We Study Billionaires - The Investor’s Podcast Network - BTC123: The Legacy Banking System in Shambles w/ Alf Peccatiello (Bitcoin Podcast)

Starting point is 00:00:00 You're listening to TIP. Hey everyone, welcome to this Wednesday's release of the Bitcoin Fundamentals podcast. On this week's episode, I have back Mr. Alfonso Pekatello, better known as Macro Elf. During the show, we talk about all the excitement happening around the world with banking and the unprecedented actions happening by all central bankers. Alf is a former bond trader at a large-cap bank and understands the plumbing and implications extremely well. We get into how the banking system works and what might come next with the spreading.

Starting point is 00:00:30 global impairment and what it might mean for Bitcoin and other asset classes. So without further delay, here's my chat with Macro Elf. You're listening to Bitcoin Fundamentals by the Investors Podcast Network. Now for your host, Preston Pish. Hey everyone, welcome to the show. I'm pumped to have Alf back here. You're such a thoughtful thinker in how the legacy financial system works and fixed income. And I love those type of of conversation. So welcome to the show, Alv. Preston, my pleasure to be here. And I guess a lot of people will be wanting to know what's going on in the banking sector, what's causing all this trouble. And so let's see if my experience

Starting point is 00:01:23 can help the audience understand a bit further what's going on. That's exactly where I want to start is because you have such a depth of understanding of the legacy system, I guess my first question is just like, what's your one over the world of everything that's happening and prioritize, like, this is one of the most important things that people really need to be focusing in and on and understanding because it has like all these other compounding effects beneath it. So where would you start? So look, I think money is misunderstood at the higher level of management even in the financial industry. Look, money in the traditional banking system or in the traditional finance economy works as follows. There are different layers.

Starting point is 00:02:04 and the safest form of money you can have in traditional finance is the liability of the government. So your money is very often a liability of somebody else in the traditional finance system. So please understand that. And there are different kind of risk that you can run by owning money in the traditional finance space, mainly two risks. Your money can be the liability of the government or it can be the liability of a bank. Let's first talk about the liability of a bank. A bank deposit, especially above $100,000 in Europe or above $250,000 in the US, it's nothing

Starting point is 00:02:45 else than an unsecured loan to a bank. As we are seeing if the bank has any stress, any mismanagement, has mismanaged the risk, has run a certain amount of interest rate risk, which was not hedged. Your money can be at some point even just wiped away. So that means you are effectively lending unsecured your money to the bank above the $250,000. That's always been the case, Preston by design. If your money at a bank is below $250,000, you have the implicit guarantee of the government of the United States. So you fall into the second bucket, which is your money is the liability of the government in this case, rather than the liability of a bank.

Starting point is 00:03:29 But it's always the liability of something in the traditional finance. Now, the liability of the government of the United States is a better proposition that being a senior lender unsecured to a bank simply because the government of the United States issues the very currency, issues the very money that we use in the system. So effectively, the government of the United States can always try to blow a hole in their balance sheet through deficits and print more of this money that we use in the system. So effectively you are somehow a bit more protected in nominal terms by having money as a liability of the government, then as a liability of a bank. People are now finding that out because depositors of SBB have been wiped out effectively.

Starting point is 00:04:18 The FDIC came in and said, no, no, no, we're going to make an exception. We're going to guarantee your deposits even above the $250,000. basically the government is saying you were an unsecured lender to SBB will make you now whole by transforming your money from the liability of a bank to the liability of the government. So we will make you whole basically through that process. People are finding that out, but this is the first big picture observation I have in the traditional finance system. Your money is always a liability of somebody else present.

Starting point is 00:04:53 So choose wisely which liability. Do you want it to be an unsecured liability of a bank that's pretty risky? Because you're often not even rewarded for that risk in the first place. This bank deposits don't yield much in the first place. Or do you want it to be a liability of the government of the United States? Through many of these forms, it can be a bank deposits below $250,000. It's implicitly guaranteed. It can be a T-bill.

Starting point is 00:05:18 It can be a money-market fund deposit, which is basically guaranteed by the government. But pick your fighter. your money is always an unsecured liability of somebody else in the traditional finance space. So, you know, people were looking at that action with the Silicon Valley Bank and they're saying, okay, well, FDIC was supposed to be anything above the 250K, that those depositors are now at risk of the actions of that bank. So the government steps in, totally backstops everybody, all the deposits at the bank. And they've set up this new precedent. of, well, the government might step in, and maybe the limit really isn't 250K if you're

Starting point is 00:05:59 banked with a large enough bank, which created this incentive of, hey, I need to get out of my community bank and I need to put my deposits at Bank of America or whatever. First of all, is there something similar happening in Europe to what happened in the U.S.? And if so, kind of describe that to us? And then more just your general thoughts on this incentive that's now popping out of these actions and what it means moving forward. Look, Preston, it all boils down to the incentive schemes that regulators have given banks in the U.S. and in Europe. Because, you know, obviously banks are there to try and make money, and they have to try

Starting point is 00:06:38 and not take too many risks because they are so important to the traditional finance space, their stability is so important that they're heavily regulated. The U.S. has failed pretty miserably, I should say, in regulating small banks. So let me tell you what I mean. In the U.S., if you're a bank below $250 billion in assets, and mind me, Preston, this is a pretty large bank. I mean, $200 billion in assets is not peanuts. It can be a pretty large bank anyway. But that was the threshold. Below $250 billion in assets, you are basically exempt from the main stringent regulation that regulators have applied to large banks after the great financial crisis.

