Transcript: These Are the Signs of a Slow-Moving Credit Crunch

The big headlines from March's banking crisis have receded and balances at some of the Federal Reserve's emergency lending facilities, like the discount window, are starting to fall. But if you look closely, there are still signs of strain in the depths of the financial system. And of course, there are still plenty of worries about whether deposit outflows from banks will lead to a broader credit crunch that could tip the US economy into recession. On this episode of the Odd Lots podcast, we speak to Ben Emons, senior portfolio manager at NewEdge Wealth and a longtime portfolio manager at Pimco, about what the banking drama means for everything from US mortgage rates to the vast "repo" market that's often described as the plumbing of the financial system. This transcript has been edited for clarity and length.

Key insights from the pod:
What is the credit data we should be watching?  — 4:17
How to watch the full banking dashboard — 6:34
Which parts of the market are showing stress? — 8:19
Conditions in leveraged loans vs. private credit — 10:05
Rate risk vs. credit risk — 14:09
What the SVB collapse means for mortgages — 16:47
Why are one-month T-bill yields so low? — 20:34
Are we facing a collateral crunch? — 24:41
Can portfolio managers exploit this market — 28:59
How Fed backstops alter this market — 31:29
The new behavior of depositors — 33:35
How are deposit shifts stressing banks? — 40:05

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Tracy Alloway: (00:10)
Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.

Joe Weisenthal: (00:14)
And I'm Joe Weisenthal.

Tracy: (00:16)
So Joe, we are recording this on April 19th, and we are firmly in the middle of bank earnings season. And so far it seems pretty good.

Joe: (00:26)
You always know it's going to be a good one when we have to state the date upfront. That's a sign. It's like, “okay, we're right in the thick of it.”

Tracy: (00:33)
Stuff is happening.

Joe: (00:34)
We're talking about news. It's going on right now. This is not some big theoretical thing where we're going to be talking about some ancient economic theory from a hundred years ago. This is right now.

Tracy: (00:44)
That's right. So you know, obviously, we had the banking crisis in March. And we have seen some signs of distress in the financial system start to fade since then. Things like borrowing from the discount window, that has gone down from the peak that we saw at the end of last month. And then, of course, if you'd been listening to Odd Lots before, then you would've known that discount window lending was ticking up for months, even before March.

But the point is that if you look behind some of these headlines — headlines about bank earnings, headlines about discount borrowing starting to come down, some signs of strain beginning to evaporate — if you actually look into the guts of the financial system, there are still some issues and maybe suggestions that there are more problems to come.

Joe: (01:37)
Right. I think that's a really good summary. Early March, with the Silicon Valley Bank implosion and some other concerns like that, that was fears of financial crisis. And it faded pretty quickly, those acute fears. But then there are the other questions, like, okay, well, the banking system maybe is still chugging along, but what does it mean for credit and how much of a mark will it leave on the broader economy in general that we had this moment and that all these banks saw what can happen if they get on the wrong side of certain trends?

Tracy: (02:11)
Totally. And you know, banks are obviously big players in a lot of different markets, but a big one would have to be bonds. All sorts of different types of bonds, from Treasuries to T-bills to commercial mortgage-backed securities to residential mortgage-backed securities. So the question is, if there's more regulatory scrutiny on all of these things, and if there's more concern about interest rate risk and duration exposure, is the banks’ appetite for those assets still going to be there?

And even though we've seen some of the crisis headlines fade away, we know that use of the Fed's reverse repo facility, for instance, the RRP, is still pretty high, which means a lot of money is still moving out of banks into money market funds and they're parking that at the Fed. So the major disaster headlines may be gone, but there is still this evidence of strains in the background, worries about a credit crunch, a possible collateral crunch. And off course, those two things are interrelated.

So we need to talk about all this. We need to get deep into the guts of the financial system and talk about what's going on. And I'm very pleased to say we have the perfect guest. We are going to be speaking with Ben Emons. He is a portfolio manager over at NewEdge Wealth. And before that, for a long time, he was a portfolio manager at PIMCO. I believe he sat fairly close to Bill Gross at the time, which must have been an interesting experience, to put it mildly. But he’s someone who can talk to us about what is going on in this market, what do banks actually mean for bonds? Are we seeing signs of an unfolding credit crunch and collateral issues? So Ben, thank you so much for coming on Odd Lots.

