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    Paul Brodsky: The Seeds of Our Destruction Were – And Still Are – Sown in the Bond Markets

    by Adam Taggart

    Friday, October 21, 2011, 11:25 PM

Paul Brodsky does not trust the bond markets. That position may seem strange coming from someone who has spent most of his professional career trading bonds, but it’s precisely this insider knowledge that has led him to start directing investors to safer harbors.

In fact, he thinks our credit system is so far out of control that it will cause a massive — and largely unavoidable, at this point — devaluation of the US dollar (and most other fiat currencies, as well).

In our interview with Paul, we asked him to explain the reasons for his concern and to detail how he sees a bond market breakdown unfolding. At the heart of the matter is the run-up in overnight systemic repurchase agreements among banks that started in 1994, which goosed the ensuing credit-driven buying orgy in our economy and has left the system much more vulnerable to exogenous shocks as a result:

All the way through 2006, a monetary aggregate called M-3, which was the only aggregate that included repurchase agreements (which is the process by which banks fund themselves with each other), grew almost 12% a year. It is an enormous amount, and that basically tells you that this overnight lending among banks provided the fuel from which all of the term credit, the 30-year mortgages, auto loans, and revolving consumer credit came — which of course has never been paid down from whence it came. So in effect, we knew that the system became highly susceptible to any hiccup.

So the system is levered at least 20 to 1, and there is effectively 20 times more debt than money with which to repay it. And so that is a long-winded way of setting the table for where we come down in our macro views. Clearly, it has great ramifications, negative ramifications for the currency, and given that the dollar is the world’s reserve currency, we think it has significant ramifications for the global monetary system in general.     

Add to this the lax oversight from the Fed at the time, which as Paul states seemed primarily focused on making sure “banks could expand their balance sheets.” Along with the repurchase agreements, the practice of “sweep programs” helped the banks gain unfair advantage while technically not breaking the letter of the law. Chris summarizes this process as:

This is a story of leverage which really began in the mid-nineties. So this is not any particular policy disaster that went off the rails in 2000 or even more recently than that. Interestingly, I have never connected the stop before between the overnights, the repos, and something else that really caught my eye in the mid-nineties. Actually, it was ninety-four or ninety-five.

I don’t know if you know about the sweep programs. For the benefit of listeners who may not, what Greenspan did was he allowed banks to essentially dodge the reserve requirements by “sweeping” demand accounts. And what I mean by that is, if you have money in a checking account, that is yours to demand anytime you want; the banks have to hold a reserve against that, by law, of 10%. But banks were allowed, through this policy tweak that the Fed had done, to effectively sweep that money out of that account just before the stroke of midnight.

So that at midnight when they take the snapshot and say, “How much money do you have to hold in reserve against?” they would sweep the money out of the way. The snapshot would be taken, and the bank would say, “Look, there is no money; we get to hold very light reserves here.” And then the money would get swept back in at let us say, 12:01. But during the snapshot period, oops; it would have disappeared.

That is where I had chased back where this credit bubble really got into high gear. And I thought it was due to the fact that banks were allowed to dodge these reserve requirements, effectively running leverage far, far higher.

At some point, the growing leverage in the system and the rising amount of new credit and money supply lead to ever larger distortions in market pricing. Paul sees this as leading to inflation:

So economics has kind of taken leave of the bond market. The Treasury bond market is no longer, we think, a true signal of interest rates, where they should be, or a true signal of inflation. It is an interest-rate curve that has been distorted by terribly distorted incentives, as we see it.

So we understand that. We do not think it is right. We would rather have markets be free to adjust to where they should be, but frankly, we do not see that happening. To your question specifically about will we have something similar to what happened in Greece here in the U.S., we do not think we are ever going to get to that point here. And it is not because we are proud Americans and we think that the U.S. is better in every way than every foreign land; that is not the case at all. We think it is not going to happen here because if anything dire happens in terms of interest rates, like the threat of rising interest rates, you would see the Fed’s balance sheet come under severe stress.

I think the Fed is going to have to continue printing. They are going to go to a significant QE3 at some point. I do not know exactly what form it will take, but they are going to have to monetize debt. The process of doing that is, I am sure your listeners know, is when you buy debt, you print money with which to buy it. That moves new money out, ostensibly into the system, but as we have seen, it only goes into banks as excess reserves. This process is the exact process of inflation, so if you print a dollar, you are diminishing the purchasing power of that dollar through dilution. And it is a very easy thing to understand that more dollars chasing the same amount of goods and services and assets must drive the price level higher for those goods services and assets. And so what we see happening is, through this process of money printing, we will have rising prices that rise much faster than wage growth or income growth, and it is going to make the ability to service debt that much harder.    

It’s these growing inflationary pressures that Paul sees leading to an accelerating devaluation of paper currencies in the coming years. He sees a revaluation of the US dollar vs. gold as a likely outcome at some future point (estimating that gold could reach a price in the neighborhood of $10,000 per ounce, if it is indeed re-monetized). 

Ultimately, he recommends that investors who are concerned with protecting the purchasing power of their wealth today get exposure to hard assets that can’t be so easily inflated away:

All of these currencies are baseless and are losing their purchasing power versus the goods and services with inelastic demand properties, such as natural resources and things of scarcity. 

Gold should be thought of as cash in the best currency. I would suggest anything scarce with inelastic demand properties, and that is, of course, how we get energy and how we get agriculture and various other things. They should be considered very strongly.

Click the play button below to listen to Chris’ interview with Paul Brodsky (runtime 49m:12s):


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Paul Brodsky is co-founder and co-managing member of QB Asset Management. Paul spent several decades trading bonds and other securities for such Wall Street firms as Drexel Burnham Lambert, Kidder Peabody, and Spyglass Capital, where he actively managed mortgage-backed derivative funds for over a decade (over 85% of investor capital in that fund was returned by June 2006, before the wide-scale credit contraction occured). QB Asset Management serves accredited investors; more information on the firm and its investment strategy can be obtained by emailing Paul


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