Convexity Maven Harley Bassman: How To Survive The Next Rate Cycle
In this episode, Adam Butler is joined by Harley Bassman, Managing Partner at Simplify Asset Management, for a wide-ranging discussion on interest rate volatility, portfolio construction, and public policy. Bassman explains his creation of the MOVE Index before diving into strategies using long-dated options to create asymmetric payoffs. They also explore the systematic risks that challenge diversified portfolios during Fed policy inflection points. The conversation concludes with Bassman’s strong case against the re-privatization of Fannie Mae and Freddie Mac, detailing the potential negative consequences for the housing market.
Topics Discussed
- The creation and mechanics of the MOVE Index as a VIX for the bond market
- Explaining complex financial derivatives by drawing analogies to fundamental physics concepts
- Constructing highly asymmetric, long-term trades based on the shape of the yield curve
- The failure of traditional diversification during major inflection points in Federal Reserve policy
- The paradigm shift to passive investing flows overriding traditional market valuation metrics
- A new trade idea involving a positive-carry call option on Treasury rates as a recession hedge
- The evolution of portfolio tools like Return Stacking and derivative-based ETFs
- Identifying U.S. immigration policy as the most significant and overlooked macroeconomic risk
- The public policy argument against the re-privatization of Fannie Mae and Freddie Mac
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Summary
In a wide-ranging discussion, convexity expert Harley Bassman shares his perspective on market structure, derivative trading, and major macroeconomic risks. Bassman begins by recounting his creation of the MOVE Index, the bond market’s equivalent of the VIX, which established a framework for understanding interest rate volatility. He explains his career-long focus on identifying highly asymmetric, long-term trades, often based on discontinuities in the yield curve and fundamental economic principles. The conversation highlights how recent regulatory changes have enabled a new generation of sophisticated ETFs, allowing strategies like Return Stacking to bring institutional-grade tools to a broader audience. Bassman addresses the failure of traditional diversification during major Federal Reserve policy inflection points, where asset classes that are normally uncorrelated move in tandem. He argues that a major paradigm shift has occurred, with massive passive investment flows overriding traditional valuation metrics, a trend he believes will only reverse when unemployment rises significantly enough to halt 401k contributions. Looking forward, he presents a new trade idea designed to hedge against a recession: a long-dated, positive-carry call option on Treasury rates that offers significant leverage if the Fed is forced to cut rates aggressively. This instrument can be paired with higher-yielding assets to protect against credit risk during an economic downturn. Beyond specific trades, Bassman identifies U.S. immigration policy as the most significant and overlooked macroeconomic risk, warning that mass deportations could trigger stagflation by reducing GDP while simultaneously driving up wage inflation. He concludes with a strong public policy argument against the re-privatization of Fannie Mae and Freddie Mac, asserting it would create moral hazard and raise mortgage costs for all Americans to benefit a small group of investors.
Topic Summaries
1. The creation and mechanics of the MOVE Index as a VIX for the bond market.
Harley Bassman explains that he created the MOVE Index as a VIX equivalent for the bond market. While running bond options at Merrill Lynch, he was inspired by the VIX’s effectiveness in level-setting equity volatility for clients and decided to replicate the concept for fixed income. The MOVE Index is a weighted blend of one-month implied volatility derived from options on two-year, five-year, ten-year, and thirty-year Treasury securities. Its weighting is 20% for the two-year, 20% for the five-year, 40% for the ten-year, and 20% for the thirty-year, with the ten-year being double-weighted because it is the primary benchmark for trading. Bassman notes that the MOVE Index’s historical data actually predates the VIX, extending back to 1988. A historical rule of thumb was to buy bond volatility when the index hit 80 and sell it at 120. However, Bassman highlights the behavioral finance challenges that make this strategy difficult to implement in practice. When volatility is low, investors are hesitant to buy a decaying asset that is constantly losing value to theta decay. Conversely, when volatility is extremely high, investors are typically in a state of panic and too fearful to take the other side and sell options. This psychological barrier often prevents traders from capitalizing on the signals. He also adds a technical note that the index can sometimes jump for a day if its one-month window captures two payroll reports. This trading framework also shifted after the global financial crisis, which ushered in a prolonged period of suppressed volatility.
2. Explaining complex financial derivatives by drawing analogies to fundamental physics concepts.
Harley Bassman demystifies the perceived complexity of financial derivatives by explaining that financial engineering is essentially the “physics of money.” He notes that during the 1990s, trading desks actively hired physics PhDs because the underlying principles of derivatives are directly analogous to fundamental physics concepts. The core idea is that the mathematical formulas governing options are identical to those used in classical mechanics. Bassman provides direct comparisons to illustrate this point, stating that “delta,” which measures the rate of change in an option’s price, is simply velocity. Furthermore, “gamma,” which measures the rate of change of delta, is the exact same concept as acceleration. He humorously suggests that anyone who passed tenth-grade physics and ninth-grade statistics could perform his job. The financial industry merely rebrands these familiar concepts with Greek letters to make them sound more sophisticated and “sexier.” This rebranding creates an artificial barrier, but the underlying math is as straightforward as calculating ballistics. This perspective reframes options trading from an esoteric art into a quantifiable science. It is a process of converting potential future capital gains into present income, and vice versa, using these established mathematical and physical laws. Ultimately, this analogy reveals that the complex world of derivatives is built upon a foundation of simple, predictable relationships borrowed directly from the physical world.
3. Constructing highly asymmetric, long-term trades based on the shape of the yield curve.
Harley Bassman constructs highly asymmetric, long-term trades by identifying discontinuities in the market, with a primary focus on the shape of the yield curve. His strategy revolves around analyzing forward rates, which he clarifies are not predictions but rather the outcome of an arbitrage-free process. The core opportunity lies in making a long-term bet on whether future interest rates will deviate significantly from what the current curve implies. A prime example of this was his successful trade betting on inflation when rates were near zero, where he purchased a seven-year put option on the 30-year Treasury. He chose the long end of the curve because it is more market-controlled and offered superior leverage through implied volatility. By using long-dated options, he creates significant leverage without the risk of a margin call, leading to a favorable asymmetric payoff profile where losses are limited to the premium paid. He packaged this professional-grade strategy into an ETF, making it accessible to a broader range of investors. Currently, with rates much higher, he has initiated the opposite trade, structuring a seven-year call option on 10-year rates to profit from a potential recession and subsequent Fed rate cuts. A unique feature of this new instrument is its positive carry of around 2%, achieved because the yield earned on the fund’s cash collateral exceeds the slow time decay of the long-dated option. Bassman suggests this product is ideal for Return Stacking, pairing it with high-yield assets like BDCs or leveraged loans. In this construction, the option acts as a powerful insurance policy against a recessionary event that would otherwise harm the credit-sensitive portion of the portfolio.
4. The failure of traditional diversification during major inflection points in Federal Reserve policy.
Traditional diversification strategies, even those incorporating a broad mix of stocks, bonds, gold, and commodities, are vulnerable to failure during specific market environments. Historical periods such as 1991, 1994, and 2004-2006 have demonstrated this weakness, where all major asset classes experience drawdowns in concert. The primary driver of this systematic risk is not merely a surprise interest rate hike, but rather a major inflection point in Federal Reserve policy. These events occur when the Fed pivots from a prolonged period of loose monetary policy to the beginning of a new tightening cycle. When the market has been conditioned to expect continued easing, the first signals or actions of tightening can cause a significant downdraft across all assets as they are repriced for the new regime.
The state of the yield curve at the time of this pivot provides crucial context for the market’s severe reaction. This dynamic is particularly challenging for risk parity strategies that rely on the negative correlation between stocks and bonds. When inflation rises, this correlation can flip positive, forcing widespread deleveraging and causing investors to sell everything simultaneously. Unlike a typical recession where Treasuries might rally and provide a hedge, these policy inflection points can see even safe-haven bonds decline alongside risk assets. The first rate hike after an extended period of zero rates is a prime example of an event that can cause everything to sell off sharply. Ultimately, these periods of failed diversification represent a systematic risk factor tied to the market’s difficult adjustment to a new central bank regime.