Ben Emons: (03:51)
Hi Tracy. Hi Joe. It's great to be here. Thank you.

Tracy: (03:53)
I'm glad we could finally get you on. One thing I was wondering, just as I was doing some of the prep for this episode, how do we actually measure credit in the banking system and what do we look at for signs of strains? I'm aware, for instance, that suddenly everyone has woken up to the Fed's H.8 data, which hasn't gotten a lot of attention for a long time, but what are we looking at here?

Ben: (04:17)
Yeah, the H.8 data, the arcane data, if you think about it. It's like, you know, we wouldn't really pay attention to it unless you were in the 1980s, a trader then, and standing at the Xerox fax machine eagerly seeing the money supply numbers coming off and then making an assessment, "Okay, the Fed is doing this, or the Fed is doing that."

And that's a little bit like what we are dealing with today too though. And you would say that data now is important because of this term called "bank credit" that's in there. There's $17 trillion or so currently that accounts for all the loans and securities that the banks have on their books, and that's ultimately how they extend credit or contract it. And so if you look at that number and a change in that, which happened over the last month or so, it was kind of a few hundred billion that changed, that's what people look at. That's a credit change.

Joe: (05:07)
Right. So every Friday, the Fed releases this table called the H.8 data, "Assets and Liabilities of Commercial Banks in the United States." And it's interesting to get this historical perspective because back in the day, 40 years ago, whatever, the Fed didn't give much in the way of communication about its policy. It just had some sort of money supply target. And so people would look at this data to see how it was doing. Now though, we get all this communication, but it gives us some additional information about the growth and contraction of credit.

Ben: (05:37)
Yeah, and indeed, I think even so that you could think of that as you listen to Fed speakers and they point to this data, they seem to be quite confident that there isn't really anything materially going on. But everybody paying attention to it means like, you know, I'm going to try to extract the signal from this because now if it does show more material decline in bank credit, in this case, then the Fed would react to this.  And that's what happened in March.

Joe: (06:04)
In terms of measuring credit, so this is volume, but how do you incorporate the surveys of businesses having a harder time getting a loan that seems to be getting worse?

Tracy: (06:15)
Or the loan officers survey where they have been reporting tighter conditions.

Joe: (06:19)
Or spreads. Obviously, we can look at junk spreads or CMBS spreads, etc. So is it one of those things where we're all blind and touching the side of the elephant and just trying to gather as many different pieces of it as possible?

Ben: (06:34)
The idea of a dashboard, right? You have all these different signals that come at you. Obviously, what you're summarizing there are different parts of the credit markets because if you were to look at spreads and you look at, say, junk bonds, that's little to do with the bank credit itself unless there's underwriting from an investment bank in there even. So it's not really what we're looking at here today: commercial bank credit, which is really about mortgages, consumer loans, credit cards, and things like that. But you're right, you have to look at a broader spectrum of measures about what credit is really doing in the economy.

Because it gets extended in different ways. So I think if we take the H.8 data and also the H.4 data, just to mention that too, which is the Fed's balance sheet data every week, the aggregate change in that does give us a sense of where we are right now. We've raised rates a lot, it starts to affect the economy. People know that eventually banks will pull back, and the earnings from banks show this too — they’ve started to provision for loan losses as a precautionary measure. But I think what happened in March was a reaction to what ultimately happened, where banks can extend credit through. And that's deposits. And deposits have obviously declined.

Tracy: (07:44)
This is exactly what I wanted to ask you. So let's step back for a second and talk about why a credit contraction could materialize. So what are the dynamics that are affecting banks at the moment? You know, I mentioned that if there's additional regulatory scrutiny on interest rate risk, then obviously that could affect appetite for certain types of bonds. But you also have a situation where banks may be nervous about the future, they may be increasing their reserves or hoarding them, and that would also start to curtail their lending. So walk us through how this materializes.

Ben: (08:19)
Yeah, I was looking the other day, Tracy, at different channels that are currently showing some signs of credit crunch stress. So one is the leverage loans, which are now syndicated loans, that have declined quite a bit. That has to do with the fact that during the pandemic boom, a fair bit of financing took place because of all the banks sitting on a lot of residual loans on their balance sheets and having a hard time getting rid of those loans.

You know, they have to be discounted at a low value, and therefore they pull back from the syndicate loan market and push it into the private credit market, which, although they have been lending, they are lending at higher rates. So it affects credit that way. Secondly, it's the commercial paper market, which is interesting as that was mentioned in the FOMC minutes too. It's frozen, so to speak, meaning there's very little issuance going on.

