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Transcript: The “Right” Price for Bonds, Demographics and Inflation, and Cheap Bets on


Featuring: Mike Green, Harley Bassman

Published Date: March 8th, 2021

Length: 01:15:24

Synopsis: With bonds selling off alongside equities and the volatility of both asset classes
rising, there is perhaps no better time to hear from The Convexity Maven himself, Harley
Bassman. In this interview with Logica Capital Advisors partner, chief strategist, and PM Mike
Green, Bassman outlines his view that this move higher in rates is the bond market finally
moving towards the “right” price after a decade of interest rate
suppression. Green and Bassman discuss the positive and negative consequences of higher
rates, a steeper yield curve, and monetary and fiscal policies like negative interest rates and
stimulus checks. They also touch on the current opportunities that Bassman sees and his
prediction of inflationary impulse due to demographics some time between 2023 and 2025.
Harley Bassman has provided a slide deck to accompany this interview which can be found
here: and his commentary on convexity can be found
here: Filmed on March 3, 2021.

Key Learnings: Bassman believes interest rates have been kept artificially low, and the current
sell-off in bonds is the market moving towards the “right” price. He also advocates for investors
to be long convexity and believes that OTM calls on equities and long-dated options on interest
rates are extremely cheap.

Video Link:
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or in connection with the use or reliance of the transcription.
MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

MIKE GREEN: Mike Green. As usual, coming from Marin County these days. Incredibly excited to have
my good friend Harley Bassman back on Real Vision for-- it's been forever since you and I have had a
chance to talk. Basically, the last time we talked was probably in the EQ Derivatives Conference in 2018,
2019? It's been a long time.

Let's talk interest rates. You are known as Mr. Convexity, you are the inventor of the MOVE index, the
equivalent of the VIX for the fixed income space. In an environment in which chaos and drama dominate
the interest rates space, there's nobody that I'd rather talk to than Harley Bassman. Harley, what the hell is
going on with interest rates?

HARLEY BASSMAN: Well, that's a good question. I would say that this notion that rates are exploding
higher and bad things are happening, it's not quite the case. I would say that when 10-years were at 0.75,
that was the wrong price. All we're doing now is going to the right price as opposed to where we were
before, which is the wrong price. I would push back at you. We've seen a significant curve steepening. I'm
quite certain we're going to talk about that today quite a bit.

I wrote about in November of 2018, I noticed, and you can see on page two, Chart 2 that the curve was
flattening and inverting, and indeed it inverted in November 2018. I said in that piece, I don't know how,
I don't know why, I can't explain it at all but by the way, the curve is the best predictor of the economy, as
well, other things but the economy, and usually you get a recession 17 months later, that's the average.
That would put it sometime in the beginning, first quarter of 2020. Lo and behold, we had a recession in
first quarter 2020.

MIKE GREEN: Now, this required you to develop a virus from bats and release it into China and then
release it to the United States, but you managed to get the recession.

HARLEY BASSMAN: Well, what I want to ask you is, do you think this counts? I'll go first. I say it does.
Because I say whenever you get some event, especially a recession, that it's always a surprise. By definition,
a surprise is unknown. Otherwise, it wouldn't be a surprise. Therefore, since the warning came, we could
not predict what it would be, but we did get it. You're saying that a bad virus doesn't count. Well, I would
say maybe a housing crisis doesn't count from the last recession we had. Does this count, Mike?

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
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MIKE GREEN: I think it does. I would actually highlight that if I look at many of the components that would
have traditionally signaled the recession, we were already there. Auto sales had slowed down, housing
sales were no longer growing at a rapid rate. We were beginning to see industrial production turned down.
We had relatively weak oil and gas prices, commodity prices around the globe. We're already weakening
going into these events.

The one thing that I would suggest people were confused by was that equity markets were at all-time highs,
that we were not seeing any real evidence of a recession from that standpoint. From my standpoint, the
profit cycle had churned. We were looking at a decline in industrial profits and business corporate profits
that's consistent with prior mild recessions. Now, it just becomes a question of, did the coronavirus actually
cleanse that dynamic, or has it somehow morphed it into something that's going to happen in the future?

I don't know the answer to that, but I definitely think you're right that the recession was predicted by the
yield curve inversion, what people should be surprised by is the equity performance into those events.

HARLEY BASSMAN: That this will then lead into we now have a significant curve steepening before we
started, that most of the curve steepening is happening from the Fed on the front end versus a rise in the
back end. I'm not quite sure about how those all line up. I tend to just look at the curve and call it a day.
The number is the number, I don't want to think too hard. If you can look at slide three now, this is a pretty
big steepening that we've had over here. We're halfway back to what is the big range.

What's interesting is we have not had what usually comes with a steeper curve. Now, when you look at
implied volatility, which is I guess my sweet spot, what is implied vol? Implied vol is a measure of fear, of
risk, of uncertainty going forward. It's the price of insurance for uncertainty in the future. I guess it's a good
segue into the bad things the Fed has done, but that's a different topic later on. Usually, you get the steeper
curve, higher implied volatility, and the reason you do that is the steeper the curve or the more inverted,
either way when the distant rate is different than today's rate, that means, since time only goes forward,
the spot rate has to become the forward rate, the future rate, or vice versa, I suppose.

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

The bigger the difference, the more uncertainty and the greater this has to travel. Therefore, you should
have a higher implied vol for a steeper curve. That hasn't happened yet, looking at this chart, which means
one of two things, either vol has to go up or you could say that since vol is not rising, that maybe that means
people believe that the Fed's going to step in and push the back end down with some kind of yield curve

I tend to be almost agnostic on some of these things, or my comment is, the two lines will come back into
sync, not quite sure how. What should be bothersome to people away from as convexity vol geeks is that
when you get higher implied volatility, you also tend to get wider corporate bond spreads, specifically high

MIKE GREEN: I agree with what you're saying there, and you and I had this conversation offline about
a week ago where we were discussing this, where my view is that we have basically seen a bond price
crash in the last week or so. My bias would be that we're heading towards a retest of that with positive
divergences, so I tend to be pretty sanguine about bonds at this point in time. I could very much be wrong
on that, but the historical demand for volatility on a yield curve steepening has two sources of it as I think
about it.

The first is that there tends to be positive correlation of volatility across asset classes, and a steepening of
the yield curve usually has been a bullish steepening of the yield curve, where the Fed is cutting rates faster
than the 10s are falling, or the 30 is falling. When you have that type of event with aggressive cutting, you
see the yield curve steepen as we did earlier in 2020. The Fed aggressively cut interest rates, and while 10s
and 30s rally, they didn't rally nearly as much in terms of percentage points as the three-month and the 2-

The other reason why it happens is when interest rates rise at the longer end, is that the mortgage bonds
increase their duration significantly. In other words, the propensity to refinance collapses, which extends
the duration of the bonds and drives private sector demand for hedging activity. That is historically why I
would think that this relationship would exist, but today, we don't see the same degree of hedging for MBS
for the very simple reason that a giant chunk of it is owned by the Fed. Does that feel that that may offset
some of the characteristics here?

