Friday, January 28, 2022

Yield Curve is Flattening

A little over two weeks ago, on January 11, I predicted the long end of the yield curve would come down, as the economy slows and the Fed commences its rate hike/QE unwind regime.

Since then, Jay Powell provided some hawkish commentary, and yesterday's GDP print came in red-hot at 6.9% for the fourth quarter of 2021, the highest quarter in forty years. Real GDP in 2021 grew 5.7% - the highest of my life by far. 

This should all be cause for celebration! The MMT crowd was write! America is back! Growth will be strong, rates will go higher!

And yet, as predicted, the 10yr/2yr spread has crashed from 85bp to 63bp, a decline of over 25%.

Not life-changing by any means, but it certainly happened faster than I anticipated.

I expect this curve flattening to continue, as the Treasury is removing dollars from the economy faster than it is replacing them. The Biden administration appears to unfortunately be listening to all the inflation hysteria in the press. Senators Joe Manchin and Kyrsten Sinema appear determined to throw the US economy into a recession, and guarantee the Democrats lose their majority in the House and the Senate in the midterms, and ultimately making Biden a one-term president, eliminating hopes for continued robust economic growth. That is not a partisan statement: the data is overwhelmingly clear that the US economy has grown faster over the last century with a Democrat as President. We don't have to be political about this, we just have to accept the reality that our economy will not grow as fast if more Republicans are elected, and prepare accordingly. For what it's worth, I am politically unaffiliated, and used to be a registered Republican.

Unfortunately, I expect this will lead to a recession, as we are starting to see with the yield curve flattening. The primary contributor to yesterday's big GDP figure was inventory builds. The political pressure to fight inflation has led to the government removing dollars from the economy. Retailers will be stuck with elevated levels of inventory, purchased at high prices thanks to the supply-chain problems, then sell them into an economy with fewer dollars to go around, forcing them to lower their prices. With FIFO accounting, that will depress earnings meaningfully (they get hit on both sides: higher unit costs with lower unit sales). 

Our elected officials, business leaders, journalists, and academics share the blame in this. They don't understand how our monetary system functions, so they insist on keeping dollars artificially scarce, using workers' livelihoods as a weapon to fight inflation. And while we can take advantage of this to make money in financial markets, their ignorance makes us all collectively poorer.

Thursday, January 27, 2022

Corporate Insiders Sold Post-IPO Stock Shares at Record Pace in 2021

 The other day, I wrote:

The American public's attitude toward monopolies and big business is changing, which is why Lina Kahn was voted in as FTC chair with overwhelmingly bipartisan support. The insiders realize the gig is up and have been selling for close to a year, which led to the IPO and SPAC bonanza in 2021, leaving public markets and retail investors holding the bag.

As reported in the FT the other day, 2021's IPO vintage saw record selling from insiders, which supports the above assertion.

Will take a deeper dive on a later date, but one thing to consider: the 2010s were a period that saw an explosion of unprofitable "tech" companies capitalized at monster valuations which could not be supported by internally-generated cash flow, and therefore required constantly raising new outside capital (and diluting existing shareholders). Some have affectionately dubbed this the "ponzi sector." This concept was encouraged by the idea that they would come to dominate and monopolize their respective industries. And while most on Wall Street blame this behavior on the Fed "lowering rates" and "pushing investors out on the risk curve," I'd like to offer a different explanation: we consistently ran budget deficits in the 2010s, which meant there was a constant stream of fresh new dollars entering the economy. The powers that be forced those dollars into specific uses, such as capitalizing new tech "unicorns" (and paying marketing rents to Facebook and Google while doing so). The combination of tougher antitrust enforcement and the federal government running a budget surplus has ruined that party, hence the absolute bloodbath that's taken place in the market for these names.

Wednesday, January 26, 2022

Follow the Flows, Not the Fed

So much obsession with the Fed these days on Wall Street and in the press. We are all supposed to believe the narrative that the violent market sell-off (S&P 500 is down roughly 7.5% YTD) is due to the market speculating that the Fed will raise rates. As noted previously, this doesn't make any sense: no one adjusts their estimate of a business' intrinsic value because they think the Fed will raise rates from 0% to 1% over the next twelve months.

The more likely culprit for the market swoon is the fact that, through January 24, the US Treasury had run a budget surplus of roughly $18 billion. When the Treasury runs a surplus, everyone else runs a deficit. Budget surpluses reflect the Treasury removing dollars from the non-government sectors of the economy. This reality is shockingly omitted from mainstream narratives.

Additionally, retail investors are hurting, which shouldn't come as a surprise. Below is an estimate of retail P&L during the pandemic, courtesy of Morgan Stanley:

Here's something I wrote in an internal email yesterday:

Let’s say you’re a retail trader with a $10,000 account balance at the beginning of the pandemic. Per the below, in 2020 you made a killing, +40%. Most, if not all, of that came in the form of ST cap gains. Assuming marginal tax rate of 30%, you netted $2,800.

As a novice, you didn’t put the $1,200 aside to pay taxes on those gains in 2021, so as you prepare your 2020 taxes, you realize you have to sell some of your holdings. Notice average P&L inflects downward in Feb/Mar 2021, as retail traders who’ve crowded into the same stocks are forced to sell to raise cash and pay taxes.

So, your new principle is $12,800. The below estimate suggests retail on average lost 15% in 2021, bringing your account balance down to $10,880. +9% cumulative over two years, vs. +45% for the S&P 500. You probably also lost money on some stupid crypto scheme. So at this point, you are likely selling what you can to make sure you can pay your taxes later this year and locking in any gains from the pandemic (if any) before you lose anything further.

Below is a list of retail-favorite stocks, according to Goldman Sachs. Not investment advice, but I would urge caution to anyone who owns these, given their stretched valuations and potentially negative flow dynamics discussed above:

AMC Entertainment (AMC) - 15.4x EV/TTM Revenues

Doordash (DASH) - 8.7x EV/TTM Revenues

Blackberry LTD (BB) - 6.9x EV/TTM Revenues

Airbnb (ABNB) - 20.5x EV/TTM Revenues

Marathon Digital Holdings (MARA) - 39.3x EV/TTM Revenues

Fisker Inc (FSR) - 70,150x EV/TTM Revenues

Roblox (RBLX) - 39.4x EV/TTM Revenues

FuboTV (FUBO) - 4.9x EV/TTM Revenues

Draftkings Inc (DKNG) - 9.9x EV/TTM Revenues

Riot Blockchain (RIOT) - 22.5x EV/TTM Revenues

Microvision Inc (MVIS) - 395.7x EV/TTM Revenues

Workhorse Group Inc (WKHS) - 404.8x EV/TTM Revenues

Canoo Inc (GOEV) - $2.2bn market cap with $0 TTM Revenues

Be careful out there...

Monday, January 24, 2022

Obsessing Over the Fed Is Pointless

I don't understand investors' obsession with the Fed/rate hikes. The only thing Fed rate hikes would do is make it more expensive for leveraged HFs to borrow money and pump up the price of stupid profitless stocks, SPACs, and crypto, hence the correction we're seeing (HFs de-grossing in anticipation of funding costs going up).

BTW, we used to have laws in this country that prevented the Fed's liquidity provisions from flowing into financial markets. These were systematically dismantled in the 80s and 90s, culminating with the repeal of Glass-Steagall. These were actions taken by Congress, not the Fed. Unfortunately, the Wall Street echo-chamber's obsession with the Fed crowds out this reality from the mainstream narrative.