Tracy: (09:08)
I always get bad flashbacks to 2008, 2009 when we start talking about commercial paper and that seizing up.

Ben: (09:16)
Yeah, and that was happening in 2020 as well. In March 2020, the market completely collapsed, and the Fed actually did something about it this time. It seems to be driven by little appetite to issue these commercial papers at this moment as one channel.

Joe: (09:33)
You talk about different slices of the credit market, I think one of our longtime guests, Chris White, talked about these different slices of the credit market and essentially each being their own world, each being their own ecosystem. So when you talk about banks no longer being able to sell into the leveraged loan market and having to move into the private credit market, what is the difference between these markets? Why do they have a different complexion? Why is the cost of funding in the latter higher?

Ben: (10:05)
Well, two things there. One, the private credit lenders, that's called special lending or direct lending, they don't act like a bank. You have to think of companies like Apollo, KKR, or Blackstone. They lend to mid-sized to smaller-sized companies that cannot go to a bank or find it harder to go to a bank, as the lending standards are tighter at a bank than they are at a private lender. Yet the interest rate that they pay, which is typically a spread over the secured overnight funding rate, is wider. The private lender will ask for more compensation for taking the risk of a company that generates, say, $50 million EBITDA per year.

On the other end, you have the syndicated loan market, which now is a bigger market with bigger companies involved. I think the leverage buyout boom that happened briefly in 2020-2021 contributed to the banks pulling back and now provisioning for [it] too, that's what showed up in the earnings data so far.

And that's actually the point you were asking about, Tracy. I really think where the crunch comes from is that if we're getting banks starting to accumulate more and more reserves, lend out less, or are less incentivized to lend, and then you're getting pressure on other markets, other credit markets that no longer have access to banks, because they ultimately provide the liquidity and the credit for the system. So, I think this is where the real issue is.

And if you think back in history, as you often do on the show, you think of Friedman and Schwartz studies about money supply, what they really looked at was what banks in the thirties did too. They started to really accumulate reserves quite significantly, and that led to a huge contraction of credit in the economy.

Now we're not there yet today because it's not like that at that time. But we have had instances of this, you know, 2018-2019 was an example, when the Fed kept reducing its balance sheet while banks in the meantime were worried about the economy and started pulling back and accumulating reserves.

Not every bank has access to the Fed reserves, by the way. So that is another aspect of that too. So I think if you summarize it, the different aspects of the credit markets show that private lending is really different from bank lending, clearly driven by different governance and underwriting standards and lending standards. But the banks themselves are in a very precautionary mode currently, and therefore there is a possible risk of further pressure on lending in the economy.

Tracy: (13:09)
So one of the interesting things that we've seen — and again, this is sort of in the background and I haven't seen it discussed that much —  but I think risk premiums on things that tend to be dominated by bank buyers, so mostly securitized products like residential mortgage-backed securities or commercial mortgage-backed securities (RMBS and CMBS), which I mentioned in the intro, risk premiums on those are higher than a lot of unsecured stuff.

I would guess the assumption is because people are thinking that banks may be less incentivized in the future to buy those types of assets given what we just saw and the additional regulatory scrutiny, or caution, that we're expecting now. Talk to us about those markets and what sort of impact you see there?

Ben: (13:56)
Yeah, we're really thinking about the agency mortgage-backed securities market in particular. That's an asset class that is still government-guaranteed, by the way.

Tracy: (14:06)
Right. So you're not worried about credit risk, just the rate risk.

Ben: (14:09)
Just purely the rate risk. And a simple math of mortgages is that if rates go up, the prepayment speed of mortgages goes down and it actually extends the maturity of a mortgage-backed security. But banks buy those because they're yielding a bit higher than Treasuries, they're liquid, there's a big market, and the Fed is involved. And that's been part of the reason.

Now as the Fed is reducing its balance sheet and pulling away from that market, the banks are left with buying more. Now what's happened during this latest episode is that banks discovered that the duration of a deposit is actually a lot shorter than what has been estimated. There have been estimates out on this that it could be as long as seven years. That's basically the idea of like the three of us have a bank account at XYZ Bank, we have a deposit in there, we trust that bank. We've stayed there for many years and we never really pull our money out unless we absolutely have to.

