The Cracks Are Showing Even as Markets Hit Record Highs | George Gammon

Key Concepts

• Subprime Auto Delinquency Rate: A key indicator of financial stress, measuring the percentage of subprime borrowers who are behind on their car payments.
• Quantitative Tightening (QT): The Federal Reserve's process of reducing its balance sheet by not reinvesting the proceeds of maturing assets.
• Counterparty Risk: The risk that one party in a financial transaction will default on their contractual obligations.
• Liquidity: The ease with which an asset can be converted into cash without affecting its market price.
• Repo Market: A market where financial institutions lend and borrow money on a short-term basis, using securities as collateral.
• Shadow Banking System: Financial intermediaries that conduct activities similar to traditional banks but are not subject to the same regulatory oversight.
• Collateral: An asset that a borrower offers to a lender to secure a loan.
• Yield Curve: A graph that plots the interest rates of bonds with different maturities. An inverted yield curve (where short-term rates are higher than long-term rates) is often seen as a predictor of recession.
• Treasury General Account (TGA): The U.S. Treasury's primary checking account at the Federal Reserve.
• Bank Reserves: Funds that commercial banks hold in their accounts at the Federal Reserve.
• M2 Money Supply: A measure of the U.S. dollar money supply that includes M1 (currency in circulation, demand deposits, traveler's checks, and other checkable deposits) plus savings deposits, small-denomination time deposits, and retail money market mutual fund shares.
• K-Shaped Economy: An economic recovery where different sectors or groups of people experience vastly different outcomes, with some thriving and others struggling.
• Bond Vigilantes: Investors who sell bonds when they believe government fiscal policy is unsustainable, driving up interest rates.
• Economic Vigilantes: Investors who buy long-term bonds when they anticipate economic slowdown or recession, driving down interest rates.
• 50-Year Mortgage: A proposed mortgage product with a very long repayment term, criticized for potentially locking borrowers into debt and artificially inflating home prices.
• Deflation in Rents: A decrease in rental prices, which can be an indicator of weakening demand in the housing market.
• Real Wealth vs. Financial Wealth: The distinction between tangible assets and access to goods and services (real wealth) versus paper assets like stocks and bonds (financial wealth).
• Universal Basic Income (UBI): A periodic cash payment unconditionally issued to all individuals on an individual basis, without a means test or work requirement.
• Pairs Trade: An investment strategy that involves simultaneously buying one asset and selling another related asset, aiming to profit from the relative price movements between the two.

System Breakdown or Wealth Transfer?

The discussion begins by contrasting the apparent strength of the stock market, with the Dow Jones reaching record highs, against concerning signals in the credit markets. George Gammon highlights the alarming subprime auto delinquency rate of 6.65%, a figure not seen since 1994 and higher than the peak of the 2008 crisis. This, coupled with the banking system's "clogging" (e.g., UBS liquidating hedge funds) and the impending end of quantitative tightening (QT) by the Federal Reserve, suggests underlying systemic stress. The simultaneous rise in gold and silver prices is also noted as a potential indicator of investor concern.

Corporate Bankruptcies and Systemic Risk: The UBS Hedge Fund Parallel to 2007

A significant portion of the conversation focuses on the bankruptcy of First Brands and the subsequent liquidation of two UBS hedge funds. Gammon draws a direct parallel between this situation and the events of 2007 involving Bear Stearns.

