How can they not know which one’s the brake or the gas? with Mike Ashton, The Inflation Guy

Mike Ashton Headshot

Stewart: My name’s Stewart Foley, I’ll be your host. Today we are joined by a repeat guest, a special guest, Mike Ashton of Enduring Investments, otherwise known as The Inflation Guy. Michael, welcome back, man.

Mike: Thanks for having me back. It’s good to be back here. I like what you’ve done with the place.

Stewart: Why, thank you. You are the source of very entertaining comments that we use for our intro. You’re never at a loss for an explanation that in some manner throws the Fed under the bus, which is perfect, right? Right before I hit the record button, you said, “We’re right when the Fed’s going to make their last increase for years to come.” So talk about, do you think there’s one more? We just had a 1.1% GDP print. Obviously, you said this months ago, they are going to be successful at slowing the economy and grinding out jobs. So here we are. What is the purpose of one more?

Mike: I think the Fed at this point has got to consider that, you have an instrument, you have a method which is very coarse, and so trying to calibrate the fine gradations of a 5.25% interest rate versus a 5% interest rate versus a 5.5% interest rate, those don’t make a lot of difference. And nothing in the Fed’s theory suggested that it should make a lot of difference. The difference between 1% and 5% makes some difference, but 5.25% or 5.5% makes no difference. So it becomes entirely behavioral and psychological what they do from this point. At least as we sit here, moments after the Fed’s tightening to 5.25%, with more pressure on banks and some signs of weakening in the labor market, it’s hard to look at that and say that the Fed really ought to keep slamming on the brakes for another 25 or 50 basis points. They’re not going to do another 200, so what the hell difference does another 25 basis points do?
I would stop, honestly, I probably would’ve stopped at 5%, but what’s 5.25%?

Stewart: One of the things that we’ve got a well-established tradition on whenever you’re on is I roll out some theory that I’ve held near and dear to my heart for the last 35 years. And you go, “Yeah, yeah, that’s all wrong.” So here we go. Here’s another one. Ready? You go, “How does this guy…” Right?

Mike: You have a lot of great theories.

Stewart: Thank you. It is strange, I don’t have the right analogy, but the Fed has a brake pedal that has about a six or eight-month delay and they push the brakes down and they tell everybody, “We’ve hit the brakes”, but nothing happens for a while. And then because nothing happens for a while, they pump the brakes again and then they pump them again. And then all of a sudden, by the time the data starts rolling in, it shows that when they started pumping the brakes, it had an impact, they’ve pumped the brakes several more times. So there’s this difference in timing of the data that keeps rolling out and the Fed’s tools don’t match up well with that timing. I’m not saying this particularly eloquently, but help me out with this.

Mike: I think it’s even worse than that. I think that it’s traditionally been understood that there is a…, monetary policy acts with long and uncertain lags is the way the saying usually runs. And that’s long been understood. Part of their calculus is they are trying to aim high in steering and steer around the next curve, which is almost out of sight. That’s a difficult job, but it’s worse right now because they’re also driving a car they’ve never driven before. And so it’s like driving a funny car. You’re stepping on a pedal and you’re not even sure if it’s the break or the gas. I mean you don’t even know how it works. Maybe this is one where the break is on the steering column. Who the heck knows?

Because in the past when the Fed wanted to arrest monetary growth, when they wanted to slow inflation, they did that by restraining the growth rate of reserves. And so they decreased the supply of loans and which caused both the volume of lending to decline and the price of that lending, the interest rates, to go up. But right now, banks are operating with far more reserves than they’ll ever need. They may or may not be capital-constrained right now, that’s a different question. But the Fed is using a different tool and that’s merely interest rates. The only theory that works with that is that they’re actually trying to affect the demand for loans rather than the supply.

So they’re doing a totally different thing than they’ve ever done before, which is, “We’re going to actually raise interest rates enough so people don’t want to borrow as much and therefore there’s less money creation.” And that seems to be working. Money Supply has contracted for the first time over the last eight months, really for the first time since we started keeping M2 back in 1959. The mortgage origination is down and demand for new loans is down from corporate and individual borrowers. But so, all of those things that you’re saying are true, there are some lags, but they don’t even have a guidepost from the way things have operated in the past because they’re doing things a totally different way. I’m not sure they know they’re doing things a totally different way, by the way, but they are.

