Josh Younger on the Origin Story of the Shadow Banking System

to try to explain what we're experiencing now. Everyone, whatever it is, always says this is just like this, and like I get it kind of, you know, like naturally this say is what we do. But I also think, like, you know, there's that danger of like knowing too much history, which is if you know your history, you think it's repeating. That's right. I mean the one that everyone seems to reach for is the seventies, right, like, oh, this is just like the seventies, We need a Paul Vulcer to

come and really tamp down inflation. And then the other one that I'm kind of partial to this one the nineteen eighteen Spanish flu. Who can forget the period after that in World War One ended up with the high inflation and then it flipped into deflation. You know, the other one that I think about. Two is the Euro

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

gets mentioned. It is the year one specific year ninety three. I don't know anything that happened in I would never you could have guessed, asked me any year in the nineteen hundreds and I would not have Yeah, what happened here? All right? So it turns out nineteen fifty three was actually a seminal year for global finance for reasons that I will not get into right now, but specifically because it ended up with a policy decision that still has

relevance today. So not only was the US specifically in the nineteen fifties facing high inflation, tension between employment and prices, things like that, but we also had an outcome that has sort of like echoed across the decades ever since I want to learn more. I'm ready. All right, Well, we really do have the perfect guests to explain nineteen fifty three and it's relevance to today to us. We

are going to be speaking with Josh Younger. He is the global head of Asset and Liability Management, Research and Strategy at JP Morgan. He has also a repeat all thoughts guests. He's no getting up there like this is. He's become not quite in the lead, but getting close alright, one of our favorites. So Josh, welcome back to the show. That's great to be back in studio, which is more exciting. So this is just your hobby now it's researching financial history.

I needed to know hobby basically, Um, yeah, it's it's just for fun. And there's so much you can do online, Like it's sin's weird to say that the internet's a wonderful thing. Like you can pull up basically anything, and the Federals, your bank at St. Louis, has been very kind to provide like an enormous quantity of documents and data so you don't have to get Dusty and archives. You can just search it. This is what I should be doing instead of just scrolling Twitter at night and

playing playing chess online. I need to go on the New York Times way back machine and see what bond market volatility was like in the early nineteen fifties. Well, okay, on this note, Josh why nine specifically, he has a lot of relevance in general. So that's the year where the European country start opening up their imports to to the dollar zone. It's the lended debt deal with the Germans after the war around German debt um. But it's also one of the years where the Feed is really

forced to make a really important decision. So it's where a lot of their desire to get out of the bond market. I'm sure we'll talk about what they did during the Second World War. It's a very controlled market. It's very heavily um managed by the Fed at an active basis. They really pegged yields on the long end, and getting out of that is complicated. And in fifty three is when the market really tests them. So we didn't have to don't fight the Fed mantra quite quite yet.

At that point But this is like a really interesting philosophical question right here, because there's always this question today or in any period, to what degree is the rate that we see on a ten year, on a thirty year, on a two year a policy rate verse a market rate. Before we get to fifty three, specifically, can you just talk a little bit more about what you're what you

said about how rates across the curve were essentially policy rates. Yeah, there's when we think about a tenure rate, like you could do one of two things. You can roll treasury bills every three months for ten years, or you can buy a tenure bond. So in a perfect world, those two things are connected through expectations. Uh. And then there's this question of should I involve some a little premium on top of them, right, the term premium, which is

unlocking my up my money up for ten years. I might be wrong in my expectations, and so I should probably be paid for that at least little excess over the expectations. And so they're connected. Most of the tenure eight is an expectation. Those expectations are often wrong, but you know that's a that's a separate issue, um. But there is a policy lever and on the on the other hand, there's the market level, which is a term premium, their demand to actually buy the bond in the first place.

So talk to us then about the state of the bond market. You know, coming out of World War Two into the nineteen fifties, you mentioned that the Fed had imposed yield curve control um basically to finance the wartime deficit. They were trying to move off of that. Again, these are all sort of familiar themes to anyone in two, But why was that difficult for them? Well, so let's get a sense of scale, right, So in in ninette,

there's about forty billion dollars with the treasury outstanding. There's about two and forty billion dollars where the treasury is outstanding. So that's about double the pre war p GDP. If you scale that, say, okay, COVID expenditures on the scale of World War two, that's about forty trillion dollars in

net treasury issuance. So we're talking about a lot of debt um and the question is who's gonna buy yeah um, And what we're dealing with is kind of nothing we got in that context, and so that's where I guess the analogy breaks down, not to start there for the episode, but like, it's a very difficult problem, which is who's going to buy the equivalent of forty trillion dollars today in debt um, and one of those participants is the Fed.

