Odd Lots - Josh Younger on the Origin Story of the Shadow Banking System

Episode Date: November 7, 2022

There are a bunch of historical analogies that people like to reach for in order to describe some of the economic trends we're seeing today. There's obviously the period of high inflation in the 1970s and early 1980s, or the disruptions caused by the Spanish Flu pandemic around 1918. But there's also a single year -- 1953 -- which not only contains some eerie similarities to today's economic environment, but also ended up having far-reaching consequences that reverberate all the way to 2022. On this episode, Josh Younger, JPMorgan's global head of asset and liability management research and strategy, tells the origin story of the decisions made in 1953 that helped create the vast repurchase or repo market. At a time when there are plenty of concerns over the stability of the market for US bonds, we go back in time to explore the reasons why repo exist at all.See omnystudio.com/listener for privacy information.

On April 4th, 2023, around 2 in the morning, a man was found stabbed multiple times on a sidewalk in downtown San Francisco. Hey, who did this to you? What happened next turned the story into a political firestorm. Reports have identified the victim as Bob Lee, the founder of Cash App. From Bloomberg Podcasts, this is Foundering, the Killing of Bob Lee, beginning April 16. Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, I feel like in our current period of high inflation, bond market volatility,

tension between central banks and fiscal stimulus, all of that, I feel like people tend to have their favorite historical analogies that they reach for to try to explain what we're experiencing now. Everyone, whatever it is always has, this is just like this. And like I get it kind of, you know, like naturally this is what we do. But I also think like, you know, there's that danger of like knowing too much history, which is if you know your history, you think it's repeating. That's right.

I mean, the one that everyone seems to reach for is the 1970s, right? Oh, this is just like the 1970s. We need a Paul Volker to come and really tamp down inflation. And then the other one that I'm kind of partial to this one, the 1918 Spanish flu. Who can forget? The period after that and World War I. ended up with high inflation and then it flipped into deflation. You know, the other one that I think about, too, is the euro area crisis.

And the tensions, you know, what they had to do sort of like plumbing-wise, what Mario Draghi had to do in terms of like sort of recreating the European sovereign bond structure on the fly to improve the transmission of monetary policy. I think some of these issues are also coming up. We really see it in the UK specifically. Yeah, that's a good one. I hadn't considered that. But today, on that note, we are going to be speaking about a historic parallel that hardly ever gets mentioned.

It is the year, one specific year, 1953. I don't know anything that happened in 1953. I would never, you could have guessed, asked me any year in the 1900s, and I would not have 20 guesses. Same here. What happened that year? All right. So it turns out 1953 was actually a seminal year for global finance for reasons that I will not get into right now. but specifically because it ended up with a policy decision that still has relevance today.

So not only was the U.S. specifically in the 1950s facing high inflation, tension between employment and prices, things like that, but we also had an outcome that has sort of like echoed across the decades ever since. I want to learn more. I'm ready. All right. Well, we really do have the perfect guess to explain 1953 and its relevance to. today to us. We are going to be speaking with Josh Younger. He is the global head of asset and

liability management research and strategy at JPMorgan. He is also a repeat all thoughts. He's now getting up there. Like this is, he's become not quite in the lead, but getting close. All right, one of our favorites. So Josh, welcome back to the show. That's great to be back in studio. Yeah, very exciting. So this is just your hobby now. It's researching financial history. I need a new hobby, basically. Yeah, it's just for fun. And there's so much you can do. do online. It's weird to say, but the internet's a wonderful thing. You can pull up basically anything. And the Federal Reserve Bank of St. Louis has been very kind to provide an enormous quantity of documents and data. So you don't have to get dusty in archives. You can just search it.

This is what I should be doing instead of just scrolling Twitter at night and playing chess online. You need to go on the New York Times way back machine and see what bond market volatility was like in the early 1950s. Well, okay, on this note, Josh, why 1953 specifically? Yeah, 1950, he has a lot of relevance in general. So that's the year where the European countries start opening up their imports to the dollar zone. It's the London debt deal with the Germans after the war around German debt. But it's also one of the years where the Fed is really forced to make a really important decision. So it's where a lot of their desire to get out of the bar market, and I'm sure we'll talk about what they did during the Second World War.

It's a very controlled market. It's very heavily managed by the Fed on an active basis. They really pegged yields in the long end and get. Getting out of that is complicated. And in 53 is when the market really tests them. So we didn't have the don't fight the Fed mantra quite yet at that point. But this is like a really interesting philosophical question right here because there's always this question today or in any period to what degree is the rate that we see on a 10 year,

on a 30 year, on a two year, a policy rate versus a market rate. Before we get to 53 specifically, can you just talk a little bit more about what you're, what you said about how rates across the curve were essentially policy rates. Yeah, when we think about a 10-year rate, like you could do one of two things. You can roll treasury bills every three months for 10 years, or you can buy a 10-year bond. So in a perfect world, those two things are connected through expectations. And then there's this question of should I involve some a little premium on top of that, right? The term premium, which is I'm locking my money up for 10 years.