5. The paradigm shift to passive investing flows overriding traditional market valuation metrics.
A significant paradigm shift has occurred in markets, moving from a value-driven, active management proposition to one dominated by passive investment flows. This change is largely fueled by the Millennial cohort, a demographic larger in number than the Baby Boomers, who systematically invest in passive equity funds through their 401(k) retirement plans. As a result of these persistent capital inflows, traditional valuation metrics like P/E and CAPE ratios have become less meaningful, with markets continuing to climb even as these metrics are “off the charts.” Harley Bassman suggests this passive flow-driven market will likely continue until a significant economic shock halts the inflows. He identifies a rise in unemployment above a 5% threshold as the potential catalyst that could turn the market, as job losses would stop the 401(k) contributions that fuel the system. This creates a potential reflexive paradox concerning the market’s current enthusiasm for AI. The investment thesis for AI is predicated on massive productivity gains, which often implies significant job displacement. If AI’s adoption leads to the predicted rise in unemployment, it could choke off the very passive flows that are currently supporting the market’s high valuations. Therefore, the successful implementation of the AI revolution could ironically sow the seeds of a major market downturn by undermining its key structural support. Despite these dynamics, it is acknowledged that over very long horizons, equities remain an excellent inflation hedge because companies can raise prices, which ultimately drives nominal returns higher.
6. A new trade idea involving a positive-carry call option on Treasury rates as a recession hedge.
Harley Bassman has introduced a new trade idea that serves as the opposite of his previous successful bet on higher rates. This new strategy is a bet that interest rates will decline, structured as a long-dated, seven-year call option on 10-year Treasury rates. Bassman’s rationale is that with bond yields near the higher end of their recent range, a potential recession could force the Federal Reserve into a significant rate-cutting cycle. This option is designed to provide a substantial payoff in such a scenario. A uniquely powerful feature of this instrument is its positive carry of approximately 2%, which is highly unusual for a long option position. This is achieved because the option is a forward-settled professional product, allowing the cash to be invested in Treasuries while the slow time decay of the long-dated option is more than offset by the interest earned.
From a portfolio construction standpoint, the option is extremely capital-efficient, offering a 40 duration. This allows an investor to gain significant interest rate sensitivity with only a small capital allocation. This efficiency facilitates a powerful Return Stacking application. Investors can pair a position in this option with higher-yielding, income-producing assets like leveraged loans or BDC equities. These credit-sensitive assets are most vulnerable to a recession, the exact environment where the long-duration call option would perform best. The option thereby acts as an embedded insurance policy, hedging the primary risk of the income-generating assets in the portfolio. This structure allows investors to pursue high current income while simultaneously protecting against the main driver of potential losses.
7. The evolution of portfolio tools like Return Stacking and derivative-based ETFs.
The evolution of modern portfolio tools represents a significant democratization of sophisticated investment strategies previously exclusive to large institutions. This trend has historical roots in concepts like Portable Alpha, which Bill Gross famously unitized at PIMCO in the 1980s by using futures for core bond exposure to free up cash for other return-generating assets. A pivotal catalyst for the modern era was a major SEC rule change approximately five years ago, which permitted the inclusion of derivatives like options, futures, and swaps directly within ETFs. This regulatory shift has enabled a proliferation of innovative tools, allowing firms to package professional-grade strategies into accessible wrappers for advisors and retail investors. Harley Bassman provides a direct example with his firm’s products, such as creating an ETF that held a seven-year put option on the 30-year Treasury to bet on rising rates.
This innovation is central to the concept of Return Stacking, which involves layering different, often non-correlated, return streams within a single portfolio. While Return Stacking involves adding leverage, this is often achieved through capital-efficient derivatives rather than direct borrowing. When the stacked strategies are negatively correlated, this approach can paradoxically reduce overall portfolio risk instead of increasing it. These derivative-based ETFs allow investors to create highly specific payoff functions and gain capital-efficient exposure to various market factors. For instance, an investor can now pair a high-yield credit product with a long-duration option-based ETF. This combination allows the investor to collect attractive income while holding an embedded insurance policy against a recessionary event that would typically harm credit assets. Ultimately, these advanced tools provide advisors with unprecedented flexibility to construct more robust and customized portfolios.
8. Identifying U.S. immigration policy as the most significant and overlooked macroeconomic risk.
Harley Bassman identifies U.S. immigration policy as the most significant and overlooked macroeconomic risk, superseding factors like tariffs, taxes, or regulation. He argues that GDP is fundamentally a product of people, hours worked, and productivity, with the “people” component being the most critical driver. Given that the U.S. has a sub-replacement birth rate, the nation depends on immigration for population growth, which in turn fuels economic expansion. The primary risk he foresees is a potential policy of mass deportation, which could remove a million or more people from the economy. This action would have a severe dual impact, creating a stagflationary environment. Firstly, reducing the number of people working directly leads to lower GDP. Secondly, it would create significant labor shortages in essential industries, forcing wages to rise sharply to attract new workers. This wage pressure would translate directly into higher consumer prices and sustained inflation. Bassman emphasizes that this is not a political judgment but a stark economic reality. He concludes that if such a policy is enacted, there will be a substantial economic cost in the form of stagflation, making it the single most important variable for investors to monitor.
9. The public policy argument against the re-privatization of Fannie Mae and Freddie Mac.
Harley Bassman presents a strong public policy argument against the re-privatization of Fannie Mae and Freddie Mac, framing it as a fundamentally flawed idea that would harm American homeowners. He begins by explaining that these government-sponsored enterprises were created to support the housing market, which constitutes 18% of the economy. Their primary function is to securitize mortgages, providing liquidity to banks and making home loans more available and affordable by lowering interest rates. This is possible because the mortgage bonds they issue are perceived as government-guaranteed, eliminating credit risk for investors. However, this system created a classic moral hazard when Fannie Mae went public, bifurcating risk and return. Private stockholders and executives reaped massive profits from taking on excessive risk, while the government was left with the losses when the system collapsed during the 2008 financial crisis.
Following the crisis, the entities were placed in government conservatorship rather than being fully nationalized to avoid a catastrophic spike in the U.S. debt-to-GDP ratio. Bassman argues that re-privatizing them now would simply recreate the same moral hazard, allowing a few wealthy investors who own the remaining private shares to make billions. These investors would once again capture the upside, while the government and taxpayers would implicitly retain the downside risk. If the entities were truly privatized without a government backstop, their bonds would trade at wider spreads to reflect the new credit risk. This would directly translate to higher mortgage rates for all Americans. Bassman quantifies this impact, stating that even a quarter-percent increase in mortgage rates would raise the median homeowner’s annual payment by approximately $800. He concludes that this is an “upside down” public policy, effectively transferring wealth from average citizens to a select few and prioritizing a one-time financial gain over the long-term affordability of the American housing market.
Harley S. Bassman
The Convexity Maven
Harley Bassman created, marketed and traded a wide variety of derivative and structured products during his twenty six year career at Merrill Lynch. In 1985 he created the OPOSSMS mortgage options product that facilitated risk transmission between MBS originators and financial institutions. In 1988, he assumed responsibility for trading and marketing IO/PO and other levered prepayment securities. Soon after this, he started purchasing RTC auctioned MBS Servicing rights and repackaged them for the securities market as BIGS – Beneficial Interests in GNMA Servicing. Later, he started a GNMA servicing conduit becoming one of the Top 20 originators in 1992. As managing and hedging prepayment risk became a priority focus for the financial markets, Harley created PRESERV, Merrill’s trademarked Prepayment Cap product. Merrill was a leader in this product category writing protection that covered the risk on tens of billions of notional mortgage servicing rights. Later, Harley managed Merrill’s initial venture into off-balance sheet mortgage trading.
In 1994, Harley assumed responsibility for OTC bond options.