So what the Fed says is in in further into the war effort, we're gonna peg gields uh specifically the front end, the one year point, and the long end. So every tenure bond, for example, yields two an a half percent or less because I'm willing to buy it to an alf percent um. Every Treasury bill yelds three. That's roughly where the curve was at the beginning of the war. It was no like particular thought given to

that in terms of like fair value pricing. It was just saying, wherever it is is where it's going to stay until until conditions allow real quickly. How much actual buying did they have to do versus the declaration of the price essentially taking care of most of it. Yeah, not that much. I mean they thought about twenty billion dollars the Fed did over the course of that period. Most of those were in bills actually, because bills at three eights are not very appealing. Tenure bonds at two

and a half or a lot more appealing. So what the market did was they extended. And actually the FED was a net seller of long and boughts towards the end of the war because deals were dipping below their target m so, so it wasn't all buying, but they owned something like the bill market by the end of the war. Um. And they didn't really have a chance to get out so easy because when you get out

of that situation, like, you can't just turn it off. Um. And so there was this outstanding question, which is how are we going to get out of the market and not completely blow up bond markets in the in the first instance, Like, how do we do this in the right way? Well, so, how how did they try to undertake that transition? I mean, nowadays you think about the FED trying to wind down its balance sheet embark on quantitative tightening. There's a lot of communication that comes ahead

of that. Was a similar thing, trying to broadcast to the market this is how we're going to do it. Please don't freak out. It was really fraught um So. Ken Garbage has done a ton of work on this and they really didn't fits and starts and very slowly, so no one ever really imagined they do cold turkey like that was never really considered. So what they said is, well, let's start with bills um. And then the Treasury said, well, we don't want to big bills. We like bills at

three eights uh. And and there was a back and forth over a couple of years, and by I think it was forty seven. Essentially the committee went to the Treasury and said, we think this makes sense. We'll figure it out for you, but we're going to do this in two days. And so it was a kind of unilateral decision by the committee. There was some sweet nurse for the treasury, but the Fed basically told the Treasury

we're doing this whether you like it or not. Uh. And then the debate moved on to the certificates of indebtedness was roughly the one year point, so he said, well,

can that be released? And by around the fifty yearly fifties, the front end of the curve out to the one year point was free to float, so billy yields came up into the one rate one one and a half percent range, So it was kind of a market rate, but the long end was still a two and a half, and they hadn't figured out how to stilt that, and that was most of the market um, even though the FED to own most of the bill markets, so that

made it a little more straightforward. But um at the long end, you know, that was most of the outstanding debt at the time. So I'm just trying to understand a little bit more. How much of the challenge of for the Fed, of extricating itself to some extent from the bond market was about the rates specifically, and what that would do to the economy were rates to jump up, versus who, um, whose balance sheet these assets would beyond? It was both. So the Treasury just doesn't like the

idea of paying more, which is test of all. I mean, they have a deficit to fund, and by the late forties early fifties, the deficits standing again, so they paid on their debt pretty fast. And then by the by the early fifties you've got the Korean War, You've got a tax bill that actually Truman vitas and has passed over his objection to cut taxes, and so there's a

fiscal expansion going on. So that that's the treasuries and incentive. Now, a lot of their documents suggested were also sensitive to the feds concern around inflation um and inflation was under control for about a year after the war because the Office of Price Administration basically fixed the price of things. They tried to renew that that organization to keep price fixing in place. Truman decides it's not a strong enough bill. He vetos it, but they can't come up with saying

that can pass the vetos, so it just expires. So all prices are released at the same time. So shock therapy.

But I don't go well, okay on that note, I mean the inflation of the late nineteen forties, early nineteen fifties, how much of that was sort of supply chain issues, you know, the transitioning of the U. S. Economy from a wartime footing to one of peace, and then I guess they went back to war relatively quickly given the Korean situation versus actual debt monetization, because you know, the FED was in the market buying back trudge, Yeah, it was.

It was. It's hard to make an attribution. I haven't seen a good attribution. But you know, the other thing. The FED bought twenty billion dollars worth of worth the treasuries during the war of commercial banks bought se so commercial banks are the real price fixtures in the treasury market during the Second World War. And when when a commercial bank buys the treasury bond, they create deposits on the other side of that. So they didn't let loans

roll off and replace them with treasuries. They had new assets. So the leverage in the banking system doubles in three years. This is new money because deposits or money, right and and some will talk about money's a spectrum, so deposits are very close to the real paper money side of

that spectrum. Uh. And so there's a view at least at the Treasury and the FED that that because banks are so heavily supporting the market and market debt, that that expansion of their balance sheets, expansion of the money supply has generated a lot of inflation. So that's on the demand side. Too much money. Um, we can debate monitorism, I guess on a different episode, but they said there's a big expansion of them to supply it at the same time, like you go from guns to butter and

