Jim Grant | What’s the Price of Mispricing Risk? Interest Rates, Repo Markets, and an Activist Fed


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and join our amazing community. With that, please enjoy this week’s episode. What’s up, everybody? My guest today is Jim Grant. Jim is the founder of Grant’s Interest Rate
Observer, a twice monthly journal of the financial markets. He is also the author of several books, including
his most recent, Bagehot: The Life and Times of the Greatest Victorian, a biography of
the brilliant and influential English banker, economic and political writer and editor of
the economist whose ideas about central banking informed the US Federal Reserve’s response
to the global financial crisis. Jim, welcome to Hidden Forces. Well, thank you. I hardly recognized myself for a moment. How are you? Good, thank you. I’m well. You look fantastic. I told you, you look fantastic, lively, vibrant. As the listeners can see. As they can see [Nodding] . You have a vibrant
bow tie as well today. It’s more colorful than– I do. I read in the Wall Street Journal that some
people find bow ties to be an affectation. So, I tweeted out. You know, people love you and I think you’re
aware of this, though I don’t know to the extent that you’re aware of the fan club,
and I tweeted on social media that I was going to have you on the program, and I asked suggestions
for questions. And one of the questions was, “Ask him why
the bow tie.” Right. What was the second best question? The second best question was, “What is he
invested in personally?” I was going to tell him, “Gold and New York
Athletic Club bags.” Right. Right. Yeah. Well, the bow tie, my father asked the same
question. I was seen on television with a bow tie many
years ago, and my late father said, “Do you think that you’re Dave Garroway?” Now, this is a cultural reference that will
not be at the front of everyone’s mind. Dave Garroway was a TV personality in the
1950s. Not 1850s Demetri, 1950s. And he looked good in it. Yeah, he did. But did you like it? Did you feel that he gave you a certain gravitas
or seriousness so you didn’t have to worry about that? Oh, I don’t know. You just liked it. I liked it. It’s buttoned up. Yeah. I like my darn bow tie, Demetri. That’s it. I like it too. It’s such a big part of who you are. Yes. The FT, Financial Times has this irksome feature
in the magazine, which is also annoying. It’s called “How to Spend It.” This is from this lefty publication that is
editorializing against all sorts of excesses in the private economy. So, “How to Spend” is the name of this publication,
and they have a weekly section when this thing appears, and the section is called … Now,
what’s it called? Anyway, it’s a feature of some aesthete. It might be the Aesthete of the Month, for
all I remember. And they always ask, what is your style signifier? And I was hoping, Demetri, that you might
ask me what my style signifier is. And I think I did, didn’t I? Yeah, it’s my bow tie. Yeah. Yeah, it’s your bow tie. Yeah, I would have guessed that. So maybe we can, in the future, I’d love to,
because I think I had actually emailed you about this months ago. Did I ghost you? Probably, forgot to respond, but no, the point
had to do with Bagehot and maybe devoting an episode to him, but tell us a little bit
about this book and who Walter Bagehot was. Yeah. Well, Walter Bagehot was a most extraordinary
character. He wrote wonderful prose. And he did it with the job title of financial
journalist. Now, financial journalism is not the most
elevated … Now, how do I say this? If you, Demetri, find yourself at the pinnacle
of financial journalism, you are still standing at sea level. That’s the way it works in financial journalism. So it’s a somewhat ordinary branch of the
journalistic trades, but Bagehot not only in his main line of work, which was writing
about markets and about the political aspects of market, quite apart from that, he was a
wonderful writer of biographical profiles and literary criticisms. He wrote things on William Shakespeare. He wrote things on John Milton. He wrote a great essay on, you name the political
figure and he probably wrote one about that figure, such as William E. Gladstone, the
long serving prime minister in Victoria in England. So he was a most gifted writer, and what he
wrote about in the financial way were things that today resonate as sharply and as controversially
as they did in his day. One of the great questions in finance is what’s
money and who says so? Right? Another question is what business do people
with large sums of money have in asking for favors from the government of all the people? For example, if you are at the head of a very
large financial institution and use zig when you should have zagged, and there is a thunderclap
in the stock market and you find yourself a little short of cash, are you then allowed
to go to the Federal Reserve and say, “I would like six or eight truck loads of hundred dollar
bills.” And they say, “Certainly, sir. What address may we deliver?” There’s been a lot of zigging lately. Yeah. Right. And the third issue that was suggested is,
that is as controversial and as inclined to argument as it was in Bagehot’s time was say
if a firm gets into trouble, shouldn’t the stockholders be responsible for making things
right? This is a little bit related to the other
one about whether the firms have a right to go to the Central Bank. But in Bagehot’s time, every firm was, well,
to start with a general partnership, meaning that the partners, the owners of the firm
were responsible personally for the debts of the firm or the pro rata share. So if there was a run on the bank and the
bank became insolvent or impaired, there was a capital call to the owners and not to the
stockholders, which I so admire that. I think it’s a great way to do business. Right? Personal responsibility. So is there collective responsibility or personal
responsibility? Is money the thing that is so designated by
the government, or is it something that’s social evolves? These fundamental questions actually have
not changed much, nor have the answers. Well, the answers have. The answers have. I can guess where you fall on that. Yeah. But listeners, note that he is staring at
my bow tie as he says that. So the other question that they mentioned,
maybe we’ll get to it, the reason I said, “Gold and the New York Athletic Club bag,”
