Didn't trade liquidity in that? Well, that's because it'd be the bank of Japan has scarfed up everything. Well, therein lies a different question. Yeah. How much. has the central banks around the world scarfed up everything and distorted where markets would or wouldn't have otherwise been, right? I think it was nuts that in the name of COVID, the Federal Reserve was buying junk bonds to support the corporate debt market. Like, I come from a school where investors lose money, and that's, you know, the name of the game. And, you know, somehow that I'm a

very, you know, I consider myself a very progressive and liberal Democrat, but the idea that investors lose money seems anathema to certain, you know, folks, particularly in, you know, conservative politics in the United States, where, you know, as you point out, the last several crises have occurred in election years of the end of Republican administrations in 2008 and 2020. And there's kind of been a rush to bail out. Holders of all sorts of different debt classes, money market mutual funds, et cetera. And so, you know, when you ask the question, are, you know, is the market going to be stressed? Part of the problem, I think, comes from like, are we going to get back to a world where we accept that investors lose money?

And sometimes they lose a lot of money. And sometimes they lose money due to bad luck, sometimes bad investments. And that I'm not sure about. There's a skit in Saturday Night Live. Do you guys remember, there's Will Ferrell Skit and more cowbell? Oh, we've talked about that. That's our signature. That you, there you go. Bring it for me, right? It seems to me the central banks around the world, whenever they see a problem,

the solution has been more central bank. Yeah. There's a problem in the repo market. We'll have a Fed standing repo facility. There's a problem in the bond market. We'll buy more bonds. There's a problem. Will, will, will.

And, you know, the thinking extends, oh, there's digital currency. Well, we should have a central bank digital currency, right? The question you have to ask yourself is, why? Is the answer? Let's make that real. Let's go to the UK two weeks ago. The new prime minister comes out, Liz Trust, with this massive fiscal stimulus package, deficit finance, tax cuts, and government spending increases.

And, you know, bond investors run. for the doors because they know they're going to be all these gilts, these analog detrateging bonds issued to finance this. And also it's going to add to inflation because the UK economy is sitting at full employment. Probably the liberal market there is tighter than it is in the United States. And so you're going to get a lot of inflation as well. So the pound falls. When I was there, I would hit parity briefly, you know, between the pound and the U.S. dollar, and guilt goes skyward. And this causes a stress in the system. UK pension funds had devised this derivative strategy to match their long-dated liabilities with their assets

that works when, you know, guilt yields do what they typically do, but guilt yields moved up five standard deviations. The arithmetic blew apart, and these guys were going to fail because the value of these derivatives collapsed, and they had to mark to market, and if they had a market to market, they had margin calls, and they had to sell, and you get into this kind of self-reying, reinforcing cycle into oblivion. You're sitting there at the bank of the year now, is it Andrew Bailey, the Bank of England, what are you going to do with that? Are you going to say, this is luck, you lose money? A couple different things on that, right? One is, there's a question about market.

Mark to market, right? And how that can be pro-cyclical in situations, right? And you don't want to blow up the entire system because of, you know, accounting. Right? There's a second question, which is, so we let pension funds put themselves in a position where they had a derivative exposure such that a five standard deviation move in a bond market it blows them up? Yeah.

Why? I mean, so, no, no, no, that's absolutely. But it was, that actually, that's where stress testing comes in. That's a really good case study where stress tests could help identify that. But, you know, that's clearly a fault in the system. But that's what happens. When you stress a system, you discover, oh, my gosh, I didn't think of that.

Look, actions have consequences. Trust is supply size. insanity, right? This is kind of like the Stephen Moore, and to use the U.S. analogy, right, there's been a stream of, you know, what I, what has been called kind of snake oil salesman economics, that if you blow the deficit sky high with tax cuts, the growth ferry comes and revenue magically solves it, right? And while this has a political popularity, the U.S. Stephen more was an architect of this strategy whom Donald Trump attempted to nominate to the Federal Reserve Board at one point. It didn't get very far, luckily, but in a different world,

things could have gone differently. And, you know, some sanity has to come into magical thinking. And sometimes are consequences to engaging too far in that situation. You know, if it's a question of time and folks need time to figure things out, that's different. But if it's a question that government should fundamentally go in and manipulate the price and asset of value of markets in order to protect favored classes of investors from losing money, I have been in the wrong with that. I don't agree with you. I just it's just the, it's easy to say in theory, but then in actual practice when you're sitting there, you know, can I make a point in the eyes of this of what's happening? There's a forthcoming book. I'm going to make a plug for by somebody we all know very well, Mark Calabria.