back and and that that's disruptive. So that's that's where analogies come in. You're really moving the economy from a very different production model UM in the year, and then you're trying to bring it back and these things don't start up that quickly. This is all so familiar. So okay, so the FED doesn't want to be UM fixing the price of all these assets. There's also this concern about too much commercial bank leverage and valid or not. So who else is there where where? What's the next step

here in terms of who enters the market. Yeah, so the non bank investors are really domestic. So something like less than one percent of the market for treasuries at the end of the war needs to the late fifties is owned by international investors. So you have to find insurance companies and you know other there's not a great deal of granularity in the old data, so it's basically like it's a bank, it's an insurance company, it's the FED,

it's an international or it's somebody else. And so you know that we don't have Pimcoes and black Rocks in the world time UM and corporations are very important. Corporation is very cash rich. Um, they have a lot of money to invest, and so to find a place to put it. But ultimately to an a half percent in worldward inflations at ten is not particularly appealing. So what

happens in the bond market? I can imagine that, you know, the combination of two and a half percent being not that appealing, plus the Fed basically you know, making it fairly clear that they would like to step back from the market. I imagine that's a recipe for some drama. Yeah, there were the what became the Accord of the Fed Treasury Accord the Treasury Fed a cord. I'm not sure what the order we're supposed to put in, but that's in uh. And that's the result of a lot of

congressional pressure in the early fifties. So in nineteen fifty the Banking Committee the Senate condads a hearing and make recommendations. You know, that's thanks for being helpful kind of thing. Um. And and the President gets involved, and there's just a lot of concern that monetary policy is worsening a very disruptive inflationary environment. And by early fifty one there's just enough pressure on the the Treasury to get along that they figure out. And one of the most important characters

in this debate is Bill Martin. So Bill Martin used to run the York Stock Exchange in the thirties, so he comes from a dealer background, he comes from the street. Um, he goes in and runs the XM bank for for Truman, and then he's brought into Treasury by by Snyder, who's the Secretary of the Treasury at the time, initially as an assistant Secretary for international affairs, but he quickly becomes

kind of a fixer. So he's kind of doing everything and he's tasked by Snyder with liaising with the Federal Reserve to figure out a way to get out of the market. Um that it's amenable to both parties, Like, what's the best way to do this? Because we kind of have to do it now? So what did what did he do? So he broke here it an arrangement that came out as a very vague commitment. So they basically just say like we've we've reached a full accord. They don't say what that accord is other than to

say we're gonna stop monetizing the debt. So then us is, how are actually gonna do this, but they do put that up publicly and make a public commitment to free the bond market UM and a couple of days later, Martin is actually nominated to Chair of the FED because mcape's deaths down, so he switches sides UM and he's confirmed pretty quickly, and by by early April he's the Chair of the Board of the FED and he's very he's very committed to this inflation fighting thing, and in

his oath of office statement he says inflation is the greatest threat, including the enemies beyond our borders or something to that effect, which you know in in April one,

three days earlier, the Rosenbergs have been convicted. H you don't get Joe Welsh saying, you know, have you no decency sir to McCarthy until fifty four, So this is the red Scare, and he's saying inflation is worse than communism or implicitly and so like he's he's very much committed to the cause, but the commitment is out there.

It's just the question of like how we're going to execute this in practice, and that's where you know, the changing of the guard at Treasury, the Eisenhower election, like people have to get into the seat for the next administration to actually affect the change in policy, because they ultimately need to agree. Snider didn't like the idea of ission above two and a half percent, So the Treasury kept flooding the market with short term death uh and then,

and that was partially for regular debt management purposes. They do some things around non market all to debt, to get the bank debt bank holdings down, but ultimately there's just a lot of institutional tension. At one point, Truman takes Martin's side at some event and says, you're a trader, right, gets very much in his face. Um. So it's it's a very like fraught situation. I feel like I'm listening to a really good, like campfire story. This is good. I just wanted to just I don't even want to

ask any questions. I just want to hear what happens next? Okay, well, what happens? What happens next? I mean, on that note, you can imagine at some point the Treasury goes back to selling longer term, right, and how does the market take that? So that's an Eisenhower administration thing that they're part of. Eisenhower's election is about inflation. Actually, one of the first television commercials ever got sent to a general

audience is about inflation. Is Eisenharer saying, my grandmother doesn't like the inflation. That's why I say it's time for a change. There's a central plank of his presidential campaign. Eisenhower answers, America, you know what things cost today? High prices are just driving me crazy. Yes, my Nami gets after me about the high cost of living. And he nominates not only Humphrey, who's committed to fighting inflation, but

a bunch of x FED people. So he brings them people in from the New York FED and other places to be senior advisors under secretaries. And so, you know, the news media at the time speculates the FED is like one this argument as to the relative benefits of low cost of debt service versus inflation. So inflation is the priority. So the changing of the administration changes the priorities. Uh, And they come and they say, we need to find