The idea that rate hikes from 0% to 1% actually impacts a firm's intrinsic value is asinine. No actual business owner cares if the Fed raises rates from 0% to 1%. There is no change in any self-respecting analyst's "discount rate" from that action. When rates fell, no one actually said to themselves "well, I better lower my hurdle/discount rate because Treasury yields are low." No one thinks they are a sucker, despite what Howard Marks says about "the Fed forcing people out on the risk curve."

The froth in today's markets (public and private) is a reflection of 1) stimulus checks sent to retail investors (fiscal policy, NOT monetary) and 2) decades' worth of pro-corporate public policy, particularly with issues related to antitrust. Inflation used to eat into corporate margins when we had more competitive markets; now, we are seeing decades' high CPI growth with record corporate margins. It's not sustainable from a societal perspective. This is why Buffett likes to use Market Cap / GNP to gauge the general level of stock prices - if too much of society's resources flow to large business owners, there is public backlash. That indicator is near record highs.

Congress and the Courts' lax antitrust enforcement for decades led to massive corporate consolidation and tipped the scales in favor large business owners at the expense of workers and small business owners. Peter Thiel inspired a generation of VCs and entrepreneurs to create monopolies, because "competition is for losers." This led to a massive surge in unprofitable, VC-funded "tech unicorns" who can only make money "at scale" (read: when they become a monopoly). Their equity price reflected the option value they would monopolize their industry. Many are now financially distressed, and are in need of fresh capital (see CSPR, SDC). The American public's attitude toward monopolies and big business is changing, which is why Lina Kahn was voted in as FTC chair with overwhelmingly bipartisan support. The insiders realize the gig is up and have been selling for close to a year, which led to the IPO and SPAC bonanza in 2021, leaving public markets and retail investors holding the bag. ARKK has been falling since last February.

(BTW, this is a net positive for real companies that generate real cash flows and can fund themselves with internally generated profits, while providing real goods and services that are actually useful to people).

Also, the stimulus checks gravy train has dried up.

Low go-forward earnings growth and antitrust are the biggest risk to investors' portfolios, particularly if you are long mega-cap tech, who arguably pulled forward a ton of sales growth during the pandemic. In addition, more competition in markets = broader distribution of profit pools, putting today's income streams at risk. What if Google can no longer rig auctions? What if Amazon can no longer copy small manufacturers' widgets and sell their own white label version on its website? What if Meta has to actually pay for the tort liability it created with its toxic social media platforms? What if these firms can no longer hide the fact that their customers' ROI's on digital ad spending are bogus? None of this has anything to do with the Fed. The current spread between ATVI's market price and MSFT's proposed offer price is ~16%, because of the risk that the FTC shuts it down.

Wednesday, January 19, 2022

MMT in a Nutshell

 I put this together for the purpose of making a power point for my firm, and figured it would be useful to share here:

MMT in a nutshell:

The US government is a currency monopolist

  • It does not “borrow” money from the private sector
  • It spends money by crediting private bank accounts with reserves, which are then used to purchase its debt (Treasuries)
  • It cannot “run out” of its own currency, and therefore doesn’t rely on outside sources to “fund itself”

Because of its currency monopoly, the US government is a price-maker, not a price-taker

  • It sets the price of credit for its own currency
  • “Bond vigilantes” are a myth

Taxes are the government’s primary tool to create demand for its currency

  • The government has to issue the currency first before it can tax it away
  • Dollars can be thought of as “get out of jail free” cards: the private sector relies on the government’s currency issuance to meet its tax obligations and stay out of jail

The US government’s fiscal deficits and debt are the non-government sector’s fiscal surplus and assets

  • They are two sides of the same coin
  • Government deficits create private wealth, while government surpluses create private sector deficits
  • The cash in your pocket is your asset, and simultaneously a liability of the US government
  • When the government “pays down” its debt it is draining the private sector of financial resources; this has historically led to recessions

Banks are agents of the government and create deposits when they make loans

  • They don’t rely on pre-accumulated deposits to “fund” new loans
  • In exchange for this privilege, they have to obtain a special charter from Congress and are heavily regulated

The economy is limited by its real resources, not by arbitrary levels of debt and deficits

  • Inflation results from too many dollars chasing too few real resources
  • Raising rates is an ineffective tool to combat excessive inflation, because it provides further economic stimulus through the income channel (pushing up aggregate demand) and restricts the productive capacity of the economy by raising the cost of funding (pushing down aggregate supply)

Markets are creatures of the State

  • They rely on the public sector setting prices, creating property rights, and enforcing contracts
  • “Natural” market forces and “free trade” are misnomers

Some implications for investors:

Treasuries perform well when credit markets are weak, and poorly when credit markets are strong
  • Banks don’t rely on pre-accumulated deposits to fund new loans, so their lending activity is a function of the creditworthiness of the opportunities available, NOT the funds that are available (a bank can always create a loan for a creditworthy borrower)
  • Treasuries serve as an alternative source of income to fund interest paid on deposits when banks can’t find attractive lending opportunities
  • Non-bank lenders rely on Treasuries as an important source of liquidity and collateral
  • Treasuries are therefore an attractive cash alternative when credit growth is weak, as they generate positive carry and perform well when credit markets become stressed
  • None of this has to do with CPI inflation, and shorting Treasuries because of a high CPI print doesn’t make any sense, unless there is anticipation that the Fed will raise rates
  • Raising rates has proven to be an inflation accelerant rather than an inhibitor, so betting on higher rates because of inflation doesn’t make sense
Public policy drives business and investment results:
  • Fiscal spending packages dictate economic flows; look for under-resourced sectors with incoming flows to find price appreciation
    • Tens of billions of equity capital raised in 2021 for electric vehicles, in part thanks to the government’s incentives for purchasing them. Many of these companies are pre-revenue and will need to deploy billions capital to ramp up production, with much of that flowing to the major steel suppliers, an industry which has consolidated considerably to basically an duopoly: Cleveland-Cliffs (CLF) and US Steel (X)
    • The government provided $25 billion in support of airlines during the COVID crisis but didn't offer similar funds for car rental companies. As a result, there has been significant price volatility in the used car market because distressed operators such as Hertz liquidated their fleets to raise cash, then upon emergence from ch. 11 needed to rebuild
  • Trade rules and regulations, including antitrust, are critical determinants of private sector resource allocation
    • Big tech under scrutiny for anticompetitive practices, in direct contrast to Obama admin, which allowed FB to acquire Instagram, and led to massive equity value creation. Contrast this with the regulations placed on big banks, who were in the "dog house" during that period. Shorting the banks and buying Tech for the last decade would have been an absolutely unbelievable trade
    • Ocean shipping reform act of 2021 could prove a headwind for container shipping companies, right at the same time their earnings peak, could make for an attractive short opportunity
  • Changes to intellectual property rights affects profitability
    • Extending or reducing drug patents
    • Protecting exclusivity for licensed media content
  • Specific judges may rule one way or another in a bankruptcy scenario which affects creditor recoveries
    • HTZ equity ended up getting some recovery after filing in 2020

Tuesday, January 18, 2022

Most Money Managers Don't Understand How Money Works

I have been an avid reader of Barron's for years, and always look forward to the annual Barron's Roundtable at the beginning of every new year.