HARLEY BASSMAN: Well, I've shaken off my Luddite tendencies and joined Twitter recently, and I
actually posted on this exact topic. It's on page five, part of it. What's happening here is, indeed, mortgages
widen or lengthen and shorten, because there's an embedded option. They're actually rather simple to
model and then you know what your principal payments are going to be over 30 years. The only question
is, will this bond be repaid in one month or in 30 years? That's what drives whether those bonds can be a
30-year bond or can act like a 10- or 12-year act like a one or 2-year.

For that negative convexity, negative profile, it drops like a 10-year, goes up like a 2-year. You get paid
extra yield for that. People used to try and manage that risk, who were the managers? Well, the biggest by
far was actually the government, but not the Fed. It was Fannie and Freddie, which I guess maybe they ran
these giant trillion dollar hedge funds, they're gone. Then you had people, a lot of real hedge funds, who I

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

call feeder fish who would try to front run Fannie and Freddie by buying and selling mortgages, hedge
them of swaps and Treasurys or futures, hedge the convexity with options and swaptions. They're gone.

With Fannie and Freddie, there's no reason for them to do this trade. The Fed owns a third of the market
and by the way, important detail, they own the worst of the worst, because Wall Street filters the bonds that
come on in, and they give the Fed the worst ones and they keep the good ones and sell them as specific
pools to investors at a little higher price. The biggest thing to think about here is who else owns these things?
Well, it's your favorite topic, Mike, index funds.

If the mortgage market is a third of the aggregate market and it's, let's say, a seven-year duration, seven-
year maturity on average. If rates go up, and that because in the 7-year to a 9-year, the index funds don't
care, because the index is now a 9-year, so they're not going to hedge either ad they own a lot of this, all
the people left. I guess you could say banks might own it, but a lot of them buy them on their books and
hold them to maturity, so they don't mark them to market. That leaves the REITs.

How big are the REITs? Annaly Agency, a few others, but really, it's not that big. This notion that convexity
hedging is going to drive the market, I think it's totally bogus. It's a great headline. If you work in the press,
why not do this, you need to fill the space somehow, but I think it's absurd. What's more interesting to me,
and this is on page five, Chart 5, is the spread between the mortgages and the risk free 10-year rate, the
swap rate. You can use the 10-year Treasury, it's the same thing.

This has averaged to about 70 to 75 basis points. That's the extra yield you get through 10 years. 2%, you
should get 2.75, and that's the extra yield you get for taking the risk of it goes down like a 10-year, up like
a 2-year. That's the convexity of that option. It's now trading in the low 30s, this is just playing the wrong
price. The option alone is worth more than that. It's actually a negative bet.

I'm not trying to describe this thing, but why is that? As a public policy concept, I suppose it's good because
the Fed is keeping this REIT suppressed and people can refinance at advantageous rate. That's a good
thing. What's bothersome is that if the Fed ever releases their grip, you can see the mortgage market

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

propped by a point, a point and a half day one because there's no marginal buyer to take on these securities
with a negative option-adjusted spread.

This worries me a lot, but the Fed has basically said they're going to go and keep buying, so I guess the
party goes on, but people speak about it. I think I've written in the past year why I like the mortgage REIT
idea. That is different than commercial REITs. Mortgage REITs are where they actually just buy the mortgage
bond not the actual asset, they usually buy it four to one to eight to one, hedge it out and give you the

MIKE GREEN: Before you move on, I just want to make sure when you say four to one or eight to one,
we're referring to a leverage ratio here, right?


MIKE GREEN: Okay. What a mortgage REIT is going to do is that they are going to use relatively
inexpensive funding costs that's coming from their investor base or from borrowing, corporate borrowing.
They are then extending the duration of that. There's effectively a duration mismatch in Annaly, for example,
or certainly in a mortgage ETF where you have daily liquidity or near term liquidity against funding on a
longer-term basis. One of the risks, of course, is that instability of capital, if people were to decide to try to
get out of these types of products could actually cause an unwind that would effectively make this chart true.
It would drive that dynamic.

HARLEY BASSMAN: Well, that's not clear. First off, these REITs are effectively closed-end funds as
opposed to open-end funds, so cash flows don't matter.

MIKE GREEN: I'm sorry. Just to be clear, I'm more referring to bond funds that also are significant owners
of these. For example, Vanguard, etc., have their Vanguard total bond index, it's about 30% MBS. I was
referring more to that than to the Annalys, etc. but please go ahead.

HARLEY BASSMAN: Well, the extension doesn't matter to them. If the end card sells, they're going to
sell everything, and which will only be a third mortgages. For these REITs, remember, you have $100 and
they buy $800 of mortgages, but they then short $700 of 10-year Treasurys or 10-year swaps or futures
to balance out. The risk you have with them is there's a convexity risk, and the spread also. I think that's
why you're seeing a lot of the mortgage REITs trading at a discount to NAV where in theory, they should
be trading flat to book value.

I think people recognize that there's spread risk there that could occur. That doesn't make them a bad
investment. Because if the book is 17.5 and it's trading at 16, well, you could take a 10% drop in NAV to
book value and still be fine. They're not short, but I think that explains why you're seeing this gap now
between the book and the trading price.

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

MIKE GREEN: When you think about that dynamic, because this is one of the areas that I think is actually
fairly interesting. If we look at what happened in 2008, which obviously jumps out on this chart, we had a
combination of duration extension that needed to be hedged, and increased inability to do so because the
quality of the product was very much in question. You effectively had a blowout in both the credit component
and in the need to hedge as mortgage, as MBS, effectively extended in duration, not necessarily because
people decided, okay, I have a new low super attractive rate, but simply because refinancing was
unavailable for the credit dynamic as well.

It got hit with both barrels. We then, in early 2020, saw the huge vol event associated with coronavirus,
but today, I would actually argue that it seems like there's a pretty good chance actually that if anything,
the Fed would step in to suppress this spread even further, perhaps take it potentially negative as they try
to incentivize lending to households over lending to financial institutions. In other words, if they were to
begin to pass through actually a subsidy, do you think there's a chance that this becomes a policy tool?


MIKE GREEN: I love talking to you, because your expressions are so good.

HARLEY BASSMAN: I just don't think they're going to go and take the mortgage spread, they're not
going to invert that. At that point, you're going to have speculators and hedge funds come in and short
them just to own the free option. That's unlikely. I think you're leaking into the bigger concept of will we see
yield curve control or not, or other kinds of control? Certainly, volatility reduction has been a specific policy
that they've been using.