Now what happened in March is that people got really worried and pulled their money out quickly. In other words, it's not seven years; it's probably seven hours. So if you think of that deposit side, the duration is much shorter and you're having a lot of mortgage-backed securities on your balance sheet that can extend the maturity as rates go up, you have this duration mismatch.

And that, I think, is the issue here now for banks. They have to reassess that gap, and there will be regulatory scrutiny coming in. Meaning there's going to be a reevaluation of banks' risk management in the wake of Silicon Valley obviously. And I think what then happens is that you could expect that banks will either decide to sell more or let them run off, so to speak, like the Fed is. Either way, more of that supply comes on the secondary market in mortgages, and it has to be repriced at a higher spread. Indeed, it has nothing to do with the credit risk underlying; it's the government, but much more to do with the liquidity risk and the bank duration risk.

Tracy: (16:06)
Yeah, it's super reminiscent of the conversation we had late last year about the sort of broken mortgage market and how banks didn't really want to hold a lot of MBS as rates were going up last year, and I can imagine this year they're even less incentivized to do it.

Joe: (16:23)
On the mortgage front specifically, I mean, would that show up in straightforward higher spreads relative to Treasuries? I mean, all things equal, in terms of like, okay, banks want to reduce their duration risk. They all saw what happened with Silicon Valley Bank. The regulators come in; would this be expected to feed through in a straightforward way to the cost of mortgages?

Ben: (16:47)
In some ways it does, because it's a market functioning, as in there's a very liquid market. So people will price in this quote-unquote higher supply that comes naturally on the market, so to speak. Because there's continuous mortgage origination that is packaged in these securities. 

Then you have to think about what happens with other investors in this space. So the mutual funds and ETFs and foreign investors, foreign mutual funds, foreign central banks, or foreign pension funds, how they respond. Now the analysis that's out there, there's an expectation that their demand will pick up as that spread implicitly widens. Money managers will find it attractive. But I do think that, on average, it should become a wider spread because banks in the United States have been the purchasers of these securities. In fact, with all my notes I brought with me here today...

Joe: (17:44)
Always love when guests bring data.

Ben: (17:47)
There's data. I would actually really specifically mention that entities with mortgage-backed securities include even credit unions, community banks, and smaller regional banks. They all rely on these mortgage-backed securities in part because their loan book is largely FHA, 
not non-agency mortgages, mostly government-backed loans.

So I think there's that change potentially coming, how much it will affect the spread. There is obviously a bit of a market functioning idea as in who will really be the buyer here. I can imagine that my former colleagues might be thinking, "Hey, you know, you're right Ben, this is interesting. We can, you know, buy mortgages," but that's not going to fill entirely the void, in my sense, given what the Fed is doing too with their portfolio, which is large.

Tracy: (18:44)
So, would it be fair to say, summing it all up, that Americans are in for higher mortgage rates thanks to a bunch of venture capitalists who put their money in Silicon Valley Bank?

Ben: (18:56)
Yeah, maybe on average.

Joe: (18:57)
Who had their money, who had their portfolio company's money in Silicon Valley Bank, in part so they personally could get lower mortgages from the bank. That seems to be part of the story, so thank you. And now we all have to pay higher mortgages.

Ben: (19:11)
It's the interest…

Joe: (19:13)
Only just to layer onto the irony.

Ben: (19:15)
Yeah, the interest-only mortgages that they have, they originate at a low cost, and it's all part of this idea of bringing all your money in, and we'll do more business with you. That's probably going to change to an extent. Now, I do think, pointing to an analysis from Bloomberg that mapped out where these interest-only mortgages were in California and on the East Coast, fortunately, it's all high-quality borrowers, people that can essentially pay off those loans without a problem. It's not subprime. But nonetheless, I think that market has changed, and that will add to rising cost of credit, I guess.

Tracy: (19:51)
Can we talk a little bit about what we're seeing in terms of collateral? Because, of course, collateral, the availability of collateral will affect the availability of credit because it's the thing that's used to secure a bunch of loans, and we have seen some signs of, I don't want to say necessarily problems, but maybe weirdness in that market.

So, I think I wrote about this in the Odd Lots newsletter, but for instance, the one-month T-bill is yielding like 80 basis points below the effective Fed Funds rate, for instance, which is something that you wouldn't expect to see unless there was a big scramble for T-bills at the moment. What is going on there?