is because either you had told me this once in a story, or I had read it in one of the
issues of Grants years ago where you talked about walking home and you had forgotten or
you had still some gold-” Oh yeah. I can confess this. The Julia Child had a three second rule of
dropping it in the floor, it’s okay if you pick up. So if enough years have elapsed since a very
embarrassing and self revealing financial mistake, it’s fine. Right? It is. Okay. So years ago I started buying Krugerrands,
which are these one ounce gold coins, come from South Africa. And one of the first purchases was in the
summer. I had 25 of these things, which was $25,000
was for me then really a lot of money. Now it’s still a lot of money. Who wouldn’t stop on the street, Demetri,
and pick up $25,000 lying there? I would. Almost everybody on this podcast would do
that. Unless it was gold, maybe they wouldn’t. There is that funny video on YouTube. I don’t know if you’ve seen it [laughter 00:07:33]. Yeah. Right. Who needs that stuff? Anyway, well, this is the point of the story. So this was, I don’t know, nineteen … was
it … hold on a second. That must’ve been in the early or mid 1990s. Nobody cared about gold. So I went to the place to buy it and I came
back with it and it was in a Grant’s canvas bag. We give these things away at our conferences. Actually, we don’t give them away. They come and pay a lot of money and they
get one for this part of the price. Okay. So I had it in mind to carry this gold home
on the subway, and I realized at about two in the morning I had not done that. I left it stacked on the desk. Now, fortunately my desk is rather like a
police crime scene. It’s not exactly what [crosstalk 00:08:16]- … they might have thought it was a paperweight. Yeah. So I was thinking, “It’ll probably be there
in the morning.” And I thought about that for the next five
hours. And sure enough, it was there. And I realized that because gold, whatever
year it was, it might have been 1998, which I think the nadir of the gold price, which
is like 200 and something dollars an ounce, and it looked like hardware, so it was safe. Exactly. No pun intended. So there are so many things that I want to
talk to you about. I did a lot of work ahead of this conversation
trying to prepare. A lot of it was just spent as, I think I told
you, or maybe I told Eric this or Evan, I don’t remember who. I talk to so many people at Grants. I love Grants and I’ve told my listeners this. And I’ve been to your conferences. Love them. Some of the best guests that I’ve ever had
on the program I’ve met through the conferences. No, terrific. I’m glad to hear that. Yeah. Like Christopher Cole came on our capital
account years ago in 2012. Had presented in the fall at Grants. It’s a great conference. Your stuff is the best. And I spent a lot of time going through Fed
minutes, and the first thing I spent a lot of time on, because with the program we don’t
focus on just markets. We do all sorts of stuff. So, whenever I do an episode like this, it’s
an opportunity for me to delve into things. And we didn’t have a chance to get to talk
about what happened in the repo market in September. And so I spent a lot of time doing that, both
reading through minutes, but also looking at official and unofficial explanations for
what happened. Maybe you can fill in our listeners, I mean
some people will already know obviously, but I’m sure they’d love to hear from you. Well, this is a very inside baseball thing
that is nonetheless very something like universal interest because it involves, again, these
big questions about Wall Street’s legitimate call on the resources of the entire government,
which we all have an interest, right? Most of us certainly contribute to [crosstalk
00:10:11]- And they have been deploying those resources. Right. So, first of all, repo is a short word for
repurchase, and a repurchase agreement is a collateralized loan, meaning a loan that
is secured by something except the borrower’s pledge to pay it. If I borrow five bucks from you, say I’ll
give it to you next week, that’s fine. But if I give you $1 million, I expect you
to sign something or at least pledge to you, Demetri, I can have one-tenth interest in
your mansion that’ll satisfy the million dollars. So, these are collateralized loans, and collateralized
by Treasury securities, by the bills, bonds and notes the Treasury issues to finance the
deficit. All right, so this is a relatively commonplace
transaction on Wall Street, but what was not commonplace, it was quite out of the ordinary
in the middle of September, was that the interest rate that people demanded to lend against
the presumably unquestioned solidity of these bills, notes, and bonds, the interest rate
suddenly got to 10%. Now, who earns 10% on a savings account or
anything except like Argentine bond? 10% is an extraordinary, it’s a usurious rate
these days. It is unnatural. So how do they get there? Well, it got there for reasons that people
can guess about. One of those reasons is that in the wake of
the great financial crisis, the government enacted all sorts of regulations that make
markets less resilient, that tell you what you can and cannot do with your money or with
your depositors’ money, that make things instead of responsive, rather rigid, or like the word
of art in Wall Street, they silo money. So they say you have to have this much set
aside in high quality liquid assets. Liquidity coverage ratios, for example. Liquidity means just what it sounds like. And it was like as water flows, so should
money. So these rules, well-intended I suppose as
they were, have backfired in their unintended consequences as so many rules do. And so JP Morgan had plenty of money they
might have lent, but to do so would have perhaps provoked the resentment or the suspicion of
the regulators who live on the premises and actually work side by side with the bankers. That’s how closely these institutions are
regulated. So you’re saying that JP Morgan needed to
have a certain amount in liquid reserves? Yeah. They’ve held more or less … fallow is the
farmer word, keep a corn field fallow for a year or two by planting hay on it or something
instead of corn just to … But anyway, it’s money on ice. It is not usable. It is inert. Thought that doesn’t explain the why they
wouldn’t have been able to borrow at a lower rate elsewhere and redeploy the capital. Correct. Correct. That explanation is quite common. You hear it quite commonly, but it’s not necessarily