• First Brands Bankruptcy: The founder is accused of siphoning $700 million, and his personal bank accounts were unfrozen by a judge, leading to perceptions of a "rigged game." Gammon dismisses the specifics of the fraud as typical "when the tide is in for so long," but emphasizes the underlying systemic implications.
• UBS Hedge Funds: Similar to Bear Stearns' subprime hedge funds, these UBS funds were marketed as "high-grade" but held significant exposure to First Brands. One fund suffered a substantial haircut (30%), leading to redemptions from the other fund, even if it hadn't experienced significant losses. This "smell of smoke" phenomenon, where investors flee even seemingly unaffected assets due to fear, forces the shutdown of both funds.
• The 2007 Bear Stearns Analogy: Gammon details how Bear Stearns' subprime hedge funds, marketed as high-grade, experienced losses. This triggered redemptions, forcing the liquidation of illiquid assets at a discount, creating a "doom loop." Bear Stearns' stock declined significantly, yet the broader stock market continued to reach new highs in October 2007, only for Bear Stearns to collapse by March 2008, with its stock falling 99% in 14 months. This historical parallel suggests that current events, while seemingly contained, could have far-reaching consequences.
• Systemic Risk Explained: Gammon explains that the monetary system is a network of bank balance sheets, akin to old Christmas lights where one faulty bulb can affect the entire string. While one bank failure might not collapse the whole system, it increases "counterparty risk" (the risk of a trading partner defaulting). High counterparty risk leads to a lack of liquidity, which in turn forces more assets to be liquidated at discounts, exacerbating the problem.

The Illusion of Liquidity and the Role of Risk

The conversation delves into the nature of liquidity and the Federal Reserve's role.

• Private Credit and Liquidity Illusion: The freezing of private credit, even in supposedly safe assets like floating-rate senior secured loans, indicates that the problem is not necessarily credit quality but the "liquidity illusion" built into the system.
• Bank Reserves vs. Liquidity: Gammon argues that bank reserves do not automatically equate to liquidity. Using the analogy of a hard money lender with $10 million, he explains that if all potential borrowers are too risky or the market is crashing, the lender will not deploy capital, regardless of how much money they have. The problem is excessive risk, not a lack of funds.
• Repo Market and Counterparty Risk: The lack of liquidity in the repo market is attributed more to increased counterparty risk within the shadow banking system and private credit markets than to a shortage of bank reserves. Even if the Fed injects more reserves, it won't improve liquidity if counterparty risk perception remains high.
• Phantom Collateral: The example of Tricolor, an auto lender accused of double-pledging collateral, highlights the potential for "phantom collateral" on bank balance sheets. If UBS can be duped, other institutions may be holding worthless assets, further increasing perceived counterparty risk.
• Collateral's Importance in a Debt-Based System: Gammon emphasizes that collateral is a crucial component of a debt-based monetary system. During the GFC, the collapse in the valuation of mortgage-backed securities, which served as collateral, led to a deflationary bust.

The Treasury Market's Warning and the Fed's "Flying Blind"

The discussion shifts to the signals from the Treasury market and the Federal Reserve's current predicament.

• Treasury Market as "Smart Money": While corporate credit spreads remain tight, the Treasury market is signaling a different story. An inverted yield curve (e.g., 1-year to 5-year yields trading below Fed funds) and a flat curve out to the 10-year Treasury indicate that the market is "highly risk-off."
• Banks' Balance Sheet Decisions: Banks are choosing to buy Treasuries rather than lend into the real economy due to the perceived risks in private credit. This demand for safe assets flattens and inverts the yield curve, contradicting the optimistic narrative in the stock market.
• End of QT and Stimulus Debate: The announcement of the Fed ending QT on December 1st is met with skepticism. Gammon argues that reinvesting in short-term Treasury bills, not long-term coupons, is not true stimulus.
• Treasury General Account (TGA) Drain: The government has drained nearly $700 million from the banking system to refill its TGA, potentially contributing to liquidity issues.
• Repo Crisis of 2019: Gammon revisits the 2019 repo crisis, arguing it was driven by counterparty risk rather than a lack of bank reserves. He posits that banks create money by extending credit and do not need reserves to do so, citing historical data showing M2 money supply growth without corresponding reserve growth.
• Banks at the Center of the Monetary System: Gammon asserts that banks, not the Fed, are at the center of the monetary solar system, creating money and lending it into existence. He questions the necessity of bank reserves for lending, as banks can settle interbank credit.
• Fed Flying Blind: A White House admission that a 43-day government shutdown prevented data collection, making the October jobs and CPI reports unlikely to be released, suggests the Fed may be "flying blind." This, combined with bond traders betting on a crash in the 10-year yield, points to "economic vigilantes" anticipating a recession that official data may not yet reflect.
• Labor Market as an Economic Barometer: Gammon emphasizes the labor market as a key indicator of the real economy's health. Layoffs announced by companies like Amazon, Wendy's, and CarMax, along with negative ADP numbers, suggest a significant economic slowdown.