Mark Calabria was the director of the federal housing finance agency. They overseaer of Fannie and Freddie. During COVID, there were huge cries to bailout mortgage servicers in the United States. He held firm. There was a huge push to provide bailouts for them. He held firm. There were stresses in the market. There were losses, but the system didn't collapse.

Well, that's only because Fannie and Freddie were a conservatorship, Aaron. If they weren't in conservatorship, they would have collapsed. Perhaps. Oh, no. I'm not talking about Fannie and Freddie. The government was sitting there behind the whole system. I'm not, let me be very clear. I'm not talking about Fannie and Freddie. I'm just talking very specifically about the liquidity for the mortgage servicing arm. Yeah, but I don't buy into that collaborative argument whatsoever. I mean, I agree with a lot of what you said, most everything up to that point in time. But when the only reason he was able

to get away with that is because they were sitting in conservators. They were government entities. So the whole system was backed by the government. So I don't know. Nothing gets more fired up than housing finance. What I would say is when the book comes out, I encourage you to read it even if it's going to aggravate you. Really? I'm going to make Ryan read it and give me a pracey.

I'm happy to do it. Because there's a lot of talk about people coming in asking for, right? It's his question, right? You know, we don't know what would have happened had the Fed not bailing on money market mutual funds. Yeah. In COVID. Right. It's an unknown hypothesis.

We do know that when you bail out an asset class repeatedly, investors assume it's going to be bailed out. I hear you. I hear you. Mark, did you see what Governor Bailey said yesterday? No. He said, you have three days. He can stop buying guilt on Friday. Yeah, let's see him do that.

Exactly. You keep going south. They're up 17 basis points today, just this morning. They were up a lot yesterday. What are they? 4.5. 4.6%. 4.6, yeah.

If they get to 5 and the pounds going to parity, I assure you. Well, the pounds down a ton. Yeah, I assure you. But anyway, you make a great team. Why was the Federal Reserve buying mortgage-backed securities as recently as last month in the United States? We had a house market that was out of control. Yeah.

House prices were going benignage. bananas, right? There's a new Fed governor, Chris Waller from St. Louis, and it was well publicized. He couldn't figure out how to buy a house in this area in the D.C. metro area because costs were going nuts and why were costs going nuts? Because the Fed buying these things years after. You have to make a distinction between the buying those securities and the timing of those purchases. I mean, when you're in the middle of the pandemic and the housing market's evaporating, I can easily see it. So that doesn't argue you shouldn't do it, but you have to be judicious about it.

So that's early 2020, mid-2020, right? Yeah, exactly. No problem there. But why continue into the teeth? I don't agree. I don't understand. Look, here's what I want to do. For the first month of the pandemic, I wiped out my groceries because I thought that surfaces were a thing, right?

Right? Then you found out surfaces weren't a thing. A year later, my kid's schools is still closed on Wednesday so they can do deep cleaning. Right. That's a good point. And you can't justify this thing. Well, you know, a year ago. Yeah. Here's what I want to do, though. I want to go around the group and ask you to each identify what in the system. globally here in the U.S. that feels most vulnerable to breaking under the stresses of rising interest rates and or recession, that could metastasize into something that could become a problem for the financial system and require some kind of bailout. You know, the system, it starts to, it's bending, feels like the system is bending, which is okay, that's what it's supposed to do, you know, financial conditions have to tighten, as they say, so that the economy

slows and inflation comes in. But we don't want it to break. But what out there is at risk of going from bending to breaking, if that makes sense? Let me start with you, Chris. Where would you go with that question? So globally. Anywhere. I'm just scouring the planet. You know, where would you be looking? I think we even alluded to it earlier. Certainly some emerging market, some market out there is vulnerable, right? Either from a debt perspective or because of the strength of the dollar, their imports, exports, trade imbalance, and there could be a cascade effect. But we had Sri Lanka, like most people don't even know Sri Lanka. Right. Yeah. So it's got to be more than Sri Lanka, no? Either has to be a larger market or it has to be many of them, right?