Ben: (20:34)
Yeah, there are, I think, three things happening.

So, as you said earlier, the reverse repo facility of the Fed is very large, and that has been for a while now. And the main reason is that, and which are particularly money market funds that are in that facility, they cannot purchase enough T-bills out there. So, one, it's the Treasury that hasn't issued more T-bills because of the debt ceiling and their account at the Fed, and that dynamic. We can talk about that in a second.

Secondly, I think there has been indeed somewhat of a hoarding of these T-bills. Now, if it isn't by those money market funds, it's by other participants. And then it's about, I think, the way foreign investors are involved in our markets because the latest data I looked up from the Fed TIC data showed an increase in holdings of T-bills by foreign central banks or foreign investors, which could be others.

So if you take that together, there is, I'd say, a limited supply of T-bills in the marketplace, then Treasury's not issuing enough of it, so to speak. By the way, the Fed owns about $300 billion of it too, which is not insignificant. So, I think it gives you a picture of that. And this is statistics from the data and notes, that out of 4 trillion T-bills outstanding, something like 2.2 trillion is pledged as collateral. That's data from the Fed.

Anything in between is sitting somewhere, someone's holding it. And so, there could be very different entities, and I think this has constrained the supply of T-bills, which is why the yield is lower.

Joe: (22:11)
Would you expect that premium to shrink a bit? I mean, I could see okay, if it's early March and you're probably only thinking two things: I don't want to take any duration risk because we just saw a bank get blown out by duration risk, and I don't want to take any credit risk because I just saw a bank collapse. But as that recedes in the past and we see some of these emergency functions start to recede again, would you expect some of that to ease a little bit as people feel a bit safer to hold something other than one-month government securities or something ultra-short?

Ben: (22:43)
Yeah, and in some ways, it's playing out as we speak. You know, the spread looks like where we were in 2008, but that's not the same idea. Even though people link it through the bank stress, and parallels to the bank stress are like, yeah, okay, 2007-2008 showed some similar events to what we just went through.

But there's a difference. One the Fed is much more in a position to do something about it very quickly. That's what we saw, and that has definitely diffused part of the crisis. And two, as you say, there are a lot of alternatives now in terms of T-bills that people want to invest in, given where rates are in fixed income.

So I think that spread will not be so inverted for a long time. But it is a combination of the technicality of T-bill markets in terms of its supply and what the Treasury's issuing and who's holding it, and the dynamic of the Treasury with the debt ceiling in its account at the Fed, against just a general sense of flight to safety that is temporary and has receded.

Tracy: (24:00)
You've been a portfolio manager for a long time, which is one of the reasons we wanted to talk to you about this. But you know, you have experienced various financial crises from a bond perspective. Talk to us about, I guess, what you saw in previous collateral crunches: 2008, Eurozone crisis. I remember writing about the repo market and the role of Eurozone government bonds in the Eurozone crisis. These were financial crises that were basically caused by collateral problems and a big crunch in the secured lending market. Talk to us about that.

Ben: (24:41)
Yeah, that was quite significant in 2008 and 2011. On one hand, it was about people literally hoarding safe bonds, and by hoarding them and not lending them out to the repo market, you're getting this repo squeeze, as they call it. In other words, if there's not enough collateral to lend out there and people need their collateral, they have to pay higher interest as a result, similar to the discussion about mortgages. The same idea, right? The reduction of the supply of mortgages because banks don't want to hold them pushes up the cost of borrowing.

Then, obviously, the derivative market plays a huge role here because that's the experience I had from 2008. It was not just the Lehman moment itself, but the recognition that Lehman was such an important player in the derivatives market because of collateral agreements that back those derivatives and ISDA agreements [the International Swaps and Derivatives Association agreements] which have quite detailed collateral agreements.

It's important because if you are managing derivatives in a mutual fund or ETF, the banks that have this agreement with you agree on exchanging collateral as margining against the mark to market position. In 2008, what happened was that the banks were not in a position to deliver that collateral or vice versa. That led to this huge crunch. On top of that came Lehman, which was a big counterparty, pulling out of the system and no longer recognizing who was facing whom in the system. Also people didn't know where their collateral was or if they could get it back. From the experience back then with PIMCO, they did a really good job at that time negotiating those collateral agreements so that the banks had no choice but to legally return the collateral unless they absolutely couldn't.