Starting point is 00:07:21 So namely, you don't have to stick to something called the net stable funding ratio. It's a lot of words, but in reality, it's just a ratio that tries to make sure that the funding of a bank is not concentrated. It's not volatile. Basically, all depositors cannot flee away at the same time, exactly like it happened with SVB. SVB was a bank below $250 billion in assets, which meant SVB did. didn't need to stick to this net stable funding ratio could have a very concentrated funding

Starting point is 00:07:51 base, which was one of the problems. The more concentrated your funding base, the higher the risk, they flee away very rapidly. And that's what happened. The other thing is, if you are a bank below $250 billion, you don't need to stick to something called liquidity coverage ratio, LCR. So this is another rule that the regulators put up to say, hey, banks, you need to have a lot of liquid assets on your balance sheet, because if Preston Alph, and everybody else at the same time goes to the bank,

Starting point is 00:08:19 wants their money back. You need to be able to service this deposit outflows. Now, this liquidity coverage ratio does something very interesting, Preston, which basically is, I mean, if I ask you, what's the most liquid asset you can have in the traditional finance space? You would say cash or any form of cash. It's just liquid there. If Preston comes and withdraws money,

Starting point is 00:08:41 I can just give him the cash and I'm done. But banks also want to make money. So they ask the regulators, is there something else I can own on my balance sheet? I don't want a stock of cash there. I want to own some liquid assets that you will consider to be liquid. I can make some money in the meantime, but they can also be used to service this deposits. Guess what? The regulator said, well, we'll treat treasury bonds, mortgage back securities as well,

Starting point is 00:09:07 basically ask cash from a regulatory perspective. Listen to this. if you're a bank in the US after the great financial crisis, Preston, you were told that you must own a bunch of liquid assets to meet this regulatory requirement, and it could be cash at the Fed, reserves at the Fed, or treasury bonds and mortgage-backed securities and some corporate bonds.

Starting point is 00:09:29 Because effectively you had no liquidity haircut on treasuries, so they will treat it as cash by the regulator, and also you needed to own zero capital, and I repeat zero capital against any potential losses that these treasuries would incur or this mortgage-backed securities would incur. Very, very little capital required. Basically, the regular set to banks go ahead and buy bonds will treat it as if they were cash. Now, there are some proportions for large banks.

Starting point is 00:10:01 They cannot own a bunch of corporate bonds, a bunch of risky credit. They need to own a lot more treasuries. For SVB, that wasn't the case. Remember, they were not subject to this liquidity coverage ratio, which meant they went ahead and bought $90 billion of mortgage-backed securities on a $200 billion balance sheet. And, guys, I've been in the business. It's just a gigantic amount of mortgage-backed securities. Basically, the regulators have, in the US, made one big mistake, which is under-regulate small banks. So give them basically incentive schemes to act as cowboys.

Starting point is 00:10:35 and the moral hazard at the SVB case was also very high because these guys didn't hedge their interest rate risk properly. They didn't apply basic risk management techniques. So they basically used the loophole that wasn't regulation to take an extremely large amount of risk. They had a concentrated funding base and they were wiped away because of that. But Europe, on the other hand, to answer your question, I mean, in Europe we do a lot of things suboptimally, let's say, when it comes to finance or banking, but regulation is much, much tighter. So, for instance, in Europe Preston,

Starting point is 00:11:11 there is no small bank that can be underregulated that easily. Regulation is tighter in the first place, and it just looks after also what's called a small bank. Also, again, guys, small banks, $250 billion in assets, that's not a small bank. Let me give you a European parallel. The third largest bank in Germany is $180 billion balance sheet. So that's the size we're talking about that in the U.S.

Starting point is 00:11:41 was deemed to be small enough not to be sufficiently regulated. So this was a pretty miserable regulatory failure, I would say, in the U.S. Wow. I'm a hardcore bitcoiner. Our show has tons of bitcoins that are listening in. And just to put it simply, I just don't trust the bank. system because of everything that you've just described. This ever-expanding manipulation in markets to control fixed income and never allow creative destruction to actually occur is what we're

Starting point is 00:12:12 really talking about. And in my humble opinion, we aren't operating in a free and open market these days. And when you look at the size and the quantity of like some of these decisions that are being made by a couple people in the room, it's just, it's kind of mind-blowing. And I just see trust breaking down. As a person that really understands the legacy banking system, do you empathize with Bitcoiners and why they're turning to other alternate solutions to storing their hard-earned capital? And just kind of what are some of your thoughts on like what this looks like from a systemic standpoint moving forward with this keyword trust? Look, the entire system, banking system is effectively based on the assumption that collateral must.