I might be wrong in my expectations, and so I should probably be paid for that, at least a little excess over the expectation. And so they're connected. Most of the tenure rate is an expectation. Those expectations are often wrong, but that's a separate issue. But there is a policy lever. And on the other hand, there's the market lever, which is a term premium, their demand to actually buy the bond in the first place. So talk to us then about the state of the bond market, you know, coming out of World War II

into the 1950s, you mentioned that the Fed had imposed yield curve control, basically to finance the wartime deficit. they were trying to move off of that. Again, these are all sort of familiar themes to anyone in 2022, but why was that difficult for them? Well, so let's get a sense of scale, right? So in 1941, there's about $40 billion for the Treasury's outstanding. In 1945, there's about $240 billion where the Treasury is outstanding.

So that's about double the pre-war GDP. If you scale that to 2019, say, okay, COVID expenditures on the scale of World War II, that's about $40 trillion. in net treasury issuance. So we're talking about a lot of debt. And the question is, who's going to buy it? Yeah. Oh.

And what we're doing with is kind of nothing. We got in that context. And so that's where I guess the analogy breaks down, not to start there for the purpose of the episode. But like it's a very difficult problem, which is who's going to buy the equivalent of $40 trillion today in debt? And one of those participants is the Fed. So what the Fed says is in furtherance of the war effort, we're going to peg yields,

specifically at the front end, the one of your point. and the long end. So every 10-year bond, for example, yields two and a half percent or less because I'm willing to buy it at two and a half percent. Every treasury bill yields three-eighth of a percent. That's roughly where the curve was at the beginning of the war. It was no like particular thought given to that in terms of like fair value pricing. It was just saying wherever it is in 1941 is where it's going to stay until conditions allow. Real quickly, how much actual buying did they have to do versus the declaration of the price essentially taking care of most of it. Yeah, not that much. I mean, they bought about $20 billion,

the Fed did over the course of that period. Most of those were in bills, actually, because bills at 3.8s are not very appealing. Ten-year bonds at two and a half are a lot more appealing. So what the market did was they extended. And actually, the Fed was a net seller of long-end bots towards the end of the war because yields were dipping below their target. So it wasn't all buying, but they owned something like 70, 80 percent of the bill market by the end of the war. And they didn't really have a chance to get out so easy because when you get out of that, situation. You can't just turn it off. And so there was this outstanding question, which is how are we going to get out of the market and not completely blow up bond markets in the first instance? Like,

how do we do this in the right way? Well, so how did they try to undertake that transition? I mean, nowadays, you think about the Fed trying to wind down its balance sheet, embark on quantitative tightening. There's a lot of communication that comes ahead of that. Was it a similar thing trying to broadcast to the market, this is how we're going to do it. Please don't freak out. Yeah, it was really fraught. So Ken Garbitt has done a ton of work on this. And they really did it in fits and starts and very slowly. So no one ever really imagined they'd do cold turkey. Like that was never really considered. So what they said is, well, let's start with bills. And then the Treasury said, well, we don't want on big bills. We like bills at 3 eighths. And there was a back and forth over a couple of years. And by,

I think it was 47, essentially the committee went to the Treasury and said, we think this makes sense, we'll figure it out for you, but we're going to do this in two days. And so it was a kind of unilateral decision by the committee. There was some sweeteners for the treasury, but the Fed basically told the Treasury we're doing this whether you like it or not. And then the debate moved on to the certificates of indebtedness was roughly the one-year point. So they said, well, can that be released? And by around the early 50s, the front end of the curve out to the one-year point was free to float. So Bill Yields came up into the one-two percent range, one and a half percent range. So it was kind of a market rate. But the long end was still at two and a half. And they hadn't figured out

how to facilitate that. And that was most of the market, even though the Fed owned most of the bill markets, so that made it a little more straightforward. But at the long end, you know, that was most of the outstanding debt at the time. June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases. The latest actions from Congress and regulators and the legal moves driving the markets. From corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines.

We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast. Search for Bloomberg Law on YouTube, Apple, Spotify, or any way. where else you listen. On the East Coast, listen as you start your day. And on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grasso. Subscribe today wherever you get your podcast. So I'm just trying to understand a little bit more. How much of the challenge for the Fed of extricating itself to some extent from the bond market was about the rates

specifically and what that would do to the economy were rates to jump up versus who, whose balance sheet these assets would be on? Yeah, it was both. So the Treasury just doesn't like the idea of paying more, which is reasonable. I mean, they have a deficit to fund. And by the late 40s, early 50s, the deficit is expanding again. So they pay down their debt pretty fast. And then by the early 50s, you've got the Korean War.