persuasive. Right? Okay. So, I don’t know why 10%, but what I think
gets us closer to the answer is why that rate has remained, if not elevated every day, why
the market has required constant intervention by the Fed to prevent it from rising above
the target ref. I forget what the target rate is, like two
something percent, the very low rate. So why must the Fed be in there week after
week, almost day after day, not quite day after day, but certainly week after week,
injecting sums which cumulate to the most extraordinary figures like $6 trillion. Since, September … These are recurring. They didn’t create $6 trillion to do this. They used a billion over and over again. Yeah. These are overnight repos and also 30 day
… Right. These are short term loans secured by the
aforementioned treasury securities. So okay, so here’s the punch line. What we think is the problem is simply that
at long last this great big deficit that appears to have been of absolutely no account in practical
finance and is now becoming like, as I say, a thing. And let me explain if I may … When you say this deficit what are you referring
to? The federal deficit, the federal deficit. Let’s take it in gross terms when we’re not
going to get cute and take out what the social security trust fund and … this is not just
debt held by public investors, but the whole shooting match. Wherever it is in the ledgers of the world,
the gross obligations of the federal government. So, as we all know, the deficits have gotten
bigger and therefore the debt has piled higher. We know this, but we also know that it has
made no visible difference in our financial lives because mortgage rates have scarcely
ever been lower, well as much VIG to get a car loan as it ever did, but that’s for our
purposes neither here nor there exactly. But mostly rates are extremely … Oh, the
state of New York, which is kind of okay financially as a rhetorical courtesy, gets to borrow 2.5%. So rates are low. So people will say, “Well, deficits don’t
matter.” 1981, Ronald Reagan appears before the TV
cameras and says to the nation … this is by the way when bond yields were like 15%,
one, five. Okay, so Reagan says, “We have a debt of $1
trillion.” It just crossed the trillion. Now we’ve gone from nothing in 1789, let’s
say it was nothing in 178 … it was not nothing, but it was sensibly little in 1789, the Constitutional
Convention, so from nothing into $1 trillion from 1789 to 2001. Today that debt is 23 trillion and the debt
has increased since August by one trillion. Well, that’s the nature of debt accumulation. It’s exponential. Well, this would certainly look like something
that is more than just been a bad habit. Well “bad” might not be the word, but anyway,
so it goes from one trillion to 23 trillion and the rate of acceleration is accelerating. So it doesn’t matter? Maybe it matters, and maybe the proof of that
consequence is that it takes the government’s main force to suppress the rate at which you
borrow to finance these things. That rate wants to move up, it’s being held
down by the Fed and its mighty interventions. So I think that this could be the leading
edge of the deficit becoming a phenomenon of practical financial consequences as opposed
to abstract political worry. So this has been a central point of debate,
which is are borrowing costs low for the government because the Fed is … Put them there. … put them there, or is putting them there
actively, because you could argue that the Fed in some ways contributed to putting them
there with its accommodative monetary policy during the boom years. Or are rates low for the government because
people perceive it as the risk off alternative in an otherwise very risky market? And you have come down on the side of it being
the Fed actively keeping rates low for some time now. Yes. I respect the other side of the argument. Some very smart people make it. What they say is that after every financial
debacle on the scale of 2008, ‘9, or even something not quite so severe, that there
was a period of … what’s the term in social life? Katzenjammer I think is the word that’s sometimes
used to describe the aftermath of a big party. So there is a period of remorse and of aching
heads, and this takes the form, in finance, of very low interest rates and very quiet
and tentative activity. “Shh, don’t talk too loud. Your father had a big night.” Okay. So that’s typical cyclical behavior. After a crash, there is a thud and then a
period of stillness and very low interest rates. That’s the book, right? All right. That’s the form. But it’s been 10 years. And why I think that the central banks have
been instrumental in keeping rates as low as they have been, is because rates have never
been lower in the 3000 or 4000 years of recorded interest rate history. I think that’s a pretty good inferential piece
of evidence that somebody is doing something new. And look no farther than Europe and to the
interest rates prevailing there. They’re worldwide, much in Europe, some in
Japan about, I don’t know, something like $11 trillion worth of bonds. IOUs are priced to deliver a yield to the
lender of less than zero. Isn’t this wacky? So you want to lend to the government of Germany,
you pay the government of Germany for the privilege of them accepting your money, and
rather than they paying you, you pay them? Yes. That’s the way it works. That’s a new, new thing. And for pedants listening, yes, there was
some of this in short term treasury bills in this country in the late ’30s, early ’40s,
yes, true. But nothing on the scale that is present today,
nor was it ever prevalent in longer dated securities, not just treasury bills. So the downward suppression of interest rates
in Japan and in Europe has naturally had its effect here as well, because the world was
one big marketplace. Right? So should we say it’s really interesting. My publication is called Interest Rate observer. And what I observe is something historic. And you’ve been observing it for a while. The last time- We just started volume 38 number one, and
can you believe it? I am, what? 45? 50 tops, right? Tops, tops. Last time you were on the program, you were
on episode 13, that was the last time you were on the show. And we talked about how there are kids that
are growing up today that have never seen an interest rate. God, what they’ve missed. But you should’ve seen them, people. They were something. They were lucrative and they were alive. They were there. You could see them. You’ve called them all sorts of things, I
