Odd Lots - Zoltan Pozsar and Perry Mehrling On The Historic Crisis Of Financial Market Plumbing

Episode Date: March 30, 2020

The plumbing of the financial system is coming under strain like never before. On this week’s podcast, we speak with two legendary experts on how the money system works: Zoltan Pozsar of Credit Suisse and Perry Mehrling of the Frederick S. Pardee School of Global Studies. They explain the extreme level of stress we’re seeing, what the Fed has done to alleviate, what more needs to be done, and what the post-crisis future may look like.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But on Vanguard, at Vanguard, institutional quality isn't a tagline. It's a big line. It's a very big. It's a few. commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio.

That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hello and welcome to another episode of the All Thoughts podcast. I'm Tracy Allaway. And I'm Joe Wisenthall. Joe, I was going to start with a really long intro for this one, but I think we can actually make it really short. What is it? I'm all for that. I'm all for, we're past the era of throat clearing and intros. There's no time for that anymore. Yeah, exactly. Okay. So anyone who's been listening to AllBots knows there's been volatility in the market. There's been a lot of drama in the repo market, specifically, a lot of things going on with money market funds as well. Who do we turn to in times of repo market madness?

I can only think of one person when the phrase repo market madness comes to mind. Yeah. And you would be absolutely right if you said Zoltan Pozar, the strategist over at Credit Suisse, he is with us once again. But to make a... this episode even better, we also have Perry Merling, who we've had on AllBots before as well. He's a professor of international political economy at the Party School of Global Studies at Boston University. And he's worked with Zoltan. They've co-authored some papers a long time ago. And in fact, Zoltan referenced one of Perry's famous quotes in one of our original episodes with him. So basically, we have two heavy hitters who are going to walk us through.

what just happened in money markets? Well, I think furthermore, I mean, obviously you mentioned Repo and Zoltan's work on this, but I think part of what is so extraordinary about this moment is just the degree to which the entire monetary system is coming under strain. And of course, pasta, we had Perion not long ago talking about this idea of the money view and how everything, all of our interactions are this sequence and series of meeting financials, obligations that we've put a that we've set forth credits, debits, deficits, and so forth, everyone, every aspect of it feeling the strain right now. So I think this is the perfect set of guests to help us understand this storm that we're

right in the middle of. Yeah, a lack of liquidity kills you quick, as Perry would say, and we're seeing a lot of that now. So without further ado, we're going to jump right into it. Zoltan and Perry, welcome to the show. Again, thank you so much for coming on. Nice to be here. Nice to be here.

All right. Maybe just to begin, Zoltan, one of the things that you always do in your research is, I know you call up a lot of the market participants and try to get lots of color on what's been going on. Can you walk us through what you've actually heard over the past couple of weeks? Well, you know, the past couple of weeks has been eventful, say to me. But, you know, when all this fallouts from the outbreak started to happen, you know, when you talk to bank treasurers in various parts of the world, I mean, initially you would call up, you know, the Japanese treasurers had treasurers in Hong Kong and, you know, ask them what they would see.

You would get conflicting color from them, right? Because depending on your business model, you were either swimming in dollars or you were we're losing dollars. So if you talk to Japanese banks who are very big in trade finance, shipping finance, and commodities finance, you know, they would say, well, we actually see a big drop-off in demand. When you talk to banks in Hong Kong or mainland China, that's a clear dollar payment for corporations, they would say that, well, we see a lot of corporate customers,

bleed a lot of cash. And so the money is slipping away from them. And because it's slipping away from them, it's slipping away from us. So, you know, dollars are a bit tight. And so it was very hard to kind of come up with a unified theme about whether this is going to be a net positive or a net negative for funding. So it was a bit confusing. And then I think it was the second week of January, you know, James Sweeney, the chief economist,

that credit cecils are third musketeer, musketeer meaning, you know, Perry, Zoltan, and James, you know, he tumbles into my office, and it just says, well, you know, this IP shock that we are going through and your stuff, I mean, this is where the two things meet because, and I think this meme from him

is going to go down in, you know, as one of those heavy-hitting memes. And he said, the supply chain is a payment chain in reverse. So that set up a certain set of sparks in my head thinking, okay, so that's useful to kind of frame everything that I hear from, from all these bank treasurers and these conflicting colors, because certainly, I mean, you know, if you're not producing, you don't need to finance the flow of goods commerce.