If we had two or three Sri Sri Lanka's cascading, then that could actually roll into something larger. It really, what I'm thinking more than anything, is the unknowns, right? We know that Europe is under pressure. Clearly, recession risk is high if not already here. And yet they do have some resources to fight against that, prevent something from spilling over. Not to say there isn't some type of sovereign debt risk there, but it's more of these other markets where we don't have clarity, right? Just like the previous recessions we talked about there, it's always something that we didn't really think about or we didn't know about the

interconnections or not enough people knew about them. So that's what's on my mind. It's going to be some of the... I'm asking you the imponderable, tell me the unknown unknowns. So what is the unknown unknown? That's what I... Well, taking that what you just said a step further, could it be a development? developed economy that runs afoul of bond markets. I mean, we saw what happened to the UK. That was clearly a massive error on their part that precipitated it. But what about, you know?

Certainly have my eye on Italy. I always have my eye on Italy, right? I was going to say, I was going to thought you going to go there, Italy, right? Yeah. And the spreads are gaping out there as well. So there's clearly risk there, although, you know, you do have this European Central Bank that does have some resources behind it still. Like, if I had to pick one, maybe it's a China, property market, right, social unheaval, upheaval, right?

There, I don't know. There again, I don't have a lot of clarity into the Chinese economy, what is really going on. And problems there could spill over and have a ripple through the globe. Yeah. Okay. Okay. Ryan, what about you? What would you point to?

Yeah, I was going to go where Chris went, but focus on European sovereign debt. I'm worried that we're going to have another European sovereign debt crisis because yields are just jumping across Europe. But outside of that, there really isn't any, that's the thing. It's like you're asking about the unknowns. So why is your probability recession 70% my friend? You know, like if there's no problem out there, you know, what, you're just saying there is something we just don't know what it is. Yeah, well, I'm worried that things are just going to get accelerated. Like, like why are high yield corporate bond spreads not increasing?

Why? Can you explain that? So tell the listener, you know, that that is an indicator that we watch for stress in the system. And it's, it's not signaling any particular, well, there's some stress, but nothing on board. Well, I think the high-eal corporate bond market's different now than it was 10, 15, 20 years ago. I mean, the quality of the corporate debt is better. You know, I think perceptions of credit risk are very low. You know, corporate profit margins are still wide. We talk a lot about. about excess savings among the U.S. households. There's a lot of excess savings among corporations. You know, the amount of cash that are about corporate balance sheets is pretty high. I love to hear what Aaron thinks about this. And I can't quantify this, but is there a potential for moral hazard? Because we already talked about that, you know, the Fed stepped into the corporate bond market during the pandemic. We do have stresses. Are they going to step back in? And that would keep spreads tighter than they would at least historically based on, you know, volatility in the

bond market, the VIX, which is volatility in stock market, all that points to wider spreads, but maybe there's a moral hazard issue. There is. That is interesting. Okay, so to frame it, though, if I look historically at the difference between an interest rate on a high yield bond, that's a below investment grade bond, that's a lower quality bond compared to a U.S. Treasury bond of similar duration, it's about 500 basis points. And the junk bond market, the high yield market was put on the planet in the late 90s, Michael Moken, you may recall, you take an average of that difference. It's 500 basis points.

Today it's sitting at 510, 520, 530. So that's nothing, right? In the teeth of the financial crisis, it was 2,000, I believe. Usually when you're in a recession, it's about a thousand. About a thousand. I think that's the... You're suggesting that maybe the spread isn't gaping out because that's the palpit in the bond market that, you know, they'll get bailed out. Yeah, I don't know how much of that explains why,

but I think that's a factor along with high energy prices, because about 10% of these high-eil corporate bond spreads are, you know, energy company. So high-o-o-prices are good for them. But I think that number one is the perception of credit risk that, you know, falls are going to rise, but they're not going to spike like we've seen, you know, in past instances. Right. But I just can't quantify this moral hazard. Yeah, I've got another explanation that I'm going to come back to when I give be my stress point, but it may help explain that. But that's interesting. Aaron, where would you go? Where would you? I'll pick up on a couple of threads that have been discussed. I think China

has a set of issues. I tend to think that your stress points are often where you have the most opacity. And it's hard to really know what's going on in China. Right. And so, and, you know, per your comment about Sri Lanka and size is relevant, hard to get bigger than China, hard to know everything that's going on within there. The way that the sharp appreciation and the value of the dollar affects their currency because they do not let their currency freely float. And so you have a series of other issues there, and that's right. The second thing I'd look at is something that exists out of no country, crypto.