You've got a tax bill that actually Truman vetoes and has passed over his objection to cut taxes. And so there's a fiscal expansion going on. So that's the Treasury's incentive. Now, a lot of their documents suggest they were also sensitive to the Fed's concern around inflation. And inflation was under control for about a year after the war because the Office of Price Administration basically fixed the price of things. They tried to renew that organization to keep price fixing in place. Truman decides it's not a strong enough bill. He vetoes it, but they can't come up with something that can pass the veto, so it just expires. So all prices are

released at the same time. So shock therapy. Why don't they just do that now? I don't get it. Well, okay, on that note, I mean, the inflation of the late 1940s, early 1950s, how much of that was sort of supply chain issues, you know, the transitioning of the U.S. economy from a wartime footing to one of peace? And then I guess they went back to war relatively quickly, given the Korea situation, versus actual debt monetization because, you know, the Fed was in the market buying back treasuries. Yeah, it was, it's hard to make an attribution. I haven't seen a good attribute. But the other thing, the Fed bought $20 billion worth of treasuries during the war of commercial banks bought $70 billion. So commercial banks are the real price fixtures in the Treasury market during the Second World War. And when a commercial bank buys a treasury bond, they create deposits on the other side of that. So they didn't let loans roll off and replace them with treasuries. They had new assets.

So the leverage in the banking system doubles in three years to 1941 and 1944. So this is new money because deposits are money. and some will talk about money's a spectrum. So deposits are very close to the real paper money side of that spectrum. And so there's a view, at least at the Treasury and the Fed, that because banks are so heavily supporting the market, they're on 60% of marketable debt, that that expansion of their balance sheets expansion of the money supply has generated a lot of inflation. So that's on the demand side.

There's too much money. We can debate monetarism, I guess, on a different episode. But there's a big expansion of the money supply. at the same time, like you go from guns to butter and back, and that's disruptive. So that's, that's where the 2020 analogies come in. You're really moving the economy from a very different production model in the year. And then you're trying to bring it back. And these things don't start up that quickly. This is all so familiar. So, okay, so the Fed doesn't want to be fixing the price of all these assets. There's also this concern about too much commercial bank leverage

and what valid or not. So who else? there. What's the next step here in terms of who enters the market? Yeah. So the non-bank investors are really domestic. So something like less than 1% of the market for treasuries at the end of the war. And into the late 50s is owned by international investors. So you have to find insurance companies and other, there's not a great deal of granularity in the old data. So it's basically like it's a bank. It's an insurance company. It's the Fed. It's international or it's somebody else. And so we don't have PIMCOs and Black Rocks in the world at the time. And corporations are very important.

Corporations are very cash rich. They have a lot of money to invest. So to find a place to put it. But ultimately, two and a half percent in a world where inflation is at 10 is not particularly appealing. So what happens in the bond market? I can imagine that, you know, the combination of two and a half percent being not that appealing, plus the Fed basically, you know, making it fairly clear that they would like to step back from the market.

I imagine that's a recipe for some drama. Yeah. What became the accord of the Fed Treasury Accord, the Treasury Fed Accord of that, I'm not sure what the order I'm supposed to put in. But that's in 1951. And that's the result of a lot of congressional pressure in the early 50s. So in 1950, the banking committee, the Senate convenes a hearing. They make recommendations.

You know, thanks for being helpful kind of thing. And the president gets involved. And there's just a lot of concern that monetary policy is worsening a very disruptive inflationary environment. And by early 51, there's just enough pressure on the Treasury to get along that they figure it out. And one of the most important characters in this debate is Bill Martin. So Bill Martin used to run New York Stock Exchange in the 30s. So he comes from a dealer background.

He comes from the street. He goes in and runs the X-M bank for Truman. And then he's brought into Treasury by Snyder, who's the secretary of the Treasury at the time, initially as an assistant secretary for international affairs, but he quickly becomes kind of a fixer. So he's kind of doing everything. And he's tasked by Snyder with liaising with the Federal Reserve to figure out a way to get out of the market.

It's amenable to both parties. Like, what's the best way to do this because we kind of have to do it now? So what did he do? So he brokered an arrangement that came out as a very vague commitment. So they basically just say, like we've reached a full accord.

They don't say what that accord is other than to say, we're going to stop monetizing the debt. So then, which is how are we actually going to do this. But they do put that up publicly. They make a public commitment to free the bond market.

And a couple days later, Martin is actually nominated to chair the Fed because McCabe Stets down. So he switches sides. And he's confirmed pretty quickly. And by early April, he's the chair of the board at the Fed. And he's very committed to this inflation fighting thing. And in his oath of office statement, he says inflation is the greatest threat, including the enemies beyond our borders or something to that effect, which, you know,

in April 1951, three days earlier, the Rosenbergs have been convicted. You don't get Joe Welsh saying, you know, have you no decency service? to McCarthy until 54. So this is the red scare. He's saying inflation is worse than communism. Wow. Or implicitly. And so like he's he's very much committed to the cause. But it, the commitment is out there. It's just the question of like, how are we going to execute this in practice? And that's where, you know, the changing of the Guard of Treasury, the Eisenhower election, like people have to get into the seat for the next administration to actually affect the change in policy because they ultimately need to agree. Snyder didn't like the idea of issuing above two and a half percent. So the Treasury kept