Within a year, Merrill was the leader in this product sector. A wide variety of products were offered including vanilla and complex options on MBS spreads and the Treasury yield curve.
To help clients more fully appreciate Volatility as a primary risk vector, he created the MOVE Index. Similar in form to the VIX Index, it is now the recognized standard measure of Interest Rate Volatility.
From 1995 to 2000 he focused on creating hedge strategies for MBS servicers and portfolio optimization techniques for Total Return and Index investors.
Harley became the manager of North American MBS and Structured Finance trading in 2001. During his tenure, he created SURF, (Specialty Underwriting and Residential Finance), a self contained Sub-Prime mortgage conduit. He supervised the issuance of Merrill’s first Sub-Prime securities. He also transitioned the structuring business to a new technology platform.
In 2006 he built the RateLab, a full spectrum US Rates Trading Desk Strategy Group. Here he worked with investors to advise and optimize their risk exposure. As a key member of the client trading business, he facilitated activity by providing liquidity to both the firm’s clients and market makers.
After a (too) brief sabbatical, in 2011 Harley joined Credit Suisse’s Global Rates business where he identified and integrated investment and hedging opportunities for sophisticated investors.
Most recently, Harley was an Executive Vice President and Portfolio Manager at PIMCO – a leading global investment management firm. Here he managed investments for the Liquid Alternative products group as well as advised on portfolio strategy across asset classes for the firm’s franchise businesses.
Presently, in addition to penning an episodic macro-economic Commentary, he manages a “hedge fund of one”.
Harley splits his time between Laguna Beach, California and New York City. He has a B.A. in management science from the University of California, San Diego and an MBA in finance and marketing from the University of Chicago.
TRANSCRIPT
[00:00:00]Harley Bassman: If you want to go and play Robinhood and do options, be my guest, but most of you should be constructing longer term portfolios where you are not going to trade that often.
Structure it right, size it, and at the end of the day, I can assure you, you will be better off. You will not be as much fun at a party, but you will be smiling at the end of the day.
[00:00:32]Adam Butler: Okay. Good morning, good afternoon, good evening, wherever it is your time. I am here with Convexity Maven, Harley Bassman, who is back on as a guest after two or three years. Harley, we had you on in, it was probably 2019 or 2020. Now, is pre-pandemic, I think. And, I know it was interesting. You had a really neat trade set up that you were working on, that you were deploying as an Exchange Traded Fund (ETF), which worked out really well.
I want to get into that a little bit later. Harley, you are currently what, a managing partner at Simplify ETFs?
[00:01:10]Harley Bassman: Yep.
[00:01:11]Adam Butler: Also invented the MOVE Index. Harley, let us start with what is the MOVE Index and how did that come about?
[00:01:21]Harley Bassman: I suspect, thank you for having me back. Fun to be here. The VIX came out, I think, in ‘94. At the time, I was running bond options at Merrill Lynch and I saw the VIX and I thought, wow, that is a darn clever idea, because the problem you had with options is how do you explain it to people? How do you level set what is high and what is low? And the VIX basically does that, in a very easy kind of way, that is easy to calculate.
I thought I would do it for bonds. It is a good way for me to go and sell options to clients at the time. It was 30 years ago, and the MOVE actually goes before the VIX because I have data going back to 1988 already in my system. So I could populate six years just with the drop of the hat. So actually the MOVE is, if you pull it up, we will go longer.
The VIX, it is just very simply a blend of one month implied volatility options on the two year, five year, ten year, and 30 year, weighted 20, 20, 40, 20, double-weighting on the ten year, because that is the benchmark for most trading, and that is it. And it is always a one month option.
You’ve got to be a little careful about it because, since it is always one month, sometimes you will get two payrolls in it, or you will pick up an extra business day. That is interesting, and so it will jump for one day. So you’ve got to be a little careful about that. Same thing with the VIX, by the way. But that is it. And the old rule was you buy at 80, you sell at 120.
This changed after the financial crisis when vol really got drilled down in the fifties and sixties, four years ago before they started hiking.
And the problem you have with the strategy of you buy it low and sell it high, is that when it is trading 60, 70, 80, nothing is happening, and nothing is ever going to happen ever again.
Why would you possibly buy this ticking, decaying, asset where you are burning theta? So no one buys at the bottom, and what is up at 140?
You are at your desk crying for your mother. No one sells options up there. They are all out of their minds. So, it gives you a sense of what is happening, but people really do not make any money off of it.
[00:03:45]Adam Butler: That is the same thing with the VIX, right? You just spend so long with the VIX hovering between 10 and 15, and it just feels like nothing is ever going to happen again. And the term structure is so steep that to buy puts against something happening is just so expensive. Like you say, you are burning so much theta, and then by the time it pays off, no one is actually able to capitalize on it. And then once you are in full panic mode, the last thing anybody is thinking about is, I want to sell vol.
[00:04:23]Harley Bassman: Oh, when the VIX is over 40, no one is selling vol.
[00:04:25]Adam Butler: Yeah, exactly.
[00:04:27]Harley Bassman: Which is why I said 40.
[00:04:28]Adam Butler: Right. So then, so who were the natural buyers of this when you created it? You were reaching out and you were pitching this buy at 80, sell at 120. Was this a structural trade that some institutions put on, or was it tactical?
[00:04:43]Harley Bassman: All option trading is basically the same when you think about it. And this is for Equities also. When you sell an option, a stock is trading at 100, you sell the 105 call for three points. What are you doing there? What you are really doing is you are taking potential possible future gains. If stock was above 105, you are taking as income right now, you are taking in the income, and so the most you can make is that three points.
You could not say lose because it is a covered call, but it is really a conversion process, kind of like this mathematical idea of converting capital gains into income, back and forth, and people have various needs at various times to go and do that.
I mean, if you really look at, we were hiring in the nineties, all physics PhDs. That is who we hired under the trading desk. The reason why is at the end of the day, derivative financial trading, financial engineering is just the physics of money. That is it.
When you look at delta, gamma, theta, all delta is velocity. All gamma is acceleration. It is the exact same thing. If you took ninth grade high school stats and tenth grade physics, you could do my job. We just changed the names around, make them Greek so it sounds sexier, but there is no difference. It is all the same formulas.
[00:06:04]Adam Butler: That is right, grade 12 ballistics. VT plus one half AT squared, then you can do most options math. So yeah, that is a good insight. Alright, and so as Convexity Maven though, you were migrated to identifying or monitoring markets, primarily Fixed Income markets, looking for highly asymmetric mispriced trades.
So what that often meant, presumably, is that you were oftentimes really quite early to the game, which meant that by its very nature you ended up burning some theta before the trade actually paid off. Can you give me any good stories or examples?
[00:07:01]Harley Bassman: For the first part of my career I was an option market maker, basically like three, six months on in. That is very heavy lifting, and why I lost most of my hair. After I became more of a prop hedge fund trader, later in my career, I pushed my trading out to three to five to ten year trading.
Where I have an idea. I think I am right. I am pretty sure I am right. I start the timing of it, and where the opportunities arise is when you get these weird discontinuities and the biggest one being the shape of the yield curve.
So, some simple math here. You are advising grandma, okay? She has $10,000. She wants to invest it. The one year Certificate of Deposit (CD) is trading at 3%, the two year CD is trading at 4%. What do you tell grandma to do with her money? Very simple actually. You can create a situation of I can earn 4% for two years, or I can earn 3% for the first year.
What do I have to earn the second year, the second one year period, so those two one year periods equal 4%? That is called the forward rate. And in this case, ignoring compounding, it is five, right? I get five, I get three, that is 4%. So the question is, do I think the one year rate will be above or below five one year from now? That is all there is to it.
People will talk about forward rates as being a prediction. That is false. It is not a prediction. In fact, people say, that kind of gets me angry. It is not a prediction, but it is the back end of an arbitrage-free process.
