INSIDE ECONOMICS

Mark Zandi:                      Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics. And I'm joined by my two co-hosts. Cris deRitis. Cris is the deputy chief economist. And Ryan Sweet. Ryan is the director of real-time economics. How goes it guys? How is everyone doing?

Cris deRitis:                       Doing all right. How are you?

Mark Zandi:                      Yeah, I'm not going to say I'm tired because I've heard from many of our listeners, "Mark, I hear you're tired." So I'm not going to say that. But I am in Tokyo and it is late in Tokyo. It's what, 9:43 here in Tokyo. PM. And I'll have to tell you guys, the world is not over with the pandemic. The pandemic is still a deal, particularly here in Tokyo. It's DEFCON 1. Everyone is wearing masks. They're very nervous about any kind of contact. It feels like where we were over a year ago. So the world is not back to normal.

Cris deRitis:                       So how does that compare with the other stops in your whirlwind tour?

Ryan Sweet:                      Your marathon.

Mark Zandi:                      I can't wait to get home. I really can't. Saturday. This is most locked down. In Dubai and Abu Dhabi, they're more relaxed, but they have restrictions. So if you go into a restaurant, you have to show your PCR test that you got tested within 72 hours saying [inaudible 00:01:40]. Yeah. And in London, they're like the US. I don't know that they even... I didn't see any masks or... Pandemic? What pandemic? It's like flu. This is like a flu now. But Singapore was... Well, now that one of our colleagues has gotten sick, I don't know. And he got sick in Singapore. I'm not sure. I feel bad for what's going to happen to Singapore. I shouldn't laugh. I shouldn't laugh.

Ryan Sweet:                      [inaudible 00:02:12] super spreader.

Mark Zandi:                      It's just like, you couldn't make this stuff up. All I'm saying is the world still... Two and a half years later we're still grappling with this thing. What a [inaudible 00:02:27].

Cris deRitis:                       [inaudible 00:02:28] Asia is more locked out. It's reflecting in the data. It's in the statistics, but [inaudible 00:02:34] doing it as well, right?

Mark Zandi:                      Well actually, interestingly enough, it's the one part of the world where inflation isn't that big a deal. And the reason it's not that big a deal is because they're still locked down. There's not a lot going on here. It should pick up. It's starting to pick up. Today, interestingly enough, today, October 12th was the first day you could come into Japan without a visa because of COVID.

                                             And I'll tell you, I was very nervous coming in because it was very unclear what the requirements were to come in. They had this app and MySOS and you had to fill it out. And if it was red you, it wasn't clear what happened to you. If it was blue, you're okay. Here's the other bizarre thing, just to throw it out there, just an observation. I get off the plane in Tokyo from Singapore and there's like a 1000... I'm making this up, but felt like a 1000 people, workers, Japanese workers that were responsible for making sure that you had all the things you needed to do to go through immigration. In a country where the working age population is declining and labor shortages are a problem, you look around and you go, "Why..."

                                             I could give you the exact number. It was probably 15 people that did the exact same thing. They looked at my app and see if I had the right color. It was really bizarre. Really bizarre.

Cris deRitis:                       Yes, it is Japan, right? Expecting all the robots there, right?

Mark Zandi:                      Yeah. Really bizarre. Anyway, one thing I have learned on this trip though, or one thing that has become obvious on this trip is that the world is in up in arms over what the Federal Reserve and other central banks are doing. The tightening in monetary policy and the stresses that's putting on the global financial system.

                                             And there's a growing concern that central banks are going to break something. That something out there, when you stress the system with high rates long enough, something is going to break. So the most obvious was when I was in the UK a couple weeks ago, was the British pound going south. And British interest rates, the yields on gilts, analog to US treasuries going north. Still a lot of storm and drag over that. But a lot of concern about that. And to discuss this issue, and this is really an issue, we got one of our most favorite, former participants in the podcast, Aaron Klein from Brookings to join us. Hi Aaron. Good to see you.

Aaron Klein:                      Mark, Chris, Ryan, it's a pleasure to be back.

Mark Zandi:                      And it looks like you're in your pajamas there, Aaron. I'm just saying. [inaudible 00:05:31]

Aaron Klein:                      The beauty of remote work. I have a face for radio. I used to do a radio show. I would do the 06:00 AM to 10:00 AM show on a commercial station as a job when I was in college because it came with a free breakfast. So it was minimum wage plus free breakfast. And I used to do a little stint where I'd breathe heavily into the microphone and say, "Did I brush my teeth?"

Mark Zandi:                      You're making this up.

Aaron Klein:                      Swear it. 99Rocks. Rocking the Upper Valley.

Ryan Sweet:                      You can't make this up.

Aaron Klein:                      99.1, 99Rocks.

Mark Zandi:                      Where's the Upper Valley? Where is that?

Aaron Klein:                      Lebanon, Hanover, New Hampshire.

Mark Zandi:                      Cool.

Aaron Klein:                      [inaudible 00:06:08] I went to Dartmouth College.

Mark Zandi:                      Very good. Well Aaron, you now have a new title I understand. This is like, you have an endowed chair, which is a huge deal because obviously it takes some of the financial pressure off and you're the Miriam K. Carliner Chair of Economic Studies at Brookings. Is that right?

Aaron Klein:                      It is. The Carliner family was very generous in their endowment. And it's a great honor to represent that work. But my portfolio remains the same. I'm doing a lot of financial regulation, financial technology, thinking about the macro economy, trying to figure out what's going on here. A little bit excited about the infrastructure bill that we have in society and the US. And also intrigued to hear about your tidbits about Tokyo since I'm heading there in a couple weeks myself.

Mark Zandi:                      Yeah, I heard. The big event with the... Was it Nomura?

Aaron Klein:                      The Nomura Foundation, I presented a paper there on the use of payments as a tool of foreign policy. Subject for another day. Russia invades Ukraine and America's response is, "You're off the SWIFT payment network."

Mark Zandi:                      Yeah, right.

Aaron Klein:                      Right? We're increasingly fighting with bonds, not bombs, and with the access to the US dollar and payment settlement as a weapon in our national defense portfolio, not as a method of extracting exchange or settlement.

Mark Zandi:                      Yeah, I mean that is definitely a topic that I'd love to explore, but perhaps we put that to the side over here. In fact, one quick question about that. Just personal interest, we're doing some work around cyber risk and one of the scenarios we're considering is an attack on the Swiss system. Do you think that's a reasonable thing to consider as...

Aaron Klein:                      Well, North Korea has already done it and [inaudible 00:08:00].

Mark Zandi:                      That's right.

Aaron Klein:                      [inaudible 00:08:02] North Korea through the Bank of Bangladesh and the New York Federal Reserve attacked. And in point, in fact, I believe the story goes, kind of had a random person not been in on a random weekend to see something, even more money would've been stolen. So I think that's a very realistic scenario. There are lots of horrible, scary cyber scenarios to think about, but the world lacks a global central bank and the SWIFT payment system provides many of those services in payment interoperability and connection that a central bank provides. But it by definition is not a governmental entity.