flooding the market with short-term debt. And that was partially for regular debt management purposes. They do some things around non-market-led to debt to get bank debt, bank holdings down. But ultimately, there's just a lot of institutional tension. At one point, Truman takes Martin's side at some event and says you're a traitor, right? It's very much in his face. So it's a very, like, fraught situation. I feel like I'm listening to a really good, like, campfire story. No, this is good. I just want to just, I don't even want to ask any questions. I just want to hear the whole story. Hopefully not a good story. What happens next? Okay, well, what happens next? I mean, on that note, you can imagine at some point the treasury goes back to selling longer term debt, right? And how does

the market take that? So that's an Eisenhower administration thing. The part of Eisenhower's election is about inflation. Actually, one of the first television commercials ever got sent to a general audience is about inflation. As Eisenhower is saying, my grandmother doesn't like the end of inflation, that's why I say it's time for a change. There's a central plank of his presidential campaign. Eisenhower answers America. You know what things cost today. High prices are just driving me crazy. Yes, my name he gets after me about the high cost of living.

And he nominates not only Humphrey who's committed to fighting inflation, but a bunch of ex-fed people. So he brings in people in from the New York Fed and other places to be senior advisors, undersecretaries. And so, you know, the news media at the time speculates the Fed is like, won this argument as to the relative benefits of low cost of debt service versus inflation. So inflation is the priority. So the changing of the administration changes the priorities. And they come in, they say, we need to find non-bank investors.

We need to find a way to sell long-term debt that doesn't inflate the size of the banking system and by extension the money supply and by extension the price pressures. And their solution is to reintroduce the bond. They hadn't issued long-term debt since 45. And they want to bring back the bond. And the question is, how do you figure out the right way to do that because the market's not used to buying? I think it was supposed to mature in 83 or something like that.

So it's like a 30-year bond. And they haven't done a third-year bond in a really long time. So who's going to buy it? How are you going to price it in a way that brings in interest from non-banks specifically? I mean, this point is interesting because when politicians talk about fighting inflation today, they're talking about various fiscal policy levers. something we need to cut spending here or we need to, you know, expand oil, oil drilling or something like that. But it sounds like in the Eisenhower administration, it was like a, they're trying to

solve it via the financial system or via plumbing in some way. Everything was basically, well, there was a fiscal lever as well, I should say. Okay. Okay. But that's always a little hard. It's fully thought to say, oh, higher taxes because inflation's higher. And that doesn't feel great for anybody. But it's a relevant to today. I'm talking. But the debt management strategy of the Treasury, when the Fed is buying debt at a fixed price, debt management is money management,

because they're in the market to buy at any price. They buy treasuries. When the Fed buys treasuries, they print new money with which to do so. And so those two things are connected, and this becomes a technocratic problem. There's actually quite a bit of public debate about debt management,

more so than you would expect, given the current climate, or at least focus on, you know, how big the 20-year sector is and things like that. But, you know, it's not like a political story all the time, but back then it would have been. But, you know, I think the key here is there's an alignment of interests. And so Snyder comes to the market and he said, sorry, Humphrey comes to the market and says, we're going to bring back the bond.

And by the way, we're pricing it cheap. So get involved. And so we're going to price it about a quarter of a point cheap to where you would have otherwise expect, given where like the victory two and a half were trading. and H-R-Tune House were issued in 45. So everybody's interested, right? So they're saying we want to blow out reception. They get five times the oversubscription.

So they get five and a half billion of orders for roughly a billion of paper. And they're feeling really good about it. The problem is, it turns out, that a lot of that five and a half billion was speculative. So people were trying to buy cheap bonds and flip them for a half a point. And so they called them free riders back then, which I haven't heard, but it's kind of a fun analogy. So, could I ask, who did they think they were going to flip them to? Unclear. Somebody else.

And so it's just a question of, you know, if you think the bond is trading fundamentally cheap, then there's probably someone else at what you think the par value should be. And so their bet was the expectations of the market were for a lower yield. They could buy it a slightly higher yield. They could flip it to someone with different expectations. And as long as you got filled, you'd be happy. As long as you got your order in sufficient size to make that interest. the Treasury also makes a mistake in filling orders on proportional basis.

So if you put in an outsized order, for example, as part of the fixed rate placement, then you got a big allocation. And the problem is if you're a spec account, that's not necessarily what you want it to happen. So a lot of good bonds get sold almost immediately. Yeah, this sounds familiar. This is like big bond funds patting their order books with corporate issues nowadays. Yeah, it was actually so concerning that they delayed allocations, which had never really been done, or at least for a long time.