If you remember the book, Liar’s Poker, what Salomon Brothers did in the early eighties was they figured out how to trade forward rates before anybody else did. They basically created free money by buying and selling this one year, one year forward rate.
What happened in the last cycle here was, we had interest rates go down to zero five years ago, and we had the MOVE go to 55. I thought, being a University of Chicago (UChicago) MBA, I believe that you print money, you get inflation, not right away, but that is it. If I have $10 and 10 loaves of bread, then it is a dollar a piece. If I go and print five more dollars out of nothing, at some point I make no more bread. The bread goes up in price, okay?
I want to buy an option, a put option on the 30 year Treasury, but I wanted to be way out there. I bought a seven year option on the 30 year Treasury basically, and we put that into an ETF, and this is the magic of why I came out of retirement. It is to simplify what we do.
There was a rule change five years ago. The Securities and Exchange Commission (SEC) allowed people to put IVs, futures, options, swaps, everything else into ETFs, that became legal. At my firm we did this.
So what we do is we take professional investment products that the big hedge funds, the Citadels use, the state of California, Prudential Insurance, and we use exact same products from Morgan Stanley, Goldman Sachs, JP Morgan, and put them into ETFs.
So I was able to go and buy a seven year option. Believe it or not, they exist, and they trade rather easily on the, not the exchange, but dealer to dealer. And I put it through ETF, and this thing went from 37 up to 114, two years ago when the Fed started hiking rates. That was a pretty good deal there. That is all it was.
[00:10:54]Adam Butler: That was a great pass. I remember watching that whole story. We interviewed you during the evolution of the thought process. The execution was brilliant, the payoff was amazing, and yeah, that rule change has just enabled such a proliferation of incredible new tools for advisors.
The ability to stack derivative-based, or levered, or option-based type strategies on top of other types of core exposures create very specific types of payoff functions.
We do the same thing at Return Stacked® ETFs, stacking Managed Futures style strategies on top of core S&P or bond exposures, and just the tools available to advisors right now are truly incredible.
I am wondering why you chose the 30 year there, instead of, if the bet was that some combination of monetary and fiscal was going to inevitably create inflation. Obviously the bet was you are going to create inflation in the next seven years.
Why not go to take a bet on the on shorter rates, on two years or five years, betting that the Fed was going to have to react to that and you would get a higher, the 30 year was not a Treasury, but the two year was, sorry, it was not at zero, but the two year was pretty close.
Would you have not gotten a larger payoff on that, or what was, the premium on those options on the two year is just so much larger than the 30 year. How did you come about that specific bet?
[00:12:32]Harley Bassman: It was somewhat technical in terms of the shape of the yield curve, and this gets really into the weeds that I am not going to do here, but also there is the, if I am trading the front end, so basically zero to five years, I am really talking to the Fed and certainly zero to two is all the Fed.
Do I know what the Fed is going to go and do? No, I do not. I know what they should do. I know what they should not have done, which is they should not have kept doing Quantitative Easing (QE) in 2013. If the Fed had just done the zero rate thing in 2013, stopped it, I do not think it would have had all the problems we have had since then.
I am not the Fed, but the back end that is going to be more market controlled, and so the Fed printing money will go to the back end, and also the shape of the yield curve back then and the implied volatility, it gave me a lot more leverage. I had to go put fewer dollars to work to get the payoff I wanted.
It is very important for people to understand is there are different ways to get leverage. Usually people hear the word leverage and think margin call, they think bad, which is true. There are other ways to get leverage.
Buying an option is a way to give you leverage without being exposed to a margin call. You have taken the leverage and embedded it into the actual structure of the security as opposed to something like buying futures contracts and levering that up. So it is once again a little complicated.
I suspect your listeners here understand what I am talking about, and Return Stacking is just adding leverage, but when the return stacks are negative correlations, it actually reduces risk as opposed to increasing it. This is what Bill Gross did, we are basically PIMCO Jr.
Bill Gross was the first guy to put derivatives into a 40 Act fund in ‘85, ‘86, where he started buying futures contracts, as opposed to buying the cash ten year. Then with the conserved cash, he bought floaters. You go and you beat the index by 50 basis points for 10 years, and they call you the Bond King.
[00:14:58]Adam Butler: The Bond King. Yeah, for sure. He unitized Portable Alpha, right? Obviously Portable Alpha had been around for a lot longer than that. Then he put it in a Unitized 40 Act product, and to be fair, really delivered for investors too, using structural alpha, but still, it was a real innovation.
So this actually dovetails, the bet that you had made several years ago, which you wrapped into the ETF, the bet that it was inevitable we were going to get inflation, and how can I create this highest convexity payoff structure betting on this inflation?
We were chatting before we went live about the fact that at ReSolve, we focus on really diversification, like global diversified risk parity portfolios, trying to account for the major muscle movements that dominate asset class movements, changes in expectations for growth and inflation.
Depending on the sources of growth, the sources of inflation, you have got kind of disinflationary growth or inflationary growth, or disinflationary contraction or a inflationary contracts or stagflation, these types of regimes. You try to put assets together in balance so that they generally hedge one another against these different types of risks and environments.
Let us call this kind of an All Weather portfolio or a Global Risk portfolio. A certain risk parity portfolio, we certainly did not invent it, it goes all the way back to Harry Brown and further back than that.
One of the things we noticed about the Harry Brown permanent portfolio, or All Weather, or Global Risk Parity, and even when you start to stack on more sophisticated managed futures style strategies, is that there are still these periods in 1991-94, 2004-2006, 2013-2017, which just seemed to take the wind out of the sails of all of the different asset classes at once.
They all go down together, bonds, gold, commodities, equities, they all tend to fall in concert. There is this systematic risk factor that is just not in a typical kind of Global Risk Parity portfolio, but which is a major vulnerability of all of these types of portfolios.
I thought that you would be a really good one to have some thoughts on what might be missing there. I think you have come at the market and were raised in the ecosystem that it might be right in the sweet spot in helping to discover what is missing there.
We will just walk through how an investor might be able to patch this potential hole in the portfolio diversification equation. What are your initial thoughts on that, given those specific time periods?
[00:18:07]Harley Bassman: Ray Dalio became a billionaire for risk parity, an idea that may have been already out there, but he just took at times, a hundred billion.
[00:18:17]Adam Butler: Right.
[00:18:19]Harley Bassman: The idea would be you have a hundred dollars, maybe you put a hundred into stocks and 40 into bonds, but via futures, and you kind of lever it up that way.
As long as stocks and bonds go in different directions, you actually reduce your volatility of the portfolio, even though you are levered up. The problem is this, you are looking at a correlation, looking backwards. You are adjusting the sizing based on that correlation, but that all assumes that the sign is negative. That one up, one down. Where did they both go together? I have written about this for many years. You go to my website and find all my stuff writing about this.
[00:19:02]Adam Butler: Let me pause because I want to make sure that we are discussing the complete picture here. So I want to expand the canvas a little bit, but beyond stocks and bonds here, because we agree on this, right, that just inverse vol weighting stocks and bonds leaves a massive hole in your portfolio from a risk perspective, which is the inflation risk, right?
Where stock and bond correlation converges on one, all of the diversification benefit that you expect between stocks and bonds is expected to go away mechanically during an unexpected inflation spike, which is why you want to also add things like commodities and gold and Treasury Inflation-Protected Securities (TIPS) or breakevens, for example, to the portfolio to try and hedge against the convergence in correlations between stocks and bonds during inflation spikes, right? So just to expand the canvas and set the table.
Even a portfolio that contains all of the elements that I just described still has these weird air pockets, right? I just wanted to make sure we started there instead of starting at the gap with just the stock, bond, risk parity, because I think we would all be in agreement on that one.
[00:20:20]Harley Bassman: You hit the nail on the head. Data shows that when inflation goes above two and a half, or ten year rates go above four and a half, the sign on the correlation flips and they both go positive. Both go negative as far as everything else. What happens is, because people tend to use these strategies very commonly when the sign flips, so they are both going up and down together.