think microscopic interest rates … But this is something that you have been talking about,
of course, and so many other people have been talking about and thinking about and just
it’s to a point where you’ve gotten tired of thinking about it. Well, people have gotten tired of hearing
about it, that’s for sure. Yeah. I’ll tell you how I feel about all of this
because the larger point that you’re getting to, and we didn’t mention this when we were
talking about the repo market. Yes, they have the $6 trillion number is in
these recurring repos. That’s not permanent money, but the balance
sheet’s been expanding. That’s a huge thing. Now, let’s back up a little bit and say what
a balance sheet is and why in the case of the Federal Reserve- You’re getting. You’re teaching people some things they never
heard before, interest rates and balance sheets. Well, no, I mean people fling these terms
around as if, oh yes, it’s like you read a sports page and now you’ve got to figure out
what WAR is: Win Above Replacement Value. Well, it is just what it is. All right, so balance sheet simply gives your
assets and liabilities, what you owe and what you own, and the Fed owes, in a way, the value
attached to the Federal Reserve notes that some of us are fortunate enough to have in
our wallets. That’s the liability on the Fed’s balance
sheet. It’s the value of the Federal Reserve notes
that it issues in return for US treasuries. Right. And the treasures are the assets. And just for listeners who aren’t familiar,
when we talk about the repo market or the interbank lending market, that is the market
in which the Federal Reserve operates as well. So when banks are going into that market to
borrow money, the Fed is also active in that market through its open market desk, but continue. We should get into some of those details. Right. Not too many. They can be. What’s interesting is how that market has
changed since IOER, since October of 2008 when the Fed moved from a corridor to a floor
system. And that I think is something that we should
talk about but go ahead. IOER. Yes. Well, ladies and gentlemen, apart from interest
on excess reserves, as Demetri was saying, so the Fed’s balance sheet is a reflection
of the oomph with which it injects credit into our lives, into the banking system and
it may or may not get from the banking system to each of every one of us, but it shows you
the Fed’s intentions. In the past three months, the Fed has the
measured oomph, strength of the Fed’s credit impulse is like an annual rate of 35%, which
is wild. And so the stock market goes up, it doesn’t
go up necessarily only because the Fed is handing it out hand over fist, but that doesn’t
hurt. Well, it’s erased this entire balance sheet
unwind from November 2018. Yes it has. Yeah. A full year. So year over year, the Fed’s balance sheet
is growing at one point something percent, but over six months it has been growing in
annualized, I don’t know, 15% or something by memory. But I do remember vividly the latest three
months, annual rate 35%. It’s accelerating. So before the crisis, the balance sheet was
just under a trillion dollars, right? It was like 800 or … Yeah, right. 890 or something, 900. Something like that. They touched somewhere between 3.8 and 3.7
trillion before they started to increase the balance sheet again now, since this repo madness. What can we infer from that? Again, this brings us back to the question
because some of the other theories, the less official theories that I’ve read don’t explain
this simply on account of let’s say treasury issuance or tax payments or liquidity coverage
ratios. There are some alternative explanations. But what are we to infer from- But wait a second, wait a second. You know something, what is it? Well, one of the things that I wasn’t aware
of is that non banks like hedge funds use the interbank market to speculate. And some of the stuff that I read suggested
that maybe some of these larger commercial banks were unwilling to participate because
they wanted the Federal Reserve to increase the amount of reserves in the system in order
to make credit more accommodative for some of these other players in the marketplace. I don’t know, maybe, but certainly if that
was the intention, they’ve achieved the shadow way they have achieved their wish because
the Fed is now in their seemingly to stay. I’m not sure how long it’ll go on, but the
Fed is in there with main force and … anyway. Well, I mean these banks, for example, like
JP Morgan who you brought up earlier, their executives are renumerated in bank stock. Their corporate share buybacks are a big part
of what we see now on Wall Street. They benefit from their stocks continuing
to rise. So there’s a lot of incentive in the market
for a lot of these actors to continue to see prices continue to rise. Right? Well, I mean I think that’s saying nothing
more than people love a bull market. Everyone on Wall Street, is more or less everyone,
except for the renegade minority that sells stocks short. Everyone does better in a bull market. I don’t think there’s anything new. So you think the banal explanations that this
is a regulatory issue, it’s also perhaps … This brings us back to the point about IOER, that
this market, even though it was always manipulated or has been manipulated since the Fed began
operating its open market desk, that the price signal within the interbank market was meaningful. Right. Well, this is a great point, Demetri. There was something in the day called the
London Interbank Offered Rate, known as LIBOR, “lie” meaning “untruth,” and “bore” meaning
tedious. That’s the denotation of LIBOR. I’ve never heard that one before. Otherwise it’s called London Interbank … So
the London rate was the rate that the big bank lenders and borrowers negotiate among
themselves to determine the clearing rate for short term money. And it wasn’t exactly discovered, in the market
we say to “a price discovered.” “Discovered,” I think, is a great term. It means that a price is the result of buyers
and sellers testing each other and deciding what’s the right price. This is also, by the way, not LIBOR, but the
repo market that we’re talking about here, this is part of the larger money markets that
were royal during the 2008 financial crisis. Sure. So before the crisis to generalize kind of