non bank investors. We need to find a way to sell long term debt that doesn't inflate the size of the banking system. And by extension, the money supply and by extension the price um price pressures. And and their

solution is to reintroduce the bond. They hadn't issued long term debt since forty five uh and and they want to bring back the bond uh And the question is how do you figure out the right way to do that because the market is not used to buying I think it was supposed to mature in eighties free or something like that. So it's like a thirty year bond and they haven't done third year bond a really long time. So who's gonna buy it? How are you going to price it in a way that brings in brings in

interest from non banks specifically. I mean this point is interesting because when politicians talk about fighting inflation today, they're talking about fiscal various fiscal policy levers and we need to cut spending here, or we need to you know, expand oil oil drilling or something like that. But it sounds like in the Eisenhower administration it was like they're trying to solve it via the financial system or via

plumbing and something. Everything was basically well, there was a fiscal lever as well, I should say, um, but that's always a little hard thought to say, oh, higher taxes because inflation is higher, and that doesn't feel great for anybody, but it's today. Yeah. But the but the debt management strategy of the treasury when the when the Feed is buying get it fixed price, debt management is money manage because they're in the market to buy at any price.

They buy treasuries. When the Fed buys treasuries, they print new money with which to do so. Um. And so those two things are connected, and this becomes a technocratic problem. There's not there's actually quite a bit of public debate about debt management, more so than you would expect given the current current climate, or at least focus on, you know, how much, how big the twenty years sector is and things like that. Um. But you know, it's not like

a political story all the time. But then it would have been. Um. But you know, I think that the key here is there's an alignment of interests. And so Snyder comes to the market and he said, sorry, Humphrey comes to the market and says, we're going to bring back the bond and by the way, we're pricing it cheap,

so get involved. So we're gonna price it about a quarter of a point sheet to where you would have otherwise expecting given where like the Victory two and a half, we're trading and Victory two has we're issuing forty five. Uh so everybody's interested, right, so they're saying, we want to blow out reception. They get five times the over subscription, so they get five and a half billion of orders for roughly a billion of paper, and they're feeling really

good about it. The problem is, it turns out that a lot of that five and a billion was speculative. So people were trying to buy cheap bonds and flip them for half a point um. And so they called them free riders back then, which I haven't heard, but it's it's kind of a fun, fun analogy. And so um, we could I ask you who did they think they

were going to flip them to? Unclear somebody else? Um. And so it's it's just a question of you know, if if you think the bond is trading fundamentally cheap, then there's probably someone else at what you think the par value should be um. And so their bet was the expectations of the market were at for a lower yield, they could buy it a slightly higher yield, they could flip into someone with different expectations, and it's as long as you got filled, you'd be happy, as only you've

got your order insufficient size to make that interesting. The Treasury also makes a mistake in in filling orders on a proportional basis. So if you put in an outsized order, for example, as part of the fixed rate um placement, then you've got a big allocation. And the problem is if you're a spec account, that's not necessarily what you want it to happen. Um, So a lot of the bonds get sold almost immediately. Yeah, this sounds familiar. This is like big bond funds patting their order books with

like corporate issues nowadays. Yeah, it was actually so concerning that they delayed allocations which had never really been done or at least for a long time, so the Fed could go through the orders and make sure that they all made sense, you know. So they were a little nervous from the start. But the von eventually prints in in I believe it was late April. Initially it's trading okay um, but it starts to weaken pretty quickly, and

in particular, the market starts to become pretty dysfunctional. And you know, one of the fun things about the New York Times and the fifties is they published bits spreads for every treasury issue on a daily basis. So imagine the poor reporter that it was after the sports section, so they had their priorities straight. But it was actually the whole business section was after the sports section. Any papers that even have stocks anymore, probably not, probably not.

But they had fex forward pricing in Europe they had so three month forwards and sterling they had. They had on a roughly weekly basis. They had daily bond market priceing. So I mean this was the only source, right, you have nowhere else to go. Okay, so the bond starts treating week then what so they're faced with a choice. So inflation is still pretty high. This is gonna sound familiar. So you have market functioning issues, right. So the solution

of market functioning issues is to buy bonds. Uh. And there's two problems. The first is the fet is committed to buy only bonds in the short end. That was part of the agreement. When they came to the accord, they said, we're only an interview in the market in the short end. And that's specifically to provide reserves, So it's not about target prices for long term bonds um. So we're gonna let the market fund the price. So I have to decide if they're going to buy long

bonds because that's where the pressure is. Bit that spreads are widening, volatilities picking up um. And then they've decided if they want to increase the size of the money supply at a time when inflation is running hot. So you have you have a you have a discrepancy in the policy goals, which is fighting inflation, you should be tightening, but to fix market functioning, you you have to ease.