So the Fed could go through the orders and make sure that they all made sense. So they were a little nervous from the start. But Devon eventually prints in, I believe it was late April. Initially, it's trading okay, but it starts to weaken pretty quickly. And in particular, the market starts to become pretty dysfunctional. And one of the fun things about the New York Times in the 50s

is they publish bid-esque spreads for every treasury issue on a daily basis. Imagine the poor reporter that has to make those phone calls. It was after the sports section. So they had their priority. straight. But it was actually the whole business section was after the sports section. Are there any papers that even have stocks anymore? Probably not. Probably not. But they had FX forward pricing. Wow. In Europe they had so three month forwards on sterling they had. They had roughly weekly basis. They had daily bond market pricing. So I mean, this was your only source, right? You had nowhere else

to go. Okay. So the bond starts trading week. Then what? So they're faced with a choice. So inflation is still pretty high. This is going to sound familiar. So you have market functioning issues, Right? So the solution to market functioning issues is to buy bonds. And there's two problems. The first is the Fed is committed to buy only bonds in the short end. That was part of the agreement when they came to the accord. They said we're only going to intervene in the market in the short end and that's specifically to provide reserves. So it's not about target prices for long-term bonds. So we're going to let the market fund the price. So I have to decide if they're going to buy long bonds because that's where the pressure is. Bit-S spreads are widening, volatility is picking up. And then they have to decide if they want to increase the size of the money supply. at a time when inflation is running hot. So you have a discrepancy in the policy goals, which is fighting inflation. You should be tightening. But to fix market functioning, you have to ease. And so they're faced with this really existential choice.

And ultimately, the world kind of bails them out in the sense that the business cycle turns mid-year right around when this is happening. So they buy a bunch of bills. They do a bunch of repo, which we'll talk about, I'm sure, shortly. but they did a bunch of financing, they offer financing to dealers. And they lower the reserve requirement on banks. They grow the size of the banking system and they buy a bunch of treasury bonds. So the second half of the year banks increase their holdings by $2 billion. Do they buy the long end though or just T-bills?

They bought the long end as well, yeah. So banks were sort of interested in not the long-end, long-end, but like intermediate type paper, you know, three to five years. And they also buy bills. And ultimately the question is, can we take the excess paper out of the market, which doesn't have a home and dealers can't warehouse? and resolve the functioning issues and kind of come at the problem again another day. Extremely B-O-E in terms of what's going on right now.

Oh, totally. Of this dual tension of like we need to maintain financial market stability, but also we're in an anti-inflation stance. And so any perception of balance sheet expansion is seen as working cross purposes. Totally. And also, I mean, just the idea of we need to expand the buyer base for U.S. bonds as well, that's kind of familiar. There's been a lot of chat recently about who is going to buy bonds, given interest rate volatility and a backdrop of higher inflation and all of that. Okay, back to the

story. So the market tests the accord. The Fed kind of backs down. And then what does it do? Does it try to go back to the period of the accord or does it try out some new solutions to this problem? Yeah, so they have two problems. One is just going to buy the bonds. And the other is the dealers are clearly not capable of intermediating a market that large, right? So they clearly are not able to warehouse securities and enough size to really damp and volatility, which is what dealers is supposed to do, right? They're supposed to find a buyer and a seller, and if they can't find each other the same day, they hold that thing in their inventory. A big problem the dealer's head was financing. So for most of the prior 70 years, dealers have been funded most of what we're called call loans.

Call loans are kind of this intuitive concept, which is if I'm a dealer, I need a certain amount of money borrowed every day. I'll post collateral against it, but I'll probably borrow it from a bank, and I'll just change the balance on a daily basis, and I'll pledge whatever bonds I have as collateral to back that loan. So that was the call loan market. The problem with the call loan market is it was kind of expensive. And when bill yields and treasury yields were below the call market rates, it meant the inventory was negative carry. Negative carry means it costs you money to hold inventory. You don't make interest income, at least, to hold inventory. So it becomes very expensive to run a dealer. when you have interest rate and expense on top of the salaries and infrastructure and things like that.

And so this has been a problem in the 40s as well. And that's when they brought back the repurchase facility. The repurchase facility dates back to 1917 when they used it to support the First World War effort. And they were concerned that there wasn't a market for treasuries back then. And so they used repurchase agreements, which are the buying and selling of a bond at different prices that kind of mimics alone. two transactions. And so that allowed the Fed to do two things. One is it allowed them to lend money to non-banks, which is critical. And the second thing is it allowed them to do that below the discount rate in principle. So they could do it at a rate that was consistent with where bills

were trading if they were below the policy rate. So this is kind of a legal workaround, right? Because I imagine the Fed isn't really supposed to be lending money directly to non-banks. I mean, the whole reason that banks have regulations and things like that is so that they can interact directly with the Fed and they have that sort of safety backstop. Is that right? Yeah. Now, Carter Glass of Glass Eagle was instrumental in the original Federal Reserve Act and he said, this is not intended for non-banks, but in the Depression, they find out that like sometimes you need to. And so 133, which becomes, Section 133, which becomes very famous in 2008, that's the authorization that allows them to do all kinds of interventions. It specifically allows for the lending or extensions of