So that's why some people have dollar surpluses. But then if you're not producing, you know, some people are not getting payments. And so that's the payment deficit of other players. And then if you think about it, you know, that kind of makes sense because in a shock like this, you know, and this became obvious at a call in early February with Hong Kong clients who were, you know, joking that, well, we just got our credit card statement. It's a big fat zero because there's nothing to spend money on. So, you know, it's natural that when something like this happens, you have. a bunch of deficit agents, as Perry would call them. You know, these are the guys that, you know, lose dollars,

and then you have a bunch of surplus agents, you know, entities and households that can't spend because there's nothing to spend on. You can't really do much in your apartment. And, you know, the banking system's role is to basically clear these imbalances between surplus and deficit agents. The problem now is that these deficits are becoming so deep and their duration is becoming so uncertain that no bank in its right mind is going to be willing to kind of land into this, you know, growing black hole, so to speak. You know, and then the stresses came from

that in interbank markets and then the Fed fed fed then, but we can get to that later on in the conversation. But basically, that's how I would frame it. And that's how, that's how these colors are fitting together that you get from bank treasurers. Perry, Perry, how would you sort of, in your big, big picture framework, describe what you see is going on? Well, Zoltan has given a good lead-in about the last several months. And we had some conversations about this before. What I particularly would draw attention to is what's happened in the last two weeks, which is clearly some market breakdown. and specifically this dash for cash that has been going on,

that there is an attempt to liquidate the treasury bonds and turn them into spendable cash, and the dealers weren't taking the other side of that. And so there was some dislocation there. And also corporations that have credit lines are drawing them down in order to have that cash on hand. So this dash for cash, it's a dash for dollar cash. That's another thing to say, that this is a global dash for cash.

And so you see that in terms of the foreign exchange movements as well. And the intervention of the Fed a week ago Sunday, okay, was a response to all of that. The kind of breakdown of the private dealer system meant the Fed stepped in basically as dealer of last resort and put a floor on the core. of the dollar funding system. Yeah, and what I would add to that is, you know, the dollar is always the orphan child of these funding market crisis, right? Because, you know, the countries where these stresses flare up,

and there have been a bunch of countries where you had dollar funding stresses over the past couple of weeks, you know, they don't have any control over it. And the Fed, historically, has been very slow and very reluctant. kind of step in to do the right thing. I think what makes this episode very special is that, you know, the set has been extremely impressive in how much they have done in how little time. And, you know, I'm not just talking about, you know, activating the swap lines that already existed and pulling out a lot of the, you know,

08 crisis measures, but also, you know, expanding the swap lines to 10, countries. That was a very big step. And, you know, launching some new, new facilities that were not launched back in 2008. So, you know, the Fed has done a heroic job in back-stopping this entire system. Yeah, it's kind of crazy to think that all those measures have been unveiled in just the past couple of weeks. And if we compare it back to the 2008 financial crisis, that was, I mean, it seems achingly slow compared to what we just witnessed, actually. Just to back up for a second, both of you have mentioned the dash for cash and specifically the dash for dollars. Can you talk to us why dollar funding is so important here? Why don't we worry about local currency funding?

Well, maybe I'll start there. So local currency funding we don't worry about because, again, every country has a central bank and every central bank can print local currency, no problem. You know, local currency is used locally. What makes the dollar special is that everybody uses it, but the one central bank that can print it is only the Fed, right? So, you know, it's true that a bunch of countries have FX reserves, but, you know, when we think about FX reserves, people often overlook the fact that FX reserves are basically investment portfolios that are not sitting in cash.

And, you know, when you need to tap into those FX reserves, you either are taking your money back from the FX swap market. So instead of lending dollars there, you kind of pull it back and you give it to your local banks. Or if it's treasuries and mortgages, you just liquidate them. And then you liquidate them, you're basically leaning on the dealer community here in New York, who then put it in the repo market. and that's where the stresses would show up. But the Fed and the swap lines are helpful in that regard in that,

they can put dollars into the system without there being any kind of step where you would liquidate assets. And the fact of someone raising liquidity, stressing out money market rates, would just kind of not be a part of that picture. But that's why the dollar is so special in that regard. Yes, so maybe a little pedantic point there. Basically, what is happening is the Fed is expanding its balance sheet on both sides. So the desire that people have for cash, okay, can be met by creating more cash.

Okay, that's what's happening on the balance sheet of the Fed, basically because the banks themselves, the farther down the hierarchy, have been tapped out by these clients who are tapping their credit lines and so forth. And the risk of making markets in these instruments has made the private dealer community not so keen on absorbing the treasuries and workbacked securities that are being liquidated. And so the Fed is doing it. And so the Fed is doing it instead. So that combination of a kind of perfect storm where there's a dash for cash and the dealer community is feeling itself constrained in meeting those demands has meant that it has it has fallen upon the Fed and I would

absolutely agree it has moved incredibly quickly and Tracy you said the last couple of weeks let us just remember it was a week ago Sunday okay it was a week ago Sunday it feels so much longer I'm sorry I was just going to say one thing we forgot to do that we've been doing lately is reminding listeners, the date and time that we are recording all of these episodes because it's important to have the context because things are moving so fast. So just a reminder, we were recording this March 25th, and we started at 8 a.m. Eastern time. We're at the point where we're specifying the hour because, again, of how fast things change. So Perry, continue with what you're, continue with your thought. So we've just really talked about this liquidity problem. And