I actually think that they're not going to do yield curve control the back end. My feeling is they're going to
hold the front end, overnight rate stays where it is, as promised, the next two years no matter the inflation
number, maybe they hold 2s, maybe 5s. I think they'll let 10s and 30s go, or at least move up. That's not a
bad thing. The government can move their funding to the front end, and the Fed could absorb it through
either money printing, and we could discuss whether it's money printing or not, what I think.

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

The back end going up is public policy good. A steeper curve helps the baking system. For good or for ill,
we no longer do barter. We don't use gold. We are a financial economy, and we're highly levered. The
banking system, maybe there's bad guys in there and certainly there were villains 10 years ago who should
have gone to jail, and didn't, but the banking system is the plumbing of our financial economy, and we
need to maintain it. Therefore steeper curve helps that plumbing system, so the government can do it. The
Fed and fiscal policy can be more efficient.

Having a good plumbing system is good. Number two is taking the whole curve down has not been at zero
cost. You've taken money from the lenders and given them to the borrowers. Is that a good thing? No,
you've done a few shows on pension fund instability. If we take the back end up, that helps pension funds,
that helps insurance companies. That's a public policy good. Steepen the curve out, I'm not saying rates
going from zero on the front end to 10 on the back but putting the back end at three, four or five is not a
disaster, I don't think, for the overall macro economy.

MIKE GREEN: When you think about the dynamics there, so if I look at-- we're going to get into very
technical descriptions here, things like 2-year 2-years and 4-year 2-years and all sorts of stuff. When I think
about the dynamics of what is increasingly priced in a year or two out, if I look at a 2-year 2-year, for
example, it's roughly 100 basis points above where we are today. In other words, forward Fed tightenings
effectively built into the system and potentially even depending on the timing of that, you're looking at more
Fed hikings.

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

If I look at a 4year 2-year, I'm looking at almost a 200 basis points spread, so an additional 86 basis points
on top of it. Do you think that there's an element of the yield curve steepness is limited by realistic Fed
policy? Are they actually going to-- we saw this with Jerome Powell in this last cycle, they tried to do a
couple of tightenings. They simultaneously tried to tighten the balance sheet which I thought was a mistake,
they probably should have moved one policy error at a time just to see what was actually driving things,
but if I look at the forward tightening that is embedded in the system today, does that feel right to you? Do
you actually think the Fed can get away with multiple tightenings?

HARLEY BASSMAN: Well, you're stepping into a soft ground right now, forward rates are not a
prediction, or a mathematical calculation of the curve. We're not predicting where things will be. Now,
you're stepping into, to get technical, should I be buying the greens, the blues and the golds? I don't know.
The curve is steepening because the 10s are pulling everything up and because that's the part of the curve,
I think, will not be controlled and you're forcing the rest of the curve to move with it.

Where do you want to put the kink? We'll put it at the 5-year, the 7-year, the 3-year. Do I think the Fed's
going to be hiking rates in two years? No, I think what they're going to be doing is they're going to be
tapering first. I think tapering by reducing or not reinvesting is the better policy, I think steepening the curve
is a better way to bring the world into line, rather than taking the front end up.

Taking the front end up is bothersome in many ways, because most people have floaters, moving people
into arbs is fine. Corporations very often will float, and the US government go fund all this spending [?] at
the front end. I'm not quite a believer that it's a prediction of higher rates in the future and more
consequences of 10s going up.

MIKE GREEN: To emphasize, I agree it's not a prediction, it is the non-arbitrage condition that is created
by a 10 being 10 one-year rates off into the future. At each point, you have to calculate what is the
equivalent 1-year 1-year, 2-year 1-year, 3-year 1-year, 4-year 1-year, etc. By the way, for those in the
audience, I'm indebted to Harley to teaching me all this stuff over the past 20 years, but then I would look
at, for example, a 4-year 2-year at 186 and say that price is probably as wrong or feels as wrong to me
on the top side as the 10s did at 50, 60 basis points sort of thing. We can disagree on that. That's part of
what makes markets but--

HARLEY BASSMAN: Four years a long time, four years an awful long time away, man.

MIKE GREEN: Yeah, I like four-year time periods, but I understand your point. To think about the
dynamics, though, in terms of this type of spread that has historically mean reverted, wouldn't you draw
the same comparison, if we were to overlay high yield credit spreads, they would look very similar or
investment grade credit spreads, they would look very similar. In a period of financial repression, where
effectively the objective from the government is to keep credit spreads low, do you think this has the same
explanatory power going forward, or do you think that I'm just constructing a narrative that matches up
with what we're currently seeing?

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HARLEY BASSMAN: Circling back to our first two sentences here, it's never different this time. That's my
mantra. It's never different this time. I can't explain why or how but I just do not think that we've reinvented
human tragedy. Hubris, greed, ego. We wrote about it, the Greeks wrote about it, Shakespeare wrote
about it. It just hasn't changed, and it's this idea that we've invented a new paradigm I just don't believe it.
It's a different song, but it's still music and I think that we'll find some way to go and cause trouble, which
is why I believe in inflation ultimately.

Is it next year? No. Is it in 20 years? I don't know. What I do think, it's going to happen in two to four years
when the demographic bubble rolls over. We could do that later on. I think we're going to get it because I
don't think you could print the coin of the realm at a faster pace than the overall growth of the economy
without inflation at some point. Now, could it take 20 years? Why not? It took 400 years for the Roman
Empire collapsed, so in the grand scheme of things, maybe not.

This policy of money printing is not going to end well. That doesn't mean it was a bad public policy, by the
way, because having the economy totally collapse either in 2009 or last year is certainly a bad idea, so
maybe deferring the pain or spreading the pain out. I think that inflation is the ultimate solution. Because
inflation is a beautiful tax. It taxes, everybody. It taxes them silently, and the politicians dumped a vote on
it. As a tax, everyone-- well, I wasn't happy, but it's the easiest one to live with in a democracy.

MIKE GREEN: I actually disagree with that. I think inflation is perceived as a policy choice. I've rarely
seen inflation be generated on a policy basis without making terrible choices that make everything worse.
To point to Zimbabwe and say inflation is a beautiful tax, obviously, it's a hyperinflation. That's the
destruction of a financial system or monetary system. That becomes very weak. This probably is not a bad
time to talk about the demographic component, which is something that you and I have spent a lot of time
talking about it for several years, and I believe is slide nine.

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
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HARLEY BASSMAN: Yeah, it's a Gerard Minack's chart.

MIKE GREEN: The 10-year note versus trend labor force growth. This is a chart that I've shown several
times in the past. Tell me how you're thinking about this.