Starting point is 00:12:57 must hold its value. And the collateral of the traditional financial system is treasuries. Everything runs around treasuries. It's very simple to understand as well, Preston, because if you go to a bank and ask for a mortgage and ask for credit, they will price your interest rate on that mortgage, on that credit, on that loan, effectively based on where treasury rates are plus a credit spread on top of it, right? So imagine also treasuries are the foundation of the repo market where banks effectively exchange money with each other in a secured collateralized way.

Starting point is 00:13:34 And that collateral is, again, treasuries. Basically, you have to think of treasuries as the foundation really of the entire machine. And you can also see the reaction of the Fed here, Preston, because what was about to happen was that some banks that were underregulated were effectively mismanaging their risk and they were facing a deposit outflow, which was very large. To services deposit outflows, they were forced to sell their treasuries. The treasuries that the very regulators told them they could own because there were as liquid as cash. But of course, because of the interest rate hike, these treasury values were much lower. So they need to take a massive capital air cut, capital loss to sell these treasuries.

Starting point is 00:14:21 And at some point they found themselves insolvent. So what happens then is if you leave this unchecked, it will generate a fire sale on treasuries because more banks will find more losses on their balance sheet. More depositors will get nervous. They will withdraw deposits and it will force a self-fulfilling mechanism where everybody has to sell treasuries to service this deposit outflows. The Fed cannot allow this to happen, right? And it's basically, again, a system which is based on trust on the value of this collapse. And if that goes away, the whole system implodes. So what the Federal Reserve does in this case is comes to the rescue and it says,

Starting point is 00:15:01 ladies and gentlemen, this collateral is worth a hundred. You bought it for a hundred. It's a hundred. Just give it to me. I don't care whether the price is 60, 70, 50 or 80. I'll take it at 100 and I'll lend you money against that at par, against its nominal value at 100. That's a yield curve control.

Starting point is 00:15:23 Wow. I mean, we'll talk about the difference between this, QE and Ilfuss Control. There's a lot of mechanics to explain, but my first reaction is, wow, this goes to show how much the system is built on the stability of this collateral. Because think about it, in 2008, the main collateral behind the banking system was house prices. In 2007, we were lending against the value of the houses like there was no tomorrow, and we were over. leveraging the system with more complicated structures and it was all based on one predicament, house prices in the US cannot go down Preston. This was the predicament. As soon as the collateral value started going down because house prices started collapsing, then you had a massive problem because it generates a de-leveraging of the system that cannot rely on the value

Starting point is 00:16:14 of the collateral strengthening anymore. And you saw what happens, what kind of creative destruction, as you called it before, unfolds. But what unfolds from it is also political challenges. It's unemployment rate much higher. It's misery. It's nothing that the politician would want to see because nobody gets reelected if he's the one to pinpoint for the great financial crisis, right? So this incentive scheme you're describing effectively make it so that the policymaker's incentive scheme is to keep the value of the collateral stable or rising.

Starting point is 00:16:46 And that's what the Fed has done. The Fed has basically said, give me the treasuries. I'll fund you at 100. it. So what happens then is a couple of banks go in and they're like, yeah, yeah, please, I'll do that because I'm in trouble. I mismanaged my risk. I used the treasuries. I didn't hedge the interest rate risk. You guys hike the interest rates. The value of the treasuries went down. I'm in trouble. Well, you're telling me I can ignore this reduction in value. I'll use the facility. So I'll lend you the treasuries and you'll fund me. What this means is that the Federal Reserve is

Starting point is 00:17:18 expanding its balance sheet again, which is something that we didn't see for a while as they were engaged in fighting inflation, trying to keep interest rates higher, shrink their balance sheet. This has now changed again. And there are some differences between these and quantitative easing and yield curve control that we can discuss. My main point is, as I told you before, the tagline is remember that your money is the liability of somebody else in the system. Choose whose liability do you want it to be? Now the tagline is the Fed and the system is predicated around the stability of collateral and it is that important that the Fed has chosen to ignore the market value, ignore what is the market assigned value to these treasuries and give them a value of a hundred,

Starting point is 00:18:08 an artificial value of a hundred just to make sure the system doesn't implode on itself. Let's take a quick break and hear from today's sponsors. All right. I want you guys to imagine. in spending three days in Oslo at the height of the summer. You've got long days of daylight, incredible food, floating saunas on the Oslo Fjord, and every conversation you have is with people who are actually shaping the future. That's what the Oslo Freedom Forum is. From June 1st through the 3rd, 2026, the Oslo Freedom Forum is entering its 18th year bringing together activists, technologists, journalists, investors, and builders from all over the world, many of them operating

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Starting point is 00:22:28 going to, you government are going to pick the winners and the losers, even though these people mismanaged risk and they should pay a consequence for that mismanagement in this system, they're not. They're getting an advantage. People from up on high are saying, no, this person's, going to get a bailout. They don't actually have to deal with the consequences of their poor decision making. And therefore, someone else is paying that price. And I think that the someone else is the general population through just terrible policy making. And so like people like me

Starting point is 00:23:03 that are Bitcoiners, we're just saying, you know what? No, my money is not somebody else's obligation because I have stuffed it into Bitcoin and it doesn't have any counterparty risk. I just can't understand how people will continue to trust this system that continues to compound and spiral out of control with larger and larger bailouts, which clearly is the trend than not going away, when you have this other thing over here that doesn't require any trust that people can buy and continue to hold and it doesn't have any counterparty risk. And if I want to move all of it to some other account right now, I can do that. and I don't have to ask for permission from anybody. I just don't know how the legacy system can compete with something like that, I guess, is where I'm going. Look, Preston, the system is based on trust, as you said before. So it's, well, from a technical perspective, trust on the value of collateral being treasuries in most cases.