And we've talked about the way the Fed has stepped in to basically enable people to switch out of their best assets, treasuries and so forth, okay, into cash. Okay. But it's a much larger market than that. And the deeper problem, okay, that the dealer community is facing, or I would say, I'm imagining. I'm going to ask Zoltan about this is that basically this whole. shock to the global supply chain is causing a repricing of assets all over the world. And that repricing is itself a big challenge. Nobody knows what value is. And the disruption of the dealer

community means that price discovery, okay, is impaired, that prices are moving because of liquidity problems, that people are mistaking for value, for valuation problems. And it's hard to sort those things, sort those things out? Yes. Yes, it's hard to sort them out. I mean, certainly you have, you know, you have, you have an industrial production shock. You have a service sector shock. You know, what makes this episode so special is that usually services is very accyclical and stable. You know, there's a bunch of IP cycles all the time. But, you know, the two never coincide. And, you know, we've never had anything as deep as what we are going through. Now, you know, certainly that is hitting the valuation of credit because, you know,

this time around it's not mortgages that are the problem. It's not treasuries that are the problem, but it's credits because it's the corporate sector that is basically bearing the brunt of this fallout. And so, you know, that makes it very difficult to value things. Then when you come to the actual market making and price-setting mechanism that the dealers usually provide. They can truly do that function either because, you know, it's not only the case that everybody is trying to kind of protect itself and making sure that you are there for your

corporate customer, who you have promised to corporate credit license. So you have contractual obligations to kind of need that. But also, you know, keep in mind, things have been moving very fast. You know, the government is now asking the banks to show forbearance, the small businesses, households, everybody in your home country. And in English, that means basically that, you know, the banks are not going to be getting interest payments. They are not going to be getting principal payments.

Because you are extending the time at which you will get those inflows, you are basically increasing your loan book. So all this forbearance and all the corporate credit lines getting drawn down is basically inflating banks and dealers balance sheets. it's adding a ton of risk-graded assets. And, you know, balance sheet is like an A4 sheet of paper that, you know, you start to scribble on when you go to the green market, I'm going to buy this and I'm going to buy that. And when you run out of space, you know, you can't write anymore. So balance sheet is finite.

And because the balance sheet is finite and you're being asked to do the right thing locally for people and businesses on the ground, there's a lot less balance sheet for, you know, less balance sheet for making markets in real. people, less markets, less balance sheet in making market in the FX swap market, less balance you to take on, you know, credit assets on your inventory to kind of smooth the pricing mechanism. So, you know, this market making stuff is becoming luxury, as I said in a recent note. And, you know, that's why it was so important and so good that the Fed stepped in as, I mean, I would even say they are like dealer of first resort because, you know, no. when it's going to have the ability to make markets on scale.

So they stepped in and they are taking on some of this market making and price-setting process. And what Perry would say is that the Fed is not making the outside spread. But that's basically what this is about. That private market-making mechanism is, I wouldn't say, broken. It's just probably taking a little bit of a backseat because you have to provide so much on the ground. Yes, I would say that it is making the outside spread. That's right. Okay.

But it's important to note that it's making, it's making this spread. It's making these markets in very specific core area of the market, okay? Not the not the whole thing. And that will keep the wheels from falling off the entire wagon, right? But there is still going to be a lot of disruption. And that's because value discovery is not so hard in treasuries, okay? because we know that the U.S. government is going to survive this crisis, even if it has to borrow another $2 trillion or whatever.

This is war finance. It's war. The U.S. will still be around. Whatever industries recover will pay taxes to the federal government, and that means that treasuries are good assets. We're not, however, sure that all these industries are going to survive, or that they will emerge from this crisis in the same form as they went into it. Okay.

The natural feeling is to imagine that somehow will just restart the economy like it was before. That seems to me improbable. And so the price discovery mechanism is also about the reallocation of capital. This is a very big real side shift. And it's important to use the apparatus of government to facilitate. facilitate that real side shift. That's not about the Fed. Okay. That's, the Fed is just providing liquidity in core markets. Okay. That's, that's a bigger problem. And the fiscal side of this is, is where that's going to be dealt with, I would imagine. Today's show is brought to you by Vanguard. To all the financial advisors listening, let's talk bonds for a minute. Capturing value and fixed income is not easy. Bond markets are massive, murky, and let's be real. Lots of firms throw a couple flashy funds your way and call it a day. But not Vanguard. At Vanguard, institutional quality isn't a tagline. It's a commitment to your clients. We're talking top-grade products across the board of over 80 bond funds, actively managed