HARLEY BASSMAN: Well, what I think is the boomers were the iceberg, pig in a python, and that the
inflation we had in the 1970s and 1980s was the boomers generation plunging into the economy, age
back then 25 to 35. Now, it's probably 30 to 40. When you come into the economy, you buy a house, you
get married, have a kid, you buy a car, you buy a washing machine, and you're demanding aggregate
demand of goods from the prior generation, which is the World War II generation, which is smaller, so you
have more demand and supply, and you get prices up. Then as this labor force growth rate rolls over from
the demographic shift, that changes.

What is projected here, and this is actually a rather old chart, but you can use it for years and years because
demographics don't change, except for immigration, of course, is you have this labor force growth rate
inflecting and coming back up again, in 2023, 2024, 2025 and this same chart, PIMCO has a nice chart.
[?] did a piece on this few years ago, you should go look it up. It's the same idea that demographics overall,
but as the boomers exit, and the millennials come in, and the millennials are as a percentage of population,
smaller than the boomers but their numbers are actually bigger.

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They're going to start demanding goods and the average age of first child in many of the blue states now
is 31 in San Francisco, 30 in New York, versus 23 a couple generations ago. We're going right into this
demographic which should create increased demand from a smaller supply. If you get that, you should get
higher rates and higher inflation. I hang my hat on demographics and I've been talking about this for five
years now. We'll see if I'm right.

MIKE GREEN: Well, one of the things that's interesting about this is, first of all, you and I very much share
this. I tend to think that this is more a function of inflation than "yields". The two are obviously linked because
the yield incorporates a nominal component to it.

HARLEY BASSMAN: Without the Fed, yes, they're the same thing.

MIKE GREEN: Without the Fed. The question that I have is I tend to sympathize with this view, although
there's a couple of things that I would point to. One is that this is based on UN medium fertility forecasts,
which have been hopelessly too high, just ridiculously too high. The second thing that I would highlight is
exactly as you're referring to, as we have shifted back the age, my guess is that we're actually going to see
reduced labor force participation amongst women that has been deferred up to this point. I'm not as
convinced that we're going to see the growth in labor force that you're forecasting here.

Just the obvious one, for example, is 2022 is increasingly baked into the cake that will have actually declined
over the last five years. Now, we can argue how much of that is recession, etc., but these numbers actually
look much worse than the chart would have a couple of years ago, I would suggest. I do think that this is
actually a really important feature, because it does raise the point. The Fed doesn't control workforce
growth. It can influence it, and policy can influence it, but it really doesn't control it. Is there an element in
your math that says, we have the illusion of control from the Fed? That we point to them, and they have the
illusion of control, but do they actually control this process?

HARLEY BASSMAN: Well, I've always thought that the three policy errors that could have been made
in the last presidency was tax policy, trade policy, immigration policy. I always thought the immigration
policy was the actual one that was the biggest problem. The other two are the airplay, Smoot-Hawley or
some tax reform. Immigration has always struck me as the one mistake, because this is why the US has not
followed the same path as Japan, or Western Europe, or China going forward as we welcome immigration,
and immigrants tend to be relatively productive.

Believe it or not, immigrants have a lower crime rate than native born people. Immigration has been good.
I'm not going to debate the policy, per se, I'm just going to say if people come into this country, that grows
labor force. It doesn't matter how we grow that labor force, that's a good thing as a public policy concept.
Control on the border, whatever. You can have your own thoughts on that. What worries me is if we were
to close that, that supply of young, productive labor, that's not good.

MIKE GREEN: I tend to agree with that. I would actually highlight that it's often underappreciated, the
role of immigration reform in the 1920s. The Immigration Act of 1925 radically slowed the pace of

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
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immigration from particularly Western Europe and to a lesser extent, Asia, into the United States, and set
the stage for housing collapses that preceded the Great Depression. I'm worried that we will have a similar
outcome here, effectively that we have taken what would have been a source of exogenous demand,
effectively new members of our society who as you point out, demand apartments, dishwashers, homes,
laundry machines, etc., not showing up on our shores and setting conditions for weak aggregate demand
going forward. I tend to be sympathetic to that.

HARLEY BASSMAN: That's a headwind, no question about it. One more comment about immigration
is one could say that immigrants don't pay taxes because they're off the books. Okay, fine, but they pay
everything else, but they rent the house they're in, that landlord pays property taxes. When they go and
they buy food, they pay taxes on that. Maybe they get away with not paying income tax, but they pay
everything else.

MIKE GREEN: I would suggest even that is probably significantly overstated. It is a subset that is in the
cash-based economy. When you think about this type of model, since 2000, this model would largely have
overpredicted interest rates. In other words, you can see the 10-year yield, the blue line is significantly
above where the red line would match it. The way I look at this effectively is going back to my point on the
4-year 2-year, etc., that the narrative of inflation, the narrative of significant growth doesn't necessarily
match up with what we're likely to experience.

There's a probabilistic event that could occur. We're seeing significant shortages and significant bullwhip
effect from restocking, etc. We saw this in the PMIs today, today being Wednesday, March 3rd, but if I look
more closely at that type of analysis, I struggle to see where around the world we have the significant
shortages, for example, that we had with China as they tooled up to service the world. Is there an underlying
source of demand do you think that is being missed that could propel us to a higher growth rate?

HARLEY BASSMAN: Probably not. I suppose if we start building bigger walls in terms of securing our
production supply lines then that can create pressures, less supply. You're presupposing that today's yield,
today's price is the right price, is the base case price. I think that's just false. I think that the Fed has pushed
rates down for a reason. We could debate at the bar whether that's a good or bad reason, whether it's

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been a winning strategy but clearly the Fed has suppressed interest rates as a policy measure. What I'm
arguing to some degree is that's the wrong number to start with.

This chart here is bothered because of the Fed, and so the question I'd push back to you is, what would be
the right price-- and forget the panic of taper tantrum, what would be the market clearing price and [?]
shock if the Fed wasn't involved? I'll let them keep the front end at zero. I'll give them that. That's the question
we have, isn't it? This is really the biggest cost of what the Fed is doing is they eliminate the information that
a market price signals to us.

When you have a flat curve, and you have low vol, it tells speculators it's okay. I can pinpoint a few reasons
but number one from the early 2000s was Greenspan's measured pace. He says, I've taken rates up 25
cents every six weeks for the next two years. Well, that means everyone in the world is going to sell a 30
basis point out of the money put for six weeks in front of free money. That's a terrible idea. You're
encouraging speculation, you're encouraging moral hazard. That's why you want a steeper curve and the
Fed to get out of this thing so we can have--

There is a cost. There's a risk, people transact and work accordingly. That's how you avoid a volatility event.
How do you signal to companies that they should be growing or shrinking their factories, or hiring or firing
people if there's no information from that yield curve?