credit to non-banks. So in 2008, that includes, you know, primary dealers. That includes a variety of real economy participants. In 2020, they do the same thing. So like the main street lending facilities and principal 133 facility. The problem with 133 is it's only allowable under exigent circumstances. So this is not a business as usual facility. This is if it really comes to it, you can do pretty much whatever you want, but you need to be at least A of the opinion that the world's about to collapse. And B, you have to be able to demonstrate that credit was not otherwise available. So it's clearly not the case for dealers in the 50s. The workaround is, well, this is a repo. It's a purchase and a sale. This is an open market

operation. This isn't Section 133 at all. This is Section 14, which allows me to transact with primary dealers. And so, yes, this has the economic features of a loan, but it is fundamentally a purchase and sale. They had to do a little bit of jimmying with it in the 20s to make it consistent with legal opinions. Like, I think it's puttable as opposed to like specific maturities. And They try to work around some legal interpretations, but fundamentally, it's just a way to lend money to non-dealers in a format that gives the committee a lot more flexibility. Just a brief, like, sort of theoretical question. Is there ever really a limit to what the Fed can do beyond the creativity of lawyers? Well, that's anything, basically.

But that's what I mean. Yeah. And, you know, we look at these documents. It's for real. You know, we look at these documents and there are debates about what they did in March 2020. Right. It's like, don't lend to banks, but actually. But in the end, or sorry, don't lend to non-banks, but you totally can.

The constraint is creativity. Yeah, creativity in Congress. So Congress can give you very specific constraints. And the courts can, in principle, stop you. I think it's tough with the Fed because the question is, what's the cause of action? Like, who's going to sue them and say, you shouldn't have lent this deal or money? So I'm not sure how much this has been tested in court. This is where my lack of a law degree is probably worth noting.

But ultimately, the interpretation of these rules is ultimately an interpretation. Fed has a general counsel. They write opinions, and there's an internal process. but they can do whatever they think to be ultimately legal. So the Fed's repo facility is created in 1917, but then in the 1950s, as you just described, it presumably gets a big boost because they've settled on it as a way to solve this problem of how do we sort of settle the debt market without sparking debt monetization and another bout of inflation.

So what's interesting here is the Fed doesn't do a ton of repo, but what they do is they demonstrate their willingness to use it. They have a big internal debate. They write a bunch of memos and they say, this is something we're committed to doing at the bill rate or higher. So basically, they're saying, we are here for the market to provide repo to primary dealers at this specific administered rate. It's not an auction. We're just going to say what it is. It's not an auction.

We're just going to tell you where we'll lend to you. And so that's important as a backstop. So it's not so much that the Fed is financing dealers. It's they're providing a liquidity backstop at a specified rate that gives other market participants willingness, a willingness to participate. in the repo market. So most funding in repo by the end of the 50s comes from corporations. And those corporations had bank deposits. Bank deposits were limited by reg Q as a depression-year regulation saying, we don't want banks competing with each other for funding. That leads to bad outcomes. And so they don't like their bank deposit yields. They go to the repo market. They get

wholesale funding rates. They get much more attractive yields. And so the Fed gives the market confidence that they can participate in this, in this sort of money-like or deposit substitute. Actually, the New York clearinghouse is really worried about this in the late 50s. a consortium of banks say, you're cannibalizing our funding. Like, we don't want people doing repo. We want people keeping deposits with us. Hi, I'm PJ Vote. My podcast Search Engine has a new two-part series for you.

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where unions and politicians are working to keep those cars off the streets. Listen to search engine wherever you get your podcasts. So, sorry, can you just walk through or make a little more clear? So this is sort of what replaced the call loan market. What is the gap in terms of like a financing cost between these two things? And what did that open up in terms of, you know, how much balance sheet or how much capacity the dealer community had? Yeah, it wasn't always a lot, but it was predictable.

And the Fed could control it. And the call-in market was prone to, they called them call-loan panic. So like you'd call your New York bank and they wouldn't have money on hand. And so you'd call someone in Midwest or some like non-New York other city bank or, you know, I don't think the rural banks were participating in this. But it was just hokey in a lot of ways and somewhat unpredictable. And they ultimately ended up going to Fed funds markets often to plug intraday liquidity gaps. And repo was better than that for that purpose.

But the price could just be maintained by the Fed funds. specifically. That was key. So if the Fed can control the price, then they can make sure it's profitable to run a dealer, and they can expand their balance sheets. So we don't have, there's some data on dealer balance sheets. I think turnover is a better measure. So turnover is a fracture of the overall market, which you want to scale it to the whole market. Between 1950, I guess 55 might be the earliest day we have to the late 60s, goes up by multiples. So the dealers are able to move the debt around much more easily. That's important because they're just. a distribution mechanism. If you want non-banks buying treasuries, you have to find them.