heroically, rates were discovered. Since then, they have been increasingly administered. So the Fed’s new pat rate, supplanting LIBOR
and really supplanting the Federal Funds Rate. It’s called SOFR, Secured Overnight Repo Rate
or something. A friend of mine calls it new Coke, and it’s
a dubious improvement on the predecessor. But anyway, all these acronyms and all that
stuff, it’s a little bit confusing, but the point of bear in mind is that the market has
been taken more and more away from price discovery and more and more toward price manipulation
and administration. And what’s wrong with that is that they, the
manipulators and administrators, don’t necessarily know what the right price is. So let me back up to the historical origins
of the Fed for just like 90 seconds. So the Fed came into the world 1913, 1914
to provide seasonal assistance for commerce, particularly for the movement of crops during
the autumn when typically there was a shortage of cash and rates would spike and crises would
fester. That was seasonal credit assistance for commerce. That was the idea. So now it is year-round assistance for the
Federal Reserve for the federal government to finance this burgeoning stupendous debt. And so the possible meaning of, if I’m right
about … if we, because I’m not alone at Grants, are right about this, right that is
that the weight of the debt is now beginning to tell in the financial markets, it’s a very
big thing. And you’re saying that what we saw in September
was partly a result of the budget deficit? Partly. There was a confluence. You mentioned tax payment data. There was a corporate PAC tax payment, but
everyone saw that coming. I mean, every time I am asked to recite the
reasons why this happened, I duly recite it. It doesn’t make any sense. So you think this is one of the first rumblings? I think it’s one of the first rumblings of
the deficit beginning to count in a way that matters in Wall Street. And if I’m right about interest rates being
unnaturally suppressed rather than naturally low, the implication of that would be that
rates are going to go up. But surely it can’t be that let’s say JP Morgan
or Goldman Sachs wasn’t willing to lend to the government at 8%. No. People were willing to lend, but they felt
constrained against lending by some of these regulations. That much I think is certain. That much is certain. But you, many moments ago, you said, “Well
why wouldn’t others …” there’s all sorts of lending outside the banking system, right? All these direct lending operate … Why didn’t
somebody come in? Well, I think this is what you get with heightened
regulation, is you get to barriers the free flow of goods and services and money. Bring that back to me to the federal deficit
because I’m not following you. How does [crosstalk 00:30:09]- Because repo rate is the rate charged for
lending against treasuries. And if there are too many treasuries, there’d
be too much demand and the interest rate would go up. Right? Mm-hmm (affirmative). So that’s your larger point. Your point is that rates are a beach ball,
they’re underwater. You’re not identifying exactly how far they
should go, but the point is they’re suppressed and that what we saw there was the hand being
taken off the ball. Well, the hand is still on the ball, but the
tell is that the hand is putting more and more pressure to keep the ball beneath the
surface, and that that pressure is measured in the amount of resources the Fed devotes
to holding the rate down. Now, you mentioned there are other people
that have taken the opposite side of this trade, people like Gary Shilling, for example- Sure, Lacy Hunt. Van Hoisington. Exactly. Lacy Hunt. Both have been on this program. What makes you feel that they’re wrong and
you are more likely correct? Because it’s my turn. It’s my turn to be right, Demetri. It is, totally is. It totally is. It’s been a long time on this one. Fair is fair. Because I don’t know, I may be wrong, but
no one profitable idea is forever profitable. Right? Things work in cycle. But in the late ’90s, maybe it started in
’98 I wasn’t woke during this period. I mean I was in high school, but I wasn’t
really- Are you woke now? I’m more woke to the market is my point. But I think it was ’98 or maybe ’99 when people
started using the term “new paradigm economy” in a way to justify the valuations that they
were seeing. Oh, sure. Yeah. That’s standard procedure from the dawn of
markets. There’s always a rationale for- I see. I’m thinking to myself lately, are we in a
new paradigm where we have to really take into account the federal government, that
the new paradigm is that the Fed genuinely will not, and that if it’s not willing to,
that that’s enough, allow these markets to correct because they need asset prices to
be high? Irrespective of what’s happening in the real
economy, that they are committed to dousing this market and preventing any kind of deflation,
and that therefore betting against the market or against inflation by thinking in terms
of traditional valuation models is no longer accurate. Like it’s a new era, right? Yeah. A new paradigm. “New era” is the phrase to [crosstalk 00:32:41]- New era, is that what people are using today? Yeah. That was what they used in 1929. Oh, 1929. Well, there’s always a new era, right, every
10, 12 years, nothing mechanical about these things. Otherwise people would catch on. But you can see it in the minutes. I mean they’ve changed entirely the way they
… Sure. Now that they want inflation, and this taste
getting used to, if you’re a gentleman of a certain age, they want it, and of course
they believe they can control things. Let’s get back just ever so briefly to this
deficit question and federal debt matters. There’s a very now increasingly established,
certainly almost mainstream school of thought called modern monetary theory, which holds
that no such thing as sound finance, there’s only functional finance. What works is what’s functional, is what’s
right. Bernie Sanders is a well known advocate of
this on the stump. And it holds that government should borrow
as much as it wants to, the Fed should print as much as it needs to until such time as
there is visible inflation, not on Wall Street but at the checkout counter. And until that time, and just go for it. And when the reckoning does arrive, just tax
people with money. That’s the approach [crosstalk 00:33:54]. Abba Lerner promoted this. Don’t laugh. Abba Lerner was a formidable intellect. He was, in his stuff. Go online and read some of his essays. He’s sometimes overly technical, but much