This past weekend, Barron's published part 1 of the series, which includes more of a macro outlook than individual stock selection.

The members of the Roundtable are typically titans of the financial industry, including legendary value investor Mario Gabelli.

I was disappointed when, upon reading this year's discussion, the very first thing discussed by the first panelist was US government debt hysteria and misinformation. Unfortunately, this seems to be endemic to the finance profession.

Scott Black, founder of Delphi Management in Boston who is also an art collector, leads off the discussion, and as mentioned almost immediately expresses misleading and false statements related to the US government's "debt" (emphasis added):

"At the time of the financial crisis, the Fed’s balance sheet was about $850 billion. Today, it is $8.8 trillion. The national debt has surged to $29 trillion, and the debt-to-GDP ratio is close to 1.3 times, both all-time highs. The Fed was reluctant to raise interest rates sooner because it feared killing economic growth.

Also, higher rates raise the interest expense on the national debt. Every one-percentage-point increase in rates adds about $290 billion of federal interest expense, so the Fed had an incentive to cap rates at today’s very low level. Given the current rate of inflation, the 10-year Treasury theoretically should yield closer to 3.5%-4%, not 1.8%. That would add $580 billion of interest costs to the budget, and the country would have no money left for discretionary spending. So, the underpinnings of the economy are pretty good, but high inflation doesn’t bode well for the market."

First, Mr. Black correctly notes the current levels of national debt and its ratio to GDP. However, what he conveniently ignores is the fact that the US Treasury's "debt" is an asset for everyone in the non-government sectors, including US households, businesses, municipalities, and foreign countries. A subtle rephrasing of his statement reads as follows: "US Treasury securities held by US households, businesses, municipalities, and foreigners have surged to $29 trillion, and the asset-to-GDP ratio is close to 1.3 times, both all-time highs." Doesn't sound nearly as scary, huh?

The same applies to interest "expense" on the national "debt." Remember: one person's expense is another's income, and one person's debt is another's asset. Higher interest expense on the national debt = higher interest income on the non-government sectors' assets.

The point about what the 10-year Treasury "should yield" is an example of the extreme hubris and arrogance that permeates this industry. The 10-year Treasury should yield whatever the correct yield is for optimal economic output for all citizens of the United States. Some MMT economists have argued the "natural" rate of government debt is 0%; positive rates are a subsidy for wealthy folks, whereas negative rates are a de facto wealth tax. The Fed has a dual mandate that is equal by law, which is stable prices and maximum employment. How would taking rates so the 10-year yields 3.5-4% (as Mr. Black proposes) achieve either of those goals? How does raising the cost of funding bring prices down, and combat unemployment and labor force participation rates that are still at worse levels than they were pre-pandemic? If anything, we are still a long, long way away from full employment, and rates should logically fall until we get there.

Finally, the comment on the US having "no money left" if rates were to go up is just absolute nonsense. The United States government cannot involuntarily "run out" of dollars, just like a scorekeeper cannot "run out" of points to assign in a basketball game. The US government creates new dollars by telling the Fed to credit banks' reserve accounts, then the banks use those reserves to purchase the government's debt. The idea that the US government has to "borrow" money from the private sector to fund itself is ludicrous. It is the other way around - the private sector needs dollars from the government so it can pay taxes, fees, fines, and other obligations the government imposes on it. Further, the US government is the monopoly supplier of dollars globally. It is a price-maker, not a price-taker. It dictates what rate it pays on its own currency-denominated "debt," and the private sector takes it. It has unlimited capacity to create new dollars to fund new debt purchases, and is also the buyer of last resort. As a monopolist price-maker, the government determines what interest rate it pays on its liabilities, whether the private sector likes it or not.

Mr. Black later says, "I would avoid fixed income like the plague." Likewise, panelist Sonal Desai says, "I’m the token fixed-income person on the panel, and I would argue that fixed income is one of the least attractive areas to invest in this year." Sounds like fixed income is pretty hated. As I write this, Treasury yields are spiking (albeit the long end of the curve is flattening), with the 10yr hitting a 2-year high. I believe this will prove to have been an attractive buying opportunity, particularly on the long end, as the Fed's rate hikes will tighten financial conditions, raising the cost of funding for borrowers right as the economy is starting to slow, increasing the risk for a recession.  Indeed, today's Empire Manufacturing Survey reported an astonishing 33pt drop m/m to -0.7. This follows disappointing retail sales in December and the second lowest Michigan Consumer Sentiment survey reading in a decade (November 2021 was the worst). Because Treasuries carry zero credit risk, an are assigned special legal denominations as type 1 HQLA, they essentially serve as a liquidity buffer during periods of stress, despite low nominal rates. Holders of US Treasury securities get paid a "liquidity premium" during periods of stress. Part of this is related to the shift from unsecured bank lending to secured lending in "alternative" credit markets, which requires pre-existing collateral; Treasuries effectively function as "base money" for alternative credit markets. They are effectively cash instruments with a positive carry.

Desai further adds:

"My last point is that we have had more than a decade of low market volatility, largely because of the large amount of liquidity in the financial system. We are at the start of a multiyear period, if not a decade, in which the markets will have to learn to reprice risk, because the consequence of a decade’s worth of extremely easy central-bank policy has been the distortion of prices and the mispricing of risk. The coming period is going to be a difficult one. I anticipate a rocky multiyear adjustment period resulting from the combination of high valuations and the unwinding of central banks’ easy money that has distorted risk assessment and capital allocation in markets for over a decade."

Again, the hubris in these statements is remarkable. Markets haven't been pricing risk? The 2014-2015 bear market in HY/distressed debt was absolutely brutal. According to law firm Haynes and Boone, LLP, there were a total of 572 oil & gas, oilfield services, and midstream bankruptcies in the six years ended in June 2021. Multiple mentions of central banks "distorting prices;" what makes central banks' actions over the last decade tantamount to asset price "distortion?" As argued in a previous post from January 11, QE has historically preceded a rise in rates, at least on the long end. Or, said differently, the Fed's QE announcements have always come after yields have already fallen. It's puzzling why these basic facts are continuously ignored by the financial media and Wall Street. The narrative is always: the Fed is "distorting asset prices."

Of course, only the Federal Reserve chairs over the last decade have engaged in this "distortion." Not Paul Volcker and his interest rate hike shenanigans.

Wednesday, January 12, 2022

Supply Side Matters and the Paul Volcker Myth

During yesterday's hearing to reconfirm Jay Powell as Chairman of the Federal Reserve, he responded to a question regarding inflation with the following:

“We can affect the demand side, we can’t affect the supply side. But this really is a combination of the two."

People, especially those on Wall Street, love to bash the Fed; I generally try to avoid Fed-bashing for the sake of it. That being said, I do have a problem with this statement. The Fed controls the supply (and therefore the price) of short-term credit. It absolutely affects the supply side of the economy. It's true that it can't create more supply of goods and services, but it can absolutely accommodate the businesses that do through its monetary policy. By raising rates, the Fed would be effectively raising the cost of funding for suppliers, reducing the total production capacity in the economy, thus restricting the supply of goods.

This is also part of why Fed rate hikes to "combat inflation" are insane. If you raise the cost of capital, you restrict economic production while at the same time forcing suppliers to raise prices - they have to make a profit after all. Not only that, but higher interest rates stimulates demand through the income channel.