MIKE GREEN: I share your concerns on all of that. I think the underlying feature that is so frustrating to
me is exactly what you're describing, which is we've robbed people of price signals. Simultaneously, we've
focused ourselves on stability. When you asked me the question of what's the right rate, I think the question
is that's very conditional. Is it, what is the right rate if the Fed continually steps in to drive stability to the
production function? Effectively preventing corporations from going out of business.

Well, if you do that, then the answer is that the right rate gets lower and lower and lower because the
marginal user of capital is becoming more and more of a zombie. We're broadly seeing this, and zombies
can't-- maybe I'm going to mix my metaphors here, but they can't be exposed to the light of market derived
rates. You actually end up pushing it down. The second thing I would suggest that happens in a highly

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financialized economy is a bond becomes less important as a hold to maturity instrument for most players,
and instead becomes a source of collateral, effectively allowing you to take a levered position.

This is the area where I struggle most. I'd actually be really interested in your thought process on this because
we see a lot of bonds that are trading at significant premiums to par, and that premium to par increases
their collateral value. If the bond is trading at 120, I can borrow against since value at 120, it doesn't matter
that its par value as 100. As we move forward in time, the value of that bond now begins to retreat back
towards par. There's a natural decline in collateral in the system that is embedded as bond prices mature.

I think this is part of the reason why we keep getting trapped in this framework of we think we're being
really loose in terms of monetary policy, and then it turns out that we're suddenly very tight, that the collateral
is not capable of supporting the system that's in place. We saw this with dynamics in 2018 where the Fed
had to stop the process of tapering the balance sheet. We're going to see this with the SLR, the supplemental
leverage ratios, where reserves need to be calculated in a slightly different way.

Otherwise, we could see bank lending contract, regardless of the steepness of the curve. How do you think
about those technical details in terms of creating a cycle of crisis that, of course, makes the Fed even more

HARLEY BASSMAN: I think it depends on the speed that these things happen. A bond going from 120
to par probably is very slow, and it's much slower than the volatility of underlying assets. I think it's a good
story, but I'm not terribly concerned by that. In the mortgage market, we keep seeing 105 bonds, instantly
converted that to par bonds via refinancing and that doesn't seem to be too big an issue right now. I am
struggling [?] the TGA account, how they're going to trade that down by a trillion dollars the next x number
of months.

I think to some degree, the Fed's words are probably most important in terms of signaling what they're
going to be doing. When people hear those words, do they think what they're saying is possible? I think it
is possible to keep the Funds Rate very low. I think it's possible to get the 2-year very low. I'm not convinced
it's possible to keep the back end very low without consequences.

The big question I've had is, let's just say that I'm right and we get a 3%, 4% inflation a few years from
now. Does that necessarily mean that being short Treasurys is going to win? No, it could be the Fed like
keeping it to and therefore you'll have a negative real rate. That's the hard part for you to figure out, is I
could be right on the underlying economics and cash flows and defaults and everything else, but it doesn't
mean I can say where it is going to be.

Now, if the Fed does keep the rate at 2% and they did some yield curve control, there's no free lunch. Then
what happens is the currency collapses. The money has to go somewhere and so to the extent the Fed makes
promises or suggestions that the market doesn't believe it's possible, that's a bad idea. If they make
suggestions that are reasonable, that are within their purview, I think that that can smooth things. Prices
moving up or down, it's never the problem. It's the speed with which it happens. That's really the issue.

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MIKE GREEN: When you say the currency collapses, what does that actually mean to you, because the
offset to that, of course, is if the US currency were to decline by any significant amount, then the rest of the
world actually would suddenly find itself at a disadvantage in terms of the ability to continue to sell their
surplus production to the US. Because the demographic problems that you highlight here are magnified if I
look to China, for example, or if I look to Europe, where the aggregate demand function is not growing ex
their ability to sell to the rest of the world. How do you think about that dynamic of what it means to have
a currency collapse in a fiat type system?

HARLEY BASSMAN: Well, you're calling me out which I appreciate. Collapse is versus what? If all the
other currencies are also fiat and going down, then we're collapsing versus I guess, real assets Is that a
good or a bad thing? Well, that's unclear to me. Gold, Bitcoin, real estate. That's I think why you're seeing
elevation of these various assets is people want to get out of fiat currency. It's a dynamic system.

Let's go back a year and change. You had German bunds at negative one half, and US rates at positive
one and a half. My kids asked me why would they buy a German bond at negative-- anybody buy a bond
at -0.5% as opposed to US bonds, to which are higher? Well, because the currency went from 106 to 121,
move 15%, so burning your 2% liquidity, that was a better idea over negative rates and a more stable

I don't know how it plays out except for the fact that the Fed can't control everything. They could grab the
balloon and squish it but someday, that's going to pop through their fingers somehow. The question is which
pops through their fingers, and ex ante, do they know what it's going to be and they're ready for it? They
know they can't control everything. They know that there will be a reaction dynamic system. If they hold US
rates down, the currency must go down. Versus what, I'm not sure, but yeah.

MIKE GREEN: If I think about that dynamic, one, using that analogy of the balloon being squeezed and
stuff popping out, I think one of the interesting questions is the balloon inflating or is the balloon deflating?
Because if you're squeezing it, and it's deflating, you're not going to get the same bubbles. My fear is that
we are too confident in the nature of the inflating balloon, because that's the world that we inhabited
through the 20th century. If I look at the 21st century, I struggle with where the growth markets are that result
in high returns on incremental invested capital.

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We see this with the leading tech companies, where their primary use of cash is to buy back their own
shares, effectively saying, there is no prospect for us to invest this incremental capital at high marginal
returns. How do you think about that in the context of what the right rate is? If you were investing in real
assets, where would you spend money today?

HARLEY BASSMAN: I'm a value investor, which has been a losing proposition for the last decade.

MIKE GREEN: I know your return is better than that, Harley, not a losing proposition, but go ahead.

HARLEY BASSMAN: I like owning things where there's a real cash flow, a real business, and there's
barriers to entry. I own California real estate, I own Manhattan real estate. Will the government tax those
things into oblivion? Perhaps they will, but they both offer very unique things that they can't make more of
them. By the way, they governments tend to go, and they were difficult to build and so I like owning those
things. There's lots of companies out there that make products and there's barriers to entry, I like owning
them. That's essentially where I go, and my horizon tends to be two to five years as opposed to two to five

MIKE GREEN: Well, when you talk about two to five years, I actually want to jump back to one of your
slides. I think it's slide seven in my deck, which is the seventh year into 20-year implied volatility. This is just
another way of illustrating the longer-term framework that you often adopt. To me, this is actually a really
interesting chart, among other things, highlighting the fact that the expectations for the next seven years are
that rate volatility for longer bonds is going to remain exceptionally muted. Is that the right way to read this
chart effectively, that you look at this and say, I'm not as convinced that they're going to be able to hold
this as stable as the market is pricing right now?