And dealers are the mechanism by which to get them the paper. And so that's when non-bank ownership starts going up a lot. Banks go from half the market to 40% to 30% by 2005, 2006, to like 3% or 4% of the market. So this is a very successful policy. Dealers are able to do a lot more volume, a lot more turnover, bidet spreads, stay relatively tight until relatively recently. And by the 2008 financial crisis, like U.S. banks are not a huge fraction or even a dominant fraction of the treasury market. They have a lot of non-bank participation. So this is the amazing thing because I think nowadays we're accustomed to thinking about the repo market

as like a source of potential instability and a big component of the shadow banking system. So you think back to 2008, the repo market was kind of ground zero for a lot of the problems that occurred in mortgage-backed securities. And then in the decade since 2008, all we've heard from the Fed and the Financial Stability Board is, oh, we need to get a handle on shadow banks, we need to reform the repo market, we need to make everything better. But as you're describing it, this was a direct policy decision made in the 1950s to solve a specific problem.

Yeah, it becomes something that's really entrenched. So the repo market is sort of the solution to their problem in lots of ways. But by the time the solution becomes very effective, now they're committed to the repo market. So, you know, a great example of that is in 82 when a bankruptcy court finds that the collateral associated with repo is subject to an automatic stay. What does that mean? It means if a dealer goes bankrupt, this court will seize their collateral and hold it until the bankruptcy is resolved. And that doesn't take a day or two. That takes a long time. And people have just sort of assumed that that wasn't the case because they're like, oh, this is a purchase and a sale.

Like, why would this be subject to a stay? I just have like a bond that I sold you and you're going to sell it back to me. We'll just do that. And the Fed. panics, basically, in 82, they lobby Congress aggressively to get specific protections for repo and other similar instruments basically legislated. So there's a bill in 84 that's meant to reform the judicial nomination process that actually has within it a protection for repo that exempts it from the automatic stay. So it gives a preferential treatment for repo specifically in bankruptcy. And that is necessary. Volker argues directly to Bob Dole at the time, like to stabilize the whole financial market, you need to do this.

So it's just an example of where you sort of find a good solution. Now it's entrenched and the more it presents issues, the more you have to like step in to provide other protections or specifically that market. So it is a shadow banking system in the sense that is treated like a money alternative, like a deposit alternative. And it's sort of wrapped with successive layers of protection. First, there's the Fed liquidity backstop, then there's bankruptcy protection. banks, for example, have different treatment under bankruptcy.

Now, repo has different treatment under bankruptcy. And by the time you get to 2008, and especially in 2020, the Fed is doing both sides of the repo market. So the Fed's doing the standing repo facility and the reverse repo facility. And so now it's very much a policy lever in lots of ways. Whether or not that's desirable is a separate question. But ultimately, repo becomes the plumbing because it's so effective in facilitating the initial policy goals of the Martin Fed. So this is really interesting. And I guess just to sort of piggyback on Tracy's last question, I mean, we do seem to have these recurring bouts of instability today in this part of the market. The market that exists solved a certain problem at the time. What is the tradeoff that we're still living with today? Because it seems like the sort of like old regime, while maybe it had issues with sort of like inflation, et cetera, the sort of the less market-based regime. so to speak, at least it was more stable.

Yeah, I think that there's different phases of cognitive dissonance here. So if you can pull dealers in and say you're the critical intermediation mechanism for the treasury market, and not only you critical to intermediating it, but getting things out of banks and into non-banks is like critical to financial stability and more important than the enemies beyond our shores, right? And that's what they're saying. So to fight the Soviets, we need repo basically. Again, relevant to today. Yeah.

So the problem with that is you need a regulatory system that recognizes the relative importance you're placing on dealers. And that took a long time. So dealers are regulated by the SEC. It's an investor protection mandate. So basically if and when a dealer goes bankrupt, we want to have funds on hand to resolve all outstanding trades. Banks are a safety and soundness mandate, which is like you can't go bankrupt.

So let's make sure you don't because you're critical to the functioning of the economy. And so those two things don't entirely mesh. And by 2006, 2007, there's a series of changes to how dealers are regulated. And all of a sudden, they have a ton of leverage. 40 times leverage is one that everyone always quotes. But like turnover in the treasury market skyrockets because not only is it not as only our dealers are allowed to take more leverage, but also treasury specifically in treasury repo, I don't really count towards risk-based capital requirements. And so there's just a lot of capacity to intermediate treasury. on trading and repo trading.

In 2008, everything gets stuck back into the banking system. So all these independent dealers, with the exception of the smaller ones, but you're either out of business or you're part of a bank holding company. So Lehman goes out of business, bears absorbed by JP Morgan, Merrill goes to Bank of America,

and all of a sudden they're all subject to that bank safety and soundness requirement, or at least within the context of the holding company as a whole. And so the market gets consolidated behind, the bank regulatory perimeter becomes like formally associated with banks. That's fine as long as treasuries don't consume a lot of, you know, what we often call in the industry like resources, meaning capital and liquidity.