Mark Zandi:                      That was at the New York Fed. Right? It was like one Saturday or something that [inaudible 00:08:45].

Aaron Klein:                      It was like Die Hard. Remember Die Hard was... Right? At the New York Fed.

Cris deRitis:                       The movie.

Mark Zandi:                      Yeah. Ryan knows all those movie. He could recite the entire script of Die Hard.

Ryan Sweet:                      No, I don't know if I could go that far, but I remember the movie.

Mark Zandi:                      Yeah, right. There's three [inaudible 00:09:02].

Aaron Klein:                      Yeah. No, I'm not going to get into whether or not it was a Christmas movie or not, which I know is a raging debate. I'm not qualified. Yeah. That's not something I have any qualification to discuss. It's a holiday that perplexes me. Nonetheless, the idea that they would steal the hard gold bars, there's more gold in the Federal Reserve Bank in New York than anywhere else in the world. But really the way to steal money is electronically. Because most money is electronic.

Mark Zandi:                      Well, it's good to have you. And just to refresh people's memories. Way back when you were... Would it be fair to say the chief economist of the Senate Banking Committee? Is that correct?

Aaron Klein:                      Correct. I served as chief economist at Senate Banking for both Chairman Paul S. Sarbanes of my beloved state of Maryland and Christopher J. Dodd of Connecticut. And then after my time as chief economist on the Senate Banking Committee, I was deputy assistant secretary for economic policy at the US Treasury Department in essentially the first term of the Obama administration.

Mark Zandi:                      Got it. And that's a good segue into, I guess kind of first thing I'd like to tackle in the context of financial market stresses. And that is, do you think the system, the financial system, is in a much better spot? And I guess the answer is probably yes, but how much better spot is it today compared to, let's say prior to the financial crisis over a decade ago?

Aaron Klein:                      Oh, I think it's apples to oranges in the US context. In the US context, the state of bank capital, of regulation of leverage is totally different than it was in 2007. There are some similarities, which I'll get into that may make folk wonder, but the level of safety and soundness within the financial system... We just had a very sharp recession as it related to COVID, completely unforeseen.

                                             Now the reasons why that recession and the response helped mitigate some potential problems from the banking system. But I think the system is in much, much better shape than it was in 2007 as a result of deep structural changes in regulation and also as a result of the human cycle. I think there's something to the three generations argument. Which is, there's a crisis in one generation, they're never going to repeat it. The second generation is scarred by it. The third generation looks back and goes, "Wait a second, why do we have all these rules and regs in place? Our grandfathers and grandmothers lived in a very different world. We can do better." They loosen things up and then, oops, there it is again.

Mark Zandi:                      Well, Aaron, to that point, there's been a recession almost every 10 years. 1950, 1960, 1970, 1980, 1990. I'm not making this up. 2000. The financial crisis messed me up, messes this up. The 2008.

Aaron Klein:                      For sure.

Mark Zandi:                      Then 2020. And I don't know that that's an accident, right? It almost goes to your point. It takes about 10 years for that memory to fade or for the people who are running the show that were running financial institutions and the regulatory bodies when the last crisis occurred, they leave and the guys that are left don't have that experience and that memory. And they go, "Oh, I've got better data. I've got better models. Those guys were idiots." And then we're off and running again.

Ryan Sweet:                      See Cris, this is why Mark's probability of recession is so low. He's waiting until 2030.

Cris deRitis:                       It's his model.

Mark Zandi:                      Exactly right. That's exactly... It's too early. It's too early.

Aaron Klein:                      Well, I suspect if you took a model that said, is the year... Recession and years that end with the number zero. And ran that against the official central bank forecast of probabilities of growth, you would win. With just the [inaudible 00:13:08] is it, if zero then recession, otherwise predict.

Mark Zandi:                      Yeah. That sounds like Ryan's models.

Ryan Sweet:                      Yeah, that sounds pretty [inaudible 00:13:15].

Mark Zandi:                      Kind of sounded like how he [inaudible 00:13:17] over his models. Yeah. And I joke Aaron. He's like a savant when it comes to this modeling. You know how Bloomberg rates people in terms of their accuracy for CPI? Which is like everyone wants to know the CPI. He is number one and they also have some... What's that measure they use? I didn't look and see, but you're like way ahead [inaudible 00:13:40]. What is it?

Cris deRitis:                       It's kind of an accuracy score.

Ryan Sweet:                      Mm-hmm.

Mark Zandi:                      How do they measure that?

Ryan Sweet:                      That's a great question. I don't know.

Mark Zandi:                      Anyway, you're like 70... I'm making this up. You're like 77 and the next person is like 59 or something. It was like a big difference.

Aaron Klein:                      That's impressive.

Mark Zandi:                      Impressive. Right?

Aaron Klein:                      In the political world in Washington, everybody focuses on Nate Silver who got a lot of elections right including '08. But there's actually a guy who's out of Emory, now runs polling firm. Drew Lintner, who's consistently beat Nate Silver.

Mark Zandi:                      Oh, really? I didn't know [inaudible 00:14:15].

Aaron Klein:                      In the political forecasting of it. He runs a firm Civics. But yeah, no, no, no. The ranking of the forecasters, that's a big thing. I hope that you get a trophy at the end of that.

Mark Zandi:                      It's a pat on the back. And then I [inaudible 00:14:28] them every once in a while.

Ryan Sweet:                      Yeah, Mark just makes fun of me.

Mark Zandi:                      Yeah, I just make fun of him.

Ryan Sweet:                      That's my prize.

Cris deRitis:                       So Ryan, do you want to reveal your CPI forecast for tomorrow? Even though this will be heard by our listeners [inaudible 00:14:38].

Ryan Sweet:                      See, now you're putting a jinx on me.

Mark Zandi:                      Oh, that's interesting. That is interesting. Yeah.

Cris deRitis:                       What do you got? What do you got?

Ryan Sweet:                      Month over month is going to be 0.2. Headline.

Mark Zandi:                      That's headline. Okay. Headline.

Ryan Sweet:                      And then core, which strips out food and energy is 0.3. Month over month.

Mark Zandi:                      So what does that make year over year? Do you know?

Ryan Sweet:                      I forget. It's...

Mark Zandi:                      I think it's about eight [inaudible 00:15:00]. In the headline [inaudible 00:15:02].

Aaron Klein:                      You know where the concept of core came from?

Ryan Sweet:                      I do not.

Aaron Klein:                      From the WIN campaign, which is Whip Inflation Now. It was a Nixonian concept that to reduce headline inflation, to reduce inflation expectations, we should take out the things that are high, which at the time were food and energy. A series of economists have published a lot of papers justifying that. That somehow we should be studying the inflation for people who don't eat or consume energy because that's a very useful subset of humanity. But the actual idea to strip it out to core was Nixonian in every sense of the word.

Mark Zandi:                      Oh, yeah. It fits. That definitely fits.

Cris deRitis:                       We need to bring back the buttons.

Mark Zandi:                      Bring back what Cris?

Cris deRitis:                       Buttons. The WIN button.