And so that they're faced with this like really existential choice, and ultimately the world kind of bails them out in the sense that these the business cycle turns made a

year right around when this is happening. So they buy a bunch of bills, They do a bunch of repo, which we'll talk about I'm short shortly, but did a bunch of financing, offer financing to dealers, UH, and they lower the reserve requirement and banks they grow the size the banking system, and they buy a bunch of treasury bonds in the second half of the year, banks increase their holdings by two billion dollars. So they buy the long end though, or just they bought the long end

as well. Yeah, so they they banks were sort of interested in not the long end long end, but like intermediate type paper, you know, three to five years, and

they also buy bills um. And ultimately the question is can we take the excess paper out of the market, which doesn't have a home and dealers can't wear a house um and resolve the functioning issues and kind of come at the problem again another day, extremely boe in terms of what's going on right now of this dual tension of like, we need to maintain financial market stability, but also we're in an anti inflation dans until any perception of balance sheet expansion is seen as working cross

purposes totally. And also, I mean just the idea of we need to expand the buyer base for US bonds as well, that's kind of familiar. There's been a lot of chat recently about who is going to buy bonds giving given interest rate volatility and you know, a backdrop of higher inflation and all of that. Okay, back to the story, So the market tests the accord, the FED kind of backs down, and then then what does it do? Does it try to like go back to the period of the accord or does it try out some new

solutions to this problem? So they have two problems, what is it going to buy the bonds? Uh and the others? The dealers are clearly not capable of interweting a market that large, right, So they clearly are not able to wear house securities enough shot size to really damp and volatility, which is what dealers is supposed to do, right. They're supposed to find a buyer and a seller and if they can't find each other the same day, they hold that thing in their inventory. A big problem the dealer's

had was financing. So most for most of the prior seventy years, UM dealers have been funded most about what we're called call loans. Call loans are kind of this intuitive concept, which is, if I'm a dealer, I need a certain amount of money barred every day, I'll post collateral against it, but I'll probably borrow it from a bank and I'll just change the balance on a daily basis, and I'll pledge whatever bonds I have as collateral to

back that loan. So uh, that was the call loan market. Um. The problem with the call loan market is was kind of expensive, and when bill yields and treasure yields were below the call market rates, it meant the inventory was negative. Carry carry means it costs you money to hold inventory. You don't make interesting comb at least to hold the inventory. So it becomes very expensive to run a dealer when you have interest rate and expense on top of the

salaries and infrastructure and things like that. Uh. And so this has been a problem to forties as well, and that's when they brought back the repurchase facility. Repurchase facility dates back to v when they used its support the First World War effort, and they were concerned that there wasn't a market for treasuries back then, and so they used repurchase agreements, which are the buying and selling of a bond at different prices. That kind of mimics alone,

but in two transactions. Um. And so that allowed the Fed to do two things. One is allowed them to lend money to non banks, which is critical uh. And the second thing is allowed them to do that below the discount rate in principle, so they could do it at a rate that was consistent with where bills were trading if they were below the policy rate. So this is kind of a legal workaround, right, because I imagine the FED isn't really supposed to be lending money directly

to non banks. I mean, the whole reason that banks have regulations and things like that is so that they can interact directly with the FED and they have that sort of safety backstop. Is that right? Yeah? Carter Glass of Glass de Eagle was instrumental in the original Federal Reserve Act, and he said this is not intended for non banks, but in the depression they find out that,

like sometimes you need to write. So the thirteen three, which becomes Section three, which becomes very famous in two thousand and eight, that's the authorization that allows them to do all kinds of interventions. It specifically allows for the lending or extensions of credit to non banks, um so to thousan eight that includes you know, primary dealers, that includes a variety of real economy participants. In two twenty they do the same thing. So like the main street

lending facilities in principal thirteen three facility. The problem with thirteen three is it's only allowable under exigent circumstances. So this is not a business as usual facility. This is, if it really comes to it, you can do pretty much whatever you want, but you need to be at least a of the opinion that the world's about to collapse, and b you have to be able to demonstrate that credit was not otherwise available. So it's clearly not the

case where dealers in the fifties. The workaround is, well, this is a repo, it's a purchase and a sale. This is an open market operation. This isn't Section three at all. Is this section fourteen which allows me to transact with primary dealers, and so yes, this at the economic features of a loan, but it is fundamentally a

purchase and sale. Um, they had to do a little bit of jimmying with it, and it's money is to make it consistent with legal opinions, like I think it's it's putable as opposed to like specific maturities, and they try to work around some legal interpretations. But fundamentally it's just a way to lend money to non dealers in a format that gives the committee a lot more flexibility. Just a brief like sort of theoretical question, is there ever really a limit to what the FED can do

