Thursday, June 21, 2012

The Real Cause of Financial Crisis: Money Market Funds

OK, so that's a dramatic statement.  This post will no doubt come across as way too sympathetic to banks, but since I see that the SEC is looking into money market funds, I thought I'd make a post about it.  

This has been a pet peeve of mine for a while.  The banks have been really tarred and feathered since the crisis.  Sure, a lot of what they did was wrong.  Many people made mistakes.  Everyone participated in the bubble, so I don't mean to say that banks are guilt free.

But I do think and have thought that the focus on banks has been overdone, especially in the press and in Washington DC.  I remember reading an article in the Economist about what Washington is doing to banks and a writer said that it's like a bar brawl; when a fight breaks out in a bar, you don't go after the guy who started the fight.  You just turn to the guy sitting next to you that you never liked and hit him.  Not because the brawl is his fault but just because you don't like him and now is a good time to hit him.

That really sounds spot on to me (what does the financial crisis have to do with credit card fees?).  When the banks are down, people pile on.  It was a good time to just hit and kick the banks since they were already on the floor.

It seems that there is so little focus on trying to get to the root of the problem.

Volcker Rule, FHA Loans
I remember reading all this stuff about the Volcker rule and hearing at the same time that even *after* the crisis, the FHA was guaranteeing mortgage loans with only 3.5% - 5% down.  I was like, "huh?".  We want to stop the banks from trading their own capital (proprietary trading, by the way, had nothing to do with the financial crisis.  Merrill Lynch got killed on warehouse/inventory positions.  Same with Morgan Stanley.  It's true that some of the positions may have been shifted into proprietary positions once the securitization markets froze, but the positions were all related to the mortgage "machine" which is all customer-related).

I am one of those people that think that maybe if mortgages were required to have 20% down payment the bubble/collapse wouldn't have happened, or it wouldn't have been as extreme.

Instead people focus on the "evils" of banks.

Glass-Steagall / Too Big to Fail
I always thought Glass-Steagall was outdated, especially because of the disintermediation of the economy over the years.  In the old days, companies relied on banks for loans, but as the financial markets matured, the bond market became a bigger part of fund-raising for companies.  It made no sense to me that a bank would be able to offer loans but not help it sell bonds.  Loans are syndicated and resold too; why wouldn't they be able to offer stocks and bonds?

Also, much of Europe didn't have the same distinction so U.S. banks would be at a disadvantage versus European universal banks in an increasingly global economy.

Anyway, I don't mean to debate all of that here, but my point is that Glass-Steagall may have contributed to the crisis in indirect ways, but I don't think it was a big factor.  The big bankruptcy that froze the financial markets and almost plunged the world into a global depression was Lehman, and they weren't a bank.  It was an investment bank.  Bear Stearns wasn't a post-Glass-Steagall universal bank.  It was an investment bank.  Merrill Lynch was also an investment bank.  The biggest busts, Fannie Mae and Freddie Mac weren't 'banks'.  AIG was not a bank or an investment bank, and they were probably one of the biggest factors in causing this collapse.

Too big to fail?  None of the above banks/investment banks that failed were really "too big".  The only big bank that had a problem that fit "too big to fail" was Citigroup, I think.  J.P. Morgan was never at risk.  Bank of America, I think, was fine until they acquired Countrywide and then later Merrill Lynch.  But up until then, I think they were fine and would have come through the crisis with no problem.  They only became "big", probably at the encouragement of regulators.  As Buffett said, they may have unwittingly saved the financial system in 2008.

We Survived Bear Stearns, Wamu, Countrywide etc.
So anyway, getting back on topic, I sort of think that in 2008 we were fine even with Bear Stearns, Wamu, Countrywide, Indymac and others going under.  Buffett thought the authorities drew a line in the sand and the worst was over after JPM bought Bear Stearns.

But boy, was he wrong. 

So what went wrong?

Money Market Funds (MMF)
I still think the market would have been able to deal with a Lehman bankruptcy.  What was not predicted at the time was the extent that MMFs were exposed to Lehman paper.  When the Federated Funds "broke the buck", that's when all hell broke loose.

This, I think, is what caused the near depression. When you look at economic figures and comments from CEOs around the world, the Lehman bankruptcy is what caused money to stop flowing and phones to stop ringing.  This is when the economy basically had a heart attack and just stopped functioning.

But it wasn't really Lehman itself that was the problem.  It was the MMFs.

How can MMFs do this to the global economy?

Let's look at what happened.  Read the 2008 J.P. Morgan annual report and Jamie Dimon talks about what happened in September 2008.  Here are some snips regarding MMFs (Dimon only points to this as one of the many causes):

And later in the report:

So let's think about this for a second.  $700 billion fled money market and bond funds in two weeks.  Of that, $500 billion was money market funds.  That's an astounding number. 