of it is not, and Keynes read this stuff and said, “Wow, that’s really good.” God help us if it ever goes into practice. But what Lerner also said is that is that
a government can do this if it owes its debt at home to domestic borrowers. We, of course, owe a great percentage of our
debt to overseas creditors. But also the idea that you would go from the
current model of managing, well, we’ve diverged from this corridor to a floor system, but
if we just take what we had in 2008, go from this model where the Fed is active in the
repo market to a place where in order to put a cap on inflation, the Fed needs to tax,
it’s a much less responsive mechanism for it. Well, is Congress going to enact a tax hike
when things get out of hand? How’s that going to work? That doesn’t make any sense. I know it doesn’t. I just want to let the listeners know that
I wasn’t born yesterday. I’m in touch with modern monetary theory too,
just like the kids. You’ve written about it. You’ve also spoken about it, and I didn’t
mention this at the top, I should have, you are the host also of Grants of the Air? What is the official name of the podcast? Yeah. Everyone’s got a podcast, Demetri. Well, yours has now been running almost three
years and it’s very successful. It’s called The Current Yield. Current Yield. Yeah, yeah. But it’s also, you say it has beautiful … what
era is that music from? Oh, that’s Count Basie, April in Paris in
1955, which happens to be the year the Dodgers won the World Series. The Brooklyn Dodgers won the World Series. That was the last year that they won the World
Series? The only year in Brooklyn. When did they leave Brooklyn? 1958. And I’m getting over that now, a little. So just to say, though, it’s great. It’s a fantastic podcast. You’re so much fun. It’s a lot of fun. And you really take as Ricky Gervais would
say or any Brit, you take the piss when it comes to Eric and his vacations to all sorts
of dangerous retreats. I told him, last time I spoke to him, I said,
“So Eric, where were you this time?” And he goes, “No, no, no, no, no.” He didn’t even want to talk about it. He’s been so traumatized by the experience. But people will have to listen to know what
that is. So we can move away from the mechanics a bit
and we’ve talked about the deficit and we talked about treasuries. You have been bearish on treasuries for a
while and you continue to be. But so far, treasures have been, as Gary Shilling
will tell you, a phenomenal investment long term. What I meant to say was yes, Gary is correct. I didn’t mean to say … But one of the things that we can perceive,
though it’s- A treasury bond is a promise to pay in a currency
that is undefined and is expandable at the whim of the Central Bank. That’s the nature of the beast. So, that’s seemingly not a very good thing
because the body that owes the money, the Treasury, also is in charge through the Fed
and the two are related, let’s not forget, in charge of creating the value that the money
embodies. They are in charge of either making money
scarcer and more valuable, or more plentiful and less valuable. So that’s a conflict of interest, right? So that conflict of interest is not very important
when treasuries yield 8%, 9%, 10% above the rate of inflation. That’s a pretty good deal, right? As it was some time ago. But when treasuries yield something less than
the rate of inflation, is this such a great investment? It has been a great investment. That’s different from “is a great investment.” Yes. So one of the major effect of all of this
is, and you alluded to it earlier, if not said it explicitly, is the distortion of prices
everywhere in the economy and also risk taking and the perception of risk. We’ve seen this in venture, we’ve seen this
in leverage loans, these are things that you’ve written about extensively over a long period
of time, and we’ve seen it in the valuation of assets and stocks and everything else. And venture capital, Uber wouldn’t be around
except for, I mean … SoftBank, the behemoth- Yeah, yeah. WeWork, too bad. Yeah. Yes. So Walter Bagehot, my hero, alluding to the
national symbol of Great Britain said, John Bull can stand anything, but he can’t stand
2%, meaning that very low rates of interest instigate specular behavior that ends in tears. That was true then. It’s true now, but Bagehot meant positive
2%. Exactly. Not negative 2%. So low rates, big trouble. That’s the age old rule, and very low rates,
very big trouble. And we’ll see. So let’s talk a little bit about, like I said,
you’ve written about this, you’ve written about what I’ve called here, the unicorn industrial
complex, not your words. That’s pretty good. Yeah, it should be … That’s very good, Demetri. In fact, I almost think I said that. Did you? Well, just now I did. Yeah. You might have. And you see here, I have these pictures here. There’s a unicorn here. I won’t bore you with that one. This is definitely not you because this guy’s
wearing a- Remember the Thurber parables Fables for Our
Time? And that unicorn was … a unicorn is a mythical
beast. It turns out it’s not. Unicorn is … They exist. They exist in Silicon Valley. So this is a woman flattering herself in the
mirror. This is a thinning mirror you can see here,
and one of the things that we’ve really seen is enormous valuations for companies that
have tapped credit markets in place of profits. And in some of the most extreme cases that
we’ve seen have been in the case of like WeWork where they just couldn’t even get the IPO
off the ground and their founder walked away with over $1 billion after not making a profit. Oh, man’s got to eat. And it’s pretty remarkable if you think about
it, because the money he made was money he raised, right? Correct. So it’s a remarkable thing. It is remarkable. And then you find these examples all over
the place. You find a real estate brokerage firm in New
York called Compass, which is VC funded, venture capital funded- Also backed by SoftBank. I think so. Anyway, the people that compete with Compass
just can’t believe. How do they do that? How do they pay these salaries? How do they pay this proportion of commissions? Well, they do it is indirectly through the
credit environment, through easy money, through free money. That’s how these structures come to be. But sooner or later they have to do something
in the way of making money, because the money runs out. The free money does run out. So I mean that’s one place where we’ve seen