beyond the creativity of lawyers. Well, that's anything, basically, that's what I mean. And you know, we look at these documents. It's true, you know we look at these documents and their debates about what they didn't. Right, It's like, don't lend the banks. But actually, I'm sorry, don't learn to non banks. But you totally count the constraint. Yeah, creativity in Congress. So Congress can give you very specific constraints

and and the courts can, in principle stop you. I think it's tough with the FED because the question is what's the cause of action, Like who's going to soothe them and say you shouldn't have lent this dealer money. Um. So I'm not sure how much this has been tested in court. This is where my lack of a law degree is probably worth noting. Um. But but ultimately, the

interpretation of these rules is ultimately is an interpretation. FET has a general council, they write opinions, and there's an internal process, but they can do whatever they think to

be ultimately legal. So the fence Repot facility is created in nineteen seventeen, but then in the nineteen fifties, as you just described, it presumably gets a big boost because they've settled on it as a way to solve this problem of how do we sort of settle the debt market without sparking debt monetization and another bout of inflation. So what's interesting here is the FT doesn't do a ton of repo, But what they do is they demonstrate

their willingness to use it. They have a big internal debate, they write a bunch of memos and they say this is something we're committed to doing at the bill Raider higher so basically saying we are here for the market to provide repo to primary dealers at this specific administered rate and industry meeting. We're just gonna say what it is. It's not an auction. We're just gonna tell you where we'll lend to you. Um And so that's important as

a backstop. So it's not so much that the FETE is financing dealers, it's they're providing a liquidity backstop at a specified rate that gives other market participants willing willingness to participate in the repo market. So most funding and repo by the end of the fifties comes from corporations, and those corporations had bank deposits. Bank deposits were limited by red Q as a depression year regulation saying we don't want banks competing with each other for funding. That

leads to bad outcomes. And so they don't like their bank deposit yields. They go the repo market. They get wholesale funding rates, they get much more attractive yields, and so the FED gives the market confidence that they can participate in this in this sort of money like or deposits substitute. Actually, the New York Clearinghouse is really worried

about this in the late fifties. So consortation of banks say, you're cannibalizing our funding, Like, we don't want people doing repo, we want people keeping deposits with us, So sorry, can you just walk through or make a little marked clearer. So this is sort of what plays the call loan market. What what does the gap in terms of like financing costs between these two things, and what did that open up in terms of you know, how much balance sheet

or how much capacity the dealer community had. It wasn't always a lot, but it was predictable, and the FIGHT could control it, and and the call in market was prone to they call them call in panics, so like you'd call your New York bank and the wouldn't have money on hand, and and so you'd call it someone in Midwest or something like not non New York, other city bank or you know. I don't think the rural

banks were participating in this, but it was. It was just hokey in a lot of ways and somewhat unpredictable, and they ultimately ended up going to FED funds markets often to a plug intraday liquidity gaps and and repo was better than that for that purpose. Um, but the price could just be maintained by the FED specifically, and

that was key. So UM, if the FED can control the price, and they can make sure it's profitable to run a dealer, and they can expand their balance sheets, so we don't have there's some data on dealer balance sheets. I think turnover is a better measure. So turnover as a fracture of the overall market, which you got to

scale it to the whole market. Between nineteen fifty, I guess fifty five might be the earliest day we have to the late sixties goes up by multiples um, so the dealers are able to move move the debt around much more easily. That's important because they're a distribution mechanisms. You want non banks buying treasuries, you have to find them, and dealers of the mechanism by which to get them the paper. Uh. And so that's when non bank ownership starts going up a lot. Banks or go from half

the market to thirty percent. By two thousand and five, two thousand and six, they're like three or four percent of the market. So it's a very successful policy. Like dealers are able to do a lot more volume, a lot more turnover bits, spreads stay relatively tight until relatively recently and and by the two financial crisis. Like not US banks are not a huge fraction or even a dominant fraction of of the of the treasury market. They

have a lot of non bank participation. So this is the amazing thing because I think nowadays we're accustomed to thinking about the repo market as like a source of potential instability and a big component of the shadow banking system. So you think back to two thousand and eight, the repo market was kind of ground zero for a lot of the problems that that occurred in a mortgage backed securities.

And then in the decade since two thousand and eight, all we've heard from the FED and the Financial Stability Board is, Oh, we need to get a handle on shadow banks, we need to reform the repo market, we need to make everything better. But as you're describing it, this was a direct policy decision made in the nineteen fifties to solve a specific problem. Yeah, it becomes saying it's really entrenched. So the repo market is are the

solution to their problem in lots of ways. But by the time the solution becomes very effective, now they're committed to the repot market. So you know. Great example of that is an eighty two when a bankruptcy court finds that the collateral associate with repo is subject to an automatic state. What does that mean. It means if a dealer goes bankrupt, this court will seize their collateral and hold it until the bankruptcy is resolved. And that doesn't take a day or two. That takes a long time.