Starting point is 00:24:01 From a user perspective is the trust that the unsecured loan that you have made to the bank, basically by having money more than $250,000 in a bank, doesn't get blown away. Because at the first signs of stress, obviously, your incentive scheme as a user of the system is to say, whoa, I'm actually running counterparty risk with my money. Yeah. I didn't know that because Preston,

Starting point is 00:24:25 most people don't know that. Exactly. That they are running unsecured risk on a bank. They get a reminder. And then there are signs of stress. So the system only works, any credit-based system actually only works if there is trust in its stability and if the collateral holds its value stable or increases its value over time.

Starting point is 00:24:49 Those are the two really major foundations behind the credit system. From time to time, we challenge those, right? Because the system in itself, if it works, leads to something very interesting, more and more and more leverage. Because look, what's your incentive scheme, Preston? If in a credit-based system, if everything is smooth, which will incentivize you do is to make use of leverage, because there is no volatility, there is no signs of stress. So how you amplify your returns is by making use of credit, by making use of leverage. If everything is stable and you're sure that your job will be there for the next 20 years, you have a set of cash flows ahead of you, right?

Starting point is 00:25:30 It's your salary. Your salary will be there, will actually grow a little bit year by year. So your incentive scheme is to make use of credit, to go to a bank and ask for a mortgage. A mortgage is nothing else than money being created now against your future cash flows coming from salaries. So what you're doing is you're relying on the stability of the system, which means you will have a stable job over time as well, and you're now getting credit for it. You get the credit creation, your mortgage. You go ahead with money that you didn't have, and now you do have, that's the credit being created by a bank and you buy a house that otherwise you couldn't afford. And you push asset prices higher.

Starting point is 00:26:11 And so banks have collateral values that go higher. So you see what the incentive scheme is here, right? If everything is stable, the system will create and rely on more and more and more credit. And, you know, the other side of credit is that because you now have a mortgage. It means it sits on your balance sheet, Preston. it's a liability. You are indebted. So for the system to keep working, you need to have more stability and it just reverberates further and further. What happens at the first sign of stress is that in a system like that, the de-leveraging is also very, very rapid and very painful. Japan has experienced

Starting point is 00:26:46 something like that in the 90s. Japan has basically told us what's the way to go, what are the pros and the cons of bringing the system to the extreme. It has already shown us that about 20, 30 years ago. In Japan, in 1989, the imperial palace of Tokyo was supposed to be worth more than the entire state of California. I mean, when I say this, this is pretty fun. But this was the result of excessive credit creation. Credit was ample and available to everybody in Japan. There was basically an over-reliance on stability of the system and more and more credit. What happened the moment and that there was a sign of stress, is that the system went into de-leverging

Starting point is 00:27:31 and look at the Japanese growth for the next 20 years. Preston, it had negative consequences for the productivity of the system, and it basically made effectively everybody poorer in real terms. Growth went nowhere for 20 years in Japan, and this is the risk you run

Starting point is 00:27:48 when you deliver such a leverged system. So it's a very inherently unstable system that we keep artificially stable system, that we keep artificially stable, because that's the incentive scheme. Kick the can down the road, lever up more, keep the system stable so we can create more credit,

Starting point is 00:28:06 generate more asset returns now, amplify our returns today, and by the very virtues of it, we're also increasing the instability of the system. So I do agree on that assessment. Yeah, it seems like we're at the, coming up on the end roads, from a global collective,

Starting point is 00:28:22 you know, all this is intertwined. When I look at the European banks, the U.S. banks, the Japanese banks, all of them versus what I would describe as non-NATO countries that are net producers and extracting raw materials. And they're saying we don't want these digital units that the NATO-based countries keep expanding and debasing at a breakneck pace. We're done with it.

Starting point is 00:28:45 You can either pay us in our currency or you can pay us with gold or Bitcoin. That's pretty much their stance. And that's what I think the whole war in the Ukraine and everything that's happening from an energy standpoint over in Europe, I think really kind of comes down to that. fundamental aspect. So I'm curious if you would agree with that. And I'm also curious kind of your thoughts on how Europe is going to be able to get any of their energy and high inflation rates down in the face of all of these banking decisions that just continue to compound on themselves, creating this more and more unstable system. So Preston, so far we talked about the sources of

Starting point is 00:29:21 leverage and instability within a closed economy, right? We discussed basically as if there is no external influence when you talk about an economy. But the reality is that global economies are interconnected and most importantly, the dollar plays a central role when it comes to the global economy nowadays and it has been the same basically since the 70s. This has led to something very interesting, which is the birth of the euro dollar system, which is nothing else than a machine that allows entities not residing in the United States to get accurate. to newly created dollars. So it's basically a dollar funding machine