Housing Market Concerns and Policy Interventions

The conversation turns to the housing market and government interventions.

• Cracks in Florida and Texas: Rising insurance costs are leading to increased inventory in these states, potentially foreshadowing a wave of home selling.
• Deflation in Rents: Gammon notes a dramatic month-over-month decline in rents in many submarkets, indicating an oversupply and a potential shift from a housing shortage narrative to a glut.
• 50-Year Mortgage: The proposed 50-year mortgage is criticized as a political move to "buy votes" and a form of "debt serfdom." Gammon argues that if the economy were strong, such a product wouldn't be necessary. He believes it will artificially inflate home prices and lock people into long-term debt without building equity.
• Impact on Home Prices and Equity: The 50-year mortgage, by increasing affordability, could drive up demand and prices. This, combined with potential declines in home equity, could significantly impact aggregate demand.
• Government Subsidies and the 30-Year Fixed Mortgage: Gammon points out that the 30-year fixed-rate mortgage is a government-subsidized product, as banks would not typically offer such long-term fixed rates without government backing.
• The "Uni-Party" and Big Government Socialism: Gammon expresses concern that both Republican and Democratic parties are converging towards "big government socialism," with no ideological check on deficit spending and expanded government intervention. This "uni-party" approach, driven by political incentives, could lead to further economic distortions.

The True Meaning of Wealth and Investment Strategies

The discussion concludes with a focus on the definition of wealth and potential investment strategies in the current environment.

• Real Wealth vs. Financial Wealth: Gammon reiterates his view that true wealth lies in access to goods and services, not just financial assets. He uses the example of communist Russia, where people had money but no goods, to illustrate this point.
• The Danger of "Free Money": While governments may resort to UBI or other stimulus measures, Gammon warns that if these do not increase the supply of goods and services, they will only lead to inflation and a decrease in purchasing power.
• The Bifurcation of the Economy: Gammon predicts that continued reliance on stimulus will exacerbate the bifurcation of the economy, leading to increased social unrest.
• Investment Strategy: Gammon advocates for a diversified portfolio that includes:
  • Gold: As an insurance policy (he holds 10% of his portfolio).
  • Cash-Flowing Assets: Real estate, commodity producers paying dividends, and short-term Treasuries (he holds about 60% in T-bills for now).
  • Speculative Bets: Such as pairs trades (e.g., long Bitcoin, short MicroStrategy) and shorting overvalued assets while hedging with long positions in broader markets.
• Bitcoin as Purchasing Power Outside the System: Gammon sees Bitcoin as a way to hold purchasing power outside of the traditional financial system, citing its portability and decentralization. However, he remains uncertain about its short-term price movements, noting that significant buying by treasury companies has not yet translated into price appreciation.
• The Importance of Owning Real Assets: The overarching theme is to own "what's real" and avoid leverage and paper claims that merely pretend to be wealth.

Conclusion and Outlook

The conversation paints a picture of a system under significant strain, with corporate bankruptcies, rising delinquencies, and a disconnect between the stock market and underlying economic realities. Gammon's analysis suggests that while a direct repeat of the 2008 crisis might be avoided due to central bank intervention, the current trajectory points towards increasing economic distortions, potential social unrest, and a widening gap between financial wealth and real-world access to goods and services. The proposed policy interventions, such as 50-year mortgages and continued stimulus, are viewed as short-term fixes that could exacerbate long-term problems. The emphasis is on understanding the true nature of wealth and positioning oneself to navigate a potentially challenging economic landscape.