This view is in direct contrast to the mainstream narrative. Take for example Jim Grant. He is relentlessly critical of the Fed, and like most on Wall Street, is a staunch rate hawk. He constantly rails on the likes of Jay Powell, Janet Yellen, and Ben Bernanke while placing Paul Volcker on a pedestal. Volcker is widely considered a hero, because he had the "intestinal fortitude" to relentlessly raise interest rates, thus "slaying the inflation dragon." But was Volcker in fact an arsonist masquerading as a firefighter? Consider the below chart, courtesy of Grant's Interest Rate Observer.

Paul Volcker was sworn in as Fed Chairman on August 6, 1979, and almost immediately "targets the money supply" as Grant's puts it. What's noteworthy is that, as we can see, the year-over-year change in CPI at this point matched the peak that followed the first oil shock in 1973. The growth rate of the CPI ended up coming down, without Volcker's draconian measures. Volcker's "attack" actually led to an acceleration in the rate of CPI growth. The evidence is unmistakable: Volcker's policies created the inflation he claimed to have destroyed. And yet, he is heralded as this hero in Wall Street folklore. 

As an aside - it's noteworthy that people on Wall Street complain ad nauseum about the Fed "interfering in the markets" by lowering interest rates, while simultaneously gushing over Paul Volcker's policies, even though he was the most radical Fed Chairman ever who ostensibly "interfered" in the rates market in a remarkable fashion. It goes to show that Wall Street, like everything else these days, is clearly a political institution that embraces narratives in support of its own self interest as opposed to objective facts. Wall Street is a huge beneficiary of higher rates, because high rates are subsidies for rich people. Any person of means in 1981 could put their life savings in a 30yr Treasury at a 15% yield; if they held to maturity they would have made 66x their money risk-free. How can that be described as anything other than a massive wealth redistribution scheme from the poor to the rich?

Don't get me wrong - if I had money to put to work and Paul Volcker gave me 15% annualized for 30 years risk-free, I'd be a huge fan of the guy too. But let's not kid ourselves with this myth about Paul Volcker's "moral crusade" against inflation; all he did was give out free money to rich friends on Wall Street.

Tuesday, January 11, 2022

Bonds: Yields on the Long End Will Come Down

 As noted in the WSJ over the weekend, the US 10yr Treasury yield finished last week at its highest yield since January 2020. This was apparently due to a more hawkish than expected tone from the latest FOMC meeting minutes, with three interest rate increases expected and an earlier-than expected wind-down of the Fed's asset purchases.

The framing in the media that the Fed will start "tapering" its asset purchases is misguided, because the Fed has already been de facto tapering since March 2021, when it launched its Reverse Repo program (RRP), which has eclipsed $1.5 trillion. The Fed holds assets such as Treasuries and agency MBS on its balance sheet, and has been lending those securities out as part of the RRP. At $1.5 trillion, that is over a year's worth of asset purchases, assuming $120 billion/mo. So it's hard to see an asset purchase "taper" having any meaningful impact, given the securities purchased are offset by them being lent out (technically a sale with promise to repurchase at a later date) by 12x over.

What's interesting is, contrary to popular beliefs, the Fed's QE programs have historically led to an increase in the yield on the 10yr (or perhaps more accurately, a steepening in the curve). It's unclear exactly why this is, because "easing" implies lower rates, and people also blame high financial asset valuations with the Fed's supposed rate "suppression." How can it be then that QE causes rates (at least the long end) to rise?

The most plausible explanation in my view is what I'll call the Collateral Scarcity Thesis (CST). CST proposes that when the Fed does QE, it is effectively removing high quality, good collateral (think Treasuries and agency MBS) from the market by placing it on its balance sheet in exchange for bank reserves. As argued by IMF economist Manmohan Singh, collateral is an important financial lubricant because institutions can reuse it for new credit creation, whereas reserves cannot be used in the same manner. He further argues that the Fed unwinding its balance sheet itself is a form of easing, because it creates capacity for banks to make new loans. Because QE removes collateral, it creates a shortage and therefore tightens credit. Tightening credit is usually associated with higher rates. Looking at historical yields (or in this case, the 2yr10yr spread), QE has been associated with rising yields/steepening curve, which is a sign of credit tightening. See below:

The green dots represent instances when the Fed has announced QE (green means go!); red they slowdown and/or stop.

As we can see, QE causes the long end to rise, and reversing it causes yields to fall. This is in direct contradiction to the narrative that QE "suppresses interest rates;" it clearly raises/steepens.

One thing to note - the red dot for March 2021 does not represent the Fed announcing an unwind of its balance sheet per se. Instead, it represents the date that the Fed announced the RRP. As stated earlier, RRP is a de facto unwind of QE, because the Fed takes in reserves and releases collateral. As would be predicted by CST, the RRP eases credit conditions by creating additional capacity for bank lending. Increasing the supply of collateral should lead to growth in bank credit. And it worked! Year-over-year growth in bank credit fell substantially in March 2021, which coincided with rising bond yields. When the Fed launched RRP at the end of March, the long end came crashing down and bank credit bottomed before starting to grow again:

So we know the taper doesn't matter because the Fed has already been tapering since March. Does this mean bonds are a buy here? That depends. I think yields will be lower six months from now, but that doesn't necessarily mean bonds are a screaming buy. It's possible that yields rise in the short term due to seasonal and/or technical reasons. For example, companies drawing on credit lines to purchase inventory to restock following the holiday season.

If demand for credit is robust, then I wouldn't expect the long bond to perform well. Higher demand for credit = price of credit (i.e. yields) go up, all things being equal. I think chronic underinvestment by the federal government for decades has the US economy operating far below its productive capacity. We haven't been doing enough to support broad-based growth. The best evidence of this can be seen in the weak Labor Force Participation and Capacity Utilization rates: 

In general, when more people are working and generating income, their capacity for borrowing (read: credit demand) increases. We are lapping tough comparative periods because of the massive fiscal stimulus that took place in 2020 and 2021, which means we may have hit peak credit demand. Higher inflation also depletes savings. And the Fed may raise rates, which I expect to flatten the yield curve. Slowing credit demand and diminishing supply as the Fed raises short-term rates are bullish for the long bond.

Monday, January 10, 2022

Investors Should Pay More Attention to Congress and the Courts (And Less to the Fed)

One of the goals for this blog is to get people, particularly investors, to understand the MMT economic framework and how it can help us make better, more informed decisions. But the MMT framework goes beyond just "money" in the conventional sense. We can adopt an MMT framing to better understand other financial assets.

Government Handouts

In her fantastic book The Code of Capital, Katharina Pistor argues persuasively that capital itself is a creature of law. The value for any asset, whether tangible (e.g. land or equipment) or intangible (e.g. patents) is derived from the State creating the property right which assigns ownership status to the asset's owner. The State also promises to enforce contracts. These facts are typically ignored or looked over in our modern discourse, but nevertheless are critical for what capitalists call "value creation." Any homeowner in the US had to purchase their house, which involved signing a contract and obtaining legal title to that property. What would happen if the government suddenly said it would no longer acknowledge and/or enforce that contract and title? What happens to your "equity?" Your equity has, quite literally, been cancelled and is now worthless. The property itself may provide utility, but without the State's legal recognition, you are no longer the owner. Libertarians and other "rugged individualist" types love to rail on "government handouts" without acknowledging they receive the ultimate handout in the form of the government's promise to protect the right to own property. Thus, similar to how the government's liabilities are the non-government's assets, the government creates economic value in the private sector by promising to use the full resources of the State to protect property rights and handle contract disputes. 