pushback. We talked about some of the pushback we might
have seen in the repo market. Another place has been in the IPO market. This was a spectacular fail. I mean, Uber was the first, I think, SoftBank
investment that really went sour, had a really crappy IPO and it’s trading well below its
IPO price, and even its listing price was below SoftBank’s latest valuations. In the case of WeWork, SoftBank actually bought
out Adam Newman, so they’re sitting on who knows how many unrealized losses from these
investments. So what do you think the significance of this
is? How much longer do you think this can go on? Or have we already reached the tipping point
in this part of the market in venture and early stage? I think this part of the market has tipped,
but you’ll notice that … in fact, I think the President United States might have remarked
on this today and a tweet, the stock market keeps going up. I think he did. He’s doing that for a while. Yeah. It’s not just that the most speculative wing
of the venture capital industry has got to hit the wall. The problem goes a little bit deeper in that
the suppliers to that particular segment of the unicorn world is also now hurting, the
people who furnished WeWork with artisanal draft beer, so no more beer orders from WeWork. And there’s been a great big network of suppliers
set up to service companies that make no money. And so those companies are hurting. I don’t think that network is quite big enough
to have a macro economic impact, but it doesn’t help things along. What about the leverage loan market? Maybe you could tell our listeners what leveraged
loans are, because that’s one place where that’s much more similar to what we did have
in 2008, because these are collateralized in some cases. A leveraged loan is one of these mystifying
terms. Leverage connotes debt, right? Leverage loan would seem redundant like botanic
garden. Every garden’s botanic, right? Right. So a leveraged loan is a loan to a speculative
grade company, meaning a company that is encumbered with debt, but to allow the credit, that’s
a leveraged loan. And so it’s a corporate loan and such companies
will borrow, for example, when they’re in the throes of being taken private by a private
equity sponsor or promoter. So let’s say a company is trading in the stock
market for evaluation of $1 billion. And along comes some private equity guy says,
“You know what, that company selling for $1 billion is actually a bargain because they
probably have too many people and they are not as efficient as they might be under our
stewardship. And we’re going to buy out the public stockholders
for a billion 200 million and we’re going to make it more profitable and we’re going
to take out a huge chunk of change for ourselves, and we will borrow some of that.” So they take out loans, they buy out the public
stockholders, and they pay themselves a dividend, and those loans are called leverage loans. And not necessarily bad, it all depends on
what the scale of lending is and how able is the company to service the debt. But as the years roll on, as the credit cycle
as we call it gets a little rank, as people take more risks, as people become a little
bit less mindful of what happened the last time, as they become bolder, the terms and
conditions of lending get easier. That is to say people in need of income, and
everybody seemingly has need of income because the interest rate is so low, those people
aren’t so demanding of the terms on which they lend. And typically these terms include such things
as a limit on how much the company can borrow. Or the terms might include a definition of
the collateral the company must keep to support and sustain the asset value of backing the
loan. But as the years have worn on since the last
crisis, these terms and conditions have become eviscerated, and some of them have vanished
altogether. So it’s been a borrower’s market and the market
has grown substantially. But we’re starting to see now that a lot of
these loans, not a lot, I should have the figures in hand, but increasingly the news
is that the weaker credits are failing, and that some of these loans are not being paid
on time or are on the verge of default, and loan prices therefore in the open market are
trading lower. So the leverage loan market is seemingly becoming
an object of suspicion rather than of fun. And there are also ETS that are built on this
type of stuff. Yep. So is this a cause for concern in terms of
contagion, or again, is this really not something that, because hindsight’s always 20/20 or
maybe that’s the wrong term, I’m actually thinking of recency bias, the focus is looking
at what happened in 2008 and using that as a template. But most people, I think, are not so mindful
of what happened in 2008. Many people on Wall Street were not around
in 2008, and it’s becoming rather ancient history. And like you said, people need the yield. It’s attractive in this world. And people perhaps are getting a little tired
of hearing about the risks, because the risks, while now becoming manifest rather than hypothetical,
these risks still have not wrecked careers. So, Jim, I want to move us to the overtime,
and it’ll be an opportunity for you to give our listeners some, maybe advice is too strong
a word, but I’d love for you to talk about some of the companies that you’ve covered
because in terms of individual stocks, you’ve really done a great job. WeWork was one example, AT&T is another. But I also want to ask you what you think
the impact that the election may have and if markets have really been pricing that in. So, for regular listeners, you know the drill. If you’re new to the program or if you haven’t
subscribed yet to our Audiophile, Autodidact or Super Nerd tiers, you can do that by going
into the summary for this week’s episode and clicking on the link that sends you to patreon.com/hiddenforces,
where you can listen to this week’s overtime with Jim, where we’re going to keep the mics
going and we’re going to talk about AT&T, we’re going to talk about the election, maybe
talk a little bit about gold, which has had a pretty good run recently, and also where
you can get a transcript of this week’s episode as well as a copy of this week’s rundown full
of unicorns, flattering mirrors, some charts of US short term interest rates and the repo
market. So, Jim, hang in there and we’re going to
keep it going. All right.