If you didn't have a good collateral agreement, you would be at significant risk. All of that contributed to this huge pressure in funding markets and what we call collateral shortage. That to an extent repeated in the Euro crisis, particularly with German government bonds. One last point on that is that this repo market, the repurchase market, becomes really dysfunctional when people cannot or are unwilling to lend out collateral, resulting in a significant squeeze.

Tracy: (27:08)
I was going to ask, have we seen any pickup in fails-to-deliver and things like that in the repo market this time around? Ben's smiling because he has the data right in front of him.

Joe: (27:18)
He’s grinning...

Ben: (27:19)
Grinning at, you know, 3 or 4 AM this morning I did look at that data. The Treasury fails had picked up actually in March, and there was a little spike there.

Tracy: (27:28)
So this would be a classic sign. So what does it mean?

Joe: (27:30)
You buy something, and they don't give it to you.

Ben: (27:33)
Yeah, it is literally that. People are unable to settle securities or settle repo transactions.

Tracy: (27:40)
You can't deliver the bond that you said you would deliver.

Joe: (27:43)
Why is that not a default?

Ben: (27:45)
Well...

Tracy: (27:46)
Because the repo market is special in many ways. I mean, Ben can talk about this obviously, but if it was considered a default, I think we would suddenly have a major seizure in credit. Part of what happens is you can kind of on-lend credit that you've been promised, so you get this daisy chain of credit that lubricates the entire market. If you start breaking the chain by saying this is a default rather than a fail-to-deliver, then that's a big issue.

Joe: (28:14)
Ben is showing me some cool charts that he has on his laptop. We should post them along with this...

Tracy: (28:20)
Let's do it.

Joe: (28:20)
Going back to the portfolio manager perspective, we were talking about mortgages and mortgage spreads and maybe what is a worse situation for a bank because they don't want to get a tap on the shoulder from a regulator. Maybe that's an opportunity for an asset manager like PIMCO or something else. In general, how much of the opportunity to pick up alpha or extra gains for an asset manager, whether it's the size of PIMCO or a smaller one, comes from essentially the constraints that are imposed on other types of potential holders that don't exist for the asset manager?

Ben: (28:59)
What comes to mind immediately is that these securities have illiquidity risk, and that's priced into the spread. There's a risk premium because if the banks are somewhat natural holders of these mortgages as they originate them and have mortgage-backed securities to manage the prepayment risk. I could imagine that the spread could add alpha to your portfolio. The other part of it is more about dislocation; how do you generate alpha? You jump on these opportunities where there's some level of dislocation, and you expect it to reverse, giving you price return out of those securities. The other part could be that as much as the Fed continues with its quantitative tightening policy and the commercial banks have to pull back or because of duration risk, you're getting this more permanent, higher level of mortgage-backed securities yielding higher more permanently, then it becomes an income opportunity. I could see certain funds allocating to these types of securities for that reason.

But from my own experience with mortgages, the challenge of managing them in your bond portfolio is duration because of the prepayment movements. They have convexity. They can sometimes be very positive if rates go up really quick, but then the other way around when yields start to decline, the convexity on these securities gets quite negative, and that could adversely shrink your duration of your porttolio versus your index, and then your alpha argument isn't really there because you'll be lagging.

Tracy: (30:40)
You touched on this already briefly, but I think there's probably more to say. How would you expect the Fed to react to all of this? Because one of the things going on at the moment seems to be a lot of volatility and almost day-to-day changes in expectations for future hikes, maybe even future cuts. People are trying to figure out what potentially lower credit circulating in the economy actually means for things like inflation. How would you expect the Fed to handle this?

Ben: (31:11)
What they did in March was expected; as the lender of last resort, they should provide liquidity. The term loan facility was a new facility, but it wasn't a surprise because the Fed has the ability now to put those facilities up in 24 hours.

Tracy: (31:27)
Literally, right? They can take them off a shelf, basically.

Ben: (31:29)
Yeah, pretty much. So the market knows this. It means that if we get the kind of credit stresses that we saw in March 2020, for example, they would revisit the corporate bond purchase program, commercial paper purchase program, and so on. There is an alphabet soup of these facilities. That would be the first reaction. The other reaction is how Lagarde looks at this crisis and says it's not affecting them, but they're on guard because it does correlate with their banking system. If bank stocks go down significantly here, so will they in Europe, and the ECB would have to react to that. Lastly, people will probably look at the two-year yield as being volatile. Will there be a rate cut? Will there be a pause? It turns out that this wasn't the reason to shift policy at this point, but it isn't to say that it couldn't be the case, and that's what we've been discussing.