Sure, it is possible for someone to defend themselves from intruders without the government's help, but do we really want to live in a world where everyone has to defend their property themselves without the support of the State? That sounds extremely resource-intensive and wasteful, and would lead to anarchy and chaos. Centuries of common law innovations and subsequent improvement in living standards suggest we are better off with the State intervening. It's important for us to acknowledge and be grateful for the government's role in private sector value creation, and recognize we are better off as a result. WE LIVE IN A DEMOCRACY. THE GOVERNMENT WORKS FOR US.

Big Tech's Secret Sauce: Regulatory Arbitrage

So if capital is a creature of the State, then it makes sense for investment analysts to pay attention to how the State's laws are, and will, influence outcomes in capital markets. Think about it - if Congress extends or reduces the term period for a patent, that will significantly impact the financial results of the patent's owner. While the mega-cap tech stocks today are frequently referred to as the best, most innovative businesses, it's worth considering an alternative view: that their success has much more to do with their favored legal status and "regulatory capture" as opposed to any sort of merit-based reason. The fact that Facebook was allowed to corner the photo-sharing social media market when it acquired Instagram shows how the government's blessing (it could have blown the deal up citing antitrust concerns) created unimaginable economic value for FB's shareholders.

Not only that, but the Big Tech companies like Facebook and Google don't have to play by the same rules as traditional media companies. Section 230 of the Communications Decency Act gives special legal privileges to an "Interactive Computer Service" to be exempt from being treated as a publisher or speaker. Instead, they are merely treated as platforms which cannot be held accountable for the content that gets posted on their sites. They have maintained this status despite evidence they have their thumb on the scale of what content people do and don't see. Because they are exempt from tort liability, and don't have to pay for the content that gets created on their platforms, Facebook and Google can generate substantially large profits by selling advertisements at structurally higher margins than traditional media companies. This has nothing to do with them being "innovative." Indeed, when was the last time Facebook innovated anything? They can't even figure out how to make a compelling online dating product!

Google's business model has historically been to take already-existing IP, repackage it and sell it as their own. Google's original search algorithm, called PageRank, was effectively a filing system converted to digital code. The company's lawyers successfully argued that PageRank was deserving of a patent, which was a reach considering there doesn't seem to be anything novel about a filing method. Nonetheless, their lawyers won which allowed Google to monopolize online search; they hold over 90% market share to this day. Google Maps is possible because of GPS, which was created by the US government. Google Books involved taking books that were already available to the public, converting them to a digital form, and using them for commercial use.

And let's not forget the fact that the internet was created by the US government. Any "internet" company today, including Facebook, Google, and Amazon, owes their existence to Uncle Sam. Public services and investments create private wealth.

Wall Street's Fed Fetish

As we can see, the business outcomes of Facebook and Google are very much a function of the legal code. If we can understand how laws affect business outcomes, we can make better investment decisions.

Surprisingly, this type of analysis is not a topic of focus in the analyst community. Investment analysts are taught to analyze and project business operating results, and also understand the competitive dynamics of its industry. Logically, one would expect that investment analysts were experts and/or paid significant attention to Washington in its capacity to write and enforce laws. And yet, instead of focusing on Congress and the Courts, Wall Street traders obsess over a different public entity: the Fed.

I have been working in financial markets for over a decade, and am still flummoxed by Wall Street's obsession with the Fed. Traders on Wall Street obsess over the FOMC's meeting minutes and press conferences. Wall Street folklore is filled with stories about how traders used to gauge the size of former Fed Chair Alan Greenspan's briefcase to determine whether a rate cute was coming or not. The whole thing is a circus and is ridiculous, and yet Portfolio Managers are still the highest paid professionals on average in the US:

Mainstream economists will defend such practices as merely a result of a magical "invisible hand" guiding market participants to optimal resource allocation. But of course, this is all the "natural" state of things, nothing to do with arbitrary power structures.

Rate Hawks

The Fed is routinely railed by influential people on Wall Street and the press for its supposed role in creating "asset bubbles" and "interfering" in free markets, thereby distorting the market's "price discovery" mechanism. Jim Grant of the eponymous Grant's Interest Rate Observer is perhaps one of the most fervent critics of the Fed, and has even likened the Fed's "suppression of interest rates" as borderline criminal. For the record, I like Jim Grant and think he is a noble man who means well, and am a subscriber to his newsletter; I happen to disagree with several of his "macro" takes however. Grant's thesis is one that is widely shared on Wall Street, which is that the Fed's monetary policy decisions since the GFC have not only interfered with "natural" market pricing functions, but also created conditions for today's massive wealth inequality. This view is increasingly embraced by mainstream media outlets including the NY Times.

The theory goes as follows: financial assets generate cash flows for their owners, and are priced using a discount mechanism. Cash flows to be received in the future are discounted to the present using a discount rate. The Fed, through its monetary policy operations, sets the near-term discount rates for money and, by extension, asset prices. Generally speaking, lower discount rates increases the present value of those cash flows. By keeping rates "artificially suppressed," the Fed has supported wealth generation for those who are already wealthy and own financial assets, exacerbating wealth inequality.

Is there merit to Grant's point is that the Fed's policies hurts "savers," by denying them income they previously were able to generate risk-free? While this seems to be conventional wisdom on Wall Street, it is a false narrative. Grant seems to think the typical saver is an "ordinary working person." It's unclear why he believes this to be the case. Perhaps "savers" included working-class people when Mr. Grant grew up, however, median household incomes have been shrinking as a percent of aggregate income share for over fifty years. Income and wealth disparities have gotten so bad that, as published in a 2019 study by the Fed, 4 in 10 Americans didn't have sufficient funds to pay for an unexpected $400 expense. With so little net savings, ordinary working people are forced to become debtors instead of creditors. Indeed, as former Fed economist Claudia Sahm points out, the top 1% of households hold one-third of the nation's wealth whereas the bottom half hold merely 2%. Not only that, but the top 1% owes 5% of the nation's debt vs. the bottom half does one-third. As Sahm puts it:

"Wealthy people - those who have tons of savings and money to lend out - get hosed by low interest rates. Inflation is even worse. Who benefits from low rates and some moderate inflation? Main Street, especially anyone with debt."

Some MMT economists have argued that interest paid on government debt securities can be thought of like any other fiscal policy decision, and are in fact subsidies for the wealthy. This framing makes more sense than Grant's argument - you can't earn interest on government debt if you don't have the financial resources to purchase that debt in the first place, which in turn requires generating income in excess of costs. Rising living costs and declining incomes for workers makes it difficult, if not impossible, to accumulate savings, and turns the working class into debtors instead of creditors. Sahm and other MMT economists' make a compelling, data-driven case that low rates in fact ease debt burdens and thus help working class people. Jim Grant's evergreen call for the Fed to raise rates is attractive for wealthy people who are net creditors, NOT workers.

So the real reason that Wall Street obsesses over the Fed is because people on Wall Street are generally rich and part of the "creditor" class; they are biased towards higher interest rates because that helps them get richer. That said, what about the argument that low rates support asset prices?