Mark Zandi:                      Oh, yeah. The WIN buttons. But that wasn't Nixonian, that was Carter, wasn't it? The WIN button? No. Or Ford maybe. It was actually Nixon?

Cris deRitis:                       I think it's Ford.

Mark Zandi:                      It was Ford. Yeah. I don't think it was Nixon. Anyway, enough of the history lesson. Although it's quite impressive the amount of history we do know. Of all the things that were done Aaron, after the crisis to try to improve the system's resilience because of what happened. The system collapsed and needed a government bailout, what would you put at the top of the list in terms of the response?

Aaron Klein:                      Higher capital.

Mark Zandi:                      Higher capital.

Aaron Klein:                      Higher capital. I mean, a lot of people get the history of the financial crisis wrong. Right? The crisis, it metastasizes in a series of situations in which you have extreme leverage, right? Lehman, Bear, Fannie and Freddie. You have AIG. You have these things that are incredibly highly leveraged. And the solution, one solution to leverage is increase capital.

                                             You had regulators like the Federal Reserve pushing changes to the Basel capital structure that would've used fancier models. They thought their models were better than Ryan's, that would've reduced the amount of bank capital. I mean, can you believe that in 2005 and 2006, the Fed and some other regulators were arguing that the banks were punitively capitalized? England went ahead of us and reduced capital ratios going right into the teeth of the crisis.

                                             Luckily Sheila Bair and the FDIC and some others, [inaudible 00:17:34] Sarbanes and Shelby actually bi-partisanly on the Hill pushed back against early adoption of these Basel capital models. So the number one change has been capital. The number two is essentially the standalone investment bank kind of doesn't really exist anymore. I mean that part of the quote, unquote, "shadow banking system" are regulated bank holding companies.

                                             And so you don't really have the same type of financial structure where you had high leverage in non-prudentially regulated, non-capital regulated entities.

Mark Zandi:                      That would be like a Lehman Brothers or a Bear Stearns.

Aaron Klein:                      Goldman Sachs is now a bank. Right? Morgan Stanley.

Mark Zandi:                      Now, that wasn't by regulation per se, that just happened because they had to [inaudible 00:18:21] a bank, right? Because if they didn't become a bank, they couldn't get the Fed's support and if they couldn't get the Fed support, they were toast. They were out. They were history.

Aaron Klein:                      Correct. But they were also a little bit Hotel California. Once they came in, they couldn't turn around and go back out.

Mark Zandi:                      Go out.

Aaron Klein:                      American Express became... There were a lot of companies, not even ones that didn't fail, but through that stress period that went into the prudential regulated bank regulatory system.

Mark Zandi:                      Cris, you probably know this, What was Fannie and Freddie's capitalization prior to the crisis? Do you recall?

Cris deRitis:                       Regulatory cap, I think it was 0.45%.

Mark Zandi:                      Yeah, that's what it was. It was 45 basis points, 0.5. Can you imagine?

Cris deRitis:                       Remember when we would run would run economic capital models?

Mark Zandi:                      Yeah. The [inaudible 00:19:07] prices never fall. Or maybe they fall on a market but they never fall across the country. They're negatively correlated. Right?

Cris deRitis:                       Well, we would actually make realistic assumptions. But the regulatory capital always was the binding constraint. You would never have an economic capital calculation that was lower than that...

Mark Zandi:                      Of course by my calculation, the loss, if you add up all the realized losses on their mortgage securities and holdings was about 300 basis points. All in. During the [inaudible 00:19:42]. So just 45 basis points of capital against 300 basis points of loss. And that's why they're still in government conservatorship.

                                             Okay. So it's interesting Aaron, once I was on CNBC and I was a guest host and Barney Frank, he was the [inaudible 00:20:00] chair of the House Financial Services Committee. That's Dodd-Frank. The senator you worked for and Barney Frank, a real character. And I asked him the same exact question. And you know what he said to me? Which I found very surprising.

Aaron Klein:                      What?

Mark Zandi:                      It was the risk retention in mortgage securities. Remember the skin in the game? He had to hold 5%. I think it was 5% risk [inaudible 00:20:26].

Aaron Klein:                      He later called that the exemption that ate the rule.

Mark Zandi:                      Yeah.

Aaron Klein:                      [inaudible 00:20:33] set the way that that retention was expanded regulatory within the Obama administration, I might add and got very upset. Qualified mortgage, QM.

Mark Zandi:                      Yeah, yeah.

Aaron Klein:                      But look, the history of financial crises is that it's never the same asset twice, right? Dutch tulips, South China Sea, Japanese real estate where you are Mark. I think that had a mark to market in the...

Mark Zandi:                      Remember 1990, circa 1990. Yeah. Absolutely. And they've never recovered from that actually.

Aaron Klein:                      And so I don't know what will cause the next financial crisis, but I'm absolutely certain it will not be US prime mortgages.

Mark Zandi:                      Yeah. There is no such thing, is there? At this point.

Aaron Klein:                      Oh, yeah.

Mark Zandi:                      Well, I mean it's a shadow of what it was. If they're subprime, it's shadow.

Aaron Klein:                      Correct. But that there's a way to do economically sound subprime lending, right? I mean, there's a risk return, right?

Mark Zandi:                      [inaudible 00:21:33] capital.

Aaron Klein:                      You can give mortgages... Capital. But also stronger underwriting. Shockingly [inaudible 00:21:40] our loans don't tend to perform as well as the model because I've never met a model that takes the data and says, "Well, assume this is false." Right? All the models. And so there are responsible products out there, just at a much smaller scale. The other thing that I found in my research is that all financial crises, not recession, there's a big difference between the two. But all financial crises involve two things. The fundamental mispricing of an asset and leverage.

                                             You have bubbles but not crises, if you have one of the two. So example, what is the value of a click, right? This was in circa 2000, one of your recession years. This caused a recession. We fundamentally did not price this new asset, an eyeball on a website and a click, and we had a giant bubble.

                                             And some things... The .com bubble popped. It was large enough to cause a recession. People lost money. But we didn't have a crisis. Why didn't we have a crisis? There wasn't leverage. You couldn't really buy and trade the Nasdaq with much leverage in that era. In large part because we had regulations from the Great Depression where they had a stock market panic ban on leverage. So you can also have tremendous amount of leverage. If you don't have a fundamental mispricing of the asset, you can lose money but not trigger a financial crisis.

Mark Zandi:                      Well, what's an example of that?

Aaron Klein:                      Right? So leveraged loans would be an example of that.

Mark Zandi:                      Oh, I see.

Aaron Klein:                      You need both as a prerequisite for a crisis. So when I'm asked the question, what could be the cause of the next financial crisis or where are you looking at? The threshold analysis I take is, is there a fundamental mispricing of an asset? And is there leverage?

Mark Zandi:                      Right.

Cris deRitis:                       You also need scale, right? You could have a...

Mark Zandi:                      It's got to be big enough. Enough dollars [inaudible 00:23:44].

Cris deRitis:                       Has to be big enough. Right? So crypto for example, I don't know how much leverage there is in the crypto markets, but it's possible that they're levered but it's not large enough to really do a lot of fundamental damage.