Joe: (32:30)
That's one of the things I wanted to follow up on. And again, I’m thinking back to how we started this conversation, which is that measures of bank credit are becoming central data points to bond traders again. And this is of the themes we talked about with Matt King at Citi is this return of monetarist thinking. To what extent is there a clear relationship between the volume of credit, the so-called money supply, and the actual change in the price level that we see in the economy? The idea that money supply and prices were correlated went out of fashion pretty hard in the 2010s. But could it come back into fashion? How much are the Fed or economists at the Fed looking at these credit numbers as being early warning signals, in one way or another, about what inflation will be doing three months or six months down the line?

Ben: (33:35)
I think you touched on how people behave with money. What happened with these deposits at Silicon Valley Bank, for example, and how quickly that went out of Silicon Valley within 48 hours, like $40-50 billion or whatever was requested. That's what they would be looking at, that behavior has changed. The money went elsewhere; it went to money market funds, but the data shows only half of the deposit flight went to money market funds.

I actually read the transcripts from the early 80s, cause I was looking at “when did rates peak and what was the Fed focused on?” And obviously they were focused on M1 and M2. They noted by the way, back then, that M2 and M1 were really rising a lot. That was part of the economy growing and doing well. So the money supply analysis does matter to the Fed today too.

If they don't see significant contraction in these aggregates, which points to a change in the economy going in another direction, that means there's money from commercial banks that went to money market funds and elsewhere. It's just recycled and ultimately gets out into the economy.

So I do think they pay attention to it because there is that link. We came out of a pandemic where production capacity was hugely shut off and had to turn back on. So that equation, the monetarist equation, plays a role because if the price level is higher and production capacity continues to be higher, the movement of money will ultimately drive the economy. I think the velocity, as tough as it is to measure, is probably higher given what's happened with this deposit flight. The Fed will try to model out not only how sensitive deposits are to changes in interest rates, but also if people change their minds about holding a deposit at the bank and using it in a different way, like a money market fund, will that alter spending behavior and therefore affect the economy?

Tracy: (35:41)
So the overall dynamic that we're seeing is deposit flight from banks and rotation into largely money market funds and cash-like instruments, which are then parking it at the reverse repo facility because they probably don't have enough T-bills to invest in. Is there a point at which the reverse repo facility becomes problematic for the economy? The Fed created it in, I think it was 2013 or 2014, as a way of better managing interest rate hikes, but is there a point at which it becomes competition for banks?

Ben: (36:21)
Yeah, and that may be happening. If you raise rates to a certain level that attracts money to alternatives — to deposits — and the banks have a hard time catching up, as that announcement from the New York Fed shows and we’re seeing that in earnings by the way coming through now, that banks are adjusting somewhat but not significantly enough, then a bloated, very large reverse repo facility indicates that money markets are getting too much money in that they cannot deploy in T-bills directly and have to go to the Fed's facility to get sort of a quasi-T-bill there. They post money at the Fed, they get interest back on that money. It’s a collateralized transaction, but literally they’re getting interest paid on that money — like the T-bill.

But that becomes problematic. Money market funds are happy, they go out there market and say “we’re higher yield.” But at some point this creates, I guess, this tension in the system, just like in 2018 when the Fed discovered there's a natural level of bank reserves that we cannot go under or we get major tension in the system. Because if we’re getting any major tax payments that are not coming in or cash withdrawals, then that causes this friction and then they have to do other things at that time. They had to, actually they bought T-bills at that time to try to reverse that situation. In this case, you probably see more of these lending facilities being initiated in order to offset the friction at the reverse repo facility.

Tracy: (37:49)
This kind of reminds me of , you know, you bring in a cat to catch a mouse and then you have to bring in a dog to catch the cat, and then, it just keeps going. It's like one lending facility to fix the tensions or frictions caused by the other lending facility.

Ben: (38:05)
They've long said they wanted to use the permanent repo facility as a way to control all of this, but people have said that if you do that, then everything will convert to that facility because it's the safest point in the system that you can go to.

Tracy: (38:21)
Right, it's almost like they're creating different tiers of money because the reverse repo suddenly becomes a specific type of money that's in competition with money in bank deposits and that sort of thing.

