Opinion

Felix Salmon

Counterparties: Bailouts and money market funds

By Ben Walsh
June 21, 2012

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Shadow banking has at least one component that non-financial types have actually heard of: money market funds. These are supposed to be low-risk investments, with accordingly low yields. MMFs are all about keeping your principal intact – a net asset value (NAV) below $1 is generally a mortal failure.

In the fall of 2008, the Reserve Primary Fund famously broke the buck after it was stuck with massive amounts of Lehman Brothers debt, unleashing any manner of craziness into a market that had been treated by many as a savings account.

In congressional testimony today, SEC Chairman Mary Schapiro said the nearly $2.5 trillion Americans have invested in money market funds are no safer than they were in 2008:

[Money market funds] still remain susceptible today to investor runs with potential systemic impacts on the financial system, as occurred during the financial crisis just four years ago. Unless money market fund regulation is reformed, taxpayers and markets will continue to be at risk that a money market fund can “break the buck” and transform a moderate financial shock into a destabilizing run. In such a scenario, policymakers would again be left with two unacceptable choices: a bailout or a crisis.

More than 300 times since 1970, Schaprio says, fund mangers have injected their own cash to keep NAVs above $1. Recently, they’ve supported their funds through “fee rebates“. That’s a particularly invidious way for funds to describe what is in effect life support and why Shapiro has called funds’ stable NAVs “fiction“. The alternative, floating asset values similar to short-term bond funds, is opposed by the industry. Vanguard said they would do “irreparable damage“. Corporate and municipal borrowers also may face higher costs, according to a recent study.

On the New York Fed’s blog, a group of Fed economists and officials make the case that much more is at stake than simply investor returns and borrowing rates: “MMFs’ vulnerability to runs not only puts their investors at risk, but also poses considerable systemic risk to the U.S. financial system”.

It may be tentative good news, then, that money market outflows hit $28.2 billion this week, the highest level in six months. And longer term, the trend is strongly in favor of insured savings accounts over money market funds. – Ben Walsh

On to today’s links:

Banks
Moody’s downgrades 15 financial institutions – Credit Writedowns

Charts
2,000 years of economic history, charted – Economist
Younger American families lost more than half their net worth between 2007 and 2010 – Economic Policy Institute

Alpha
“We are extremely lonely” – Meet the hedge fund manager who wants to invest in Greece – Bloomberg

Billionaire Whimsy
Larry Ellison just bought a Hawaiian Island – Businessweek

The Singularity
Why software is better at investing than 99% of active investors – Techcrunch

Facebook
Congress declares it’s looking into “substantial problems” in the IPO process – WSJ

New Normal
The US’s for-profit prison industry by the numbers – ProPublica

Must Watch
Syrian satirist: “They broke my hands to stop me drawing Assad” – Guardian

Oxpeckers
BBC’s Mark Thompson is in talks to be the next NYT CEO – Guardian

Long Reads
Why women still can’t have it all – The Atlantic

Crisis Retro
Banks have complex structured products that they’d love to sell to wealthy Asian clients – WSJ

It’s Academic
Famous economic theory may be backed up by, you know, what actually happens in the real world – MIT

Boondoggles
Why did the environmental movement send 40,000 people to a failed summit in Rio? – Foreign Policy

EU Mess
Greece is now being forced to sell a famous state-owned resort – Bloomberg

The Fed
The Fed has an inflation ceiling – The Atlantic

China
China’s factories are in their eighth month of contraction – Reuters

Comments
14 comments so far | RSS Comments RSS

IMO, the big picture story of the financial crisis has been that it was a run on the shadow banking system followed by the complete failure to regulate the shadow banking system. It’s a travesty.

The regulators have completely missed the mark here.

To a first approximation, the shadow banking system is MMMF + commercial paper + repo. And it’s just as unstable as it ever was. Yet nothing is done about it.

Posted by RueTheDay | Report as abusive
 

never understood this $1 guarantee….I give somebody (a bank, whoever) a dollar, and then tomorrow, I go to get it. If they invested in overnight funds only, then, most likely, at least there is $1 there. If times are tough, maybe not. The $1 guarantee is silly.

Posted by pete_keyboards | Report as abusive
 

I agree with @pete_keyboards. The ultimate recovery for holders of the Reserve Primary Fund was 99 cents on the dollar, albeit without access to some of that money for an extended period of time. Runs on money market funds occur because of the fear of being the last person out at a fund whose assets are ultimately worth only something like 95 cents on the dollar or more, because that 5% (or lower) loss turns into a full loss for the last holders after everyone else exits at a mythical $1 NAV.