Starting point is 00:30:01 for entities sitting outside the United States. If you run the global reserve currency in our system, you have one job and one job only. To keep your egemony, you have to make sure that dollars flow freely outside or otherwise for other people that cannot create dollars is going to be very hard in periods of stress to cope with the system that depends on a resource,

Starting point is 00:30:25 the dollar, that you are. are in charge of. Your job is to keep this flow of dollars free and smooth for the outside world. So now what has happened is something very interesting because if the system keeps growing like it did, the euro dollar system over the last 20 years, what happens is that take a corporation in Brazil that sells soybeans or whatever they sell some commodities, right? If most of your invoicing is in dollars, most of your trades are denominated in dollars. What you have done to enhance your business model over the last 20 years is also leverage in dollars, issue dollar bonds, get some dollar loans from a bank.

Starting point is 00:31:08 This is a very interesting system because the Brazilian company now in the Eurodollar system, ingrained in the global dollar system, needs two things. To be able to sell their soybeans denominated in dollars as much as they can, that brings in earnings, right? But it also needs these earnings to service their leverage on dollars. So what happens at the moment, then the global trade stop, that the growth, global growth comes down is that the company will scramble for dollars because it still has dollar liabilities to service, dollar leverage, but it doesn't see new dollars coming in because global growth is coming down. Very interestingly, what happens in that case is that even if the

Starting point is 00:31:52 very, very problem is this dollar-centric system. The dollar gets a benefit out of it because these companies are scrambling to try and get the dollars they need to pay their debt. So the system deflates the leverages and it leads to a stronger dollar, which creates more problems to other companies indebted in dollars because their debt become worth more while their earnings are coming down. So it's a dollar-recking ball. The irony is that we have built a system where the problem in itself, the structural problem is the over-reliance on the dollar, and to destroy the system, to change it, basically, you first need to see a rush to the dollar, such a destructive rush to the dollar that it de-leverages the entire system until we say, maybe this wasn't the

Starting point is 00:32:40 best idea after all. We should look for another system that makes more sense. But you see the irony, right? Because a lot of people are saying, look, dollar dominance will fade away. And it's hard to say when, Preston. I mean, these are very long cycles. They take decades to unfold. I do agree it will in the end. We have seen global reserve currencies change every 80, 90 years. On average, we don't know if it's going to be 80 or 100 years. My most important point is to destroy the system from within, for the system to implode, you finally need first the dollar to appreciate so much that it basically kills everything else around it, and only then you will realize that the system doesn't work anymore. And I think people instead expect the dollar

Starting point is 00:33:26 to steadily depreciate in a destructive mode. But I think the path of blister resistance is that you see one of these incredible rushes up in the dollar that just the leverages everything else around it, and then people will realize that that wasn't the right system in the first place. as an American, as you're talking about the dollar and the advantage of it expanding, I think of a chess scenario where it's like the queen is such a powerful piece. And when you ask amateurs, like what their favorite piece is, they almost always say, oh, the queen. But you also have to understand that the queen has a huge disadvantage in that you have to protect it at all costs, because if you lose it in the game, your chances of winning are slim the nun. And so you're almost

Starting point is 00:34:10 become a prisoner of its power in that you have to respond when somebody checks it with a, or they could take it out with a pawn. And so I see a very similar scenario with the dollar where it's become so powerful that the United States is now having to make decisions that are sometimes decisions that it doesn't want to make, but it has to make because they can't allow for the instability in the dollar because some other country or some other thing has forced it to provide liquidity or swap lines or whatever the case might be. And so I see it in a very similar way. And your point about it becoming so strong and so powerful is basically akin to it holding the same power as the king itself, where if that piece goes out, the whole game is lost

Starting point is 00:34:58 is kind of where we're going with dollar dominance. We're seeing the issues of the balance sheets showing up with banks that are actually connected to the Fed rails. How do you see the risk kind of maturing from here with respect to shadow banks and insurance companies that have this massive float that often denominate that float into treasuries that might have long duration treasuries sitting on their balance sheet as where maybe disaster strikes next here in the coming months. Look, Preston, this is the right question because if we have now defined that the Federal Reserve will try their incentives. is to do their best to keep the collateral value stable, the treasury value as a collateral

Starting point is 00:35:46 value, as stable as possible, and they have the tools for it. For instance, their new bank term funding program that we discussed before giving a par value to treasuries, even if their market value is way below par, they have the tools to ensure that. What you need to look for next is, okay, if the Fed wants to keep the system artificially stable, they can. what is that the Fed cannot control to a certain extent. That's where normally you find the release valves historically.

Starting point is 00:36:18 And you pointed to the shadow banking system and in general other actors in the financial market that are less close to the Fed. And I think that is a very smart thing to do. And I see one big issue overall, which is credit markets. So look, credit stress is something that is very hard to fix for the Federal Reserve.

