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Editor's Note: After Part 1, several readers asked me to explain HOW shadow banking works. Fair enough. Time to pop the hood on this $100 trillion machine and see what makes it tick. Warning: This gets technical, but stick with me - by the end, you'll understand the financial Matrix better than most people on Wall Street... Dear Fellow Traveler: Remember Zoltan Pozsar from Part 1? The former Fed economist who gave us the best definition of shadow banking… In 2014, he created what might be the most important financial diagram you've never seen. This thing is called "The Money View." Think of it as the blueprint for the Matrix. And once you see it, you can't unsee it. Proceed with caution… The Four Pillars of Financial HellForget everything you think you know about banking. The real financial system rests on four core institutions that would make the Founding Fathers burn the Constitution: The Central Bank (your friendly neighborhood money printer), traditional Banks (the ones you actually see), Dealers (the shadow banking puppet masters), and Money Funds (where your "safe" cash goes to party with derivatives). Here's the beautiful part: each of these institutions has its own definition of what "money" actually is. What you call "money" depends entirely on where you sit in the financial food chain. For you? Money is cash and your checking account. For banks? Money is reserves at the Fed. For dealers? Money is overnight Treasury repos. For money funds? Money is overnight repos with dealers. See the pattern? Everyone's "money" is someone else's IOU. It's IOUs all the way down, like some demented Dr. Seuss book written by Goldman Sachs. The Repo Market: Financial Fentanyl But here's where it gets really fun. There isn't enough "real" money to go around. Institutional cash pools - foreign governments, massive corporations, pension funds - have trillions they need to park somewhere safe. Problem is, they can't use regular bank accounts (no FDIC insurance for billions), there aren't enough Treasury bills to buy, and they're too big for traditional "safe" investments. So where does this money go? Into repos - repurchase agreements. These are the shadow banking system's drug of choice, and like all good drugs, they're highly addictive and eventually kill you. Here's how they work: Cash-rich institution lends $100 million overnight. Cash-poor institution hands over $100 million in Treasury bonds as collateral. Next day, they reverse the trade. Repeat daily, forever. It's like a financial merry-go-round where everyone's convinced they're the only ones not going to throw up. Sounds safe, right? After all, it's backed by government bonds! But when yields rise, bond prices fall, and your "safe" collateral becomes expensive toilet paper. And when everyone needs cash at the exact same time - which happens with the regularity of a Swiss watch - this system seizes up faster than a 1987 Yugo in a Minnesota winter. The Players in This Rigged Casino You've got Cash Portfolio Managers desperately searching for safety, Risk Portfolio Managers desperately searching for yield, and Dealers making money off both of their desperation. It's like a three-way Mexican standoff where everyone's gun is loaded with leverage. Cash PMs lend billions to dealers via repos. Dealers take that cash and lend it to risk PMs who need leverage. Risk PMs use borrowed cash for leverage strategies, then use those new assets as collateral to borrow even MORE cash. When it works, money flows efficiently from savers to risk-takers. Everyone's happy. Markets get liquid. Money managers think they’re actually smart… But the entire system runs on one massive assumption. It’s the belief that overnight funding will always be available. Every single day, trillions of dollars of repos mature and need to be rolled over. It's like a game of musical chairs where the music never stops. Until it does.  The Beautiful Disaster of 2008Bear Stearns and Lehman Brothers were dealers in this shadow banking system. When cash PMs got scared and stopped rolling over their repos, these firms went from "fine" to "extinct" faster than you can say "moral hazard." Your 401(k) lost half its value not because of some housing crisis, but because this shadow money system imploded like a neutron star. So what did we do? We learned our lesson and simplified the system, right? Narrator: Nope. After 2008, the Fed introduced Reverse Repos (RRPs) to give money funds direct access to the Fed's balance sheet. What started as an emergency tool became permanent. It's like treating a gambling addiction by building a bigger, fancier casino next to the old one. The system that nearly collapsed in 2008 is now LARGER than it was before the crisis. We've solved exactly nothing. There's more leverage, more complexity, more interconnectedness, and your retirement is still the collateral. Shadow banking isn't some abstract financial concept. It's the circulatory system of modern finance… And like any circulatory system, when it clots, everything downstream dies. The best part? Most of the people running this system don't understand it any better than you did before reading this. They're flying a $100 trillion airplane while reading the instruction manual. But now you do understand it. At least now you know what carnival ride you're strapped into. Stay positive (and maybe buy some gold), Garrett Baldwin About Me and the Money Printer Me and the Money Printer is a daily publication covering the financial markets through three critical equations. We track liquidity (money in the financial system), momentum (where money is moving in the system), and insider buying (where Smart Money at companies is moving their money). Combining these elements with a deep understanding of central banking and how the global system works has allowed us to navigate financial cycles and boost our probability of success as investors and traders. This insight is based on roughly 17 years of intensive academic work at four universities, extensive collaboration with market experts, and the joy of trial and error in research. You can take a free look at our worldview and thesis right here. Disclaimer Nothing in this email should be considered personalized financial advice. While we may answer your general customer questions, we are not licensed under securities laws to guide your investment situation. Do not consider any communication between you and Florida Republic employees as financial advice. The communication in this letter is for information and educational purposes unless otherwise strictly worded as a recommendation. Model portfolios are tracked to showcase a variety of academic, fundamental, and technical tools, and insight is provided to help readers gain knowledge and experience. Readers should not trade if they cannot handle a loss and should not trade more than they can afford to lose. There are large amounts of risk in the equity markets. Consider consulting with a professional before making decisions with your money.
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