digital assets. There's been a fundamental misdebate about the value of these assets, and they've swung wildly. I've not seen that much leverage in the system, but then you kind of wonder some of these algorithmic stable coins, some of these other things, what are the assets backing tether, the world's largest stable coin, which seems to be deeply opaque, and is the functioning of those markets more brittle than we know, and is there more interconnection and intercontagion within those markets than we fully appreciate? And so could there be a domino, right? Usually with a financial crisis, the question you're asking is kind of what's the spark of the flame? Yeah. Right? And then the domino effect, right? So if we've been doing this in 2007 and

somebody had come and said, U.S. non-prime mortgages, and somebody said, oh, that's small, The Fed says it's contained, right? Somebody would have had a walk through. Well, countrywide takes out Lehman, Lehman takes out AIG, AIG, da, da, da, right? And so you're asking what the spark is, you know, something in China, something in crypto. No. Digital assets.

I want to be a little bit broader, right? Because there's all sorts of different, you know, NFTs or sorts of other things. And by the way, that's not to say that these things that, you know, inherently makes you a skeptic, right? In the dot-com story, I think that the stock value of Amazon went from basically, you know, zero to $100 a share to $9 a share. So it lost over 90% of its value in the dot-com bubble, and now it's, what, $3,000? Was $3,000?

So, you know, at one minute, you can, Amazon lost 90% of its value when the bubble pop and then was the single bet. If you bought at the peak of the bubble in 2000 and held, you wouldn't have problems like these pension funds that you alluded to earlier, right? You'd be a super wealthy person. But the other thing that I'm concerned about that isn't a market is the group think endemic in central banks domestically and internationally. You know, there has not been a single dissent at the Federal Reserve among the seven governors appointed by the president and confirmed by the Senate to 14-year terms in order to give them flexibility, the

point of having independent monetary policy in part is to let governors express their differing opinions. Do you know the last time the Federal Reserve governor dissented on a vote on monetary policy in the United States? 2005. Yep. Mark Olson. He thought we should pause tightening because of Katrina. Think about all the crazy stuff that's gone on in monetary policy since 2005 with a unanimity among the governors greater than Saddam Hussein's vote chair. Let me push back on the Iraqi elections.

I mean, I'm sure there's a lot of dissent, but they just decide that they're not going to express it in a public way with a vote like that, right? That they want to make it clear to the markets that they have come to a consensus, but it doesn't mean that it was an easy consensus to come to, right? And I would be shocked if it was, right? So I can't really be the,

benchmark. To me, at a certain point, you have to vote your conscious and you have to vote what you believe in. The fact that no one has dissented itself makes dissents, this is the snowballing effect. When you used to have dissents that were common, it wasn't such a big deal, right? So you voted, you know, among the governors, it was six to one or five to two, right? There's still a consensus. It's not like you're tipping the vote. But now you have a culture where you can't disagree publicly. You can't, right? The burden to do this becomes higher and higher, the longer this street goes, which itself then reinforces we can't dissent. I don't think there was anything wrong or unhealthy when there were dissents in monetary policy for the first 90 years of the

Federal Open Markets Committee, right? What changed since 2005 in which we don't have, public dissents aren't, are now subject to such a greater threshold, we've never seen it. But, you know, when I talk to central bank officials in the Fed, I don't get, I don't get this group. I mean, there must be some group think going on, but I don't get the sense that, I get the sense that there's significant debates about these issues. I don't get the sense that they're all on the same page. I mean, if you look at Governor Waller, I thought he was going to be the closest dissenting recently because of some of his comments. But when it came, push came to shove, he voted it in line with all the other governors. So group, you know, group think doesn't mean

that there isn't robust discussion. It means that there's robust discussion among the same group. And then the pressure to stay within the group is very hot. So you're saying you think the, the kind of the problem here may actually be monetary policy itself that we're making bad monetary policy decisions because we don't have that kind of diversity or thought, or at least the courage to express that diversity of thought. There's a lot of research that shows that diversity of experience of thought improved group out decision-making outcome. That makes sense.