Stewart: That’s the kind of statement that I just go, “Okay, that’ll make it onto our next iteration of our intro.” The Federal Reserve that employs more PhD economists than anybody on Earth, they-

Mike: Don’t hold that against them.

Stewart: Understood. I have friends there. How can they not know? How can they not know which one’s the brake or the gas? I know you have a very good reason for saying that, without a doubt, you know this game very well. Why is it that they don’t know which one’s the gas and the brake?

Mike: Let’s think about how you become a PhD in anything. You become a PhD in anything by studying an existing framework and learning that framework very, very well. If you’re a mechanical engineer, then it is really important that you understand the framework that’s been laid down over thousands of years for how things operate. Learning that framework incredibly well is what gets you a PhD. In economics, the framework that they’re studying is not one that we’ve finalized. The economic science is fairly new, and honestly, if you look at the number of booms and busts we’ve had over the last a 100 years, we clearly are not doing it right yet.

If you’re going and you’re studying a framework that we know is not right, but that’s all they have. The sort of person that does that is also then not the sort of person who wants to burn the framework down because they’ve just spent a lot of time learning it, and they don’t really want to push it and experiment and ask, “Well, in what way is the framework wrong?” Because part of the answer could be, “It’s all wrong. We’re wrong from first principles.”

Stewart: You make a very good point, which is the last thing the market wants to know is that the Fed scratches its head and goes, “I don’t know.” They’re looking for the Fed for signals, and the Fed always knows. The Fed knows what to do, maybe they’re wrong, whatever. But at the end of the day, there’s some market confidence in what the Fed’s up to.

Mike: I don’t know about that. I don’t know if that’s really true. I think the Fed has credibility in the sense that we think they’ll do what they say they’re going to do. And I think that investors understand the framework. Look, as an investor, you’re not trying to guess about whether the Fed is going to be doing the right thing. You’re trying to guess what the Fed’s going to be doing.

Stewart: Whether it’s right or wrong, but…

Mike: Right, and all that’s necessary is that you understand their framework. You can watch a basketball game and you can guess whether or not team A is going to be throwing up a whole bunch of three-point shots, even if it isn’t necessarily the right strategy right now, because they’re just a team that throws up three-point shots. So if you’re trying to guess what they’re going to do, starting with, “Well, what’s the right thing to do?” Isn’t always the right way to start. I think investors understand that.

I think investors nowadays, the market seems to play on the basis of a guess of what the next meeting is going to produce, and not, will that be successful? Having said that, 10-year interest rates are down to the low threes, which certainly suggests that the market is acting like the Fed will be successful. But I don’t know that most experienced investors look at the Fed with awe and appreciation that, “Gee, these guys are super smart.” Because we know that if they were super smart, they wouldn’t be at the Fed, they’d be in a hedge fund.

Stewart: Oh, Michael. That’s going to cause some consternation among my compliance team.

Mike: It’s going to make a bunch of my friends mad too, but-

Stewart: That’s okay.

Mike: … anyway.

Stewart: Let’s talk about a little different topic. There have been some bank failures, and I’m not trying to make light of that. There’re significant problems, and as a guy with an insurance asset management background, insurance companies get this, I don’t know, this reputation, “Oh, they’re slow, they’re stodgy.” It’s like, you know what? The insurance… I’ve said this many times at different events, and I think I’ve said it on podcasts, but if not, here goes, the insurance industry has the most sophisticated asset management professionals on the planet Earth. You could not, if you are an endowment CIO, foundation CIO, public pension CIO, I think it’s extremely unlikely… You would have the capital markets piece but there are so many other factors that go into managing insurance money.

For example, when the wind blows, “Oh, the wind blew. Oh, we’ve got a huge claim now.” All of a sudden. So they’re not just managing interest rate risk, they’re managing a whole… Not to mention, highly regulated. So I stand on my word of, and if somebody wants to come on and debate that with me, I’m here, that insurance money is the most sophisticated money in the world.