Aaron Klein:                      That's right. That's right. But the size has to be built upon leverage. It can't just be that there's a lot of money in it.

Cris deRitis:                       Okay.

Aaron Klein:                      The money has to be levered.

Cris deRitis:                       Fair enough.

Mark Zandi:                      So before we get to the stress points in the system, Cris, let me go back to you. To the question I posed to Aaron. Of all the things that were done in the wake of the financial crisis to try to make the system more resilient, certainly capital number one, top of the list. What else would you put on that list that you think is important?

Cris deRitis:                       Yeah, my number two, this might be controversial, is actually stress testing the institutionalization, a more formal process, forcing institutions to run stress testing exercises, examine the results, report on the results. I think in the midst of the crisis that was very therapeutic, right? Kind of shed light on the risk, it calmed some nerves. And I think now we've continued that process. I think that is beneficial.

Mark Zandi:                      I mean, sounds a little self serving because we do a lot of that for a living. Help the financial institutions with their stress testing from capital stress testing to climate. But I agree with you. Did you see that recent speech from former Fed governor Tarullo on stress testing? Did you catch that Aaron?

Cris deRitis:                       I saw that you sent it to me early this morning. I haven't read it yet.

Aaron Klein:                      I did. Brookings non-resident fellow Dan Tarullo. Yeah, I mean look, I'm a little less sold on stress testing. I think Cris' comment is spot on. I think that's my former guy's boss, Tim Geithner would've put that too, if not number one with capital.

Mark Zandi:                      That was his name of his book wasn't it? Stress test or something. [inaudible 00:25:50]

Aaron Klein:                      The way that banks are regulated is twofold. One is risk weighted capital and the other is simple leverage ratio. And simple leverage ratio has a series of faults, right? Just says you have to have 10% capital, pick a number, whatever that number is, you can't go below it. And so banks naturally try to maximize their return on assets, which should drive them to riskier positions because that creates higher ROI on a simple leverage ratio. On the other hand, with the simple leverage ratio, you can't gain it.

Mark Zandi:                      Yeah.

Aaron Klein:                      There's no way you can move stuff around and hide risk or this or that. 10% is 10%. The other one is the risk weighted system where we're going to sit there and say, "Well, we know that this type of debt is riskier than this type of debt, which is riskier than this. So we're going to differentiate your capital charge and we're going to have a really sophisticated model. Maybe it'll be not quite as good as Ryan's because it's run by the government, but really super smart people. And this is going to be more accurate. And so banks are going to have to a less risky portfolio relative to their main capital."

                                             So in that way it solves for the problems. The problem is what if your risk weights are wrong? Which we've seen repeatedly in large part because a financial crisis involves the fundamental mispricing of an asset.

                                             And there's no reason to think the Federal Reserve or government is going to fundamentally correctly price an asset better than the market. There are many reasons to think it might be worse. And some to think it might be better. But structurally speaking we misprice assets all the time. That's part of evolution and innovation. So I've found in my travels that you get people who adhere to one of the two models.

                                             Institutionally the Fed loves risk weights, right? The FDIC tends to prefer simple leverage ratio and people fall into different camps. I've put myself in the camp of chopsticks. Which, I can eat a lot of food with two chopsticks. I can eat somewhat with some level of class. With one you're just spearing. And I think you need to be comfortable using either as the binding constraint. And what I found is that regulators and often academics and bankers, et cetera, fall in love with one or the other and they get nervous when the other one is the binding.

                                             There's either not enough capital or there's too much capital because their preferred metric isn't binding. And so I'm more skeptical of some of these models, stress tests. I mean, what was the stress test for COVID? How did the stress test work during COVID?

Mark Zandi:                      Well, they actually ran a set of scenarios during COVID as I recall. I don't know if it changed anything in terms of their capitalization, but I think it was helpful for identifying things. But you're right, they couldn't do that ex-ante for sure.

Aaron Klein:                      So I'll do something I'm not supposed to do on a podcast, which is admit that I was wrong. So when COVID started, people were like, "What's going to be the first problem on institutions' balance sheets?" And I looked it up and what did I look for? I looked for leverage and mispricing of an asset. And I found used cars. There was a huge amount of used cars, particularly subprime, which a lot of used cars... I think only 30% of Americans buy their car new.

                                             And used cars were rolling off car lots with 140% loan to value because shady practices by used car dealers, shocker. They may not be the most reputable business people on Earth in terms of adding things to the loan, warranties, et cetera. They were financing these things very high. So these things were negatively collateralized. They were sometimes leveraged in somewhat collateralized loan obligations. A bunch of the acronyms you recall from the financial crisis.

                                             There were a few credit unions in particular who I thought were not well capitalized and deep into this market. And there used to be an old adage, "Well, used cars are safer than houses because you can sleep in your car but you can't drive your house." So there's a group of people that will preference their car over defaulting on their apartment or their home. But COVID changed that, right? In COVID, there's nowhere to drive to. Now what happened? Used cars which are definitionally a depreciating asset, we have the entire history of the used car market available to us by data, and it is only ever depreciated. And so my [inaudible 00:30:58] assumed that a 10 year old civic is worth less every month. First time in human history, the price of a 10 year old car rose sharply, sharply.

                                             And there wasn't a problem in the market. If I'd walked up to any of you in 2019 and said, "I have a model, and in my model the value of used cars goes up 30% year over year."

Mark Zandi:                      We have a whole business modeling that actually. I don't know... Mike Brisson is our colleague who does that. I'm not sure whether he got that right or wrong. I just want to go back to your chopstick analogy, which is a very good one. But it is important that you have chopsticks that are finely tailored and tuned, right? Because if you set the leverage ratio too high, you really incent these institutions to do things you really don't want them to do. So you got to get that exactly right and it's a bit of a calibration. Yeah,.

Aaron Klein:                      That's right. And they have to work together.

Mark Zandi:                      They have to work together.

Aaron Klein:                      What I've been most concerned about in looking at regulators is they buy into one of the two approaches and then don't like the other. So they don't try to make them actually work together. Instead they try to say...

Mark Zandi:                      That's a great point. That's a great point. Okay. So I think we've established that the system today, and this replies to the US but similar things happened in much of the rest of the world in the wake financial crisis, at least the developed world. So the global financial system is probably feels like sitting on a more solid foundation than it did 15 years ago.

                                             So with that as a backdrop, let's come forward to the current point in time in this growing concern that because central banks, the Fed and other central banks are jacking up interest rates so fast and so high and prospects are that they're going to go higher and stay high for an extended period of time, that this is going to create stressors in the financial system. Expose problems and the system break will break again.

                                             Or I mean, taking the extreme case here, the scenario, but some flavor of that is what it's kind of pervading the conventional thinking out there in the marketplace. Aaron, do you think that that's a reasonable concern at this point? How are you handicapping that threat at this point?

Aaron Klein:                      Yeah, so I mean a couple things. Getting back to one theme we have, right? Nobody modeled the Fed using 75 basis point hikes. [inaudible 00:33:39]

Mark Zandi:                      And that's going to be the norm. Yeah. And that's the norm. Yeah.