And, you know, that part of the tension in diversity is healthy disagreement. And, you know, you know, I think the system would be healthier if we had more divergent opinions that were more comfortable taking it through to its logical conclusion, right? You know, and so systems can function very well and tolerate public dissent. And I've grown nervous, right? You had, the Federal Reserve has been here for over 100 years. And we've only had this period of no dissenting since 05, which is also.

been as crazy a period as one could have in monetary policy and financial regulation. There's a financial regulatory corollary here. We do have some dissents among the Reserve Bank presidents. Neil Koshkari's dissented. I think Bullard's dissented. I think Lack. You've seen wrong dissents, right? I think Lacker from Richmond was calling for tightening in going into the crisis because he was soaking of inflation, right? Group think, you know, The flip side, you know, part of the, if you want to push against group, think, one of the common answers is, well, so, Aaron, do you want to have dumb ideas expressed? And my answer to that is, yeah. Yeah, actually, I agree with you.

Because you got to hear the dumb ideas to knock them down and make sure they're dumb ideas, right? So, yeah, totally agree. Hey, let me throw out mine, and I know this is probably something you disagree with Aaron, but it's leverage lending. And here's what it is that makes me, it goes back to your point about opacity. you know, the amount outstanding, you know, the central banker, not excuse me, a CEO of a major bank once told me, if it's growing like a weed, it's probably a weed. And that describes the leverage loan market, you know, since the financial crisis and before that. And just the level set for the listener, leverage lending is lending by generally banks to highly indebted businesses.

not the big guys, but generally SMEs, small, mid-sized companies. A lot of it's related to private equity firms that come in and they buy up companies and they lever them up to juice up their equity returns and make them more attractive. And about half, I'm making this up, but roughly speaking, half of those leverage loans go into CLOs, collateralized loan obligations. This is, you securitize the loan into a security and you sell the security CLO. I'm actually not at all worried about those loans. We at Moody's know those loans very, very well.

It's very transparent. We know everything about those loans. The cash flows and the covenants and everything. And the CLO structures, they seem to be quite good. They navigated through the financial crisis, no problem, under a lot of stress. What worries me is the other half that is out there in the financial system. And we're talking $7,800 billion, outstanding, that's growing very rapidly. and they are completely opaque.

We have no idea what's going on there and what they look like. And that makes me nervous because if these companies start running into a real problem, then that goes to the heart of the American economy and the financial system more broadly. And Ryan, I wonder if one reason why the high-yield market is, it feels like a higher quality market, you know, the underlying quality of the market's better because the bad stuff is going into the leverage loan market. You can either take a loan, you know, you can go to the bond market as a company and raise debt. That's the high yield market. Or you can go to a bank and borrow that's the leverage loan market. So maybe the lower quality stuff is going over into the leverage loan market.

And it's messing up the spreads in the bond market and the high yield market. What do you think about that, Aaron? There was a big, a lot of people were talking about leverage lending. There was a big story in the Washington Post by Damian Pelletta in 2019 where he said he interviewed 31 people and I think all but two expressed concerns about leverage lending being systemically risky. And I thought to myself, I wonder who the other one was. And so, you know, it's fine for me to out myself. in that situation, because I realized I was a little bit in the minority on it, I would point out that there wasn't a problem in the leverage lending market exactly when you'd see a recession that you would expect, but that's not a fair test because of the giant bailouts.

Well, and also interest rates fell. I mean, the leverage loans come under problems in a rising rate environment, a high rate environment, and they didn't get stressed. I mean, when we're focused on that in 2019, that's when the Fed pivoted, remember, because of the Trump. of trade war and the economy was weakening very rapidly. We might have had a recession without the pandemic in 2020. And so rates came back in, so it took the pressure off. So I don't know if it had a fair stress. That may well be fair.

You know, there's also lots of questions about, you know, the future of commercial real estate and other things that are tied into that market. You know, but I get, can market suffer giant losses? Yes. Can you have a bubble? Yes. Can you create a financial crisis out of that? I struggle to see it.