HARLEY BASSMAN: Oh, what I read is not that the market's predicting something per se, but there is
massive supply of long-dated volatility, long-dated options into the market, from structure notes, specifically
from bonds issued in Taiwan, which [?] talk about, but also to say, there's a huge seller of that option, that
volatility, and there's very few buyers of options, which of course is something we both agree with the terms

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of options. Call options in the US stock market are way too cheap. It doesn't mean we're bullish, it just
means it's the wrong price because people sell call options to go and take short term income.

Over here, I do think as well as it's too low. I think the best value in the market right now is to buy these
long-dated options on interest rates. A 7-year option on the 20-year interest rate which locks a box like a
7-year option with 30-year Treasury. It's extraordinarily inexpensive because the implied vol is the key
driver more than the rate actually. The reason why I want to own this is not because I'm dead positive rates
are going to be higher, but that I know that if rates go higher, that's going to be Armageddon.

That's where you want to go to chart, you can go to 10, you can go to 11, you can go to 12. All these
charts here all say the same thing, which is, for the last x number of years, we've seen stocks and bonds go
in opposite directions, they hedge each other. You've seen people like Bridgewater become billionaires
using what's called risk parity, where they might buy-- with $100 of assets, they'll buy $70 of stocks, $130
of bonds so they're levered two to one. That's because they go like this, and they balance out, and they've
all gone up.

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What would happen if that correlation flipped, and stocks and bonds went down together and up together?
That's what all these charts are saying. You have Gerard Minack, you have one from Credit Suisse, you
have the Bank of America, it's all the same data. It shows you that rates for inflation, which may be different,
but I'll call them the same, get 3.5, 4.5, somewhere there, that correlation will flip. If we get stocks and
bonds going down together-- we've seen that happen, we saw in March and we saw before that. When
they got together, it is really a problem. Because then, everything is in liquidation mode.

I want to own that option, that insurance policy that if we ever get to 4%, that I am stopped out, that I own
a lot-- I own some big heavy volatility because if a one-year option, if the vol goes up by 10%, the price
doesn't really move that much. A 7-year option with vol that's up 10%, that option was up by a lot. I want
to own that risk, and I want to own the direction risk that higher the rates, I make more money. Truth be
told, the option expires worthless, God bless you, man. This is the ultimate insurance policy for anyone who
is in financial assets, which is basically anybody with money is in financial assets because we're a financial

MIKE GREEN: Which is unfortunately a shrinking share of the population that has money, but as a joke.
I actually have an interesting question on this, which is if I think about this type of correlation, and I agree
with you 100% that the Fed put more accurately is described as a Fed reaction function that says anytime
financial assets fall in value, we're going to cut interest rates, which then causes bonds to go up in price
and establishes additional buying power for equities.

There's a good paper by Jonathan Parker of MIT that came out in 2020 that highlights this mechanism.
People have heard me talk about it from the collateral standpoint, but I also wonder if there is-- maybe the
better model for this is the correlation when rates go negative.

HARLEY BASSMAN: Real rates or nominal rates?

MIKE GREEN: Nominal rates, which may or may not happen. It becomes an interesting question, because
if you think about what the Fed has done with a positive yielding 10-year bond, or even a 2-year bond for

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that matter. If the price of that bond is going to behave in the opposite direction of equity prices, so negative
correlation on price but a positive expected return, because it carries a positive interest rate and has no
credit risk associated with it. What you've actually done is create a synthetic put with positive expected
return. You now can buy as many puts as you want, and you're not going to lose money if you hold it to

HARLEY BASSMAN: To the extent you believe negative nominal rates possible, which I doubt.

MIKE GREEN: Right. Even if you don't believe that negative nominal rates are possible, you can't actually
lose money on a hold to maturity basis buying a positive yielding 2-year bond. You can lose it in real terms,
but you're not going to lose it nominal terms and nominal terms is what ultimately drives portfolio
construction. Nobody's ever come to me and said, hey, your collateral has fallen in real terms, and therefore
I'm going to execute a credit agreement against you.

Is there a chance that the signal on this flips in the other direction? In other words, if they were to decide
that they can't do anything other than take interest rates negative on the next crisis, would you expect this
relationship to continue to hold? Because I think it actually would look like a seagull. I think that you'd
actually see it flip in the opposite direction as people suddenly discover they no longer have positive carry

HARLEY BASSMAN: This is hard to imagine, because I don't believe in negative rates. There's no
evidence they've worked in Europe or Japan. By the way, they are not the world's reserve currency. To the
extent we go and create negative rates, you basically rip the plumbing out of the world's financial system.
As we said at the very beginning, the banks are the plumbing of our system. I just don't foresee it happening
or being helpful at all.

I suppose if in that world of four-dimensional chess, where you have a risk of going to negative 5%, I
suppose you're right, in theory, but that presupposes that rates can go negative, which I think they can't.
Which, by the way, is one of the reasons why you've seen the move so low, is that you're hitting this zero
boundary condition and as rates go up, the move will catch up with the rest of the market. That's a small
technical matter case, people were curious why the move is still trading at low 60s.

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MIKE GREEN: I actually completely agree with that, that if you're bound at the zero point, this is going
to be one of the interesting questions. To me, it falls into the category of there are no atheists in foxholes. If
we experience bad enough events, I have to believe that the Fed is going to take actions that are designed
to improve the liquidity function. Taking rates negative is certainly something that we've seen and when you
say you don't believe in them, what you're actually saying is, it's not that you don't believe in them in the
same way you don't believe in the Easter Bunny, because clearly they exist. You're saying you don't believe
that they're effective in the same way I might just describe--

HARLEY BASSMAN: No, I think it doesn't work. I think that if they did it in this country, you'd have
people with pitchforks and torches storming the Fed. By the way, the Fed has other tools. They can go and
buy credit bonds, they can be Japan, buy equities, for God's sake. You're talking about a real fundamental
economic problem, you're talking about a financial crisis. A financial crisis they can fix, they can just print
money and buy the assets, that solves that problem. The underlying economy, they can't fix, but the Fed has
other tools much more effective than taking rates negative.

Taking rates negative means that by lowering the financing, I'll get some other dolt to go and buy an asset.
The Fed just buys it themselves. Why try to work for the system? Japan's doing and will the Fed do that?
Unlikely, but certainly that's vastly more effective than being an intermediary and taking rates negative.

MIKE GREEN: Yeah, I tend to agree with that. We won't know until the next crisis what they're definitely
going to do, but I think that the world has generally accepted that buying the assets directly is more
impactful. The challenge is if they begin to buy equities, and I would argue this about Japan, aren't you
eventually just starving the private sector, the income associated with that?