Aaron Klein:                      Because we hadn't seen that for 30 years and the model never thought about that. To the global ripples of the rise in the value of the dollar associated with that, with dollar denominated debts. So I think other countries, particularly in the developing world, are going to have problems. And the problems are going to cause recessions and there may well be a recession caused in the United States by this.

                                             So you're going to have double or triple whammies where the US is a net importer of goods, sees a domestic slowdown, there's a global debt overhang, particularly in countries with dollar denominated debts. And they've seen the changes in the value of the currency and you have a problem there. Those are problems of economic growth. Recessions, expansions, those are not financial crises. And I think there's a big distinction between the two. When it gets to the question of a financial crisis, returning to Japan where you are, I believe this is what... Yesterday was the third day that the Japanese treasury 10-Year didn't trade.

Mark Zandi:                      Oh, I didn't know that. Is that right? Didn't trade?

Aaron Klein:                      [inaudible 00:34:55] liquidity in that.

Mark Zandi:                      Well, that's because the Bank of Japan has scarfed up everything.

Aaron Klein:                      Well, therein lies a different question. How much has the central banks around the world scarfed up everything and distorted where markets would or wouldn't have otherwise been? Right? I think it was nuts that in the name of COVID, the Federal Reserve was buying junk bonds to support the corporate debt market. I come from a school where investors lose money and that's the name of the game. And somehow that... I consider myself a very progressive and liberal democrat. But the idea that investors lose money seems an anathema to certain folks, particularly in conservative politics in the United States.

                                             Where as you point out, the last several crises have occurred in election years of the end of Republican administrations in 2008 and 2020. And there's kind of been a rush to bail out holders of all sorts of different debt classes, money market mutual funds, et cetera. And so when you ask the question, is the market going to be stressed? Part of the problem I think comes from like, are we going to get back to a world where we accept that investors lose money? And sometimes they lose a lot of money. And sometimes they lose money due to bad luck, sometimes bad investments. And that I'm not sure about. There's a skit in Saturday Night Live. Do you guys remember, Will Ferrell skit More Cowbell?

Cris deRitis:                       Oh, we've talked about [inaudible 00:36:37].

Mark Zandi:                      [inaudible 00:36:38] That's our signature skit. [inaudible 00:36:39]

Aaron Klein:                      There you go. Bring it for me. It seems to me the central banks around the world, whenever they see a problem, the solution has been more central bank.

                                             There's a problem in the repo market, we'll have a Fed standing repo facility. There's a problem in the bond market. We'll buy more bonds. There's a problem... We'll, we'll, we'll. And the thinking extends. Oh, there's digital currency. Well we should have a central bank digital currency. And the question you have to ask yourself is why? Is the answer [inaudible 00:37:13].

Mark Zandi:                      Let's make that real. Let's go to the UK two weeks ago. The new prime minister comes out, Liz Truss with this massive fiscal stimulus package, deficit financed tax cuts and government spending increases. And bond investors run for the doors because they know there are going to be all these gilts that are analog to treasury bonds issued to finance this.

                                             And also it's going to add to inflation because the UK economy is sitting at full employment. Probably the labor market there is tighter than it is in the United States. And so you're going to get a lot of inflation as well. So the pound falls. When I was there it hit parity briefly between the pound and the US dollar. And gilts go skyward.

                                             And this causes a stress in the system. UK pension funds had devised this derivative strategy to match their long dated liabilities with their assets that works when guilt yields do what they typically do. But gilt yields moved up five standard deviations, the arithmetic blew apart and these guys were going to fail. Because the value of these derivatives collapsed and they had to mark to market. And if they had mark to marketed, they had margin calls and they had to sell. And you got into this kind of suffering, reinforcing cycle into oblivion. You're sitting there at the Bank of England. You're now, is it Andrew Bailey at the Bank of England? What are you going to do with that? Are you going to say, "[inaudible 00:38:46] lose money." So, yeah.

Aaron Klein:                      Couple of different things on that, right? One is, there's a question about mark to market and how that can be procyclical in situations. And you don't want to blow up the entire system because of accounting. Right? There's a second question which is, so we let pension funds put themselves in a position where they had a derivative exposure such that five standard deviation move in a bond market blows them up?

Mark Zandi:                      Yeah.

Aaron Klein:                      Why?

Mark Zandi:                      No, no, no. That's absolutely right. That's where stress testing comes in. That's a really good case study where stress tests could help you identify that. But that's clearly a fault in the system. But that's what happens when you stress a system you discover, "Oh, my gosh. I didn't think of that."

Aaron Klein:                      Look, actions have consequences. Truss' supply side insanity. This is kind of like the Stephen Moore to use the US analogy. There's been a stream of, what has been called kind of snake oil salesman economics that if you blow the deficit sky high with tax cuts, the growth fairy comes and revenue magically solves it. Right?

                                             And while this has a political popularity, in the US Stephen Moore was an architect of this strategy who Donald Trump attempted to nominate to the Federal Reserve Board at one point, and didn't get very far luckily. But in a different world things could have gone differently. And some sanity has to come into magical thinking. And sometimes there are consequences to engaging too far in that situation. If it's a question of time and folks need time to figure things out, that's different. But if it's a question that government should fundamentally go in and manipulate the price and asset of value of markets in order to protect favored classes of investors from losing money, I have a problem with that.

Mark Zandi:                      I totally agree with you. It's just it's easy to say in theory. But then in actual practice when you're sitting there [inaudible 00:41:14] eyes of what's happening.

Aaron Klein:                      There's a forthcoming book I'm going to make a plug for by somebody we all know very well, Mark Calabria.

Mark Zandi:                      Yeah.

Aaron Klein:                      Mark Calabria was the director of the Federal Housing Finance Agency. The overseer of Fannie and Freddie. During COVID there were huge cries to bail out mortgage servicers in the United States. He held firm. There was a huge push to provide bailouts for them. He held firm. There were stresses in the market, there were losses, but the system didn't collapse.

Mark Zandi:                      Well, that's only because Fannie and Freddie were in conservatorship, Aaron. If they weren't in conservatorship, they would've collapsed.

Aaron Klein:                      Perhaps. [inaudible 00:41:52]

Mark Zandi:                      The government was sitting there behind the whole system.

Aaron Klein:                      Let me be very clear. I'm not talking about Fannie and Freddie, I'm just talking very specifically about the liquidity for the mortgage servicing arm.

Mark Zandi:                      Yeah. But I don't buy into that collaborative argument whatsoever. I mean, I agree with a lot of what you said, most everything up to that point in time. But the only reason he was able to get away with that is because they were sitting in conservatorship. They were government entities. So the whole system was backed by the government. So I don't know.

Ryan Sweet:                      Yeah, nothing gets Mark more fired up than housing finance.

Aaron Klein:                      What I would say is, when the book comes out, I encourage you to read it even if it's going to aggravate you.

Mark Zandi:                      I'm going to make Ryan read it and give me a [inaudible 00:42:39].

Ryan Sweet:                      I'm happy to do it.