They have to delever. What they do is they sell everything. You have seen gold and TIPS and everything else go down the tubes. I would not say that tends to be temporary.
[00:20:53]Adam Butler: Yeah.
[00:20:54]Harley Bassman: Which is why I always say sizing is more important than entry level. Trying to time it, you are going to fail, okay? You got to size it so you could take a rattling of the markets and not get stopped out, because that is what happens with these markets is, everything goes south. Correlation one: people get stopped out, they do not get back in again, and then the whole thing unravels.
[00:21:19]Adam Butler: Let us go back to ‘91 and ‘94 and even ‘04. I think the amount of these kind of levered, diversified kind of permanent portfolio, All Weather portfolios, they were still pretty small relative to the size of the overall markets, and yet you still do have these periods when kind of everything goes down together.
Maybe if we sidestep this whole discussion of kind of risk parity and just talk more about these strange environments where diversification fails, where you’re a typical kind of long-only portfolio that is trying to diversify between inflation and growth sensitive assets, all of those inflation and growth sensitive assets all flop together, right?
My supposition, which I mentioned before and which could be totally wrong, which is what I wanted to grind through with you, was that it might be due to an unexpected increase in the expected cash rate, right? The Fed comes in and either jawbones a potential unexpected rate hike that the market had not been pricing or expecting, or they actually come in and do a surprise rate hike. Maybe the market was expecting 25 and they came in with 50 or 75, but something happened.
I am just wondering, so first of all, am I right in my intuition that many of the time periods that I highlighted may have had that drawdown in everything partly, or mainly for that reason? Are there other things at play? Then we could talk about how can a long-only investor best diversify against that kind of everything falls together outcome?
[00:23:17]Harley Bassman: I do not think it is the surprise factor that you mentioned. I guess you could be, everything is a surprise nowadays. I think it is the inflection points on the yield curve, or really the inflection point of the Fed which kind of dries it. If the Fed is hiking rates and they hike and they hike, that is not quite a surprise. You kind of know what they are doing.
It is when do they come, when do they get a reverse course? When is the first cut coming? And that is what we saw happen over here. That is when the markets ran, and when the first hike happened, rates were zero for a long time. When they hiked, well, then everything blew off the map. I think identifying these inflection points in the Fed and thus more importantly in the yield curve is important.
If you go look back, the curve was max-inverted in late ‘23, ‘24, and it is now positive and it might go and it is probably going to go a lot more positive. I think it is the yield curve that is driving it. That has been driven by the Fed.
So it is not the actual, if they are in a hiking process and you are 25’s and toss in a 50, like you might call it a surprise, I would say it is going the same direction. It is stopping, is also not a big deal.
[00:24:36]Adam Butler: So it is more this sort of inflection point.
[00:24:39]Harley Bassman: When they turn.
[00:24:40]Adam Butler: When the market has been going along as if the Fed is going to stay loose forever, and the Fed makes the first noises, or takes the first steps on the tightening cycle, that is when you get these big downdrafts.
[00:24:55]Harley Bassman: Or the easing, actually, easing in theory is helpful because you lower the present value of cash flow changes, but when they are cutting rates, that is a signal. Probably they are worried about the economy and that could be a challenge, and also the back end of the curve often goes up, which we saw this time. Everyone thought when the Fed cut rates, we were going to see everything come down. It did not. Twos came down by a hundred and bonds went up by 50.
[00:25:28]Adam Butler: It is not so much always that the backend goes up. It is that the, what is it again? It is a bull steepening, right? It is like the short-term rates come down faster than the long-term rates.
[00:25:43]Harley Bassman: But this time here, we actually had the backend go up.
[00:25:48]Adam Butler: In the modern context.
[00:25:49]Harley Bassman: This is not, we have not invented tragedy here. This has happened before.
[00:25:55]Adam Butler: Gotcha. Okay.
[00:25:56]Rodrigo Gordillo: Sorry to interrupt, but I did want to take a quick second to remind listeners that while we do absolutely love providing our audience with world class guests and weekly investment insights, we wanted to remind you that we actually do our best work outside of this podcast. We try to do this by providing cutting edge, globally diversified, and systematic investment strategies that are designed to be broadly non-correlated to traditional equity and bond portfolios.
We actually manage private and public funds, as well as bespoke separately managed accounts for investors that seek the potential to smooth out portfolio returns in the long run. If you do want to see that theory that we have been talking about put into practice, please do go ahead and check us out at www.investresolve.com. Now back to the podcast.
[00:26:38]Adam Butler: In ‘91, ‘94, there is not just one type of situation. It is not just the Fed is unexpectedly hiking. It is also, where is the yield curve when the Fed pivots? That is also a really important context.
[00:26:57]Harley Bassman: Look, up until now, at least, what has been the best predictor of recession? Inverted curve.
[00:27:08]Adam Butler: Right.
[00:27:09]Harley Bassman: Two-tens, but actually three month to ten year Treasury, not swaps, that has the best historical 40 year record of particularly a recession, which, we have this a while ago and it, we came out recently, where it finally flipped over.
Theoretically, we are supposed to get a recession in six to 18 months. Theoretically, we should get a recession between December of this year and June of next year. Will that happen? I do not know, but that is the best historical correlation of recessions.
[00:27:46]Adam Butler: For a global portfolio that is risk balanced between Treasuries and equities and gold and commodities, a recession is painful because the equities and the commodities obviously drop, but the equities and commodities, they do not have a huge amount of weight. Gold can go either way, right? Gold can drop, typically early in a recession and then it begins to rise once the Fed drops into negative real rates territory, in order to stimulate growth, or fiscal kicks in or what have you.
Treasuries can be relied upon typically too. Rates are going to fall and Treasuries are going to rise, and you have got a risk appropriate allocation to Treasuries. As long as you have got one or one and a half or two pistons in the diversified portfolio working, you are typically okay.
These situations that I am really trying to narrow down to that sort of ‘91, ‘94, ‘04 type situations, Treasuries drop, stocks drop, gold drops, commodities drop. TIPS, breakevens, do not do much. Those particular periods that I am mostly trying to really keen in on, I am wondering whether you have got any particular intuition on that particular situation.
[00:29:08]Harley Bassman: If you are trying to get me to predict the next…
[00:29:11]Adam Butler: No, I am not really trying to narrow in on what is the systematic risk factor. Not like what is going to happen in the next few months, but rather what is the systematic risk factor in common with those incidents and is there a strategic allocation that one could add to a diversified portfolio, that is trying to manage against inflation and growth shocks, that would help to mediate those specific types of experiences?
By the way, I am now hammering you and I feel, but I do feel like you have got some insight. What does do well when the Fed does pivot from loose, to beginning to reset market expectations for a tightening cycle? What does well in that period?
[00:30:10]Harley Bassman: I think there has been a systematic change, a paradigm shift over this last 30, 40 years that you are kind of looking at, as I think we went from a value active manager proposition to a passive flow situation, my partner, Michael Green, has done excellent work on this entire topic. Although he has been wrong on interest rates and inflation, I think he is right on passive, what is driving it.
I think what is going on over here is this. The Millennial cohort, they have jobs, big companies, they do matching 401Ks. I have told all my kids just max out those 401Ks, put 70-80% into an equity passive, I am not going to mention a ticker, S&P, put 20-30 into some IG five year corporate bond fund. Reinvest it, divs, called me in 30 years.
I think what is happening is, these flows, just from this bulging demographic of the Millennials. Remember, Millennials are actually bigger than the Boomers, by number, now. The Boomers were bigger by percent of the country, which is why we drove everything and took everyone’s money, but they are pretty big out there.
If this money keeps going into passive, value does not matter. We have all the CAPE and everything, every other value metric is off the charts right now. I do not see it changing until we see unemployment go above 5%. I am picking the number out of the hat.