Treasury is a risk-free. Treasury repo is risk-free or at least nearly risk-free. And so depending on how it's haircuted and so forth. And so like if it doesn't add to your risk-weighted assets, which was the binding constraint on banks for a long time, you've got a lot of elasticity. You can grow and shrink in treasury balance you very straightforwardly. leverage constraints come later, and they are inconsistent with that, or at least under some

circumstances. Well, this is exactly what I wanted to ask about. So today, there is this big question mark over the Treasury market about who is going to buy and also intermediate the bonds. So we have a lot of interest rate volatility. Dealer inventories are lower than they happen historically. Like, what exactly is going on there? Like, the repo market exists. It experiences spasms from time to time, but the Fed comes in and for the most part seems to fix them or at least set up new programs aimed at fixing them. Why is this still happening? Why do we have that concern? So it's a little different every time, which is unfortunate, but ultimately... It's why we keep having episodes. Yeah, yeah. But you're seeing banks to buy more treasuries now,

right? So like there's a certain amount of increased monetization of the debt through the commercial banking system, not necessarily through the Federal Reserve. And so that's helping, where it was helping for a while. It's not so much helping anymore. But I think the issue is repo is a form of money substitute that has the implicit backing of the Fed, but it is not really wrapped in the same kind of cloak as deposits. And so deposit funding is stable and sticky funding at low cost. Repo funding is fine until there's an issue and then it's sort of more prone to instability than more traditional forms of bank funding. And as you go further out the spectrum, We're talking about Treasury repo.

Then you can talk about mortgage repo. In 2007, we could have talked about non-agency mortgage repo. And then there's a question of the collateral credit quality as well as access to liquidity. And so like repo is just not money in the sense that deposits are. And so if banks are being called upon to intermediate treasuries as a core banking activity in effect, they're still funding it with a form of funding that's reserved for dealers and that's the investor protection world. So there's a little bit of cognitive dissonance there. But what the Fed is doing is they're backstopping both sides of the market.

So repo is receiving those kind of controls. And there are other central banks where repo is the primary policy rate. So this is not particularly unusual. Whether or not it's desirable is a separate question. And whether or not those facilities are effective is another one. You were talking about dealer inventories now. I think I was on to talk about this pretty recently. I remain relatively sanguine, I guess.

And prices are moving around. the world is moving around. Like the world is as volatile as the treasury market is volatile. And so like, that's not necessarily, I wouldn't say it's a good or bad thing, but it's certainly not unexpected. Dealer inventory is being low, off the run trading not being particularly high as a fraction of total. Like you don't see a lot of the monetization of treasuries in the form of sales to source cash in the way that you saw in 2020. So could that happen? Sure. If dealer inventories were going to rise rapidly and we had the same kind of dash for cash dynamic. Like I think we'd run into similar problems. Ultimately, those issues have not been fixed, at least on a fundamental basis. But, you know,

the market is functioning, even if it is illiquid. I might have said precisely that a few months ago, but I still believe it's the case. We've come full circle then. And I got to say the idea that the treasury market is as volatile as the world itself. That's a good quote. It's a good line. Yeah. All right. Well, Josh, that was amazing. I learned so much. Yeah, I can't believe this is what you do, you know, for fun in your evenings, but absolutely fantastic, super educational. And I think you're one of the few people who can draw a direct line between, you know, something that happened in 1953 and a lot of what we're experiencing today. Yeah. Yeah. And I should, I should thank Lev menand as well. He's been really helpful with this. And he does this for a living. So, you know, I'm not. We got to get live on some point. I've watched some of his like lectures. on YouTube and stuff. Really interesting. Yeah, you want to understand the banking system. And where it comes from and why we have certain rules the way they are.

Okay, good. We'll make that happen. All right. Thanks so much, Josh. Thank you very much. So, Joe, that was fantastic. I mean, I actually feel like I kind of sat down and listened to like a narrative story. I love that.

You know what, this although it confirms this like long view that I've had about all these questions about how many of the solutions to problems are about recreating the exact same thing under a new language or when it's like it's still the same thing. And so like it always like sort of drives me crazy where it's like, okay, well, we want the Fed to backstop it. We don't want it to increase the money supply measured this way. So it's on someone else's bounty. But it's still like economically the same thing. Like all these conversations like they kind of drive me crazy just because it's like, I don't know, just have to fed by it all. It solves the problem. Okay. That's a little extreme. But you get, you know what I agree with you on the branding. Like never

underestimate the power of branding and giving something a different name, right? So this is now a money-like deposit, except it's not really a deposit. But that's the point. So many different things in the end when you work it back are still just some sort of like either fed back, implicitly or explicitly, like fed-determined instrument. It's just like how many layers of pretend do we want to have so that it looks like it's just some like thing out in the market. Okay, so we've discovered that Joe doesn't want free markets anymore. There's no such thing. There's no such thing. It's all creating the illusion that there's like these like real markets when in the end it's like, I don't know. That's my, that's always my take. That's true. I mean, the central bank at a very basic level is setting interest

rates, right? So like, okay. All right, well, on that very high level of philosophical note, shall we leave it there? Let's leave it there. This has been another episode of the Oddlots podcast. I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. Follow our producer, Carmen Rodriguez, at Carmen Armin. all the podcasts at Bloomberg under the handle at podcasts. And for more Oddlots content, go to Bloomberg.com slash oddlots. Tracy and I blog there. We also have a newsletter, a weekly newsletter where we talk about some of our guests and episodes

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