Mike: I agree with you. I think that insurance investors, I think they think about risk in a very open-ended way. Like “What crazy stuff could happen here? Let me think about that and how or what can I do about that?” Not all investors.

Stewart: They look at their liabilities, they look at their liabilities and they go, “Gee, lo and behold, life carriers have longer bond portfolios than P&C carriers.” Because the nature of their liabilities is such that it, that’s how it works. I remember writing down dutifully in, I want to say it was Finance 363, I don’t know. Money and Banking, University of Missouri, back when the earth was cooling. Professor John Stoll actually came out and said, “Banks and insurance companies manage their assets versus their liabilities.” And I dutifully wrote that down. What’s astonishing to me is that you’ve got banks that have demand deposits that treated those as long-term liabilities and invested in long-term assets and then only to discover that, “Gee, we’ve got a mark-to-market issue. Our depositors now want their money back.” How does this mismatch of assets and liabilities not get a capital haircut by the regulator?

They can see what the bond portfolio is, they can see what the liabilities are. How does that… Because that is bedrock insurance asset management, it is having enough, when the wind blows, you wreck your car and you present your claim to whoever it is, they write you a check. They did it through the GFC, they did it through the same interest rate environment. People go, “Yeah, the insurance industry, blah, blah, blah.” The great financial crisis was an isolated case that was around credit default swaps. The industry as a whole came out of that very healthy. What is going on where this, what I think is to be a relatively straightforward ALM, flew out the window?

Mike: Look, absolutely. I think that this is so very different from the GFC from the banking side too, because this is not a credit problem. It’s not a weird structure problem, it’s a duration problem. It’s a Bond Math 101 problem. I’ve said it before and I’ll say it again, this is a problem that any regulator with an HP 12C and a lick of common sense should have seen coming eight months ago.

Stewart: 100%

Mike: But not every bank has this problem, and not every bank has the same regulator that doesn’t know how to use an HP 12C. Most banks do have demand deposits and they’re very short-dated and they make long-term loans or hold long-dated assets in some form, whether they’re loans or they’re long-dated securities. And the regulators created part of the problem themselves by saying that if you’re holding something in a hold-to-maturity book, that you can’t hedge it in the traditional way, you can’t hedge the duration back. But good, well-managed banks know how to effectively do the same thing without running afoul of all the rules. And most banks are well-managed. So you see all these statistics about these huge mark-to-market losses or unmarked losses in hold-to-maturity books. But what you don’t see is that in most cases, these banks have unmarked hedges of some kind in the other direction.

So most banks don’t have that problem. And most regulators, because they know how to use an HP 12C and have a lick of common sense, wouldn’t let the average bank run into that problem. That’s why you know the big money center banks are not going to have an issue here. Most of the banks that are having problems right now, judging from the ones that have both failed or the ones whose stock is under pressure are all in the San Francisco Fed’s district for the most part. I think that that says that you have something that’s idiosyncratic to a particular regulator that just wasn’t doing its job. I think we’ll eventually figure that out, that it means the banks weren’t doing their jobs, but also the regulator who could have caught this a year ago didn’t, and we really ought to know why.

I agree that certainly for community banks, the risk management, I guess, philosophy or the risk management education, I guess, is not as strong as it is at insurance companies. At big money center banks, it is, but at community banks, maybe not so much. But again, this was not a complex risk thing where we’ve got hurricane risk, we need to reinsure. This is literally, “I have assets with a 10 duration and I’ve got liabilities with a 1 duration. Gee, what do I do about that?” Well, that’s not hard.

Stewart: You were on the same podcast as I was with Geoff Cornell who said that when you’ve got risk, that you are not charging for a risk you’re taking in your risk management methodology or your system, that people will take that risk all day long. In this case, it’s an interest rate mismatch that these guys were taking, the risk they were taking, they went way out the yield curve because rates were low and they could get more yield by going out the yield curve, and then rates go up and they’ve got an unrealized loss and everybody says, “Oh, I want my money back.”