As for the fee rebates, those are a result of near-zero interest rates, not a stable $1 NAV. Assuming that we someday return to a normal interest rate environment, that issue goes away.

Posted by realist50 | Report as abusive
 

The way the Fed et.al. handled this back in crisis-08 looks to me like one of the few bright spots in an otherwise miserable record of failure.

When the run started they issued a blanket-guarantee of MMMF balances to depositors, didn’t they? That calmed-down the incipient panic in the commercial paper market – and brought a dead-stop to the flight-to-safety that was threatening to strangle the entire financial system. And it didn’t cost anything – they never paid a dime on that guarantee, did they?

If only – they had thought it through and crafted something similar to that for AIG, the world might be a completely different place now.

Posted by MrRFox | Report as abusive
 

@MRRFox: runs on MMMFs were almost entirely a liquidity problem; AIG was a massive solvency problem.

You can contain the former by loaning liquidity against unsecured assets (or credibly guaranteeing to do so).

You ‘contain’ the latter by injecting liquidity in exchange for equity (hopefully in the form of post-bankruptcy DIP after prior equity is wiped out and prior unsecured creditors take large cramdowns.)

How would a simple liquidity program have helped AIG? They became massively insolvent when they posted $100 billion in losses.

Posted by SteveHamlin | Report as abusive
 

@SteveH – I have only a layman’s knowledge of AIGs CDS technicals. AIUI, the immediate crisis of solvency for AIG was a requirement that it post cash collateral with counterparties as credit quality of insured items deteriorated. Would have been no strain at all IMO to get out of that cash-crunch by replacing the cash-drop with a Fed guarantee. (Like any counterparty in the world was gonna say “No” to anything like that if the Fed asked for it?)

At the time, the equity position of AIG was taking hits from unrealized losses on the same items covered by those cash deposits, so both liquidity and equity appeared to be evaporating. But the positions AIG held have since recovered back most of what they gave up, haven’t they?

If I’m not missing something in this, it seems like a situation where a little out-of-the-box thinking might have got us on the path of this kind of approach to the entire rescue project, instead of the brute-force raid on the Treasury that was actually used. Am I all wet on this?

Posted by MrRFox | Report as abusive
 

MrFox, I don’t think you’re all wet (at least not on this). I could never understand why the Fed or even the treasury didn’t offer to guarantee (for a fee to AIG) their collateral, as you suggest, that seemed like the least expensive and invasive solution. I could only surmise that the scholars (Geithner and Bernanke) got schooled by the sharks (Blankfein and Paulson). The latter two scared the former two into believing the world would collapse if they didn’t cover Goldman’s positions immediately.

I vaguely remember one of Felix’s regular readers writing a “fiction” comment about how AIG put up collateral for the swaps they sold to Goldman, and the market value of the collateral was then marked down to market by Goldman, which effectively forced AIG into technical default on their collateral agreement. It sounded more like reality to me, though.

Posted by KenG_CA | Report as abusive
 

MrFox, your proposed solution would have been much worse for taxpayers than what actually happened.

Let’s take some example numbers for illustration. Suppose AIG had written CDS on $100bn of assets, which the market was valuing at $60bn, and on which AIG had posted collateral of $35bn, but no longer had the cash to post remaining $5bn that counterparties were demanding. Let’s for the sake of argument also suppose that it has been decided that the government is going to bail them out.

Your solution says the government will promise to guarantee AIG’s collateral commitments. ie the government will post the $5bn and any more that may be demanded by lending AIG the cash required. There was another solution (which was actually implemented) that the government would simply buy the assets at “100c on the dollar”.

Let’s compare the two in a downside and an upside outcome.

Downside outcome: the assets turn out to be worth only 40c on the dollar. In your scenario, the taxpayer posts $25bn in additional collateral. AIG is insolvent, so the taxpayer loses almost all this money. What actually happened: the assets were purchased by the taxpayer for $60bn, and $5bn was loaned to AIG. Result, the taxpayer loses roughly $25bn.

Upside outcome: the assets turn out to be worth $80bn. In your scenario, the taxpayer is repaid the $5bn that was initially loaned. AIG shareholders get $20bn upside. What actually happened: the taxpayer gets repaid the $5bn that was initially loaned, and most of the $20bn upside. Result, the taxpayer gains most of the $20bn.