18 Replies to “Jim Grant | What’s the Price of Mispricing Risk? Interest Rates, Repo Markets, and an Activist Fed

  1. Whoever you are – this channel deserves million of followers – not 10k. As good/better than Real Vision, incredible guests – they are always interviewed properly because its clear youve always done your homework.
    Congrats i've not seen anyone do it as well as this.

  2. when you start with economics based on a commodity backed dollar (the old gold standard) and banks (granted the holding company exemptions of public scrutiny) that have become nothing more than criminal gambling institutions your arguements are already skewed.

  3. libor, the rates that were manipulated by a tiny cabal of bankers for their own benefit effecting everything in the economy. a criminal act that led to the current regs.

  4. stock buybacks (manipulations that were understood as such after the depression and outlawed until ronnie the bought and paid for reagan made it legal again) see margin stocks and derivatives of. it creates fairydusted bubbles that benefit the people who's main compensation are stock options at the expense of the rest of us when the bubble bursts.

  5. Mostly a discussion about a serious matter coveyed frivolously, rather than respecting the audiance listening for the value of advice.
    Instead of making sound clear explinations on subject of repo loans & the role of interest rates in its entirety, conversely it seemed to be more of bits & pieces with firevlousness overshadowing it..!

  6. Would you like to support the show? Subscribe to Hidden Forces and Access the Overtime Segment with Jim Grant here >> https://www.patreon.com/hiddenforces

  7. Negative bonds are balance sheets tools. Not investment vehicles.
    The issue with the repo problems is lack of collateral for secured loans between institutions. Bill white that you had on recently had the right understanding. Please get him on again. Great knowledge of plumbing and theory.
    Deficits are just money printing. It allows government to spend without taxation because as population goes up you need more cash to keep prices from deflating. So high deficits are super inflationary. Low deficits are required and the advantage of Fiat money is you can print money for very cheap and spend it before anyone else. Probably get Steve Keen back on and have a talk about the nature of government deficits.
    And the US only owes US dollars. Even if it is to overseas borrowers.

  8. Excellent Interview: I like Grant's Theory that Market Rates are trying to make a comeback if only in the Repo Market right now, this trend will widen out to the general market.
    So do you think the Long Lived Bond Bull will come crashing down?

  9. The LBO Example that Grant gave in this video at time 43:55 is exactly what happened to the once former public company Web.com that I still work for. The former CEO wasn't very efficient but the new private owners have swung the pendulum far to the other side. We've gone from about 2500 people in the Fall of 2018 to under 1000 peeps now. And, the highly levered private owners Sirus Capital are still looking for more to cut. They even used the credit of Web.com to borrow the takeover treasure chest. It doesn't matter. It's a Zombie company that they can't bring to life no matter how many peeps they cut.

  10. The Fed has been able to get away with suppressing interest rates for so long because The USD is still the World Reserve Currency. Every Country that every had the status of having the World Reserve Currency always abused that status to their currency's demise!

  11. The Fed came into being in 1913 in order to make money (dividends) for their private member banks by indebting the U.S. Government. Then they forced the U.S. Govt. to create Taxation to put the Citizens in Serfdom !

  12. 16:08 US national debt:
    1789 to 1981: climbs from $0 to $1 trillion.
    1981 to 2019: climbs from $1 trillion to $23 trillion.
    August 2019 to present: climbs an additional $1 trillion.

  13. So great you had Jim Grant on. It's always such a great pleasure to get that splash of fresh water in the face. Markets have been superfluous unicorns riding rainbows lately. All one can do is laugh at the absurdity of it all.

  14. Man I love Jim Grant. The dude is so dynamic and love the bowtie. Let's face it not a lot of us can rock the BT. I sure am gonna try one day. Slick Jim!

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