Yeah, yeah. I just worry, you know what I worry about? Two things in that regard. One is credit stops flowing to that very important part of the economy, and that has real economic consequences. And the second thing is that's a lot of debt, you know, $800 billion that's sitting not on bank balance sheets. That's sitting out there in the so-called shadow system.

you know, the rest of the system that's not regulated well doesn't have a lot of capital, or we have no idea how much capital they have. They're not doing stress testing as far as we can tell in a reverse way. And that's, and it's opaque. Yeah, so therefore, if a problem develops anywhere, you know, creditors to those institutions, they run for the door because for all those institutions, you know, for all those institutions because they don't know who's good, who's bad. That's what I worry about.

But anyway, a lot to worry about. Let me just finally end, because we've, actually, there's a great conversation in what longer than I anticipated. Do you think, you know, given what we know about where interest rates are headed here and, you know, what's going on in the economy and the prospects for not a recession of a very tough economy over the next 12, 18 months, do you think the financial, is your betting that the financial system will bend and not break, or do you think there's a reasonable probability that in fact will get something that breaks here.

And I'll ask both Aaron and Ryan. I'm just very curious what you think. Go ahead. I may not have sort of that. I mean, I'm happy to say, I think, you know, it's very, it's nerve-wracking to ever be out there and probably say I don't think it's going to break. I know like Ben don't break defense watching American football.

That being said, you know, I think we're in a much better situation than we were in the past. And, you know, I also think you don't want a system to collapse, but it's about time investors who made bad bets lose money. You know, I think we're developing a more and more inequitable system where the larger, the investor and the worst the bet, the more they get bailed out. And the little people, when they make a mistake, well, you're not that important. And that exacerbates income and wealth inequality in society.

I'm very concerned about, you know, what we've done bailing out money market mutual funds. and then you look at stable coins and you say, well, you can't bail them out their crypto, they're outside the world. You go, well, you know, crypto's owned by young, far more by young and by people of color than winning more than mutual funds. You're really owned by older, you know, heavily white folk. One of my favorite statistics, the Federal Reserve surveys, very wealthy people to try and find out what they have.

Do you know what share of African Americans own corporate debt, individual corporate debt according to the Fed? I'd say three percent? Yeah, less than five. Zero. Zero. They couldn't find a single one. Oh, my gosh. That is amazing.

And we're bailing out the corporate debt market. And I know there are lots of different investors, et cetera, and these things trickle through and workers are impacted by that as well. But if you look at it, I think like contingent upon holding corporate debt, the median amount was, I should look this back up again before I quote a number of $600,000 or something. I mean, the people that own this own a lot. Yeah. I think that was the mean.

There's a big mean, median distinction here. Yeah. But the concentration of it skewed by race is astounding. Yeah. In this country. And so, you know, that kind of concern to me, start surely. Makes a good point. You make a great point.

What about you, Ryan? Are we going to bend and not break? They're going to bend, bend, but not break. But that doesn't mean we don't have to have, you know, conditions are going to tighten and sufficiently enough where we most likely will have a recession. So, but we're never going to have a financial crisis. You thought I was going to trap you. Yeah, I agree.

I knew you were tracking it. Ryan's is a recession bear. But yeah, I hear you. I hear you. Okay, well, I think we covered a lot of ground and we can keep on going. But, you know, I know how to get a hold of you, Aaron. So. Well, thank you for having me on.

always fun and I really appreciate the opportunity. Yeah, I appreciate the other. We lost Chris, so unfortunately, I think he had family responsibilities, but it was wonderful to have you have you on. And I think at this point, we're going to call it a podcast. Anything you also want, are you on Twitter, Aaron? Do you have a Twitter account? I am. I'm at Aaron D. Klein. You got to put in my middle initial. Somebody beat me to the punch. There's several other and Klein's out there, one of whom didn't pay his AT&T cell phone bill and dinged my credit score for years. Well, that's the problem with having a more common name.

What about you, Ryan? What's your Twitter handle? At real time underscore e-com. And of course, I'm at Mark Zandi. I beat everyone to the punch, so I got lucky. Anyway, thank you for the great conversation, and we're going to call us a podcast. Take care, everyone.