by a 200-person global squad of sector specialists, analysts, and traders. These folks live and breathe fixed income. So if you're looking to give your clients consistent results year in and year out, go see the record for yourself at vanguard.com slash audio. That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Perry, I want to just act. Both of you start with Perry on this point a little bit further because I think it's key. We've seen, as you mentioned, okay, the Fed can easily make a market in treasuries. We've seen an expansion of the Fed's role in other sort of private credits, money markets,

high quality investment grade company credit and so far. of how far can the Fed go in this realm before it becomes clearly outside of anything that the Fed is equipped to do in terms of backstopping and keeping the flow of credit going to industries that, as you point out, you know, may not exist post-crisis? Well, it's important to the details of these facilities are still coming clear, but so far as I can see, they're following the playbook of 2008. which is, it's very important to appreciate that the Fed is basically not taking credit risk, okay, that it is the Treasury or some other body, okay, that is going to be taking credit risk. The Fed can expand its balance sheet. There is essentially no limit. I mean, you could put the entire financial system on the Fed's balance sheet. And that's sort of what we do in wartime. But I don't think we're, we want to do that because getting it back off the balance sheet is

not so easy. And so that's what we're trying to do is to be selective and think about what comes after. Yeah, I mean, maybe I can share a little anecdote that it's just, it's just remarkable how, you know, the reflexes of the market don't really change because a lot of, a lot of investors, you know, that they are buying, you know, that are buying credit from the world over. hedged basis. You know, credit is cheap now because the Fed cut rates zero hedging costs are way cheaper. So this is a great opportunity to kind of load up. And, you know, old habits die hard, but I would agree 100% that there will be some long-term implications from, you know, what debt is

viable and what is not. And, you know, when you look at corporate credit. defaults over time, you know, what you notice is that you always have sectors that were hit by something unexpected and that was their undoing. So like Kodak in Rochester, New York, and the cigarette companies and all this stuff, right? So you always have these things. And I think COVID-19 is another one of those where if you have some long-lasting changes to the ways people live. I mean, maybe no one's going to go to, you know, not to pick on certain sectors, but, you know, you can, you can let your imagination run free. So, you know, and, you know, there's going to be a lot of sectors within the IG universe, the investment grade universe,

that are going to be subject to these changes and maybe some of that that is not going to be viable. The Fed is following this dictum of, you know, lands freely against what's normally is good collateral. Right. And so, you know, in the current circumstances now, that includes credit. But again, what we have so far is a one-page term sheet. You know, it's unclear who can issue into it. It's unclear at what price they will take, you know, the primary issue, and it's unclear what price they will buy.

The secondary paper, it's helping the liquidity and kind of make sure that people are not having cash flow problems, assuming in a way that, you know, this stuff is going to go away in six months. And if it doesn't, I think that, a completely different conversation and a much more complicated situation. So since we're talking about credit risk and timelines here, I wanted to ask about banking regulations in the current scenario because even though we've seen this massive volatility, we haven't really seen the banks necessarily strained or at least not strained in the way

they were back in 2008. Lots of people are talking about how this is vindication for the regulators. For instance, all the banks have to hold high quality liquid asset portfolios now that cover, I think it's a month's worth of outflows or something like that. So how have those measures helped in the current crisis? And also, how have they sort of played a role in what we've seen over the past few weeks as well? Oh, they have helped a lot. So, you know, I get that question a lot, you know, should the regs be ease? And I would say absolutely.

not, you know, that would be a mistake. You know, just for context, in 2008, you know, the way the, you know, the game used to work is, you know, someone would call the Fed on Friday saying, well, we don't have money, we can't open up on Monday. And then everybody had to go in, you know, on the weekend to kind of figure stuff out for the Monday open. And so, you know, in my mind, you know, the whole purpose of Basel 3 is to kind of elongate that response time to 30 days.

You know, so the reason why we managed to get this far without the banking crisis is because the banking system has been fortified by liquidity buffers, by capital buffers, by limits on balance sheet, limits on, you know, what banks can carry on their books, all these things. And so that is a very important part of the picture. and that's why we don't have a viral outbreak with a banking crisis. You know, if we had this outbreak in 08, we would have had a banking crisis because of this, because of this outbreak.

So, you know, that's a good thing. You know, when you go into the finer detail, you know, you will realize that some jurisdictions already required their banks to match outflows in one currency with addicted assets in the same currency and some jurisdictions have not. So that's why, you know, when these dollars started to sleep away in certain parts of the world, you know, the liquidity problems showed up very quickly because, you know, you had your HQA, your liquid asset in local currency, but your outflows were happening in dollars. So you have to go into the FX stock market to kind of reach the difference. But but so, you know, the regulations were a good thing in the current context. In terms of this luxury thing that we talked about, right, that banks have finite amount of balance.

sheet, you know, because you're being asked to provide more for the real economy, you don't have as much balance of market making. Should be ease the recs for that? No, because, again, you know, the first and foremost goal of the regulator and the set in this country and other central banks, too, in this environment is to make sure that, you know, people don't take money out of the bank. Okay, so that's very important to keep all these things in place. And again, you know, the technology exists for central banks.

to become market makers in the repo market and in the FX swap market. I mean, the repo market, everybody can kind of lend in on the margin and the Fed is doing it. It's now on the minute repos. And now we have the swap lines with 15 central banks. And, you know, those central banks are basically swapping currencies between each other just like banks and dealers would. You know, whatever currency or banks in the local jurisdiction need, you can just give it to them through repo operations, you know?

