Caitlin Long

Coronavirus: The Pin that Popped the Credit Bubble | Caitlin Long on The Pomp Podcast

Check out The Pomp Podcast Episode Page & Show Notes

Key Takeaways

  • “The virus is just the pin that breaks the bubble, the credit-bubble is by far the bigger issue” – Caitlin Long
  • An important distinction: Some assets are IOUs (I Owe You), others are not
    • All financial assets (stocks, bonds, ETFs, deposits) are IOUs of levered, unsustainable financial institutions
    • There are many other assets you can own outright, under your control (Examples: Land, house, car, agricultural property, jewelry, precious metals, cryptocurrencies)
  • Interest rates have been held artificially low, causing all kinds of massive capital misallocation
    • Many projects wouldn’t have proceeded had the real cost of capital been known
  • Counter intuitively, safe-haven assets are the first to be sold during crisis
    • “When you see gold go down it means we are really having serious liquidations” – Caitlin Long
  • Caitlin encourages you to think in real terms instead of nominal terms – This means you come out ahead if:
    • In a deflationary environment, your assets go down by less than your cost of living
    • In an inflationary environment, your assets have higher inflation rate than your cost of living
  • “I really don’t care about the price of Bitcoin, I care about one thing and one thing only: is the network working, is it stable? And you know what, the network stability is stunning in the face of all the volatility and volume increases” – Caitlin Long
  • There is no substitute for educating yourself, use the weeks at home to educate yourself – “Opportunity favors the prepared mind”
    • Use quarantine time to educate yourself, read books, read history. Teach yourself how to control your own private keys
      • On controlling private keys, Podcast Notes recommends using hardware wallets like  Ledger & Trezor  to securely store your digital keys – They are convenient, reliable, and support over 1000 coins & tokens

Books Mentioned

Intro

US Treasuries and The Repo-Market (Repurchase Agreement)

  • The US Government issues treasury bills to fund itself. Primary dealers (big financial institutions) are required to participate in bill auctions
  • Big banks fund themselves through the repo market – Here is how:
    • Banks post securities (especially treasuries) as collateral for short term borrowing, usually overnight
    • Repo market is levered up (meaning one collateral is posted multiple times) – Caitlin estimates leverage to be 6-9 times

How the Coronavirus Caused Stress in the Repo-Market

  • Big corporations have been heavily borrowing cash because of the economic slowdown, raising the repo rate – For instance, Boeing drew 13.5 billion on its revolver (Revolving loans are issued to big companies to provide back-up liquidity, they are not meant to be drawn upon)
    • Banks don’t keep this kind of liquidity lying around and they have to post more collateral to get more repo financing, seizing up the market
    • This triggers a run on the shadow banking system, but issuing more US treasuries is subject to debt ceiling limits
  • “The virus is just the pin that’s bricks the bubble, the credit-bubble is by far the bigger issue” – Caitlin Long

“It’s All Debt, It’s All an IOU (I Owe You)”

  • Treasury bonds are IOUs of the US government, just like the monetary base being IOUs of the Federal Reserve. Even the dollar is an IOU “Pay to the order of”
    • Pile more IOUs on top, with leverage, and the question becomes: what happens in a deleveraging environment?
    • People rush to the “risk-free” asset: treasury bonds. But in reality: There is no liquidity in these markets (which is why the Fed intervened with trillions of liquidity issuance)
  • The banking system is an IOU: You don’t legally own your deposits in the bank, it’s a promise to pay from the bank
    • The same is true in the securities industry:  The shares you own in a brokerage account are IOUs (obligation from the counterparty to deliver the assets)
      • And they have an obligation from a different counterparty to deliver them the assets, and so on – Daisy chain
  • US had a 10% increase in total outstanding debt just in the last 2 years
    • “That’s a huge increase in debt, we certainly didn’t grow GDP 10% over the last 2 years, let’s put it that way, we just levered up in a drunken stupor” – Caitlin Long

A Debt-Financed Economy is Unstable

  • “If you are a bank, you raise capital when you can, you don’t wait until the wheel starts coming off because then you dilute your shareholders so massively”Caitlin Long
    • However, “They have been bailed out so many times, why would they dilute their own equity? They will wait for another bailout”
  • The US became the strongest economy post-WWII because it had the strongest balance sheet and an equity-financed economy
    • Meaning the borrowing was done from someone else’s savings (As opposed to borrowing against the future to consume more today)
      • But the last time the US had a year in which savings exceeded borrowings was in 1968
  • People used to think debt doesn’t matter because “Debt is money we owe to ourselves.” The government can keep using monetary and fiscal policy to stimulate the economy
    • That said, the size of stimulus packages being thrown at the current crisis reflects how much bigger the bubble has become
    • Monetary stimulus means “The 50% of Americans that can’t make a $400 emergency payment are about to get even more of their wealth stolen”
  • The US balance sheet now has $87T debt vs $104T net-wealth, the problem?
    • The debt is real but the assets backing the wealth are not ($20T were taken off the stock market recently)