Starting point is 00:36:39 We're talking about companies having a weaker balance sheet. We're talking about the real estate market, taking a deep dive. The Fed has a much harder task in controlling those because they're further, further away from the epicenter of the system, the repo market and treasures that they can so much influence. Now, let's look at the housing market, for instance, and I want to talk about real estate for a second because it's interconnected between shadow banks, banks, pension funds, insurance companies, etc.

Starting point is 00:37:08 Between 2014 and 2021, Preston, interest rates were basically zero in the US the whole time. They were negative in Europe, by the way. Now, take a European bank. It has deposits and it has assets. And if interest rates are at negative levels for European banks not to lose money, they need to charge their depositors as well, right? Because if their assets are making negative returns, the only way not to lose money is to charge your depositors as well. By law, European banks

Starting point is 00:37:41 couldn't apply negative interest rates on deposits in most cases for years, which meant that they were basically destined to lose money unless they did something on the asset side, Preston, and they did so. They took more risks. How do you take risks? Well, you either take more interest rate risk, but European banks are very well regulated, so it's very hard for a European and bank to take a huge amount of interest rate risk, they need to hedge it very closely, which means you take other risks, credit risks. So you buy securities that offer credit spreads on top of the risk-free rate. The housing market is a hive for such securities. I mean, during the great financial crisis, we learned about all sort of securities you can create on top

Starting point is 00:38:27 of a loan, on top of a mortgage, CDOs, CLOs, etc. The regulation had made it more complicated to make debt leverage, but there were many securities, leverage loans, CLOs, commercial mortgage-backed securities that offered higher yields. So banks, in a low-interest rate environment, went ahead and bought a lot of them. The same happened to insurance companies and pension funds for the same reason. Preston, if you need to generate returns to meet future obligations, being your pension contributions to be paid out, for example, and your bonds are yielding nothing, you're going to look for yield somewhere else. So what I'm saying is when the system was too much artificially compressed and stable,

Starting point is 00:39:11 this bred instability by giving the incentive scheme to shadow banks, asset manager, pension funds, banks, insurances to go and buy higher-ealding assets, mostly in the real estate market. Fast forward to today, mortgage rates in the US have gone up from 3 to 7%. and we're seeing housing sales down 40% on a year-on-year basis. The market is basically frozen. Buyers are cut out. They can't afford.

Starting point is 00:39:41 Sellers are trying not to sell because why would you sell if you're not forced to? You locked in a mortgage rate at 3%, which basically means the market is frozen. Now, I think the stress is coming to surface now. We have had the first default of a commercial mortgage-backed security of over $500 million by Blackstone. Blackstone and KKR are effectively the largest real estate investment trusts in the world. And before the default of this commercial mortgage back securities, both companies had gated to redemptions on the two largest real estate investment funds they had,

Starting point is 00:40:18 which in plain English means that if you were an investor that invested into this real estate investment trust and you want your money back, Preston, you can't have it back. You can only have a little bit each quarter. And why? Because if Prestonoff and everybody withdraws money from these funds, they are forced to sell the assets, which means they need to sell offices, stores, multi-houses, etc. In this market where there is no buyer, this will lead prices to go down and this will lead probably to fire sale coming up next. When I hear all of this and I look at the first default on a commercial mortgage back security and I think of the amount of leveraged real estate securities

Starting point is 00:41:00 that have been bought by shadow banks, pension funds and insurance companies and banks to try and generate some yield over the last seven to eight years. And I look at the state of the commercial and residential housing market today, I tend to think that while people are focusing on liquidity risks, that the Fed can backstop if they really want to. They can, and they are trying hard to that. They're missing the big picture, which is the credit stress, which is brewing under the surface. How long do you think that this is going to take to kind of percolate out? Are we talking three months, six months window? Look, the amount of credit creation going through the system was already pretty negative

Starting point is 00:41:39 before this banking stress. Now you have banking stress. In that case, money flows to the safest form of collateral you can have. Credit dries up further. Nobody wants to land very aggressively in an environment where there is banking stress. So this will compound the credit flow weakness that was already existing before this stress, which means, Preston, look, I think policymakers have the tools to try and backstop this liquidity crisis that we saw. There are going to be a couple of casualties, but overall, they have the tools to backstop this because it's coming from an epicenter very close to their control. It's the treasury market, and they have almost a duty from a policymaker perspective to backstop the value of the collateral.

Starting point is 00:42:27 And as we have seen, they have some very creative tools to make sure that artificially the system can be kept stable for a bit longer. On the credit side, they don't have these tools. And it's not even their job to have these tools, to be honest. So the answer is, look, my out-of-consensus call on the macro compass, which is the research firm that I run, was the recession in the US would start in late second quarter this year. So that would be like May or June. I think this cold is now vindicated even further because what you're seeing is a credit crunch, basically. So further deterioration in credit conditions for the real economy, which will probably accelerate the downturn.