Ben: (38:34)
The reverse repo facility is considered to be safe, so it's the safest asset you can have. It's obviously a really complex issue, not easy to solve. I think for markets it continues to mean that we're going to face another episode like this for sure. The more that facility grows, as one indicator to our earlier discussion, that's a sign of stress.

Joe: (38:56)
So, just to look at the big picture, we have not seen credit fall off a cliff yet. We are seeing some signs of stress and difficulty, but it hasn't been a total collapse. Nonetheless, there's something going on. It sounds like from this conversation there are a few distinct stories. There was the acute shock at the beginning of March related to Silicon Valley Bank, but also, as you pointed out, 2021 was an insane year when everyone got drunk on the "line go up," and some of that just naturally has to be unwound.

Then there is the stress of rising rates creating competition for deposits, particularly at smaller and regional banks where they may have been doing very well with net interest margins but suddenly might have higher funding costs if they want to keep their deposit base. Each of these seems like slightly different sources of stress. How would you think about all these factors we're talking about in terms of what could drive the availability of credit?

Ben: (40:05)
I do think it's the deposit story that is the significant change because what it did was make banks become cautious as they start to build up reserves. This is a really important underlying trend there against the fact that you have an uncertain economy. So the opportunities to lend are by definition diminishing. I think the way people responded to what happened at Silicon Valley Bank has woken up even the markets, saying that you have the ability to withdraw money so fast and so quickly through an app in the digital age. You cover crypto a lot. This doesn’t have much to do with it, but it is in the context. Digital payment systems could cause more shocks going forward, in my opinion.

Joe: (41:02)
It's interesting that we're waking up to this. We did an episode right before Silicon Valley Bank with Joe Abate at Barclays who put out a note recently talking about the bank waking up so-called "sleepy deposits," which is suddenly people realizing that they can get higher yield and higher safety in one move, like what's the catch?

Tracy: (41:22)
This is exactly it. I remember I actually pitched a story idea, right after our conversation with the New York landlord, where he was like “why do I want to be in the business of renting out apartments when I can get 6% on a money market fund or a bank deposit?” And I remember pitching a story about “how higher rates are changing everything.” That’s exactly what we’re seeing, right? It’s like the reconfiguration of money because of the higher rates that we haven't seen for many, many years. Anyway, Ben, we're going to leave it there, but we're so glad we could have you on. That was an amazing discussion. Thank you so much.

Ben: (42:06)
Thank you, Tracy. Thanks, Joe. It's really great to be here.

Joe: (42:07)
This was really fun. Thank you so much, Ben.

Tracy: (42:23)
So, Joe, I thought that was fascinating. I can see a headline about, you know, “venture capitalists pulling money causing higher mortgage rates for millions of Americans,” just doing absolute numbers in terms of traffic, but maybe we won't do that. There is something there, though. We have seen this deposit flight set in motion, and it seems natural to assume that there is going to be some sort of impact on banks who may pull back from certain markets.

Joe: (42:48)
It's really interesting, and there are so many different factors. Getting a handle on what's going on with credit at any given moment is really tough. And I thought Ben explained it well, that there's no one credit market; there's bank credit, entities like PIMCO, private credit entities like Apollo, etc. Spreads are different from volume, you have surveys of private borrowers, you have surveys of bank lenders. You’re trying to get a handle on it. We're not in a crisis by any stretch, but it does seem that money is less freely available than it was maybe several months ago.

Tracy: (43:25)
well, this is the other thing. I think people naturally, they hear the term "credit crunch" and they think of 2008 and they think sharp, dramatic pullback in credit availability. And that's not necessarily the way it has to play out. You can have slow-moving crunches that maybe affect certain markets more than others, and I would imagine that's probably what we're going to see.

Joe: (43:49)
And, again, that's what the Fed is going for, in some sense. What is interest rate policy but an attempt to make credit more expensive with the goal of scaling the economy and fighting inflation? And so, to the extent that all these things are coming together to put pressure on credit availability, and again, it goes back to the Matt King conversation and the pretty straightforward return of monetarist thinking on some level. On some level, we're watching the plan.

Tracy: (44:14)
Yeah, it's the reconfiguration of money in the financial system based on these new rates that are available in different ways or at different places. Shall we leave it there?

Joe: (44:26)
Let's leave it there.

You can follow Ben Emons on Twitter at @Marcomadness2.