I am saying that is what will stop the passive flow, is people not having jobs, because if you do not have a job, you are not getting a 401k, coming at you. I think that is going to be what is going to turn the market. I think value has no meaning, because I can guarantee you, my kids have no idea what the PE is of the S&P. They do not even care. They said we are going to do this in 30 years. It all balances out. Truth be told, they are right.
Inflation and equities are a great inflation hedge over the very long term, because a company can raise prices. By definition, inflation is raising prices and therefore the nominal return of stocks is always going higher with inflation.
The PE might be lower or higher, but if the company doubles their prices, they are going to make twice as much money and the stock price is going to double, basically with the same PE. So over the long period of time, average will go up as long as you think there is going to be population growth and inflation.
[00:32:54]Adam Butler: I think if you, my sense anyways, is looking historically that, in general, equities do well in an inflationary boom up until a certain threshold.
[00:33:08]Harley Bassman: When? When tens get above four and a half or inflation above two and a half, yeah.
[00:33:12]Adam Butler: At which point, the market tends to get skittish about inflation expectations, he inflation genie kind of escaping the bottle and…
[00:33:25]Harley Bassman: Forget that. Just the pure bond math of it. I know Amazon will make a trillion dollars in 30 years. Question is, what do I discount that trillion dollars back to today? Discounting that NPV at 2% versus 5% is a very different animal.
[00:33:41]Adam Butler: I know, I hear you. Then we had 2.5% TIPS yields out 30 years a year ago, and here we are at 22 times forward PE on the S&P. I know Mike and I have chatted extensively about the passive flows and I agree.
I wonder, I have had this hypothesis about, so there is a lot in the news lately about AI displacing jobs, I think in a way it is a little bit overblown. I think some parts of it are almost under-blown a little bit. The irony is you have got a market that is pricing AI companies as though there is going to be a massive proliferation of AI and robotics.
What are they going to do? Who is going to buy them if they are not going to massively increase productivity? How do you increase productivity by displacing lower productivity workers? The unemployment rate is going to tick higher in the, at least in the short, intermediate term while this takes place.
If that is true and the passive flows argument is also true, then I wonder if these companies are not sowing the seeds of their own destruction, because once you have got a certain threshold of unemployment, like you say, then those passive flows turn from at the margin positive, to at the margin negative, and multiples begin to contract even while profit margins at companies may continue to expand, and you may have the market kind of treading water or even dropping while profit margins continue to expand and earnings grow nicely. Is that something you guys have contemplated internally?
[00:35:40]Harley Bassman: My job is not to go predict the market. My job is to give you products that you can use to predict the market. What you are describing is fiber optic cable 30 years ago. We all have these predictions of it. We laid a gazillion miles of cable under the sea and then we discovered, oh, with all this cable out there, the price per foot is pretty small, not what we thought it was.
It is because it all went bankrupt. AI will be the same thing. The price, the monopoly profits that it is getting will stop at some point. We will find out what happens as far as job displacement. Cars came out, and all the guys who were making saddles and buggy whips, they all got jobs eventually. We had the same thing with NAFTA, out-shoring to China and Vietnam and everywhere else.
I would say that the grand political problem, which is why we have our current situation, not assassinations by the way, is that we, the government did a lousy job of transferring, retraining, helping to move around people who were doing, making furniture in North Carolina. They should have learned how to go and do welding and plumbing, because those jobs pay a bloody fortune. Any qualified welders are making over 100K a year. We, the government should have been involved in there, in this transition. I think our current politics is basically that we did not do that, thus we widened out the income gap, and that is not good.
[00:37:17]Adam Butler: The American Society of Engineers says that there is a 3.6 trillion dollar infrastructure gap in the U.S. We desperately need to replace pipes and bridges and all manner of other types of infrastructure. There could have been massive investment in retraining and deploying these to rebuilding America.
The choice was to drive all of those profits to a narrow group of companies who benefited most from hollowing out America’s industrial base, and then redeploying all those excess profits to buybacks and dividends into the capital coffers. We are definitely on the same page there.
[00:37:58]Harley Bassman: Look, but once again, what I am saying is over my horizon, all will be fine. You are saying over the next year or two, how am I going to trade this thing? You are right. Also, there will be bumps along the road.
I just do not think that AI is going to go and destroy civilization. I think we will just do different things. The computers are not going to go and weld pipes or build robots, someone is going to go and just do that other stuff for it. It is just bumpy, and I expect our politics will adjust at some point for that rational idea. I do not believe China is going to overtake us, ever, at least not in my kids’ lifetime.
[00:38:41]Adam Butler: It is funny because you either are betting, you have got all this money in market cap indices, the vast majority of which is effectively betting on AI at the moment. AI and data center investment is propping up the economy and AI market caps and expectations are propping up the cap-weighted indices.
That obviously is predicated on the fact or the expectation that AI and robotics is going to be broadly embraced by the global enterprise market, which if it is true and happens on the timeline that might justify the valuations and the investment that we are seeing, would result in massive job displacement.
You have got that kind of bet already happening, but if it plays out like that, I think you are going to get unemployment that would then undermine the valuation expansion or multiple expansion that we have had through passive flows.
You have just got this weird kind of reflexive bet on at the moment. I think that, I think it is fun to toy with everybody’s expectations, and if everybody gets what they want, will they actually get what they want, or will something very different happen at a market-cap investment level?
[00:39:58]Harley Bassman: Not to go and shill my own products, but we just came out with a new product six months ago that is the opposite of the bet of rates going higher. It’s a bet that rates are going to go lower. It’s a seven year option on the 10 year rates.
You should be happier. It’s a 10 year, not a, not the 20 year, and this option because of dynamics, and you go to my website, I’ve written about this, actually earns a positive 2% yield. You’re long an option, limited loss, unlimited gain, with a positive yield.
[00:40:37]Adam Butler: Okay, so what’s the bet on, what’s the bet you’re making here, Harley? This is like the next version of your other bet, the PFIX bet, right?
[00:40:49]Harley Bassman: It’s the opposite. Yes.
[00:40:50]Adam Butler: Yeah. So why this and why now? Why is it structured this way?
[00:40:56]Harley Bassman: I felt that up at 5% on bonds we’re getting to the higher end of the range. Could it go higher? Yeah. Could inflation keep going? I think it will, but we’re getting up to where that’s starting to be an impact on society.
So now it’s will we get that transition? Will the Fed start to cut, maybe even more than just a little, because they have to, because actually we do have that recession coming, as the curve kind of indicates. If that happens and you get those power windows down rate environment, having a 40 duration instrument with positive carry, think of what you can do with that.
You only got a, the AG is a six, six and a half duration. I could put a dollar to work and get a 40 duration, so I only got to buy 15% to get the same duration exposure. And the other 80% can go to any, get the gold to this, to that and do your return stacking idea. That’s pretty clever.
The trades I like, I mean there’s been some of these, I’m not going to mention tickers, floating rate loans that yield 7%, 8% or some of the Business Development Company (BDC) equities, they are, they yield 8, 9, 10%. If you get 8, 9% compounded, that’s equity returns forever.
You have credit risk in there. What’s going to cause the credit risk to go and go south? It’s going to be a recession. We got recession rates, it’s going to go down hard, it’s going to hard.
I got a 40 duration asset in my pocket. I’m looking pretty good, and that’s the clever idea of getting leverage via this option, as opposed to buying five futures contracts. You have five futures contracts, all of a sudden you lose five to one on the way down. Also, you buy an option, you lose one for one, make three to one, four to one.
That sets a different, that’s pretty clever, and once again, these are professional instruments that are available, only the pros, and putting them into ETFs is a clever idea. So that would be my best idea right now is to go and buy this long-dated call option. You don’t go buy a lot of it, and then put some income producing investments in there.
I’ll say one thing that’s very important is when, if you go look at anything that’s not like ultra high grade, in fact even IG also has a negative duration, high yield’s a negative duration. You can have rates go down by a hundred and have high yield bonds go south, because that spread can widen more than the bond. The Treasury goes down.