What’s interesting to me is when you say, “Okay, fine.” Nobody’s looking at that mismatch going, “Hey, excuse me, there’s a big gap here.” And someone said, “Well, this is because there was some legislation passed that said that banks of under 250 billion don’t have to do stress testing, but every other year.” This is a number that you can know that number any time of the day, throughout the day. It sits on your desk and when that number hits a certain level, the fire alarm ought to go off. Right?

Mike: What’s your net DV01? Or two numbers? What’s the duration of my assets, the duration of my… At most, it’s two numbers.

Stewart: Right, but my net DV01… So for the unindoctrinated, what’s a DV01? Just in case there are folks who don’t know the term.

Mike: That’s dollar value of one basis point. When the yield on my portfolio of assets, whatever it is, changes by one basis point, how many dollars do I lose or gain, depending on which direction that yield goes. If you have a million dollars of 10-year notes, your DV01 is something like $980, one basis point will make or lose you a little bit less than a thousand bucks.

Stewart: When you say net DV01, that’s assets and minus liabilities, that gap, right?

Mike: That’s right.

Stewart: Whatever it is, that DV01 is your net DV01.

Mike: That’s right. Assuming you have a parallel shift and all yields go up 20 basis points, what happens? And of course, if you’re sophisticated, it’s not just a parallel shift. You have metrics that measure your exposure to a twist and all those things, multifactor yield curve models, and so on. But we don’t need that in this case.

Stewart: No.

Mike: You don’t need fancy, this is a very, very simple problem. And again, it’s, anybody who said, “Gee, I just didn’t understand what was going on,” that person should be fired and maybe in jail. It’s just really, it’s malpractice. It’s financial malpractice, and it really should not happen. In the GFC, there were a lot of really, CDO cubed and things that were dumb to do because we didn’t understand them. But then it was understandable why nobody exactly knew where the next bomb was going to go off because it was really… Plus it had to do more with large institutions where counterparty credit risk was a big part of the contagion. Well, this is not a big part of the current contagion. No one has lots and lots of counterparty credit risk to First Republic, partly because obviously they aren’t doing a lot of hedging with derivatives.

Stewart: It’s funny. I’m at the gym and the woman at the front desk is like, “My husband said that this happened because people can move money from their phones really quickly.” I’m like, “Yeah, no. That’s not what it is.” This is like exactly what you said. It’s like an HP 12C solves this problem, right?

Mike: Yeah. This is not a problem that just happened.

Stewart: Right? No, and to your point, it’s not due to default, it’s not due to distrust assets, it’s none of that.

Mike: But what they mean is, and it’s an important point, that if you have a hold-to-maturity asset and you never have to sell it, then you hold it to maturity and you never realize the loss. You have the loss, but then it is the failure of accounting for not recognizing that loss, but it’s hold-to-maturity and that’s the whole point. And then when you have the deposits leave, so you have to sell the securities, that’s when you realize the loss. So there’s something to the fact that, the idea that if your deposits leave suddenly, that suddenly you find out who’s been swimming naked, but that’s not the source of the problem. The source of the problem was that you had long-dated assets that were losing a crapload of money and you were just hoping that nobody ever made you mark them to market.

Stewart: One of the reasons I love to have you on is, people should know this, we have no notes, none. We just start talking. I hit the record button, and we just start talking.

Here’s one that I’ll just get your take on this. We were fortunate enough to have Phil Titolo on from MassMutual, and Phil had mentioned this idea that given the condition of the banking system, “It is unlikely, I don’t see…” This is one person’s opinion, just one guy’s opinion that “I don’t see a way that banks expand their lending.” Given where they’re lending to businesses, for example. What that tells you, at least in my mind, where it leads me is that direct lending done by insurance companies is going to be… There was some chatter around, “Well, once the 10-year hits 4%, all this private credit money is going to dry up and they’re going to go right back to the public markets.” And it’s like, ah, it looks to me like this private credit market is alive and well and going to continue to grow and to disintermediate the banks further. What’s your take on that?