HARLEY BASSMAN: Look, all these policies, at the end of the day, there's a core problem that there's
too much debt and too much money in the system relative to the economy. For 12 years now, we've been
trying to go and pay for it over in various ways and defer the ultimate denouement which will come. Will it
be a debt Jubilee? It is biblical, so why don't we do it again. Somehow, we have to go and untangle this
debt bubble that we have, will it be done slowly or quickly is unclear.

I think the current policy is a good idea. I think the money has been printed, it's in the system. There it is,
it's just not being used because it went into the banking system and not into people's hands who spend it. I
think this fiscal package 1.9, 1.6, 60, whatever, it's a big number, and it's going to happen. That money
is going to go to people who spend it. You and I have done pretty well, we get $1,000, it's not going to be
spent all that quickly. 40% of the population, or at least the last Fed study a few years ago, could not come
up with $400 in a heartbeat if they needed to for a broken car, or a medical bill or a dishwasher, whatever
it might be.

40% does not have access to $400 on the spot. When they get a check from the government, they're going
to spend that money in the economy. That is a public policy good. Will some millennials go buy some
GameStop options? Perhaps, but this money will go into the economy directly as opposed to, are we going
to pray over the Fed in their past efforts?

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MIKE GREEN: I'm a little bit less sanguine about that. Because one of the challenges when you have this
type of event is that your data systems begin to break down. What we see is a large surge in savings rate
is difficult to disaggregate. There's actually some recent materials that have come out that highlight that the
lower income portion of the population is actually more stressed today than they were going into
coronavirus, despite the increase in unemployment benefits, despite the transfers, etc.

Broadly, I'd suggest that that seems to make sense when we're looking at a world where something like
40% of those who owe rent are behind on their rents. It doesn't strike me as plausible that they have suddenly
improved their financial situation. To me, that's the group that's going to spend it. The marginal player,
where we started to see improvement has largely been a function not of the income replacement but has
been a function of expense avoidance. It's somebody at the 80th percentile who can't go to restaurants
anymore, or who can't travel and take their family on vacation.

I'm a little bit less convinced than you are that we have this giant untapped amount of spending going
forward, but that ultimately will only be seen in the future. We don't know the answer to that. I think that's
one of the challenges. Again, you bring up the fantastic point that when we talk about the forward rate
levels, or we talk about these components, these are not forecasts, these are non-arbitrage conditions, and
can basically be thought of as the center of a forward distribution of potential outcomes. It becomes a
question of is it up or down from there.

HARLEY BASSMAN: Well, I'll just say this. Maybe what I'm describing as a policy measure sucks, but
okay, fine. What's your plan B that's better with the cards we have dealt in front of us, or the policymakers
have dealt in front of them, what's the better policy? Unless we want to go to the Andrew Mellon concept
of liquidate the farms, liquidate the banks and just flush the whole economy down to cleanse the pipes,
which in theory is a good idea except for the human factor of people being on the streets.

I don't see a plan B is away from this. I don't like it at all. It's terrible, but the Fed had their window. 2013.
They should have backed off, let the market move and that was the window and they chickened out and
that's that. Yeah, QE1 had to happen, but QE infinity after that was foolishness. I wish we had a Paul
Volcker to go and take the bullet for doing what was necessary back then. I ask you, what's plan B or plan
C if this is the wrong one?

MIKE GREEN: I think that's absolutely the question to ask. The history of bailing out overlevered economies
through modest inflation is not particularly strong. It's the idea that you can reduce debt loads through
inflation tends to fly in the face of the fact that those who are most adversely affected by inflation are not
those who are the wealthiest, but those who are closest to the marginal survival point. They are in turn
forced to take on debt to try to continue to feed their families or keep their themselves in homes where the
rents are rising, for example.

Inflation is not a good mechanism for redistribution, and unfortunately tends to benefit those who are closest
to the money spigot first, and have best access to credit, which gives you the ability to lever an exposure. I
don't actually think it's the solution. I do think that you mentioned one of the biblical solutions, which is a
redistribution, a debt Jubilee, which is taking assets from the rich and giving them to the less well-off, those

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who are indebted. That type of redistribution, I think is almost certain to happen at some point. It becomes
a question of when and how aggressively so.

Real Vision viewers have heard me talk about the dynamics of how that was important in Caesar's rise to
power in the Roman Republic, that sort of populist movement is eventually going to be inevitable. I think
part of the irony for me with the Biden administration is that it's so inherently conservative. We've
abandoned the $50,000 debt Jubilee for student loans, we've abandoned the $15 minimum wage, we're
increasingly cutting back in the levels of support that are being discussed to provide to the economy. $2,000
stimulus checks have become $1400 stimulus checks.

Those $1400 stimulus checks have now been reclassified into a component of eliminating a tax credit and
effectively distributing it on a smoother basis, which has different impacts, but is far less impactful than
adding to it. I don't know. I continue to fall into the camp that says, I think we're going to be surprised that
the economy is weaker than people think it is, that most of the price increases that we've seen to date are
relative price increases effectively, meaning you get to buy less because it now costs you more to fill up your
car at the gas station, so you do less with that.

I don't know that-- I very much am skeptical of the idea that we've got some fantastic reopening that is
going to be hugely accelerative in terms of economic activity. What is your thinking about the reopening
process and whether this is inflationary or whether it is disinflationary as people return?

HARLEY BASSMAN: Unclear if it's inflationary, certainly there's going to be positive GDP if people will
get jobs or get hired again. Maybe the actors can go back to working at the bar. That's a good thing. I
think the more interesting concept is pumping, the process of helping this public with money, and where's
this money going to go to? Will it go into people's hands, as we hope, as I've projected, or will it go just
back to the stock market?

This is why I like owning options on both sides of the equation here, because I've identified a bubble, but I
haven't said, is it going to pop tomorrow, or is it going to keep getting inflated? Owning the downside put
clearly is a clever idea, but those are expensive. Owning the outright call is actually the much more clever
idea, once again, not because I'm bullish, but because it's so cheap, if I'm wrong, who cares? When you
create these portfolios where you own both sides, it does more than create a profit for you. It stops you from
doing bad things.

If you own some insurance policy like in March, it stops you from selling in March. If you just didn't sell in
March, you've done great. Think about it, the market's much higher than it was January 1st of last year. The
only trade you had to do in March was just not sell, you have to buy and if only insurance policies allow
you to do that, that's a good thing. I do think that the government is going to pump money in, I think both
sides are in favor of that, and I think that if that money goes into financial assets, we could melt up somewhat

MIKE GREEN: I think this is going to be the interesting point. You brought up a really interesting dynamic
that you tend to own the options, that you view the options is really cheap. There's a sizable fraction of the

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population, though, in the investment community that looks at these types of problems and says, yes, it's
cheap, but I can't stomach burning. I can't run a negative carry. What I saw happen with the bond crash
in the past couple of weeks is players who had purchased protection, as you point out, it's expensive to bet
on lower yields and so one of the ways they had defrayed that cost was selling protection against higher
yields, effectively selling the ratepayers.