Aaron Klein:                      Because there's a lot of talk about people coming in asking for... Right? It's this question. We don't know what would've happened had the Fed not bailed all the money market mutual funds in COVID. Right? It's an unknown hypothesis. But we do know that when you bail out an asset class repeatedly, investors assume it's going to be bailed out.

Mark Zandi:                      I hear you. I hear you. I hear you.

Ryan Sweet:                      Mark, did you see what Governor Bailey said yesterday?

Mark Zandi:                      No.

Ryan Sweet:                      He said he has three days.

Mark Zandi:                      Oh, about he's going to stop buying gilts on Friday. Yeah. Let's see him do that.

Ryan Sweet:                      Exactly.

Mark Zandi:                      [inaudible 00:43:16] keep going south.

Ryan Sweet:                      Yeah, they're up 17 basis points today. That's just this morning. They were up a lot yesterday.

Mark Zandi:                      What are they? 4.50, 4.5.

Ryan Sweet:                      4.6%.

Mark Zandi:                      4.6% yeah. If they get to five and the pound is going to parity I assure you...

Ryan Sweet:                      Well, the pound is down a ton.

Mark Zandi:                      Yeah, I assure you. But anyway you make a great point.

Aaron Klein:                      Why is the Federal Reserve buying mortgage backed securities as recently as last month in the United States? We had a housing market that was out of control. House prices were going bananas. Right? There's a new Fed governor, Chris Waller from St. Louis and it was well publicized. He couldn't figure out how to buy a house in this area, in the DC metro area because costs were going nuts. And why were costs going nuts? Because the Fed kept buying these things years after [inaudible 00:44:05].

Mark Zandi:                      You have to make a distinction between buying those securities and the timing of those purchases. I mean, when you're in the middle of a pandemic and the housing market is evaporating, I can easily see it. So that doesn't argue you shouldn't do it, but you have to be judicious about it.

Cris deRitis:                       So that's early 2020, mid 2020. Right? Okay. I have no problem there. But why continue?

Mark Zandi:                      No, I agree.

Cris deRitis:                       [inaudible 00:44:32] into the teeth. Even you agree.

Mark Zandi:                      I don't understand.

Aaron Klein:                      Look, here's what I want to do. For the first month of the pandemic, I wiped down my groceries. Because I thought that surfaces were a thing, right? Then you found out surfaces weren't a thing. A year later my kid's school is still closed on Wednesdays so they can do deep cleaning.

Mark Zandi:                      Right. That's good point.

Aaron Klein:                      And you can't justify this thing, "Well, a year ago..."

Mark Zandi:                      Yeah. Here's what I want to do though. I want to go around the group and ask you to each identify what in the system globally, here in the US, that feels most vulnerable to breaking under the stresses of rising interest rates and/or recession. That could metastasize into something that could become a problem for the financial system and require some kind of bailout.

                                             The system, it's bending, feels like the system is bending, which is okay. That's what it's supposed to do. Financial conditions have to tighten as they say, so that the economy slows and inflation comes in. But we don't want it to break. But what out there is at risk of going from bending to breaking? If that makes sense. Let me start with you Cris. Where would you go with that question?

Cris deRitis:                       Globally, right?

Mark Zandi:                      Anywhere. Anywhere. I'm just scouring the planet. Where would you be looking?

Cris deRitis:                       I think we even alluded to it earlier. Certainly some emerging markets. Some market out there is vulnerable, right? Either from a debt perspective or because of the strength of the dollar. Their imports, exports, trade imbalance. And there could be a cascade effect.

Mark Zandi:                      But we had Sri Lanka and most people don't even know Sri Lanka. So it's got to be more than Sri Lanka. No?

Cris deRitis:                       Yeah. It has to be a larger market or it has to be many of them. If we add two or three Sri Lankas cascading, then that could actually roll into something larger. Really what I'm thinking of more than anything is the unknowns. We know that Europe is under pressure. Clearly recession risk is high if not already here.

                                             And yet they do have some resources to fight against that and prevent something from spilling over. Not to say that there isn't some type of sovereign debt risk there, but it's more these other markets where we don't have clarity. Just like the previous recessions we talked about, there's always something that we didn't really think about or we didn't know about the interconnections, or not enough people knew about them. So that's what's on my mind, is it's going to be some of the...

Mark Zandi:                      Yeah, I'm asking you the imponderable. Tell me the unknown unknowns. So what is the unknown unknown? Taking that, what you just said a step further, could it be a developed economy that runs afoul of bond markets? I mean we saw what happened to the UK. Now, that was clearly a massive error on their part that precipitated it. But what about [inaudible 00:47:52].

Cris deRitis:                       Yeah. Certainly have my eye on Italy. I will always have my eye on Italy. Right?

Mark Zandi:                      I was going to say, I thought you were going to go there. Italy. Right.

Cris deRitis:                       And the spreads are gaping out there as well. So there's clearly risk there. Although you do have this European Central Bank that does have some resources behind it still. If I had to pick one, maybe it's China. Property market, right? Social upheaval, right? There again, I don't have a lot of clarity into the Chinese economy. What is really going on and problems there could spill over and have a ripple through the globe.

Mark Zandi:                      Yeah. Okay. Okay. Ryan, what about you? What would you point to?

Ryan Sweet:                      Yeah, I was going to go where Cris went. But focus on European sovereign debt. I'm worried that we're going to have another European sovereign debt crisis because yields are just jumping across Europe. But outside of that it really isn't... That's the thing. It's like, you're asking about the unknown [inaudible 00:48:50].

Mark Zandi:                      Well, so why is your probability recession 70% my friend? If there's no problem out there. You're just saying there is something we just don't know what it is.

Ryan Sweet:                      Yeah, well I'm worried that things are just going to get accelerated. Like why are high yield corporate bond spreads not increasing more?

Mark Zandi:                      Yeah, can you explain that? So tell the listener, that is an indicator that we watch for stress in the system and it's not signaling any... Well, there's some stress but nothing untoward.

Ryan Sweet:                      Yeah. Well, I think the high yield corporate bond market is different now than it was 10, 15, 20 years ago. I mean the quality of the corporate debt is better. I think perceptions of credit risk are very low. Corporate profit margins are still wide. We talk a lot about excess savings among the US households. There's a lot of excess savings among corporations. The amount of cash that are [inaudible 00:49:45] corporate balance sheets is pretty high.

                                             And I would love to hear what Aaron thinks about this. And I can't quantify this, but is there a potential for moral hazard? Because we already talked about that. The Fed stepped into the corporate bond market during the pandemic. We do have stresses. Are they going to step back in and that would keep spreads tighter than they would at least historically based on volatility in the bond market, the VIX, which is volatility in the stock market, all that points to wider spreads. But maybe there's a moral hazard issue.

Aaron Klein:                      There is.

Mark Zandi:                      That's interesting. So to frame it though, if I look historically at the difference between an interest rate on a high yield bond, that's a below investment grade bond. That's a lower quality bond. Compared to a US treasury bond of similar duration, it's about 500 basis points. So in the junk bond market, the high yield market was put on the planet in the late '90s. Michael Milken, you may recall. You take an average of that difference. It's 500 basis points. Today it's sitting at 5.10, 5.20, 5.30. So that's nothing, right? In the teeth of the financial crisis, it was 2000 I believe, 25...