People have just sort of assumed that that wasn't the case, because like, oh, this is a purchase in a sale, like why would this be subject to a day I just have like a bond that I sold you, and you're gonna sell it back to me. We'll just do that. Uh And And the FED panics basically in eighty two they lobby Congress aggressively to get specific protections for REPO

and other similar instruments and basically legislated. So there's a bill in eighty four that's meant to reform the judicial nomination process that actually has within it a protection for REPO that exempts it from the automatic stay. So the preferential treatment for REPO specifically in bankruptcy um and and that is necessary. Vulcar argues directly, it's Bob doll at the time, like to stabilize the whole financial market, you need to do this. Um. So it's just an example

of where you sort of find a good solution. Now you're now it's entrenched, and the more it presents issues, the more you have to like step in to provide other protections or specifically that market. So it is a shadow banking system in the sense that is treated like a money alternative, like a deposit alternative, and it's sort of wrapped with successive layers of protection. First, as the FED liquity back stopped in, there's bankruptcy protection. You know

banks for example of different treatment under bankruptcy. Now REPO has different treatment under bankruptcy. And by the time you get to two thousand eight, and especially in the FED is doing both sides of the real market, right, So the FED is doing the standing REPO facility and the reverse REYBU facility. And so now it's very much a

policy lever in lots of ways. Um whether or not that's desirable as a separate question, but but ultimately REPO becomes the plumbing because it's so effective in facilitating the initial policy goals of the Martin Fat. So this is really interesting, and I guess just to sort of piggyback on Tracy's last question, I mean, we do seem to have these recurring bouts of instability today in this part

of the market. The market that exists solved a certain problem at the time, Like what is the trade off is that we're still living with today because it seems like the sort of like old regime, while maybe it had issues with sort of like inflation, etcetera. Um, the sort of the less market based regime, so to speak, at least it was more stable. Yeah. I think that

there's different phases of cognitive dissonance here. So you know, if you can pull dealers in and say you're gonna in your the critical intermediation mechanism for the treasure market, and not only critical to intermediating it, but getting things out of the out of banks and into non banks is like critical to financial stability and and and more important than the enemies beyond our shores, right, And that's what they're saying. Um So to fight the Soviets, we

need REPO basically and again relevant to today. Yeah. Uh so the problem with that is you need a regulatorriticism that recognizes the relative importance you're placing on dealers. And that took a long time. So dealers are regulated by the SEC. It's a it's an investor protection mandate. So basically, if and when a dealer goes bankrupt, we wanna have

funds on hand to resolve all outstanding trades. Banks are safety and sound is mandate, which is like, you can't go bankrupt, so let's make sure you don't because you're critical to the functioning of the economy. And so those two things don't entirely mesh. And by two thousand and six seven there's a series of changes to how dealers are regulated, and all of a sudden they have a ton of leverage UM forty times leverage is one that

everyone always quotes. But like turn over, the treasury market skyrockets because not only is it uh not as only our dealers allowed to take more leverage, but also treasury specifically in treasury rebo like don't really count torture the space capital requirements, and so there's just a lot of capacity to intermediate treasury bond trading and repo trading. In two thousand eight, everything gets stuck back into the banking system.

So all these independent dealers, with the exception of the smaller ones, but like you're rather out of business or

you're part of a bank holding company. So Leaving goes out of business, bears absorbed by JP Morgan, um, you know, Mary all goes to Bank of America, and all of a sudden, they're all subject to that bank safety and soundness requirement or at least within the context of the holding company as a as a whole, uh, And so the market gets consolidated behind the bank regulatory perimeter, it

becomes like formally associated with banks. Um, that's fine as long as treasuries don't consume a lot of you know what we often call the industry like resources, meaning capital and liquidity. Treasuries are risk free, treasurys risk free or at least nearly risk free, and so depending on how it's haircutted and so forth and so like, if it doesn't add to your risk weighted assets, which was the binding constrainting banks for a long time, you've got a

lot of elasticity. You can grow and shrink and treasury bounty pretty straightforwardly. Leverage constraints come later and they are inconsistent with that, or at least into some circumstances. Well, this is exactly what I wanted to ask about. So today there is this big question mark over the treasury market about who is going to buy and also intermediate the bonds. So we have a lot of interest rate volatility. Dealer inventories are lower um than they have been historically.