So that infrastructure is, to kind of backstop this market-making mechanism that private banks normally do. And so I think that would be the preferred path that you see some expansion in central bank balance sheet, central banks becoming more active as market makers. And then you kind of preserve the banking system and the existing book of business that they have in this, you know, protective casing of Basel tree. And then over and above that, you know, when you think about how the banks should be kind of enlisted to kind of finance the war effort, as Perry mentioned before.

I don't know. I mean, it's going to be a combination of probably, you know, government guarantees on loans that you make in this environment and, you know, central bank funding of those loan books and whatnot. But I think you should, you should conceptually think about that as a separate book of business, you know, your COVID-19 book of business that you will be building over and above, you know, whatever your pre-exexie. instinct book of business was. But again, you know, don't touch the regs because that would

be more harm than good. You know, one of the things that you hear people say in terms of getting through this crisis, and it goes to what you were just talking about with forbearance Zoltown, but I think it's important, is they say, like, why can't we just put a pause on everything? All payments stop. Nobody has to pay their mortgage for the next three months. Nobody has to pay their rent, et cetera, they would keep cash in people's pockets while they're not working and so forth. Talk to us about either of you, but Zoltan, maybe you can start and Perry, please then add in your thought. Yeah. I'll take that one. I'll take that one. This is a high level point. Yes. So here's the thing from the money view, okay, that one person's cash outflows or

another person's cash inflows. So that when you say, well, one way for me, to build up my cash balances to make to match my my my diminished inflows to my is in fact just to stop stop paying you know but that of course spreads the virus right because then somebody else is going to have a diminished cash inflow so that's that's that's a concern okay and he sort of that's what Zoltan was hinting about about this forbearance right that so you want to make sure that you don't have a multiplier effect that comes from that. And you can do that if you're using the government's balance sheet more generally, not the Fed here.

You know, that so it's that, yes, I'm not paying my mortgage, but the government's paying the mortgage, you know. So then you stop that spread. And that seems to be sort of what the idea is behind this fiscal package. And in multiple areas of the, of the economy. The Fed is trying to keep the short-term money markets operating. Notice, you know, it is important what Zoltan said to distinguish between that kind of thing

and this fiscal operation, the longer-term war finance, though, that's a different story, okay. But putting out these liquidity swaps at 25 basis points, that's a very tight spread. Okay, so that's tighter than it ever was in 2008, I think. You know, so this is the central bank saying, forget this cross-currency basis swap thing, okay, that you've been desperately trying to do, you know, to facilitate global dollar funding, we'll do it. The central banks are stepping up big time.

That's a very strong message. And so I just want to underline that. And the commercial paper facility as well, we haven't talked about what's been happening in the money market mutual funds. Okay. And the way, this is really backstop for the money market mutual funds

where there's this shift out of prime funds. Why? Because there's concern that the bank credit and the corporate credit that are the assets of these funds may not be what we thought they were and these prime funds are marked to market. So you have shifting a run,

you already have a bit of a run on these prime money market mutual. That's not happening in banks. It's not happening in banks. That's what Zoltan was saying. And I'm just observing that it is happening to some extent in prime money market mutual funds. And it's being backstop by banks. So just on that note, another thing that's sort of come up once or twice is the notion of whether or not the Fed has the right tools to solve something that's sort of happening on the, I hesitate to use the word shadow banking side of things. But, you know, we're are talking about money market mutual funds. We're talking about some of the big buyside players who are suffering in all of this. We're talking about the repo market as well. Does the Fed have the right tools or is the Fed sort of hamstrung by having to deal with banks as intermediaries? Well, you know, they have they had the right tools, I would say. But this is like, you know,

a sword. It's just a matter of high wielding. You know, everybody can pick up the sword. And again, you know, the scaffolding is in place. And I think what needs to be done now is basically just, you know, calibration and making sure that the things fit a little bit better together. You know, this shadow banking point that you mentioned, Kerry trading is basically what got us into trouble in 2008. You know, Perry's description of carry trading and shadow banking is money market funding of capital market lending.