What's your reaction to that? Because that goes back to our question of, what happened in the last couple
of weeks? You don't think it was convexity hedging, you don't think we entered what you would trademark
as the convexity vortex, this idea that you moved into a regime in which the market participants needed to
hedge but we unquestionably saw a crash. What do you think was the driver? Big move. It's very similar to
what we saw following the Trump election in 2016. The bond yields spiked significantly in a high duration
instrument that caused 25 plus percent corrections in bond prices.

HARLEY BASSMAN: Look, I started on Wall Street when Ginnie Mae 12s were trading at par. Going
from 1 to 1.5 does not strike me as a crash. I'm also relative man. I think you're circling around this idea
of convexity and whether you want to be long or short, anyone on this cast who has not read my piece on
my site, it's a thought piece about convexity explaining it to people in simple terms. It's an educational
piece. There's no trade involved in that.

Convexity really is this notion of limited gain versus limited loss, which way do you want to be on that?
People tend to go and misidentify risks. They overvalue small risks like lightning strikes or shark bites, which
never happens, and yet people will get into a taxi and not put their seatbelt on. This is total insanity. People
just don't value risk properly. I, as a general rule, like being long convexity, which means I like owning the
leverage. I like making three versus losing two. That's long convexity in a simple concept, versus losing five,
making four. That's negative convexity.

When I'm long optionality, long convexity, long acceleration, however you want to call it, I have unlimited
gain at the limited loss. If I'm running a hedge fund where people care about what I make or lose every
month, I'm not doing a hedge fund. That's just the way of business for me. I don't care about month to
month returns. If you're invested in that, God bless you, man, but I don't care. If you're looking at the longer
term, look at all the billionaires out there, where do they make their money? They made it by being long the
option, and the long option was equity.

Think about it. If a corporation has stocks and bonds, you buy the bond, you get the coupon, and then you
get back 100, and that's it. If you're wrong, you lose everything. You're short at option. Limited gain,
unlimited loss, and the stock is a call option. What you could lose, you could lose what you pay for the
stock, and your gain's unlimited. All these guys who've made all this money in the last decade, they're long
call options, not short them. They're long the equity. They're long the unlimited upside versus limited

That is a career enhancing profile if you have the patience to ride the daily volatility as time goes by, and
whenever you see a financial crash, convexity is always lurking at the scene of the crime. It's always a short
convexity. The Wall Street blow-up that took up Merrill Lynch, they were just short options effectively. They

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

were exposed to short options, but the structure of the portfolio they had was long one option, short five
options and all the guys that had that trade on, they all blew up. 1987, short options. Long term capital,
short options.

MIKE GREEN: Yeah, there's a variety of almost unlimited number of stories behind that. I wonder to what
extent-- you and I actually bonded over this dynamic great. When I became very active in rate options
following the GFC, you became a mentor to me in this process. I wonder to what extent you and I have
grown up in an environment in which the low levels of yield have created a surplus of options selling activity
and now, we're seeing with WallStreetBets for example, in the equity markets, maybe they're less willing to
sell those options. Maybe they're more interested in buying them.

I'm wondering if something similar could emerge in fixed income. I don't know the answer to it. That's a
theoretical question to you. Is there a scenario under which you can see that regime change?

HARLEY BASSMAN: I think institutions like selling options, because if you think about when you sell an
option-- let's say you have a covered call, so you buy IBM at 100, and you sell the 110 call, what you're
really doing is converting the potential capital gain of the strike price over 110 into dividends, current
income. People like selling options, because they're selling potential income for current income, and people,
it's a safety idea. People are not risk neutral, they're risk averse. They prefer the money today versus a lot
more money in the future. Is that a good idea? As a portfolio manager, it's terrible but it is human nature.

MIKE GREEN: Well, it's one of the interesting things we've seen following March 2020. In particular,
actually, from November 9th of 2020 with the first vaccines, we've seen the quality factor, because if you
think about what you're doing when you buy Coca Cola and sell 10% out of the money call option against
it, exactly to your point, what you've effectively done is create a high yield bond in Coca Cola. If you're
going to do that, then quality becomes particularly important because you want to make sure that you're
buying something that should not fall by 50%, because you do have that downside risk.

Post the vaccines, we've seen an explosion in the riskier names, the most levered names, really coming off
of even the March 20th, March 2020 lows. We've seen outperformance of the most shorted names. We've
seen outperformance of the most levered names, the junkiest names, quality versus junk is experiencing one
of its largest draw downs, and that's happening at the exact same time that the retail establishment is
rushing out to buy call options.

I wonder if that's being flipped to a certain extent. In other words, are we looking at an environment in
which people have actually chased call options, and chased that positive optionality for very good reason?
They've been well compensated for doing so, but are we setting up an environment in which maybe flipping
that, returning to the higher quality names, etc., has value? I don't know the answer. I'm genuinely exploring

The correlation, or the flip side of what you're describing, is if rate vol is going to rise, that's very bad for
high yield or lower quality credits which would also extend to the worst equities. Paradoxically, if that's
happening on the perception of inflation, I think a lot of people are positioning themselves to the idea that

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MGIC: The “Right” Price for Bonds, Demographics and Inflation,
and Cheap Bets on Volatility

an inflationary condition or an increase in inflation expectations would be very good for those more cyclical
junkier names because it's creating this nominal growth of the economy. I struggle with maybe that needs
to be flipped. Again, you're hearing me ask a lot of questions, because I don't know the answers right now.

HARLEY BASSMAN: Well, theoretically, assuming the credit you're comfortable with, you're supposed
to go and sell the junk bonds you own and buy the underlying stock, you have the upside and if the company
goes bad, you lose either way. You should be buying this. Since this is also, in theory, the cheapest in the
market right now versus the Fangs. It's not unreasonable. Seeing the millennials buy stock options, I like
that. GameStop stuff's a little crazy but it's an optimistic view of the world and I think being optimistic is a
good thing, so I like that.

MIKE GREEN: Well, that's one of the things I've always loved about you, Harley, is despite the fact that
you're coming from the fixed income world, and despite the fact that you correctly identified the dynamics
of convexity, you are a relentlessly optimistic individual. Your sunny disposition matches with your California
origins. Harley, you have put together a fantastic slide deck, we're going to include that with the materials
that are provided. I would as always love to sit back down with you and let's shoot for about six months. I
know you're working on some exciting projects that you can't really talk about right now, but I'd love to
explore those with you in the next couple of months as those come to the public eye. Does that sound like a
fair deal?

HARLEY BASSMAN: Sounds very good, man.

MIKE GREEN: Awesome. Harley, as always, it was great chatting with you. Thank you so much.

HARLEY BASSMAN: Thank you. Have a good day.

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