Starting point is 00:43:09 And especially when it comes to the real estate products and the real estate market, I see things going pretty much sour over the next few quarters. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. Risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process

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Starting point is 00:46:53 during COVID and how it basically just turned into basically free money for banks that took out the loan and they just dissolved the loan part of it. It just became money into the system. It almost seems like we're going to see that times two, times three, as they try to resolve a lot of these risks that I agree with you are coming in three to six months from the time we're recording this. And I think it's going to be way bigger than what people can even begin to wrap their head around. Would you agree? Yes, I think there is a risk because of the size of the market, the housing, the real estate market is by far the biggest asset class in the world. If I would ask you,

Starting point is 00:47:36 Is it the bond market or the equity market? People would say, I think the equity market, you need to combine the bond and the equity market together and you still are not at the size of the global real estate market. This is how big it is. It's a very leveraged system because of the mortgage market underlying it. It's a very credit-driven system. We have just discussed incentive schemes over the last seven to eight years for institutional investors to go and pile up on leveraged products in the space to try and generate some.

Starting point is 00:48:06 So I think there are quite some, quite a confluence of negative factors that could make this pretty bad. The fourth one is the following. This always surprises in me, Preston, but in 2020, we printed the ridiculous amount of money. And I mean, like, real economy money. I mean, like, money for Preston enough directly in our pockets, which was just bank loans giving away, like there's no tomorrow, checks reaching our inbox, straight away. we know that are liability attached to it, like literally new money that you can spend, no liability attached to it, right?

Starting point is 00:48:41 Now, we did so much. And if you wait, if you pulled all that money into the system and you wait 12 months, you are undoubtedly going to see stronger growth, stronger inflation, people have more spending power. They literally have more spendable money that you have created. And so we saw this temporary growth and inflation, right? that was the end of 21, the beginning of 2022. But guys, in 2022, we have abruptly stopped doing that.

Starting point is 00:49:08 No new stimulus. Bank lending, came down slowly but surely as the economy started deteriorating. So you are seeing basically this inflationary impulse from a credit creation perspective that is at least as bad as the credit creation on the way up. So for what reason you shouldn't expect now the same magnet or even a bigger magnet person as you just discussed, as you had a strong growth and a strong inflation impulse on the way up, you should expect quite some deterioration in economic conditions as the result of the opposite effect that we had in 2022. It just works with a lag. So you need to wait for another three to six months,

Starting point is 00:49:48 but I think that we're getting pretty close to the point where the tightening in conditions, both in credit and in financial condition that we saw in 2022, the system can't handle that, together with the natural embedded leverage that we have built in the system, in the products behind it, and all that we have discussed so far, I would say making the case for a relatively bad recession is not something you should discard. We often talk about all the issues and kind of where it's going. And whenever I think about central banking in this legacy system that we all operate within, And it just seems like it's a crescendo that's just growing in systemic stability as we're moving right on the timeline. How do you see this resolving itself?

Starting point is 00:50:35 You know my opinion. My opinion is I think Bitcoin has a major role in how this all gets resolved and actually bring stability to the system in the long run. I'm curious if you agree with that or if you see some other way in which they can actually write the ship and actually bring stability back to the world without ever growing. systemic risk. No, I don't, I don't think that's possible. Preston, it's, if you want the world to grow organically without having to engineer leverage and credit, that happens via more people actively contributing to economic growth. So a growth in the labor force and by more productivity.

Starting point is 00:51:19 If you have those two, then the world can grow organically. And it makes sense, right? you're growing the pie by having more people contributing to growth and having them more productively so contributing to economic growth. So then you don't need any artificially created environments or credit creation or leverage to boost growth. But look at the two things I just discussed, labor force growth where, like if you look at Europe, Korea, China, Japan, most developed economies, they will have a negative labor

Starting point is 00:51:49 force growth over the next 20 to 30 years, Preston. negative labor force growth, which means you don't even have enough new young people to replace the retirees. You'll have a shrinking labor force. So you have less people contributing to economic growth. When it comes to productivity, we already made most of the, most of the, we already saw most of the benefits of technology permeating many sectors of the economy. So that productivity growth is behind us. We keep growing year by year in terms of productivity, but it's too little. So then you have to use these tricks. You have to create more credit. You have to get more leveraged year after year after year. And again, the policymaker incentive scheme will be to try and

Starting point is 00:52:33 keep the system as stable as possible. They will manage, probably for a bit longer. This will increase the inherent instability of the system in the first place. So where does it end? It's actually a good question. Look, I think this is rather a death by a thousand cuts than anything else. The pandemic was the perfect excuse to try and restore the system, Preston, because it's an exogenous event. It's something that you can't control and you can't predict, right? Policymakers could have said, well, the system is deleveraging.

Starting point is 00:53:10 We need a new form of money. We need a new credit system. If you want to make the credit system, otherwise we need a new sound money system. Let's work to it together. This could have been an option. The reality has been the option. opposite, where they have doubled, triple, quintuple, the normal reaction they have, right? Gigantic QE programs, gigante fiscal deficits program, artificial stability being brought back

Starting point is 00:53:32 to the system. And this tells you where the incentive scheme lies, Preston. It lies into bringing the system to a higher and higher and higher level of inherent instability by trying to make it more stable. And I think that's where we are going to go. What's the end game? look, this is a very interesting question and the reality is there is one asset which is already sitting on the balance sheet of most of these decision makers, policy makers I mean, and that's gold.

