This is breaking the dollar. The podcast that dismantles some of the biggest misconceptions about money.

Presented by Gainesville Coins.

Welcome back to Breaking The Dollar, I'm your host Everett Millman and we're going to be doing something a little bit different. For this week's episode, we originally planned on discussing how to store your gold and silver, but it was a crazy week in financial markets to say the least.

So a lot has happened and I just wanted to jump in and explain a little bit about what's going on in the repo markets and what the heck is all that.

And then we will get back to our normally scheduled programming next week.

So essentially the big news that kind of shook markets in the past week had to do with the overnight lending markets and it kind of spilled over into what are called the funding markets, like the credit markets. It has to do with something called Repo operations.

And I think a lot of us, we hear the word repo and we immediately think of repossession, but that's not what a repo means in this context.

It's a repurchase operations. Really it's a fancy term for how the interbank lending markets work for very, very short term loans.

We often call it overnight lending and you'll hear it referred to as the money markets.

This is literally short term money, so it has an interest rate under normal circumstances, very close to the benchmark fed funds rate.

What had everyone freaking out and panicking was that there was a shortage of dollars and I really mean you know, dollar assets like treasuries available to loan out for these inter bank overnight lending markets, not enough dollars.

There was very high demand.

All of the sudden for these overnight loans, the repo rates skyrocketed. Predictably, the federal reserve had to step in and as the lender of last resort and smooth over and paper over this shortfall in how many dollars were available to lend.

Now, I don't want to get too much further into the weeds of like, okay, what actually went on down in the trenches and in what people keep calling the plumbing of the financial system because really you have to be an active trader in the money markets to really understand everything that went on to explain this crazy incident and what this actually meant.

What's fascinating to me is that first of all, it seems like a very bad sign just on its face. It is an emergency measure that hasn't been used since 2008.

The fed has not had to step in with open market operations in the repo market in a decade.

That's a troubling sign about a leak springing in that plumbing or piping beneath the financial system, because normally these type of operations go on every night, every day, and it's not a big deal.

Nobody talks about it until something goes wrong.

Now, as I said, the fed initially stepped in and injected $75 billion of liquidity into the markets for four straight days.

So this wasn't just a one off thing like was initially being reported.

Obviously there was a continuing problem with the amount of dollars available to lend between banks just to cover their overnight expenses, but what I found most fascinating is the debate that this has sparked within the financial community.

So on one side you have people who are justifiably concerned and freaking out that this is a sign that the fed is losing control over short term interest rates and is having to resort to policy tools that are sort of unconventional and extraordinary at least in terms of the fed not having to use it for the past 10 years.

Then on the other side of the debate you have people who are kind of stressing caution and saying we shouldn't be alarmed because this is a somewhat normal thing that the fed can do and what it's doing is working. So there's really nothing to see here. This is not as strange as people are trying to make it out to be and this is actually evidence that the Fed's open market operations actually work.

Those are the two sides right now.

One side saying everyone's overreacting and one side saying this is not being reported on enough, this is not being treated as a big deal and between the two sides you really get into a quibbling over just the words we use that some have said and I think is fair to say, that this is really like a bailout for the banks.

There wasn't enough money in the banking system to cover overnight expenses and then there were a couple of reasons cited for why this happened, that there were insufficient reserves held by the banks, that there was this tax bill coming due for the beginning of the new fiscal year.

Those seem like kind of dubious explanations, at least the tax bill one.

I mean every bank has a tax compliance department. They have a whole department of people who handle these things.

You're telling me that the biggest banks in the country didn't know that that bill was coming up.

It's a very predictable event when you have to pay your taxes and I'm almost positive they can get an extension on something like that.

So that doesn't stand to reason that they wouldn't have seen that coming and that's why there was this sudden shortfall in the overnight lending markets.

And yet that is one thing that is being widely reported. Again, there's this perception being perpetuated in the media that there's nothing to see here. This is not a big deal and anyone who tells you that this is the beginning of a bigger problem or that it really reveals some of the deficiencies in the underlying structure of the financial system.

They want to convince us that that's all hogwash and that anyone saying that is an alarmist and we shouldn't use words like bailout and that this is not the same thing as QE, quantitative easing, and fair enough, I understand, you know, being precise and discussing things as they actually are, but I can't find any other way to comprehend what has happened in the repo markets.