And, you know, we've talked about some of this stuff on earlier episodes, but, you know, when we talked about the curve inversion and the foreign hedge buyers, hedging costs and all that stuff, I mean, that's carry trading and that's money market funding of capital market lending because whoever comes to the U.S. to buy dollar assets that are relatively better yielding than zero interest rates in a bunch of jurisdictions, and then you hedge it back that dollar, the hedge that dollar asset back to local currency, that's basically. basically borrowing dollars and rolling those dollars, you borrow every three months in the FX wealth market. So, you know, when you're looking for the reincarnation of the shadow banking system, that's what it is. You know, it's not SIVs and it's not conduits and it's not credit hedge funds that invest in mortgages. But rather, it's basically the post-Q-E theme, which is that in a bunch of jurisdictions, you know, Europe, Japan, Scandinavia, you had negative interest rates and pension funds with positive liabilities in those jurisdictions came to the U.S., which was the highest yielding G7 economy where you could buy stuff. And, you know, you bought treasuries, you bought mortgages,

you bought investment great stuff. You know, a lot of that stuff was basically companies issuing debt to buy back their stock to pay dividends. You had financed a large, private equity boom, CLOs, all these things, and you hedge it back to local currency. So, you know, the Fed is essentially backstopping the shadow banking system again. The only thing that's missing in this whole edifice is probably has less to do with the Fed. I think for the Fed, the big stuff was to extend the spot lines to jurisdictions other than the original five, which were, you know, Canada, the UK, Europe, Switzerland and Japan.

The responsibility now is with the local central banks that were given, the new local central banks that were given access to these swap lines, the new and the old central bank that have access to the swap lines, which is to kind of take the big step and go around banks and lend those dollars to end users directly, right? Because what I mentioned about banks being asked to show forbearance to local businesses and households, you know, that's a theme in every country where, where, where, where we have an outbreak. And so the banks are not really going to have the balance sheet to take the dollars from the central bank at OISPOS 25, which is very cheap, very tight, even compared to the 08 prices,

and pass it on at the same price to the end users because the banks don't have the balance sheet to do that. So when you commit balance sheet to be an intermediary, the price at which you will lend those dollars on is going to be way higher. And that's precisely what you see. in the FX swap market where, you know, implied yields are way bigger than OIS plus 25, when we're talking about stuff like OIS plus 100, OIS plus 150 in some jurisdictions.

And that big spread is going to exist for as long as the central banks that get the dollars from the Fed make a big step and start lending those dollars on to end users directly. that could be local pension funds, local life insurance companies, you know, asset managers that run separate accounts for these life insurance companies and pension funds. So, you know, a theme that we've been emphasizing all these years in some joint work with Perry and James Sweeney is that, you know, the central banks should be backstopping markets, not institutions.

And so for now, we are still very institution-specific in that everything we are trying to do, we are trying to do through the balance of a bank. But again, I think this is the time to probably consider broadening the entities that we do operations there. I want to ask a question, Perry, to you about what the post-crisis landscape looks like. Because I remember, I think I was watching one of your lectures on YouTube, and you described in one of them how the economy essentially consisted of all of us, making these big, taking these big risks, these promising future obligations. I think you compare it to sort of building

a bridge and we don't really know where the bridge is going. And anyone who has a mortgage has committed to making a monthly payment for the next 30 years of their live, despite the fact that they really have no idea what's going to happen over the next 30 years of their life between their employment, the stock market and everything else. After we have this incredibly sharp, severe shock to everyone's cash flows all at the same time, this truly like, traumatic global episode. You have a lot of economists, they're like, okay, we're going to have some sort of V-shaped recovery. After we get the virus beat in Q2, then we're going to get this Q3 rebound as everyone goes back to work and spending. But what does this look like to you

when in terms of the future of people being willing to commit themselves to making long-term financial obligations after coming through an experience like this? Well, That's the big one, isn't it? Okay. And this gets back to what we were talking about 20 minutes ago, okay, about that this is a shock that is changing the landscape. Okay. And so as you're, that in terms of building this bridge, you know, we were building this bridge toward the future. And the last mile of that bridge has just all collapsed.

Okay. And the shore that we thought we were building toward is not, it turns out it's not there. And so we need to build in another. direction. And what that direction is will emerge from millions of decentralized decisions or guesses or views about that. There'll be some, you know, government guidance, but just go back to 2008, okay, and observe that what happened in terms of the expansion of credits since 2008? It's really mostly a story about the periphery, about the emerging market economies, Okay, expanding dollar borrowing.

Okay, Zoltan said how, you know, these pension funds in Europe are coming and buying assets in the United States. They're buying dollar assets in Brazil, okay? They're buying dollar assets all over the world. It's the offshore system. It really expanded and was the locomotive of the world economy after 2008. I don't know that anyone expected that, okay? that was driven by the negative interest rates in Europe and the very positive interest rates, you know, in the periphery. This is a dollar crisis.