Starting point is 00:54:03 It's already sitting on the balance sheet of central banks, of governments, and it's been already this hard asset that we have tried to pin credit creation against during the gold standard until the 70s. Gold, though, has a lot of problems with it, right? I mean, it's not fit for a new system in a new technological environment. Gold is not optimal to serve that role anymore. So digital assets can play a role into it, but then you need something that is reliable, trustable, scarce that cannot be increased in supply. So when I say digital assets, obviously you need to shrink your field if you want to try and refer to that asset, then probably Bitcoin gets the closest to it. And look, this is a very long-term process, Preston. And I don't think

Starting point is 00:54:49 it's going to be disruptive in a way that a major external event accelerates it. Otherwise, the pandemic would have been the perfect candidate, ex ante, right? It's an exogenous event. Still didn't serve the purpose. So I think it's rather going to be a death by a thousand cuts, trying to make the system more stable, but in reality making it more unstable as we go. And then at some point, the system will have to move to something different. This is my last question for you, Alf, is there's a lot of people, writing and talking about the U.S. and many other countries being in a death spiral with respect to as they look at their tax receipts and they look at these higher interest rates that they have

Starting point is 00:55:31 to roll their debt over to the interest expense is exceeding what they're bringing through the door. So are we in a debt spiral? If you talked a little bit about this potential for deflationary forces and call it six months to a year from now, hopefully we're dropping rates back down and not realize it. that death spiral. But in the long term, is this the start of the debt spiral that eventually kind of percolates out or do you not see that being where we're at? Look, there are two things to be said there, Preston. The first is what really matters in our traditional finance system is real returns and real interest rates. A lot of government liabilities are actually indexed to

Starting point is 00:56:14 inflation. So that means that if nominal interest rates are going up, because it's a lot of government liabilities are up because inflation is going up, then you have kind of natural offset because these liabilities are indexed to inflation in the first place. That's the first comment, which makes the problem a bit less problematic, but still makes the problem exist if you have much higher nominal interest rate on your debt, even if some of your liabilities are indexed to inflation, you're going to have a problem over time. Well, the answer again is policymakers can fix problems artificially so that are very close to the core of the system. And in this case, this could be fixable artificially via Ilkirf control, for example. We have done it already during

Starting point is 00:56:57 the Second World War and post the Second World War to make sure that we could fund the war. We could fund the rebuilding post-war. So we have said, look, these are the cost of borrowing. Even if inflation goes higher or lower, we're going to keep it there fixed. And this is the health curve control, right? So we've seen Japan doing that now for many. years. Again, those are not sustainable solutions to structural problems we have discussed, Preston, but people need to be realistic and understand that the closer you are to the core of the system, treasuries, repo market, the value of collateral, interest rate on debt, this system can be made artificially stable. This increases long term, the instability of the system. It breeds further

Starting point is 00:57:41 instability, which often pops up somewhere else. And in this case, can be the housing market, the credit market, the shadow banking system, as we discussed. So frustration can run very high for a long period of time because this can take a lot to play out towards the end game. And I invite people to follow the cycle, study macro, be informed, and also respect the cycles and the time lags that we are discussing while keeping an eye on the big picture. I know it can be difficult, but it also can be done and it helps people, I think,

Starting point is 00:58:16 investing their money in a more risk-adjust, generating better risk-adjusted returns for their investment portfolios, always keeping the big picture in mind, but respecting these macro cycles and policymakers incentive schemes that we discussed. Alf, I love having you on. I love having these conversations.

Starting point is 00:58:33 I always learn something new whenever you come on, but give people a handoff to your Twitter feed or anything else that you want to highlight. Well, if they want to follow my work, the best way to do that is on the MacroCompass.com. So the MacroCompass is my macro research and portfolio strategy firm. What I do there is I try to break down this complex macro topics in plain English and also keep people informed about macro developments and market developments by giving them actionable investment strategy so they can better manage the risks around the macro cycle while keeping in mind what's the big picture ahead. All of that, it's on the macrocompus.com.

Starting point is 00:59:18 And obviously, I have a Twitter feed as well. That's at Macro Alf, where you'll find snippets of all these macroanalysis and occasionally some pizza pictures because I am Italian after all. All right, Alf, thank you so much for making time and coming on the show. Thanks, Preston. Always a pleasure. If you guys enjoyed this conversation, be sure to follow the show on whatever podcast application you use. Just search for We Study Billionaires. The Bitcoin-specific shows come out every Wednesday, and I'd love to have you as a regular listener. If you enjoyed the show or you learned something new or you found it valuable, if you can leave a review, we would really appreciate that.

Starting point is 00:59:57 And it's something that helps others find the interview in the search algorithm. So anything you can do to help out with a review, we would just greatly appreciate. And with that, thanks for listening, and I'll catch you again next week. Thank you for listening to TIP. To access our show notes, courses, or forums, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decisions, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permissions must be granted before syndication or rebroadcasting.

We Study Billionaires - The Investor’s Podcast Network - BTC123: The Legacy Banking System in Shambles w/ Alf Peccatiello (Bitcoin Podcast)

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