Ryan Sweet:                      Usually when you're in a recession, it's about a 1000.

Mark Zandi:                      About a 1000.

Ryan Sweet:                      I think that's the [inaudible 00:50:58].

Mark Zandi:                      You're suggesting that maybe the spread isn't gaping out because that's the Powell put in the bond market that they'll get bailed out.

Ryan Sweet:                      I don't know how much of that explains why, but I think that's a factor along with high energy prices. Because about 10% of these high yield corporate bond spreads are energy companies. So high oil prices are good for them. But I think that number one is the perception of credit risk. That defaults are going to rise, but they're not going to spike like we've seen in past instances. But I just can't quantify this moral hazard.

Mark Zandi:                      I've got another explanation that I'm going to come back to when I give you my stress point, but it may help explain that. But that's interesting. Aaron, where would you go?

Aaron Klein:                      So I'll pick up on a couple threads that have been discussed. I think China has a set of issues. I tend to think that your stress points are often where you have the most opacity, right? And it's hard to really know what's going on in China. And per your comment about Sri Lanka and size is relevant, hard to get bigger than China, hard to know everything that's going on within there.

                                             The sharp appreciation in the value of the dollar affects their currency because they do not let their currency freely float. And so you have a series of other issues there. And that's where I'd start. The second thing I'd look at is something that exists out of no country, crypto. Digital assets. There's been a fundamental debate about the value of these assets and they've swung wildly. I've not seen that much leverage in the system, but then you kind of wonder. Some of these algorithmic stablecoins and these other things, what are the assets backing Tether? The world's largest stable coin? Which seems to be deeply opaque. And is the functioning of those markets more brittle than we know? And is there more interconnection and intercontagion within those markets than we fully appreciate?

                                             And so could there be a domino, right? Usually with a financial crisis, the question you're asking is kind of what's the spark of the flame, right? And then the domino effect. So if we'd been doing this in 2007 and somebody had come and said, "It's US subprime mortgages." And somebody said, "Oh, that's small. The Fed says it's contained." Somebody would've had a walk through, well, countrywide takes out Lehman, Lehman takes out AIG, AIG... Right? And so you're asking what the spark is. Something in China, something in crypto.

                                             Digital assets. I want to be a little bit broader, right? Because there's all sorts of different NFTs, there's sorts of other things. And by the way, that's not to say that these things... That inherently makes you a skeptic, right? In the .com story, I think that the stock value of Amazon went from basically zero to a $100 a share to $9 a share. So it lost over 90% of its value in the .com bubble and now it's what? $3000? Was $3000. Amazon lost 90% of its value when the bubble popped and then was the single... If you bought at the peak of the bubble in 2000 and held, you wouldn't have problems like these pension funds that you alluded to earlier, right? You'd be a super wealthy person.

                                             But the other thing that I'm concerned about that isn't a market is the group think endemic in central banks domestically and internationally. There has not been a single dissent at the Federal Reserve among the seven governors appointed by the President and confirmed by the Senate to 14 year terms in order to give them flexibility. The point of having independent monetary policy in part is to let governors express their differing opinions. The you know the last time a Federal Reserve governor dissented on a vote on monetary policy in the United States?

Ryan Sweet:                      2005.

Aaron Klein:                      Yeah. Mark Olson. He thought we should pause tightening because of Katrina. Think about all the crazy stuff that's gone on in monetary policy since 2005 with the unanimity among the governors greater than Saddam Hussein's vote share.

Mark Zandi:                      Let me push back on that.

Aaron Klein:                      In the Iraqi elections.

Mark Zandi:                      I mean I'm sure there's a lot of dissent, but they just decide that they're not going to express it in a public way with a vote like that. They want to make it clear to the markets that they have come to a consensus. But it doesn't mean that it was an easy consensus to come to. And I would be shocked if it was. Right? So that can't really be the benchmark.

Aaron Klein:                      To me it is. Look to me, at a certain point you have to vote your conscious and you have to vote what you believe in. The fact that no one has dissented itself makes dissents... This is a snowballing effect. When you used to have the dissents that were common, it wasn't such a big deal.

                                             So you voted among the governors, it was six to one or five to two, right? There's still a consensus. It's not like you're tipping the vote. But now you have a culture where you can't disagree publicly. You can't. Right? The burden to do this becomes higher and higher the longer this streak goes. Which itself then reinforces, we can't dissent. I don't think there was anything wrong or unhealthy when there were dissents in monetary policy for the first 90 years of the Federal Open Markets Committee. What changed since 2005 in which public dissent are now subject to such a greater threshold, we've never seen it.

Mark Zandi:                      But I talk to central bank officials, the Fed, I don't get this group... I mean there must be some groupthink going on. But I don't get the sense that... I get the sense that there's significant debates about these issues. I don't get the sense that they're all on the same page.

Ryan Sweet:                      I mean if you look at Governor Waller. I thought he was going to be the closest to dissenting recently. Because of some of his comments. But when push came to shove, he voted in line with all the other governors.

Aaron Klein:                      Groupthink doesn't mean that there isn't robust discussion. It means that there's robust discussion among the same group and then the pressure to stay within the group is very hot.

Mark Zandi:                      So you're saying you think the problem here may actually be monetary policy itself. That we're making bad monetary policy decisions because we don't have that kind of diversity or at least the courage to express that diversity of thought. That's what you're saying.

Aaron Klein:                      There's a lot of research that shows that diversity of experience, of thought improves group [inaudible 00:58:06] decision making outcome.

Ryan Sweet:                      That makes sense.

Aaron Klein:                      And that part of the tension in diversity is healthy disagreement. And I think the system would be healthier if we had more divergent opinions that were more comfortable taking it through to its logical conclusion. And so systems can function very well and tolerate public dissent. And I've grown nervous.

                                             The Federal Reserve has been here for over a 100 years. And we've only had this period of no dissenting since '05, which has also been as crazy a period as one could have in monetary policy and financial regulation. There's a financial regulatory, corollary here. We do have some dissents among the reserve bank presidents, Neel Kashkari has dissented. I think Bullard has dissented. I think [inaudible 00:59:06].

Mark Zandi:                      [inaudible 00:59:07]

Aaron Klein:                      You've seen wrong dissents, right? I think Lacker from Richmond was calling for tightening going into the crisis because of inflation, right? Groupthink, if you want to push against groupthink one of the common answers is, "Well, so Aaron, do you want to have dumb ideas expressed?" And my answer to that is, yeah.

Mark Zandi:                      Yeah, actually I agree with you. Because you got to hear the dumb ideas that knock them down and make sure they're dumb ideas, right? Yeah, totally agree. Hey, let me throw out mine. And I know this is probably something you disagree with Aaron, but it's leveraged lending. And here's what it is that makes me... It goes back to your point about opacity. The central banker... No, excuse me. A CEO of a major bank once told me, if it's growing like a weed, it's probably a weed. And that describes the leveraged loan market since the financial crisis and before that. And just to level set for the listener, leverage lending is lending by generally banks to highly indebted businesses. Not the big guys, but generally SMEs. Small, mid-sized companies. And a lot of it's related to private equity firms that come in and they buy up companies and they lever them up to juice up their equity returns and make them more attractive.