Yes, it is. Okay. But what will emerge out of this? I think we don't know. And it will be helpful to have some idea at some point because once you see distantly the shore, then you can start making. promises, right? That you know where you're building toward. You know what you're building toward. Right now, I think we don't know what we're building toward. We're imagining that particular industries are definitely on hold. You know, all the restaurants are shut, all the theaters are shot,

you know, talking about New York City. But presumably that's not forever. That's just a virus thing. But there are the supply chains, the rebuilding of the supply chains or the dismantling of them. You know, this story about onshoreing all of our pharmaceutical production or things like that. These take time. It's dismantling part of the bridge that had been built and building the bridge in a different direction. Zoltan, I'd love to hear your thoughts on the long-term implications for the way the financial system works, specifically, since you've been writing about basically the lingering impact of what happened in 2008 on how the repo market works and what it means when it clashes with the winding down of the Federal Reserve's balance sheet.

How do you see this playing out over the longer term? Well, it's probably too early to say. I mean, obviously, you know, some of the basic questions is, you know, how long is this going to persist? is just going to be recurring. Are we kind of going to have to reorganize our economies and way of lives and ways of finance around this? But I think the regulations are going to be still in place. Probably the regulations are going to be a bit tougher because, you know, this is no different from global warming and what it means of finance and stranded assets. and all the good work that the Bank of England under Governor Carney has highlighted in the past.

You know, this is just a variation on that theme where, like, you have now this viral outbreak that's causing havoc across the financial system. So global warming could be that issue in a couple of years. So I guess one thing that can come out of this is, you know, all these tail risks that we talk about, but if it don't happen, they are very real, they can happen. So should we do anything over and above Basel 3 to kind of fortify things? That's number one. Number two, I think longer term supply chains are going to be rethought because whether this is one in a 100 year or one in 20 year

or one every two years or twice every year event, I think what's becoming very apparent is that the way we have organized the world around us doesn't really work. I mean, you can't have just one country produce everything and everybody being exposed to that link in the chain. You know, what the issue debt for is going to be thought about. I think even the government can think about ways to kind of put caps on, I don't know, stock buyback, stuff like that

because, you know, corporations should be taking a share of making sure that when things like this happen, you know, they can, they can, they can read to more efficiently, you have spare factory capacity and all these things. And then third, I think, you know, when it comes to, we talk about the banks, we talk about, you know, what companies are going to be running their supply chains, but they can issue that for, you know,

what's a reasonable amount of debt load that you can run with, right? I mean, a part of the reason why we have to, you know, backstop the IG market is because a lot of debt that, was issued was basically there to do financial engineering, you know, buyback stocks and pay dividends and all that stuff. So maybe our tolerance for that going forward is going to be less. Then the third thing, you know, portfolio investing. I mean, the only the only theme that's been driving those flows is where is the yield the best. You know, as Perry said, you know, I'll issue in dollars because my local yields are even higher. And then I'll buy dollars because my local yields are zero. You know,

So I think when you are a portfolio investor and, you know, your government can very easily put its footbam and say, all right, all this, you know, yield chasing cross-border stuff, let's put an end to it. And how about we, you know, issue more sovereign debt, you buy that stuff and we spend the money on building more hospitals, more dams, I don't know, you know, use your imagination. But basically, at a time of war finance, which is a theme we referred to earlier, I think the emphasis is going to be on financing stuff locally and less on the global themes. And so I think this is just going to fracture the world of finance for sure. It's going to change it. And I think it's going to make the world onto, you know, little separate islands floating in the ocean. But you're not going to be as connected and as global as. as you have mentioned this idea of maybe reorganizing supply chain so that one country isn't

responsible for making one critical item. And Zoltan, you previously described the supply chain as basically a payments chain. So I'm wondering, what happens to the status of the dollar in the international financial system? Do you think we might see a concerted effort to sort of move away from it a little bit. Perry, I'd love to hear your thoughts and then maybe Zoltan. Well, it's the, my view on these things is watch what markets are doing. And at the moment, everyone wants dollars, you know, that they don't want gold. They don't want, you know, this is, this is what money is internationally. So I think that it is, and the dollar is strong, not, not weak. So I, I, I, I, I, I, I don't see.

a move to a multi-currency system, Zoltan's story about breaking up the global system into individual nation-states, I hope that doesn't go too far, okay, because there's a lot of productivity gains that come from distribution, division of labor internationally. And it's a big productivity shock to the globe

if you break all that down. But I do think there is a challenge to the globalization. I think that financial globalization could continue, even if real-side globalization is pulled back. There are big efficiencies in having a single world currency for trading and for finance, and I think that we're seeing that. It does require somebody to manage it,

And that is, if there's a particular country that's issuing that currency, that's what we're seeing, that the U.S. is sort of managing that. And that's a responsibility. And it is, it's a good thing. It's a good thing. Yeah, I mean, two things I would add to that. I mean, I certainly agree with the productivity games we've had from, you know, specialization and all that. But I guess that's precisely the problem that we were too efficient and specialized. And, you know, if you went to business school, you would learn about, you know, synergies and this and that.