That’s why you got to go and buy over, buy duration. So if you go use this option ETF, you could get 12 duration in that by buying twice as many of it and that’ll offset you, put that with a high yield product. Not there you go.
You’ve got a high yield instrument portfolio with an embedded insurance policy.
[00:44:15]Adam Butler: High yield spreads are pretty grim at the moment too. What do you see as the sort of ideal pairing like between the trade that has the best current carry, but that is most vulnerable to the type of risk that the new product that you’ve constructed is best designed to hedge?
[00:44:42]Harley Bassman: I like buying the loan products or the BDC products and then pairing that with my levered call option product.
[00:44:54]Adam Butler: Leveraged loan ETF plus A.
[00:44:57]Harley Bassman: You know who they are, or the BDCs, I like them also, and the big, there’s four name brand ones. There’s one that’s really big. I own them, and they’re not going to blow up. I would say that sometimes if the yield’s too good to be true, it is okay.
You’re better off sometimes taking a little lesser yield and having a product that’s just not going to blow on you, and there’s a lot of people who look at these very high returns. If you’re looking, it’s like it’s yielding 12%, there’s a reason for that. Junk bonds yield 6, 7, 8. If I’m getting 12, I’m taking a risk. And now it might be risk you want to take, and I’m fine with that. I will tell you, likely you don’t, you have not looked under the hood to see what risk you’re taking.
[00:45:58]Adam Butler: Yeah, no, I hear you. So you’re able to get a 2% carry. Is that because the yield on the underlying is higher than the carry on the option?
[00:46:09]Harley Bassman: It has to do with the fact that when I buy the ordinary options that you buy and sell on the exchange, you have a suitcase full of cash and you give it to someone, they give you an option or vice versa. They give you a suitcase full of cash, and trade’s right there.
In the Pros market, we don’t trade options by giving you cash back and forth. We say, I will pay you.
So a seven year option on the ten year rate that I do with Morgan Stanley or Goldman Sachs, we agree upon a price and I’ll pay you at expiry. I’ll pay you in seven years, and we do all the calculations, and when we do that, we solve a lot of problems, because we don’t know what the rate that Goldman Sachs borrows short-term money at is different than where Morgan Stanley, worse than that.
Think about company in Switzerland, company in Japan, company in Germany. The Euro with the yen, the short term rates are everywhere. It’s very hard to agree upon what a future, what a thousand dollars a year from now is worth. We all agree it’s worth a thousand next year, but what’s worth today, we don’t know.
So we, what we’ve done is we trade forward and everyone’s happy, so I buy these options forward, so I have all the cash, I put the cash in. The Treasuries are earning 4.25%. The option itself decays very slowly because it decays at the square root of time. So going from root 7 to root 6, not that big a number, whereas going from root 3 to root 2 is a very big number.
So that, going that long day option, time decay goes up and flattens as opposed to interest rate, which goes linearly. When you have this versus that, that little triangle out there is positive carry, and that’s, and once again, that’s why I like dealing with these long-term options because they allowed me to go and do something.
Usually people want to go and they want to make money right now, they want to go to the party and brag what they did. I guess I saw in the news, some Twitter thing yesterday, some guy bought an Oracle option for a penny, and it was ended up being worth $8. The end of the day, it’s fine, the guy’s a hero, but away from that small detail over there, you should not, if you want to go and play Robinhood and do options, be my guest, but most of you should be constructing longer-term portfolios where you’re not going to trade that often.
Structure it right, size it, and at the end of the day, I can assure you, you’ll be better off. You won’t be as much fun at a party, but you will be smiling at the end of the day.
[00:48:53]Adam Butler: I love it. Alright, I want to talk about your letter about Fannie/Freddie, but before we do, any other low hanging fruit kind of opportunities that you feel are page 16, could move to page 3 and eventually to page 1 over the next three to six months.
[00:49:13]Harley Bassman: Look, mortgage bonds are still the cheapest, the best risk/return out there. They were trading 175 over. They’re now 100 over. That’s still more than their long-term average and it’s still more than credit bonds. They’re trading only 50 over, so you won’t get rich, but new issue mortgage bonds, yielding five and change. I’ve done dumber trades than that to go put money at 5% with no credit risk. It’s not a big winner, but that’s what’s part your money.
Other than that, things are, we are in this transition period now, the Fed kind of turning over and the curve going positive. It’s plus 50 right now, twos, tens, it’s going to go back to a hundred. I could promise you that. The question is, how’s it get there? Front end, down back, end up.
The most important thing from a macro standpoint, from my view, is this. It’s not tariffs, it’s not tax, it’s not regulation. They’re important. That’s not where the rubber hits the road. It is immigration policy. I’m telling you right now, this is the big one.
There’s the government, not withstanding them being fired all the time, has calculated there’s 75,000 illegal immigrants who were bad guys, bad girls. Also, they have tickets, they do bad things. We go and deport them. I’ll go buy the ticket and pay for the gas. That’s, ship outta here.
We start going up to a million people. That’s a whole different animal, because Gross Domestic Product (GDP) is people, times hours, times productivity. That’s it, nothing more, nothing less, people, hours, productivity.
Productivity ain’t going to get that much better. I guess you could say AI maybe, but not really. Hours, how much more can you work? It’s people, it’s population. We have negative net immigration right now. We have a birth rate in this country under 2.1. Theoretically we have negative population growth right now. That is not good.
Jim Bianco in his last Macro Voices said that because of this calculation where we used to need 120, 130, 140 payroll every month to break even, he thinks it might be only 20 or 30 now, break even because population growth is negative.
If he, if we really go to the screws here and kick out a million people or more. That’s going to be really bad. I promise you, this will end in tears. I’m not making a comment whether it’s good or bad. If you believe that we have an immigration problem and you sincerely believe that we should deport a million people, I will say, that’s your opinion. You’re welcome to it. I have no problem. Just know there is a cost to that. If you’re willing to pay that cost, God bless you.
[00:52:17]Adam Butler: Yeah, if you want to deport people and you understand that GDP is number of people, times hours worked, times the amount that you’re paid, then you just, I guess you need to have a policy that is ready to provide enough fiscal to offset the negative shock from these private sector employment deportations.
[00:52:45]Harley Bassman: It’s stagflation, man. We’re going to have lower GDP and higher inflation because you know what, if we lose the immigrants who are working in the chicken plucking factories and send ’em back to Mexico, we have to raise the wage, the marginal wage to bring in different people into that job, or we’re not going to be eating chicken.
So it is inflationary and negative GDP. This is a, this is the big one. If we go through this policy, by the way, he might stop, we might stop doing it.
[00:53:12]Adam Butler: Right.
[00:53:13]Harley Bassman: I’m just saying that’s to watch out for, is the immigration policy.
[00:53:17]Adam Butler: Great insight. Alright, let’s pivot to your recent letters. You said you had a longer letter, which I read a few weeks back, and you’ve now condensed it, and submitted it to some popular newspapers, journals, et cetera. What’s your main thesis here?
[00:53:40]Harley Bassman: Look, Fannie and Freddie, Ginnie, they were created by the government to go and support the housing market. If you remember the movie, It’s a Wonderful Life, the Savings and Loan (SNL), they make loans to people to buy houses, and let’s say they have a hundred dollars, they make loans for a hundred bucks. Once they loan all the money out, that’s it. They can’t loan any more money.
What the government did was say, okay, we’re going to securitize these loans, so the bank could take that a hundred dollars in loans, give it a Fannie, Freddie, Ginnie, they’d securitize it, make it basically government guaranteed bonds, sell ’em to the market, a hundred dollars comes back to the bank, they could lend money again. It’s a way to go and massively increase the available funds for housing. Housing is 18% of the economy.
[00:54:31]Adam Butler: You did a really good job in your letter, Harley of explaining the public good the creation of Ginnie and Fannie and Freddie did in the economy. What was the initial motivation for, so you talked about it, but I just want to make it really explicit, that this was policy that was brought in by the government, expressly to allow every American to own a home at the time, was the ambition.