                                             And about half... I'm making this up, but roughly speaking. Half of those leveraged loans go into CLOs, collateralized loan obligations. This is you securitize the loan into a security and you sell the security CLO. I'm actually not at all worried about those loans. We at Moody's know those loans very, very well. It's very transparent. We know everything about those loans, the cash flows and the covenants. And the CLO structures, they seem to be quite good.

                                             They navigated through the financial crisis, no problem. Under a lot of stress. What worries me is the other half that is out there in the financial system. And we're talking $700 billon to $800 billion outstanding. That's growing very rapidly. And they are completely opaque. We have no idea what's going on there and what they look like. And that makes me nervous because if these companies start running into a real problem, then that goes to the heart of the American economy and the financial system more broadly.

                                             And Ryan, I wonder if one reason why the high yield market, it feels like a higher quality market, underlying quality of the market is better, because the bad stuff is going into the leveraged loan market. You can either take a loan... Going in the bond market as a company and raise debt. That's the high yield market. Or you can go to a bank and borrow. That's the leveraged loan market. So maybe the lower quality stuff is going over into the leveraged loan market and it's messing up the spreads in the bond market, in the high yield market. What do you think about that, Aaron?

Aaron Klein:                      So a lot of people were talking about leveraged lending. I think there was a big story in the Washington Post by Damian Paletta in 2019 where he said he interviewed 31 people. And I think all but two expressed concerns about leveraged lending being systemically risky. And I thought to myself, "I wonder who the other one was." And so it's fine for me to out myself in that situation because I realized I was a little bit in the minority on it. I would point out that there wasn't a problem in the leveraged lending market exactly when you'd see a recession that you would expect. But that's not a fair test because of the giant bailouts.

Mark Zandi:                      Well, and also interest rates fell. I mean, leveraged loans come under problems in a rising rate environment, a high rate environment. And they didn't get stressed. I mean, when we were focused on that in 2019, that's when the Fed pivoted, remember? Because of the Trump trade war and the economy was weakening very rapidly. We might have had a recession without the pandemic in 2020. And so rates came back in. So it took the pressure off. So I don't know [inaudible 01:03:13].

Aaron Klein:                      That may well be fair. There's also lots of questions about the future of commercial real estate and other things that are tied into that market. But can markets suffer giant losses? Yes. Can you have a bubble? Yes. Can you create a financial crisis out of that? I struggle to see it.

Mark Zandi:                      Yeah. Yeah. I just worry... You know what I worry about? Two things in that regard. One is credit stops flowing to that very important part of the economy and that has real economic consequences. And the second thing is, that's a lot of debt. $800 billion, that's sitting not on bank balance sheets. That's sitting out there in the so-called shadow system. The rest of the system that's not regulated well. Doesn't have a lot of capital or we don't have no idea how much capital they have. They're not doing stress testing as far as we can tell in a reverse way.

                                             And it's opaque. So therefore if a problem develops anywhere, creditors to those institutions, they run for the door for all those institutions because they don't know who's good, who's bad. That's what I worry about. But anyway, a lot to worry about.

                                             Let me just finally end because actually this is a great conversation and went longer than I anticipated. Do you think given what we know about where interest rates are headed here and what's going on in the economy and the prospects for, if not a recession, a very tough economy over the next 12, 18 months, is your betting that the financial system will bend and not break? Or do you think there's a reasonable probability that in fact we'll get something that breaks here? And I'll ask both Aaron and Ryan. I'm just very curious what you think. Maybe I'll start with Aaron.

Aaron Klein:                      I'm happy to say I think it's nerveracking to ever be out there and publicly say, "I don't think it's going to break." I never liked bend, don't break defense. Watching American football. That being said, I think we're in a much better situation than we were in the past. And I also think you don't want a system to collapse, but it's about time investors who made bad bets lose money. I think we're developing a more and more inequitable system where the larger the investor and the worse the bet, the more they get bailed out.

                                             And the little people when they make a mistake, "Well, you're not that important." And that exacerbates income and wealth inequality in society. I'm very concerned about what we've done bailing out money market mutual funds and then you look at stablecoins and you say, "Well, you can't bail them out. They're crypto. They're outside the world." You go, "Well, crypto is owned far more by young and by people of color than money market mutual funds." Which are really owned by older, heavily white folk. One of my favorite statistics, the Federal Reserve surveys very wealthy people to try and find out what they have. Do you know what share of African Americans own corporate debt? Individual corporate debt according to the Fed.

Mark Zandi:                      I'd say 3%.

Ryan Sweet:                      Yeah. Less than 5%.

Aaron Klein:                      Zero. 0.0. They couldn't find a single one repeatedly in their survey.

Mark Zandi:                      Oh, my Gosh. That is amazing.

Aaron Klein:                      And we're bailing out the corporate debt market and I know there are lots of different investors, et cetera. And these things trickle through and workers are impacted by that as well. But if you look at it, or I think like contingent upon holding corporate debt, the median amount was... I should look this back up again before I quote a number. 600,000 or something. I mean the people that own this own a lot.

Mark Zandi:                      Yeah.

Aaron Klein:                      I think that was the mean. There's a big mean median distinction here.

Mark Zandi:                      Yeah.

Aaron Klein:                      But the concentration of it skewed by race is astounding in this country. And so that kind of concerns me structurally.

Mark Zandi:                      Makes a good point. You make a great point. What about you Ryan? Are we going to bend and not break?

Ryan Sweet:                      Yeah, we're going to bend but not break. But that doesn't mean we don't have to have... Conditions are going to tighten sufficiently enough where we most likely will have a recession. But we're not going to have a financial crisis.

Mark Zandi:                      You thought I was going to trap you?

Ryan Sweet:                      Yeah. [inaudible 01:07:35] I knew you were trapping me.

Mark Zandi:                      Ryan is a recession bear. But yeah, I hear you. I hear you. Okay, well I think we covered a lot of ground and we can keep on going but I know how to get ahold of you Aaron.

Aaron Klein:                      Well, thank you for having me on. This is always fun and I really appreciate the opportunity.

Mark Zandi:                      Yeah, I appreciate that. We lost Cris, so unfortunately I think he had family responsibilities. But it was wonderful to have you on. And I think at this point we're going to call our podcast. Are you on Twitter, Aaron? Do you have a Twitter account?

Aaron Klein:                      I am. I'm @AaronDKlein. You got to put in my middle initial. Somebody beat me to the punch. There's several other Aaron Kleins out there. One of whom didn't pay his AT&T cell phone bill and dinged my credit score for years.

Mark Zandi:                      Well, that's the problem with having a more common name. What about you Ryan? What's your Twitter handle?

Ryan Sweet:                      @RealTime_Econ.

Mark Zandi:                      And of course I'm @Markzandi. I beat everyone to the punch. So got lucky. Anyway, thank you for the great conversation and we're going to call this a podcast. Take care everyone.