Like what exactly is going on there? Like the repo market exists, it experiences spasms from time to time, but the FED comes in and for the most part, seems to fix them or at least set up new programs aimed at fixing them. Why is this still happening? Why do we have that concern? So it's it's a little

different every time, which is unfortunate, but but ultimately that's why. Yeah, yeah, but you're seeing banks to buy more treasuries now, right, So like there's a there's a certain amount of increased monetization of the debt through the commercial banking system, not necessarily through the Federal Reserve um and and so that's helping where it was helping for a while, it's not

so much helping anymore. UM. But I think the issue is repo is a form of money substitute that has the implicit backing of the Fed, but is not really wrapped in the same kind of cloak as deposits. And so deposit funding is stable and sticky funding at low cost. Repo funding is fine until there's an issue, and then it's sort of more prone to instability than than more

traditional forms of bank funding. And as you go further out the spectrum, you know, we're talking about treasury, but then you can talk about mortgage repot in two thousand and seven could have talked about non agency mortgage repo, and then there's a question of the collateral credit quality as well as access to liquidity and so like repo is is just not money in the sense that deposits are.

And so if banks are being called upon to interveeding at treasuries as a core banking activity and effect, um, they're still funding it with with a form of funding that's reserved for dealers, and that's the investor protection world. So there's a little bit of cognitive dissonance there. Um, But what the FED is doing is their backstopping both sides of the market. So so repo's perceiving those kind of controls. And there are other central banks where repos

the primary policy. Right, So this is not you know, particularly unusual. Um, whether or not it's desirable as a separate question, and whether or not those facilities are effective. There is another one. You're talking about dealer inventories. Now I think there's I think I was on to talk about this pretty recently. Um, I remain relatively sanguine, I guess, and you know, prices are moving around, but the world is moving around like the world is as volatile as

the treasure market is. Volatile and so like that's necessarily I wouldn't say it's a good or bad thing, but it's certainly not unexpected. Um dealer inventories being low off the run, trading not being particularly high as a fraction of total, Like, you don't see a lot of the monetization of treasuries in the form of sales to source

cash in the way that you saw. So could that happen? Sure? Um, if the in inventories were going to rise rapidly and we had the same kind of dash for cash dynamic like, I think we've run into similar problems. Ultimately those issues have not been fixed, um, at least on a fundamental basis. But um, you know, the market is functioning even if it is a liquid I might have said precisely that a few months ago, but I still believe it's the case.

We've come full circle then, and I gotta say the idea that the treasury market is as volatile as the world itself. That's a good quote. Yeah, all right, well, Josh, that was amazing so much. Yeah, I can't believe this is what you do you know for fun um in your evenings, But absolutely fantastic, super educational and I think you're one of the few people who can draw a direct line between you know, something that happened in ninety three and a lot of what we're experiencing today. Yeah, yeah,

and I should. I should thank Levin and as Wealth has been really helpful with this, and he he does this for a living, so you know, I'm yeah, I've watched some of his like lectures on YouTube and stuff really interesting. You want to understand the banking system and there it comes from, and like why we have certain roles in the way they are. Okay, we'll make that happen, all right, thanks so much, Thank you very much, so Joe,

that was fantastic. I mean I actually feel like I kind of sat down and listened to like a narrative story.

I love that, you know what this although it confirms this like long view that I've had about all these questions about how many of the solutions to problems are about recreating the exact same thing under a new language or when it's like it's still the same thing, you know, and so like it always like sort of driving me crazy where it's like okay, well we want the FED to backstop it, but we don't want it to increase the money supply measured this way, so it's on someone

else's balance, but it's still like economically the same thing. Like all these conversations, like they kind of drive me crazy just because it's like I don't just have to fed by it all it solves a problem. Okay, Um, well that's a little extreme, but you get I agree with you on the branding, Like, never underestimate the power

of branding and giving something a different name. Right, So this is now a money like deposits really, but that's the point, Like so many different things in the end, when you like work it back, are still just some sort of like either fed back implicitly or explicitly like fed determined instrument. It's just like how many layers of pretend do we want to have so that it looks like it's just some like thing out in the market. Okay, so we've discovered that Joe doesn't want free markets. There's

no there's just there's no such thing. There's no such thing. It's all creating the illusion that there's like these like real markets, when in the end, it's like that's my it's it's always my ticure. I mean, the central bank at a very basic level is setting interest rates? Right, So like, okay, alright, well on that very high level of philosophical note, shall we leave it there? Let's leave it there. This has been another episode of the Addoughts podcast.

I'm Tracy Alloway. You can follow me on Twitter at Tracy Alloway and I'm Joe Why Isn't All? You can follow me on Twitter at the Stalwart, follow our producer Carmen Rodriguez at Carmen armand follow all the podcasts at Bloomberg under the handle at podcasts. And for more odd Locks content, go to Bloomberg dot com slash odd Lots. Tracy and I blog there. We also have a newsletter, a weekly newsletter when we talked about some of our guests and episodes and other things that we're interested. You

can subscribe there goes out every Friday. Thanks for listening. T T T thing to me to