Root of the problem: Misallocation of Capital

  • Interest rates held down artificially cause massive capital misallocation
    • Corporations issuing debt to buy back their stock at peak of the stock market is essentially destroying capital (They would have been better off just paying out dividends or holding on to their cash)
    • Many projects wouldn’t have proceeded had the real cost of capital been known
  • Caitlin explains in her tweetstorm how The 7.5 trillion total debt added to the US balance sheet in the last 2 years probably represents destroyed capital – the investment will not pay off in terms of real economic returns

History Shows that Government Intervention Prolongs the Pain

  • 1920 witnessed a short depression that was as nasty as the great depression of 1929 (Unemployment went up to 12%, GDP dropped by 20%)
    • President Warren G. Harding decided to pay off a third of US debt, and overruled the Secretary of Commerce (Herbert Hoover) who wanted to intervene to prop up industries and keep companies in business
    • We should learn more from 1920s depression instead of directing all the attention to the great depression
  • Caitlin’s advice: Governments need to get out of the way and let markets restructure quickly
    • “Banks would rush to the market to raise equity capital if they knew they were really on their own, and by the way, their stock prices would go up if they did” – Why?
      • “When the reason for the stocks going down is default risk concerns, alleviating these concerns raises stock prices up”
  • The mainstream political and economic thinking is “We have to decide which industries we are going to save”
    • Caitlin disagrees: “No we shouldn’t, we should be letting markets allocate capital to those that will produce new capital from it, as opposed to those that will actually consume the capital and make us worse-off”
    • The short term pain is the market cleaning out the bad things, preventing this cleaning action builds up bubbles

Why Safe-haven Assets Sell-Off During a Crisis

  • Counter intuitively, safe-haven assets are the first to be sold during crisis – Why?
    • Because they aren’t somebody else’s IOU – They are the first to get sold when cash is really needed (This is why gold plunged in 2008)
    • “When you see gold go down it means we are really having serious liquidations” – Caitlin Long

Thinking in Nominal vs Real Terms

  • Caitlin encourages you to think in real terms instead of nominal terms – This means you come out ahead if:
    • In a deflationary environment, your assets go down by less than your cost of living
    • In an inflationary environment, your assets have higher inflation rate than your cost of living
  • Think: The stock market going up just means dollar value is going down
    • Caitlin adds: If all you are paying attention to is the numerator, you are missing the point, you have got to pay attention to the denominator and whether it is changing value or not

Let’s Talk Bitcoin

  • The market cap of Bitcoin is expected to be more volatile than something like S&P 500
    • S&P 500 experiences 9.5% volatility = Bitcoin moves 51% on a relative basis
  • “I really don’t care about the price of Bitcoin, I care about one thing and one thing only: is the network working, is it stable? And you know what, the network stability is stunning in the face of all the volatility and volume increases” – Caitlin Long
    • Every 10 mins, the Bitcoin blockchain added a new block, it never has been price stable, but it is systemically stable
  • In the Legacy world: foundation is unstable, everyone is focused on getting price stability
    • In Bitcoin: foundation is stable, they don’t care much about price stability
      • Bitcoin optimizes for the long-term

Closing Thoughts

  • The most important takeaway: Some assets are IOUs, others are not. This could become a pretty important distinction
    • All financial assets (stocks, bonds, ETFs, deposits) are IOUs of levered, unsustainable financial institutions
    • There are many other assets you can own outright, under your control (Examples: Land, house, car, agricultural property, jewelery, precious metals, cryptocurrencies)
  • Whether the Fed is able to re-inflate the system or whether we really are in a paradigm shift, in either case you should be prepared – How?
    • There is no substitute for educating yourself, use the weeks at home to educate yourself – “Opportunity favors the prepared mind”
    • Use quarantine time to educate yourself, read books, read history. Teach yourself how to control your own private keys
      • On controlling private keys, Podcast Notes recommends using hardware wallets like  Ledger & Trezor  to securely store your digital keys – They are convenient, reliable, and support over 1000 coins & tokens
  • “Hard work is again going to truly be rewarded, the system is going to be a lot fairer and a lot more stable. We are going to have a lot more visibility into it. The elites who have let us down are not going to be in power to the same extent that they are today. This is actually a better world, we just have to get from here to there and take care of our families and neighbors in the meantime” – Caitlin Long
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Notes By Mostafa Khaled

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