Mike: I think the private credit market is alive and well and is going to stay alive and well, for the most part. I don’t agree with the premise that banks aren’t going to expand their lending. Banks are constrained from lending in one of two ways: reserves, and there are plenty of reserves, or capital. Now, obviously, some banks have a capital constraint here because they know they actually have losses, and so therefore can’t lend. But by the way, you’d rather have a long-dated loan instead of a long-dated security. But I think that a well-managed bank right now doesn’t have big capital issues. None of the money center banks have big capital issues, so why can’t they expand their lending? They’re not reserve constrained. Heck, JPMorgan just bought out a bank and made a whole bunch of money.

I think that the supply of credit is not a problem in this cycle. It’s the demand for credit that so far has been the issue because the much higher interest rates have dissuaded some borrowers, but I don’t think that’s going to stay the case for long. I’m not terribly worried about the whole banking system and or system of credit and lending.

Stewart: All right, one more. I did two podcasts yesterday, and by the way, today is Wednesday, May 3rd. One of the things I like to do is timestamp these podcasts because stuff happens so quickly that I think it’s important just to know when it happened. So yesterday I did two podcasts on real estate, commercial real estate, and one of the statistics that I heard is that 60% of bank-owned commercial real estate loans are in regional banks, as opposed to something like 25% for the larger banks. Do you think that’s true? And secondly, does it concern you?

Mike: Yes and yes. I think that’s true, and it concerns me to some extent because clearly, while residential real estate is not particularly in any sort of problem this time around, residential real estate prices are down 1% or something like that, they’re not falling. In real terms, they’re dropping quite a bit, but we don’t care about real terms when we’re making a loan. We care about nominal terms and nominal residential real estate prices aren’t going down. That’s not true for commercial, although I saw somebody with an estimate saying that commercial real estate prices are going to fall 20 or 25% in nominal terms, so 40% in real terms, and that’s just not going to happen. I feel fairly confident that we’re not going to see a 40% decline in commercial real estate values because they weren’t overvalued by a tremendous amount. They might have been overvalued by some, but not tons.

Stewart: I think the concern is office. I think the major concern is office and depending upon the geography, that some workers are simply not going to go back or as much as they did. I think that there’s a lot of concern around office being significantly overvalued. That’s where I think that’s coming from.

Mike: And banks are going to end up essentially owning a lot of that when developers walk away. And I do think that that’s a potential issue, but that’s also where the enormous shortage of apartment housing probably, maybe that’s the way it ends up getting worked out, is we take some of those big office buildings and turn them into apartments. So maybe that’s how we finally square the problem with supply on that side of things.

Look, I am concerned about that. I think there are some banks that have much bigger commercial real estate portfolio problems, and I do think that office is a bigger concern. Having said that, an office building is still a real asset, and unless you really think that people are just not going to be in offices at all and we’re just never going to fill up those offices again. I guess that’s a possibility, but I guess that’s for smarter people to figure out. I think this is just a question of, how does the market end up clearing, and I think you’ll get people buying those distressed properties at down 10% or down 20% or whatever, certain properties down 30 or 40%, but financing them not with bank loans, financing them with inflation-linked bonds or whatever. I think there are ways that we can get out of that issue. However, there are certainly some banks that have a bigger problem with that than other banks.

Stewart: Very good.

Mike: That is not a very helpful answer.

Stewart: Yeah, it is. It’s always good. Listen, man, I love having you on. I really do. I enjoy having you on. I appreciate your views and your expertise, and I always learn something. I think we have a great conversation, and thanks again for taking the time to do it, man. Thanks so much, Mike. Really.

Mike: No, I have a lot of fun. And as you know, I’m not unwilling to share any sort of opinion, even unfounded ones, so I’m a perfect guest.

Stewart: You do have an opinion and that does make you the perfect guest. Absolutely. We certainly appreciate it.

We’ve been joined today by Michael Ashton, who’s the CEO of Enduring Investments, also known as The Inflation Guy. Thanks for listening. If you like us, please rate us, review us on Apple Podcasts. We certainly appreciate it. My name’s Stewart Foley and this is the podcast.

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