As I said, for four days, the fed stepped in. It was just basically providing funding out of thin air because it has the power to do that. But for four days we heard this is going to be temporary, that they were kind of assessing the situation as they go and then at the end of last week we found out, oh no, this is going to be a permanent fixture for the next six to eight weeks or longer. To me, that doesn't inspire a lot of confidence.

It makes it seem more like a bailout because it kind of covers up the fact that it is a out. I know that this concept in itself of repo markets and overnight lending, it can be a little abstract and difficult to grasp because it is nothing like the regular person or businesse's day to day experience with a budget and with funding.

The banks really do play by a different set of rules.

The reality of the financial system is very bizarre compared to our standard form of accounting. The best comparison I can make is that it'd be as if you ran a shop.

Let's say you were a car salesman and you had a lot full of cars and all of your accounting of your inventory of how many cars you had, cause maybe you're using all of your cars as collateral for loans. It would be as if that accounting happened every morning and as long as when you shut the lights off before you leave for the day, you had X amount of cars on the lot. Let's just say a thousand, you needed a thousand cars to backup your loans.

That all you needed to prove was that you had that for the brief moment from when you closed.

When you open the doors the next morning, you could spend the rest of the business day with almost no cars on your lot, not enough cars to cover all of your lines of credit.

That sort of what this fed injection of money into the money markets really represents. It is simply on paper for accounting purposes covering the need for dollars in the banking system for the brief period overnight until operations begin the next morning.

That may be a bit of an oversimplification of course to try and connect it to the real world, but what it reveals is that the real world of banking does not make a whole lot of sense compared to what you and many actually experience.

So to put this in perspective, I think what's most important to take away from this is that we should pay attention to the actions of central banks like the federal reserve and not so much what they in the media are telling us about their actions.

Even if it's not a full blown crisis and we are all freaking out too much about this repo market stuff, if the fed has to step in and use its emergency tools, that should tell us that the financial system is not perfectly stable right now.

If the fed has to continue to cut interest rates as it did right in the middle, right in the midst of all of this last week, if it were doing that, that means the underlying economy cannot be doing great.

It needs easy credit, it needs some sort of relief. Otherwise the central bank wouldn't resort to these measures if it didn't have to.

I think that on its face is common sense.

You don't throw money at something and effectively bail something out if there's no underlying problem to address.

And so again, you get one group of people on one side of the debate that say, well, this is normal. This is nothing to worry about. It means everything is going to be okay and that's fine, but I see nothing alarmist to just being prepared for if this continues to get worse because the signs don't appear to be good.

We should be paying attention and questioning why is this happening or what is actually happening and you don't have to understand everything about how the finer details of the interbank lending market works and how repo rates work to see that these sort of structural things are going to have other ramifications.

I think this could have big implications just in the credit markets in general because leverage is so high because there are all of these collateralized loans.

It's essentially what the repo operations are.

They are loans that are collateralized, that are made up of a bundle of treasuries.

That's why it's treated basically as good as dollars. It's a very short term.

Money is not good when those things are not functioning like the normally should. When they require an intervention from the fed, they are essentially a bail out for the first time in over 10 years.

By definition, that is not normal and I think that's what we all need to all keep in mind going forward and adjusting our investment portfolios accordingly.

If you believe the thesis that we are late in the economic cycle, it only makes sense to sort of rotate into a more defensive portfolio and that does mean things like gold and precious metals, things that are not exposed to some of these imbalances and distortions and deficiencies in the financial system itself.

So that wraps it up for this week's episode. I hope you enjoyed listening today. We appreciate everyone for tuning in and as I said earlier, next time we will get back to an episode about all the best ways and potentially lesser options for storing your gold and silver. So you want to be sure to check that out.

Today's episode was presented by our sponsors, Gainesville Coins.

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Everett Millman

Everett Millman

Managing Editor | Analyst, Commodities and Finance

Everett has been the head content writer and market analyst at Gainesville Coins since 2013. He has a background in History and is deeply interested in how gold and silver have historically fit into the financial system.

In addition to blogging, Everett's work has been featured in Reuters, CNN Business, Bloomberg Radio, TD Ameritrade Network, CoinWeek, and has been referenced by the Washington Post.