USA vs. Europe vs. Japan

The main problem I have with this thesis is that other countries have also had very low, including negative, interest rates, and their stock and real estate markets have not experienced anything like the capital appreciation we've seen in the US over the last 20 years. As Nathan Tankus, head researcher for the Modern Money Network, writes (emphasis added):

"As economist JW Mason pointed out many years ago, the U.S. has more assets which see paper price increases because more of society’s wealth is converted into property which can be freely bought and sold. Countries like Germany have lower stock valuations because of worker representation and influence on companies and a higher proportion of renters. Those renters have strong legal protections for their tenancy which decreases measured real estate values."

When it comes to tech companies, Europe has been at the vanguard of consumer data protection with its GDPR program. The continent is not as friendly to business owners than in the US, and this is reflected in the legal code. We can also look at a country like Japan, which is notoriously shareholder un-friendly, and see that zero percent interest rates and QE have done little support Japanese asset prices, at least compared to the US.

Below is a 20yr comparison for US (S&P 500, blue), Europe (Euro Stoxx 600, black) and Japan (Nikkei 225, yellow) stock market returns for the period ended December 31, 2021:

That's not to say interest rates are completely irrelevant. Again citing Tankus:

"For one thing, capital gains come from falling interest rates, not low interest rates. Sustaining the same interest rate stance doesn’t have the effect of increasing capital gains, and certainly not to the extent that actually lowering interest rates does. This sort of capital gains happened in the 1980s when rates were falling from 20+% to “merely” 7% or so. Holding interest rates at the same level shouldn’t be conflated with this interest rate effect. Further, from an inequality point of view, the high returns provided by such high interest rates is as relevant as these capital gains. It's not hard to get rich when you are earning your principal back in just a few years."

Perhaps it's true the Fed created inequality when Paul Volcker took interest rates up north of 20% and caused a recession in the early 1980's. But the tech-driven, relentless US stock market gains over the last decade or so can be better understood as the result of the laws on the books, not because of an expansion of the Fed's balance sheet or "money printing."

So, stop obsessing over the Fed. The Fed is a creature of Congress, and doesn't have nearly the impact on financial outcomes that Congress and the Courts do.

Thursday, January 6, 2022

Financials Model Portfolio

 In light of yesterday's write-up about how the business model of banks is widely misunderstood, below is a model portfolio I put together with banks and other financial services providers at the end of 2021 (Disclaimer: not investment advice). This portfolio includes banks and other financials-related businesses that 1) provide critical financial services for real people and real companies and 2) are offered at a decent value. I'll provide some deeper dives on individual names in the future, but for now I will post it and update the performance each quarter. For performance-tracking purposes, assume that all dividends are reinvested in the shares.

The reason these are offered at a decent value is that capital has flowed away from traditional financial services and into "the future" of finance such as FinTech, cryptocurrencies, DeFi, web 3.0 projects, etc. My prediction is that financial innovations will inevitably accrue to the incumbents, because of their "franchise" relationship with the US government and global scale.

The portfolio is designed to include both blue-chip stalwarts as well as small-cap, growing business. The idea is that companies like JPM and BAC will likely generally track with the S&P 500, and their share repurchase programs puts a floor on their price. Smaller stocks like MGI, which I believe is severely undervalued, will hopefully enable the portfolio to generate returns in excess of the market averages.

As of the end of 2021, the TTM P/E ratio for the S&P 500 was about 25x. The average TTM P/E ratio of this portfolio is 11.6x, slightly under half of the S&P.

Without further ado, here is the portfolio (figures as of 12/31/21):

Bank of America Corp (BAC) - 13.7x TTM P/E ratio, largest US bank by deposits

JPMorgan Chase & Co (JPM) - 10.1x TTM P/E ratio, second largest US bank by deposits

Goldman Sachs Group Inc (GS) - 6.2x TTM P/E, premier institutional financial service provider with growing consumer franchise

Bank of New York Mellon Corp (BK) - 14.8x TTM P/E, largest institutional assets custodian in US, only commercial bank that offers tri-party Repo services

State Street Corp (STT) - 13.2x TTM P/E, second largest institutional assets custodian in US, third largest ETF franchise

BlackRock Inc (BLK) - 23.7x TTM P/E, dominant ETF business, spinoff of Aladdin software subsidiary would be accretive

H&R Block Inc (HRB) - 13.7x TTM P/E, second biggest tax preparer in US by volumes, growing financial services

MoneyGram International Inc (MGI) - 1.0x EV/Sales (no GAAP earnings on TTM basis), second largest global remittance servicer with dominant cash remittance business and growing digital business, trading below replacement value, refinanced expensive debt in 2021 which cut interest costs in half, expect substantial margin expansion and cash generation in 2022, recently launched share repurchase program

Western Union Co (WU) - 8.8x TTM P/E, largest global remittance servicer with growing digital business

Virtu Financial (VIRT) - 7.4x TTM P/E, high frequency trading duopoly, competes with Citadel Securities, EBITDA margins consistently north of 50% historically, Citadel is the engine that made Ken Griffin one of the richest people in the world, these guys are their biggest competitor and it trades at a single-digit multiple of earnings?! Also, like their CEO, passionate about his business

Berkshire Hathaway (BRK/B) - 7.8x TTM P/E, Buffett = GOAT, diverse mix of fantastic businesses, including insurance and banking, Buffett is the best bank analyst in the world, Berkshire is the largest company in the US by assets, trading at single-digit multiple of trailing earnings, buying back tons of stock

Discover Financial Services (DFS) - 7.0x TTM P/E, digital banking and payments giant

American Express Co (AXP) - 17.2x TTM P/E, dominant banking and payments franchise, millennials starting families and purchasing homes is a tailwind for credit card business

Synchrony Financial (SYF) - 7.1x TTM P/E, dominant consumer finance franchise

Didn't make the cut (too expensive as multiple of earnings) included the following:

Euronet Worldwide Inc (EEFT) - 43.9x TTM P/E, fast growing remittance servicer

Square Inc (SQ) - 125.8x TTM P/E, fast growing digital payments

Intuit Inc (INTU) - 85.9x TTM P/E, Largest tax preparer in US by volume, dominant financial services software franchise

Fair Isaac Corp (FICO) - 40.0x TTM P/E, Consumer credit score monopoly, CEO recently purchased large chunk of stock

Mastercard Inc (MA) - 43.8x TTM P/E, Payments juggernaut

Visa Inc (V) - 46.0x TTM P/E, Payments juggernaut

PayPal Holdings Inc (PYPL) - 45.1x TTM P/E, Digital money transfers juggernaut


Wednesday, January 5, 2022

Are Banks the Most Misunderstood Businesses in the World?

research piece released last December by Morgan Stanley titled "Cryptocurrency vs Traditional Finance" included this back and forth between Stani Kulechov (Founder and CEO of Aave) and Giulia Aurora Motto (Banks and Fintech Research at MS, emphasis added):

[SK] Lending and borrowing: DeFi vs banks. We currently see some overlaps between DeFi and wholesale markets, especially on collateralized lending, yet DeFi in its pure decentralised form doesn't translate exactly to the way the fractional reserve banking system operates today. For example, unsecured loans, a mortgage or a corporate loan would require some form of centralised layer on top of current DeFi protocols as the vast majority of lending in DeFi is over-collateralised at the moment. In contrast, banks typically collect deposits, carry out a credit assessment and then lend this money out by taking some credit risk where the loan is unsecured, leading to money supply expansion. Stani Kulechov, however, didn't see this as a hurdle, and in fact argued that all lending is somehow over-collateralised, by a property, or also by data. Looking forward, he thought that tokenizing real world assets (for example London properties) is the most tangible opportunity to add assets on-chain and expand the use cases for DeFi beyond crypto.