So, in your scenario, the taxpayer takes all the downside risk and gets none of the upside. In what actually happened, the risk/reward is more evenly balanced. Whatever your view on the value of the assets, what actually happened is obviously better for the taxpayer. If you believe AIG had a liquidity and not solvency problem, what actually happened is clearly better.

Posted by niveditas | Report as abusive
 

KenG_CA, no, the collateral was not marked down. As MrFox says, the “insured items” were marked down. Collateral is typically cash or treasuries. It would be insane for it to be “marked down”. You obviously have a bee in your bonnet about Goldman and are incapable of understanding the economics of the situation. I will not waste my time trying to explain it yet again.

Posted by niveditas | Report as abusive
 

@NiveD – Now that was a little over the line toward KenG, don’t ya’ think? The GS conflicts of interest with the (temporarily) former GS people who purported to be acting in the public interest was/is obvious. It taints with appropriate suspicion everything that was done. That’s why conflicts of interest are so insidious. Lighten-up, buddy.

IDK about your analysis of the econ of the matter. These were a crazy form of insurance that AIG wrote. Collateral had to be posted (and re-posted) even before there is any actual loss. AIUI, most of those insurance contracts never had to be paid on, at least not yet. IDK how many actual defaults on CDS-covered items happened – do you? Likely there were some out of Lehman and perhaps out of Greece, but how big was that?

For everything else, all the liabilities end when the term of the contract expires – “lapse” is the legal term for that. Any item not in default then is no longer a problem, right? So, how many were/are in actual default?

Posted by MrRFox | Report as abusive
 

niveditas, I was recalling a hypothetical analysis of Goldman’s involvement in AIG’s collateral problems written by someone else, although I do think there was validity to that premise. The chain of events that triggered the government’s takeover of AIG was a collateral call by Goldman, which demanded payment because they felt the value of collateral posted by AIG wasn’t enough to cover their potential losses. Whether it was the value of the collateral or the assets that were being insured, the value of both were not established by AIG, but by a third party. Who was that third party?

Posted by KenG_CA | Report as abusive
 

Wow, it is like Groundhog day.

niveditas, from recollection, KenG_CA has had this explained to him at least 7 times. First couple of times, he can be ignorant. Another 4 times, maybe he gets away with it because he is clearly “special”. But frankly by now, we have to accept that he simply can’t accept the facts because they clearly violate his happy world-view that GS is the root of all evil and got some sort of special treatment from Paulson, despite the fact that whenever someone tries to give an example, it never quite stacks up and so they are left to give make vague noises about how “obvious” the conflicts are.

At the risk of getting lectured on structured products by someone doing equities in Dallas:

GS explanation of pricing:

http://online.wsj.com/public/resources/d ocuments/WSJ-20100802-GSMBS

and here are all the non-existent trades that apparently never happened after Feb 2008:

http://fcic-static.law.stanford.edu/cdn_ media/fcic-testimony/Derivatives/Goldman %20Sachs%20Follow%20Up%20Exhibit%20GS%20 MBS%200000039095.pdf

A diligent reporter could of course dig through this to check trades on tranches insured by AIGFP. From recollection of a 3rd hand story there was at least one post AIGFP takeover by gov that GS did with a European hedge fund.

Posted by Danny_Black | Report as abusive
 

@DannyBlack – Good to see you back, Danny Boy. You were missed – much like The Roadrunner would miss Wily Coyote.

The conflicts of interest inherent in former GS people acting for government in any matter involving GS has been explained to you previously. Before you presume to pass judgment on others in such circumstances, perhaps you should be guided by this injunction -

“Judge Not Lest Ye Be Judged!”

Posted by MrRFox | Report as abusive
 

Danny, I don’t think even you can deny that Goldman made a collateral call to AIG that precipitated the takeover of AIG. The collateral call had to be triggered by either a decrease in the underlying assets that the swaps were covering, or a decrease in the value of the collateral posted by AIG (I don’t believe it was all cash and treasuries that AIG had put up, as you consistently claim). There were no realized losses at the time, which was the gist of this thread, that the government didn’t need to cover losses that had not materialized yet, they could have provided a guarantee that ultimately wouldn’t have been utilized.

So one way or another, the value of assets that AIG was either holding or insuring had been marked down. By somebody. Was it AIG? No. Tell me who wrote down the value of assets that enabled Goldman to demand more collateral be posted by AIG. And if you can’t answer it without resorting to insults usually sourced in high schools and drunk tanks, don’t bother.

Posted by KenG_CA | Report as abusive
 

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