[00:55:04]Harley Bassman: To help, lowering, by significantly lowering interest rates, you made housing more available. Remember, nobody buys a house, a rich guy buys a house, or they don’t buy a house. They sign up for a payment plan. The payment plan is driven by the price of the house, more importantly by the interest rates. You bring that rate down by 2, 3 points, all of a sudden, that massively changes the ability to go buy a home, because your payments come down by a lot.
[00:55:31]Adam Butler: Yep.
[00:55:32]Harley Bassman: That’s what Fannie and Freddie and Ginnie have done, is massively lowered it, because now people who buy these mortgage bonds, it’s government guaranteed money, so they have no risk. Would you take out a, would you give a loan to your next door neighbor?
I doubt it. You charge him 15% probably. You have no idea who this guy is. Take it out government money, ah, fine. So they radically changed the availability of housing to do that. They lowered the price, and increased the availability.
The problem we had here was that Fannie Mae went public and had an Initial Public Offering (IPO) in ‘68, and what you did was you created this bifurcation of risk, where the stockholders got the upside and the government got the downside.
So what the guys at Fannie Mae did was they said, good idea. Let’s go and juice it up. They bought $750 billion of their own mortgage bonds, hedged them out.
So they thought, took those profits and they took a, they went into the stock and the value of Fannie Mae went up 8X and they got options on those stock and they got, the CEO made $90 million over the course of six years, okay? He’s supposed to be a government employee, as far as I’m concerned. He’s cleared up $90 million bucks, and then the financial crisis hits, the whole thing blows up, and the government goes and owns the bag.
This was always a bad idea. This is called moral hazard. It’s classic moral hazard, where the gains and losses go different places. We’re back to a world where the government has the whole thing, kind of, sort of. We did conservancy as opposed to pure bankruptcy.
The reason they didn’t do it is at the time, there was about $5 trillion of Fannie/Freddie to ventures and mortgage bonds out there. If the government took it onto their books, then we would’ve seen total national government debt, not liabilities, this actual debt go from $10 trillion to $15 trillion, and that would’ve taken the debt-to-GDP ratio from 65 to 100.
Reinhard and Roff, they’ve written about, once you go over 90%, you tend to have a dulled economy, which where we are now, we’re like, I think we’re 110%, 120% right now, which is why growth is also lousy. Someday we’ll have to deal with that different topic entirely.
They should just take the thing over. They’re thinking of re-privatizing this. Who wins? There’s a few guys that own a lot of this stock and they might make billions of dollars, for what purpose, to go once again, bifurcate the risk and return. The stockholders are going to go and I presume get money.
They have to take, if they get, if they earn more than Treasuries, that means they’re taking on risk, but the risk is the government’s risk once again. We’re paying people from the government’s risk, and if we actually really do privatize, which we won’t, but if we really did well, those mortgage bonds are going to trade to a wider spread because there’s more risk than them.
[00:58:40]Adam Butler: Yeah. The cost of capital to all homeowners goes up dramatically.
[00:58:44]Harley Bassman: If we only had a quarter percent, just a quarter percent increase in the mortgage rate nationally, that would take up the average or the median mortgage payment by $800.
That’s about people pay for Christmas presents, man. We’re going to suck out Christmas cheer and give it to a few rich guys. This is public policy gone upside down. It’s a horrible idea.
[00:59:11]Adam Butler: I remember reading that statement in your original letter.
[00:59:13]Harley Bassman: I’m totally against this. I hope they don’t do it. Hopefully it’s just talk.
[00:59:19]Adam Butler: How do people still own shares in Fannie and Freddie?
[00:59:22]Harley Bassman: They’re listed.
[00:59:24]Adam Butler: Oh, they’re listed, right?
[00:59:26]Harley Bassman: No, they are, they trade on their stock exchange, but they never went bankrupt. They traded for 25 cents, 50 cents a share five years ago, 10 years ago.
[00:59:34]Adam Butler: What does it mean to them to reprivatize it if they’re already trading private shares?
[00:59:39]Harley Bassman: I think the government owns most of these shares, and the government…
[00:59:44]Adam Butler: So there’s some small float that the government doesn’t own, and they’re going to…
[00:59:47]Harley Bassman: So the government will go sell these things, fine. They’ll go and make $50 billion or whatever it is. Really, they’re going to do a one shot deal of an amount of money, that’s they’re barber at the club, and basically screw all the American homeowners. This is upside down public policy.
[01:00:07]Adam Butler: They’re basically selling another $50 billion put option, right?
[01:00:13]Harley Bassman: I suppose, but it’s, it, look, it’s a bad idea in so many ways. Look, if they really want to do it, then really privatize the whole thing. Then the buyers of the stock, they’re not going to be quite as happy if they think that stock is really going to zero this time. But we can’t do that. We just can’t go and beg the same reason why. When they talk about they’re going to shut the government down, in a month or so, really, they can’t do that.
You can talk and talk, but the U.S. government is not going to default. We just can’t. So it is just more talk to go and have trading ideas. It is bothersome that we even have this kind of conversation.
[01:00:55]Adam Butler: What kind of investors are agitating for this privatization, do you think? Without naming any names?
[01:01:05]Harley Bassman: Look, it’s all public information. You just go to Bloomberg and type it on, in HDS, to give you all the names of who owns the shares. It’s real easy.
[01:01:13]Adam Butler: Obviously people with a serious profit motive and without naming names, some of them have been very public supporters of the current administration.
[01:01:29]Harley Bassman: Got to go there. All I’ll say is this. You go to HDS, the top line is 115 million shares. It was trading at a buck 50 before the election, trading at 14 bucks. Now you do the math okay.
[01:01:44]Adam Butler: Yep. Say no more. Awesome. I hope you find someone who will print it. Maybe the Financial Times will print it, like you say. That’d be great, or one of the American newspapers would be even better, but let’s hope it gets some publicity, because I think it’s a really important message to get out there.
I appreciate you writing it, and I appreciate you sharing all of your wisdom and all your ideas again here with me today, and it’s always just an unbelievable pleasure.
I know you’re traveling to Italy next week, are you?
[01:02:14]Harley Bassman: Indeed I am. We leave on Saturday, my third grandchild is arriving. My daughter has a postdoc, physics PhD in Pisa, Italy. She’s working on quantum thermodynamics, and she’s been there longer than I thought she was, and she might be there even longer than I think. She’s doing very well, and someday you might go and see, she might start a company someday you’ll be dealing with her.
[01:02:38]Adam Butler: That’s exciting and I can’t think of a better reason to visit Italy. You’d want to go anyway, but to be able to visit new grandchildren and spend time with family even.
[01:02:46]Harley Bassman: I’ll say this, everyone says, oh, Italy, Tuscany, it’s incredible. It’s wonderful. I said yes. If you go for a week, you’re going to love it. I was there for six weeks for the first baby. After about week three, it’s pizza, it’s pasta, and that’s it. You cannot get sushi or Chinese or Mexican or anything else. It is affordable though. You get a great pizza for $8, a good pasta for $9. It is very affordable, so that’s good, but six weeks is kind is a little long.
[01:03:14]Adam Butler: Palate diversity matters a lot. You do not realize it until it is missing.
[01:03:25]Harley Bassman: Yep.
[01:03:25]Adam Butler: Awesome. Alright, thanks again, Harley. Really appreciate it, and I’m sure we’ll have you back on in a year or two to reflect on what’s happened, and I’m sure the environment will be completely different. We’ll have lots want to talk about, but until then, save travels and chat soon.
[01:03:43]Harley Bassman: Excellent. Thank you.
[01:03:45]Rodrigo Gordillo: I did want to take a quick second to remind our listeners that, the team works really hard on these podcasts. We spend a lot of hours trying to get the right guests and we do a lot of prep work to make sure that we’re asking the right questions. So if you do have a second, just do hit that Subscribe button, hit that Like button, and Share with friends, if you find what we’re doing useful.
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