[GAM] Morgan Stanley view: regulation evolution key to watch. The higher yields that users can achieve by depositing funds in DeFi protocols, relative to fiat bank deposits, definitely raises the question of the role of traditional banks and their role in lending out deposits, and hence we will watch this space extremely closely. We think the next key steps will come from regulation, as the key enabler for further institutional involvement, and more use cases to emerge beyond crypto.

On its face, this sounds reasonable. Banks do indeed lend out deposits, right? Right????

As a matter of fact, banks DO NOT lend out deposits. Banks create deposits when they make loans. This is a shockingly misunderstood reality. Many economic textbooks repeat the myth that banks lend out deposits. People in high finance and other positions of power, such as Ms. Motto and Mr. Kulechov, likewise believe this to be truth.

But it isn't true. To find out why so many have fallen for this fantasy, read on...

Money Scarcity Myth

There is a mass delusion that permeates our society which can generally be referred to as the Money Scarcity Myth (MSM). MSM promotes the idea that money is inherently scarce; that it must "come from" private savings and investments. Believers in this illusion insist that government spending must likewise come from taxes or borrowing from the private sector, and therefore "crowds out" private investment. This fallacy feeds into our politics, culture, laws, and general way of life, and has created other falsehoods related to money.

However, as MMT shows us, the truth is exactly the opposite: private sector savings and investment are uses of the government's money; the government is the source. Think about it: private sector savings and investments in the US are (generally speaking) denominated in dollars. But where do those dollars actually come from? The federal government! Indeed, it is helpful to think of Uncle Sam as a currency monopolist. In the US, Congress has legal authority to "coin money" as per the Constitution. The US government pays the non-government (i.e. "private") sector in for goods and services in dollars it creates. It can purchase anything that is for sale in its own currency. Since President Nixon ended the Bretton Woods system in 1971, the dollar has been a free-floating currency without any sort of fixed conversion feature.

Before we get to banks, a quick note on where MSM likely comes from. People have long believed that gold and other "precious metals" are "real" money. This seems to be one reason for the lingering false view that money is inherently scarce. In addition, MSM is generally accepted as fact by economists of the "neoliberal" school, which has been the dominant school of economic thought in the post-WWII period. It's unclear if these economists, at least the early pioneers, knew better or intentionally sought to confuse and/or obfuscate the public about money. Consider the following from Nobel prize-winning economist Paul Samuelson, who in a 1995 documentary on John Maynard Keynes, said the following (emphasis added):

“I think there is an element of truth in the view that the superstition that the budget must be balanced at all times [is necessary]. Once it is debunked [that] takes away one of the bulwarks that every society must have against expenditure out of control. There must be discipline in the allocation of resources or you will have anarchistic chaos and inefficiency. And one of the functions of old fashioned religion was to scare people by sometimes what might be regarded as myths into behaving in a way that the long-run civilized life requires. We have taken away a belief in the intrinsic necessity of balancing the budget if not in every year, [then] in every short period of time. If Prime Minister Gladstone came back to life he would say “uh, oh what you have done” and James Buchanan argues in those terms. I have to say that I see merit in that view.”

How incredibly ironic it is that critics mock MMT by calling it the "Magic Money Tree" while at the same time praying at the altar of silly religious cults promoted by the likes of Samuelson, where the all-powerful "invisible hand" magically guides markets into optimal resource allocation and "equilibrium" states (FWIW Smith's invisible hand comment has been taken completely out of context over the centuries by economists and historians). 

At its core, money is a human invention. Economists generally define money as a medium of exchange, a unit of account, and a store of value. Money's abstract nature (you can't hold a "unit of account") means there is no limit to how much money can be created, just like there is no limit to how many inches can be used for measurements, or how many points can be scored in a sports game. A scorekeeper can't "run out" of points; a person can't "run out" of inches to measure a tree; and a sovereign nation that has control of its own currency can't "run out" of money.

That's not to say there aren't real resource constraints; in all three examples above, there are no doubt real limits to how many "units" are needed to "account" for each of those situations. But the fact remains that the units themselves are limitless.

Banking 101

What does this have to do with banks? Most people, including those on Wall St, believe in MSM which, following its logical conclusion, implies that banks must obtain deposits or find other sources of pre-accumulated scarce money in order to "fund" the loans they create. However, this is fundamentally untrue. As explained brilliantly in a 2014 article released by the Bank of England, banks don't accumulate deposits and lend them out; they create deposits when they make loans. See the graphic below:

Source: Bank of England

Consider someone taking out a mortgage. Let's say, for argument's sake, they borrow $750,000 from a bank to fund the purchase of a new home. The total purchase price is $1,000,000, so they will contribute $250,000 cash as their down payment.

In our modern economy, people don't generally keep $250,000 in cash laying around. Instead, the $250,000 is held in a Deposit account at a bank. In other words, the $250,000 of cash exists as a digital accounting ledger entry on a commercial bank's balance sheet. This reflects a credit relationship. The "money" is an IOU "due from" the bank and represents the Buyer's legal property and contributes to their net worth to keep the accounts in balance. Assets = Liabilities + Net Worth. When a deposit-holder demands cash, or orders the bank to transfer the "due from" IOU to another person's account (internally or at another bank), the bank is legally obligated to make good on that payment.

Here is what the home purchase transaction looks like, before during and after:


DURING (i.e. after the loan is made, but before the house transaction settles):


Note: this assumes both the Buyer and Seller hold their deposits at the Bank who created the loan. As we can see, there was no change in net worth for any party before, during, or after the transaction settles, but in aggregate there is more "money" than before, as the bank's deposits when from $250,000 to $1,000,000. How did this happen? The bank approved the loan and credited the buyer's account with $750,000, which along with the $250,000 cash already held was transferred to the Seller. The Seller holds $1,000,000 in a deposit account at the Bank. In exchange, the Buyer now owns the House, and the Bank has a $750,000 IOU from the Buyer. The Bank did not obtain this money from an already existing account - it created it ex nihilo.

The Finance Franchise

Why do banks have this special privilege of curating money out of thin air? The best explanation can be found in a fantastic 2017 Cornell Law Review article, which argues the relationship between commercial banks and the US government resembles a franchise arrangement: the government is the franchisor and issues a special license called a bank charter to its franchisees, the banks. The product they are selling is the full faith and credit of the United States, expressed as a form a fiat money called dollars. McDonalds franchisees procure Big Macs; US commercial banks procure dollars.

The privileged status of banks as public money franchisors gives them priority status versus other lending institutions. While non-bank lenders need to obtain scarce deposits to make loans (or other investments), banks do not have such constraints (they do have other limits and are heavily regulated, however). In fact, banks have exclusive legal rights to hold deposits, which themselves have special legal carveouts in that each deposit account is guaranteed up to $250,000 at 100c on the dollar by the FDIC. Deposits are a lower cost of funds than other forms of capital, including debt and equity. And they are critical for making payments and, therefore, to the proper functioning of the economy. This is why US government had to bail out the banks during the GFC, because the public's deposits were at-risk. Banks generally make money by charging interest on loans, less any interest paid on deposits and other debts, and operating costs.