And we can eliminate duplications. And we can have one company that makes breeding machines in the world. So I would disagree with you, Perry. So I think that is going to come under review. But hopefully we are going to keep a lot of the good things about globalization in place. We just kind of recalibrated. So let's put it that way. In terms of the dollar, again, I would have worried if the Fed doesn't do the right thing in terms of the spotlines, but again, they did.

And so I think the dollar is going to probably come out stronger from all this because of it. And so that was a good thing that the Fed did. Okay. Well, absolutely fascinating conversation. It was so good to have both of you on. And I guess the next episode we do, we're going to have to get James Sweeney on and we'll have all three of you,

the Money Market Trio. The three Musketeers. Let's do it. I'm already looking forward to that. It is really a treat and an honor to get to talk to both of you. So thank you for taking the time. Great.

Stay safe. Bye-bye. So, Joe, I thought that was an absolutely riveting conversation. we touched on so many of the sort of smaller technical themes, but also some of the big picture themes. And what I really like about talking to Zulton and Perry is that they always bring that real world perspective. This is what they're actually observing in financial markets at this moment in time, or in the case of Perry, this is how real world behavior can actually affect the flow of money. Yeah, that really was a treat getting to talk to both of them at the same time like that.

I don't have too much to add because I think they said it all. I love Perry's analogy of this idea, we were building a bridge somewhere and that last mile of the bridge has been destroyed. And until we know what the end of the, what the new shore looks like, no wonder things are so chaotic and unstable in financial markets, because until we have some view of what that looks like, how can you do anything? Yeah. And I think the conversation really crystallized the idea that what we're seeing.

in markets right now is this cash shortage or a run on cash and a run on dollars specifically. So it really highlights the centrality of the dollar, which is something that we've discussed in a bunch of previous all-thoughts episodes now. And it also highlights the power of the Fed, right? Like the Federal Reserve right now is basically responsible for keeping the entire global financial system afloat. And I take Zoltan's point that what they've done so far has been great, But I guess my question is, if this were to happen again in, you know, four years time or a longer horizon, would the Fed do the same thing? Can we always rely on this one body to sort of inject as many dollars as needed into the financial system? Yeah, you know, thinking about past episodes we've done, one that I would recommend people listen to is David Beckworth.

We talked to him last summer regarding that mark. that Mark Carney speech in Jackson Hole last summer, which got a lot of attention because he identified this exact issue, which is that, you know, we don't have a gold standard anymore, but we do have a dollar standard. And essentially that everybody has to all around the world, I love, I think it was, as Perry put it, it's like European investors going to Brazil for dollar investments. Like that is the world we live in, which is that no matter where you are, essentially. essentially you're scrambling and looking for ways to acquire dollars or make money in dollars. And we're really seeing that need and demand on sort of hyper speed over the last few weeks. Yeah. And the other one has got to be Hian Sung-Shin from the Bank for International Settlement. Yeah. He's done so much research on this about specifically how a stronger dollar sort of feeds into the rest of the world. And that's certainly something that we're seeing again at this moment in time.

And I would encourage anyone if you're at home, pull up a chart of the dollar over the last three months and just look at the straight lineup. It is really one of the most jaw-dropping charts. The stock market crashing is a jaw-dropping chart. But the straight line up in the dollar is the sort of purest crystallization of this incredible demand for what is essentially the sole global currency. Yeah. If you're stuck at home, pull up the dollar chart and listen to a couple of all-thoughts. episodes all about the dollar. That's a good use of time, I'd say. That's a good way to pass the quarantine time. Yeah, exactly. All right, well, this has been another episode of the All Thoughts

podcast. I'm Tracy Allaway. You can follow me on Twitter at Tracy Alloway. And I'm Joe Wisenthall. You can follow me on Twitter at the stalwart. Zoltan isn't on Twitter, but Perry is on Twitter, although he doesn't tweet enough. And he tweets a bit. You should follow him on Twitter at P. Merling. And of course, you should follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And you can check out all of the Bloomberg podcasts on Twitter under the handle at podcasts. Thanks for listening.

The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini. We'll bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off.

And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you. you wherever your weekend plans take you. Watch us on Bloomberg Television. Listen on Bloomberg Radio, stream the show live on the Bloomberg business app, or listen

to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. What separates good leaders from transformational ones? I'm Jessica Chen, and in season two of Leading By Example, we'll sit down with executives like Grace Chen of Bertie Gray to find out.

It's important to understand where you spike, but also really acknowledge where you don't and find people who can fill those gaps. Listen to leading by example, executives making an impact on the IHeart radio app, Apple Podcast, or wherever you get your podcasts.