The logic behind this "franchise" relationship is to distribute power and money-creation capabilities across all sectors and regions of the economy, rather than concentrating that power in a single entity. The profit the banks generate is their reward for promoting the nation's economic progress.

King Dollar

So what if banks have special licenses to print dollars? Why do people want to accumulate dollars anyway? There are myriad reasons for demanding dollars, but the most fundamental is simple: taxes. The US government's ability to levy taxes, fees, and fines is the primary driver for the public's demand for dollars. Taxes are a form of debt, and the US government demands dollars to be paid for tax debts. In fact, some have made the analogy of the dollar as a "get out of jail free" card. But dollars are useful for other debts, too. In fact, any dollar bill reads "THIS NOTE IS LEGAL TENDER FOR ALL DEBTS, PUBLIC AND PRIVATE."  The US government will always accept dollars in nominal terms for the payment of such debts. And, it is actually illegal for the US government to default on its debt

You may have noticed that a dollar bill is labeled as a "Federal Reserve Note." The bills in your pocket are your assets; given the immutability of double-entry accounting, they must be offset with a corresponding liability. Indeed, as noted on its website, Federal Reserve Notes (i.e. the physical dollar bills people use to pay for goods and services) are in fact the Fed's liabilities. Your assets are the federal government's liabilities. A liability implies some sort of obligation. When the Fed issues dollars, it is creating an obligation to accept that dollar in its full nominal value for future payment. The dollar will eventually find its way back; taxes are typically due upon death. And like Ben Franklin said, there are only two certainties in life: death and taxes.

This is an important concept to understand - the US government's liabilities are the non-government sector's assets. There is a circularity in the sense that both the federal government and the non-government sector both simultaneously represent the People of the United States. So, they are essentially two sides of the same coin, just with different accounting identities (sort of like how the Bank in our above example had a $250,000 Cash asset and a $250,000 Due to Buyer liability). In a literal accounting sense, the assets and liabilities (including net worth) of the federal government, households, businesses, and municipalities net out to zero. Assets and liabilities must match for the accounts to be in balance. 2 - 2 = 0...Every. Single. Time.

Speaking of the Fed...

Commercial banks by law must be members of the Federal Reserve, the central bank for the United States. While "The Fed" has some characteristics of a private corporation, it is ostensibly a public institution and an agency of the US federal government. It serves as an intermediary between the finance arm of the Executive Branch, the US Treasury, and the commercial banks. Indeed, it is like a "bank for banks" and a "bank for the government." When the Treasury collects taxes, the cash is transferred out of the taxpayer's deposit account at their bank and into the Treasury's General Account at the Fed, because the Treasury by law can't draw on an account at a commercial bank. This cash is held on deposit at the Fed, and is called a "reserve." When "primary dealers" (usually subsidiaries of bank holding companies) purchase debt from the Treasury at auctions, by law they have to use cash reserves held on deposit at the Fed for payment. So in every way, the cash used for the purchase of the US government's debt is "paid for" by money created by the government.

The Fed can't lend money or purchase debt directly from the Treasury. If it wants to purchase the Treasury's debt as part of its monetary policy, it credits the seller's bank account with reserves in exchange for the debt securities.

The Fed is in charge of promoting price stability and full employment in the economy, for which it conducts monetary policy - mainly buying and selling the Treasury's debt securities, creating and destroying bank reserves in the process. Like deposits for customers, banks do not lend out reserves (although they can use them for payment with other banks that have accounts at the Fed). The real purpose of reserves is to ensure banks have sufficient liquidity to make payments as they come due. This is why QE isn't really "money printing" - it is more similar to a credit card company raising its customer's credit limit. A higher credit limit improves liquidity, and ensures payments can be made in a pinch, but doesn't necessarily lead to more spending or investment.

Putting it all together

So in summary, banks are part of an exclusive "government franchise" that gives them a license to print the government's money, which is always in demand because the government demands taxes and other payments, and promises to always accept its own currency as payment.

The general public, including Wall St sharks and FinTech CEOs, still believe in MSM and that banks need to obtain scarce deposits to fund their loans. This is fundamentally not true. Legally, banks should be considered as "structurally senior" to other lending and financial institutions, because they are essentially agents for the government who provide absolutely critical services for the overall economy. And, they have a lower cost structure because they can hold deposits, which the government guarantees.

Understanding these basic facts about how banking actually works can help us better understand money and the economy, and gives us a leg up against Wall St "experts."

Until next time,


Saturday, January 1, 2022

Happy New Year and Welcome to the Modern Money Ventures Blog!


Thank you for taking time to read my new blog, Modern Money Ventures.

This blog will explore a range of interrelated topics including finance, economics, law, politics, and culture.

The inspiration for this blog came from learning about a heterodox economic framework known as Modern Monetary Theory (MMT), which completely upended my understanding of economics, finance, and money. MMT proposes, among other things, that nations which create and issue their own currency have no limits on how much of that currency they can issue. Our economy is limited by real resource and political constraints; not financial ones. Taxes and government bonds do not “fund” spending programs for a monetary sovereign nation; it’s actually the other way around - money created by the government funds taxes paid and debt purchased by the non-government sector. Government debt liabilities are assets for the non-government sector. Banks don’t lend out deposits; they create them when they make loans. Much of this is explained in Stephanie Kelton’s fantastic book, The Deficit Myth, which is probably the most important book written about money and economics since Keynes’ General Theory. Indeed, the way that economics has been taught and interpreted in the post-WWII period by our nations’ institutions, both in the public and private sector, has been wrong on many fronts. Money is fundamentally an invention of humans to facilitate the sharing of resources within a society. Understanding what money is, how it works, and the institutions which create and destroy it, is critical for a society to make the best use of its real resources and achieve maximum prosperity.

The purpose of Modern Money Ventures is to build bridges between MMT economists, the investment community, lawmakers, and “mothers and plumbers” (i.e. everyone else with a stake in how we allocate resources as a society). We will use the teachings of MMT as a framework to make better decisions, both for public policy and for private interests. This blog is explicitly non-partisan; indeed, if there is one thing we can take away from recent history, it is that politics are ostensibly arbitrary. We will promote and/or critique specific policy decisions in an apolitical way (one of my pet peeves in the media is how lawmakers are always listed with either a “D” or an “R” next to their name, which automatically triggers biases). We will also use an MMT framework to evaluate trends and flows in the overall economy, and the impact on specific sectors and companies (IMPORTANT: none of this should be taken as investment advice, please do your own research).

My day job is a research analyst for a boutique investment management firm based in NYC. We focus on companies going through some sort of financial stress and take positions in the credit or equity-linked securities of those companies. This blog will remain free from a subscription or ads for the time being, as I believe it is in the public’s interest to better understand these concepts.

Finally, this is a virtual place where writers and commenters will treat each other with respect. We will share thoughts, new ideas, and critiques without being rude to one another. Our focus is on the merits of a person’s arguments, not the tribe they belong to.

Let the games begin!


On Inflation

[Note: I originally started writing this piece on December 23, 2022, then got held up with holiday festivities. More posts for the new year ...