For reference, here are the total deposits as of December 2007 of some of the largest U.S. banks around that time (I used 2007 instead of 2008 because of some large mergers that happened in 2008; 2007 would show more what the typical bank looked like before those emergency mergers):

Deposits at Big Banks, December 2007

J.P. Morgan:                   $740 billion
Citigroup:                       $826 billion
Wells Fargo:                   $311 billion
Bank of America:           $805 billion

So $700 billion fleeing bond and money market funds is like a real bank run of tremendous magnitude.  Even if we just look at the money market funds, $500 billion moving out is like having a total bank run on one of the largest banks in the U.S.  Can you imagine what would happen if there was a real bank run at Citigroup or JP Morgan?  Yes, the economy would collapse.  You can't have $500 billion flee like that and not have a huge impact on the economy!

(I know there are people that would argue that it makes no difference because cash moving out of one place will just move to another so net-net, nothing changes.  But that's not how the market and economy works; when there is a panic and money moves out, yes, they move into treasuries and other risk-free assets and deposits at 'safe' banks and yes the sellers of those treasuries would use that money to redeploy it elsewhere.   But that doesn't happen immediately and that disruption is what causes chaos; not any real disappearance in cash).

The FDIC and the Fed is designed to prevent this.  Notice that no matter how much trouble Citigroup was in at the time, I don't recall anyone withdrawing their deposits.  Even at Wamu and other 'failed' banks, I don't remember hearing anyone moving their deposits out.  There were some cases like Indymac, but I think most failures happened smoothly in terms of transferring deposits to strong banks.

This is precisely what the FDIC is for, and it worked as it is supposed to.

But the problem was that there was no FDIC for money market funds, and the MMFs didn't have to put up any capital to support their assets.  Now think about that;  MMFs can do business with NO CAPITAL to support their assets, and yet they are allowed to pretty much guarantee principle. 

How can that be?!

The banks can guarantee deposits up to the FDIC amount because the FDIC backs the deposits (well, actually, the banks don't guarantee anything; the FDIC does).  And for that guarantee, banks pay the FDIC fees.

So the MMFs were like banks with 0% Tier 1, 2, 3 or whatever capital.  Yes, they are short term and don't make long term loans and yes, they are limited in the credit risk they can take.

But they did take a loss on Lehman paper. 

The funds are fighting all sorts of regulations to correct this anomaly.  I don't think they should be allowed to guarantee principle without either an FDIC-like government backing or some capital to support the guarantee.  It just makes no sense at all.

If they only make short term loans, and only to high quality credit, then the government guarantee fee would probably be pretty low, or the capital requirement would be low too; much lower than at banks.

Anyway, to me, that's a huge hole in the financial system that seems like a much bigger problem than anything else I hear people talking about; hedge funds, derivatives, Glass-Steagall, proprietary trading etc...   None of those things, to me, are remotely close to being an issue compared to the MMFs.

It is so ironic that people seem so focused on the complex and rail against it while overlooking the huge risk that exists in the simple, plain vanilla thing that I personally think had a far bigger role in the near collapse of the global economy.

Don't get me wrong.  There was a problem in back in 2008 and we would have had some sort of recession.  I don't mean to say that nothing would have happened if MMFs were properly insured or capitalized. But it does seem to me that it was the single, biggest factor that changed a typical credit boom/bust cycle into a near collapse; look at the economic figures *after* September 2008.  That was not because Lehman ceased to exist.   It was because of a huge 'run' on MMFs.

Anyway, I know this is a controversial issue and many will not agree, but that's OK.  Again, I don't write this to find people to agree or disagree.  I just wrote it because I don't hear this point of view all that much.


  1. If I sent you my two-page solution to the MMF problem, would you look at it, and tell me what you think?

    1. Sure. If you post an email address, I'll email you (and I will delete the post with the email address as soon as I get it).

    2. I won't need to post my e-mail address; anyone who reads the Aleph Blog can get it there. Here is the proposal I submitted to the SEC.

      I think it is the best compromise proposal outstanding; it is similar to, but more definite than the one the CFA Institute put together. The trouble with most proposals is that they either want to change MMFs drastically, which will kill them, or they don't want to change at all, which is dumb.

      Let me know what you think.



    3. Hi, that is certainly interesting. I agree that one solution is to allow MMFs to lose money like any other ETF. I don't have a strong view on whether MMF should be allowed to break the buck or keep guaranteeing the buck, as long as it is consistent; if they are not capitalized or insured, they shouldn't be allowed to guarantee principle, period.

      You are right that market forces should decide what MMF has credit risk etc...

      I can see why the MMF industry would not like it, though, because the appeal until now of MMF's has been the principle guarantee aspect of it.

      If the MMFs are allowed to have credit events, then your idea might be a good one.

      I still tend to think that if the industry wants to guarantee the buck, they should be allowed to but a government insurance backing or something would be necessary.

      Banks have the FDIC, and until the financial crisis, the FDIC has never lost money on bank failures; FDIC fees have covered losses. Any loss that exceeded FDIC funds during the crisis will be earned back by the FDIC through higher FDIC fees charged to banks. So contrary to common perception and the press' misunderstanding about it, taxpayers do NOT pay for bank failures. (and the biggest failures in the last crisis were not even FDIC failures; AIG, BSC, LEH, MER, FNM, FRE etc. were not FDIC institutions).

      SIPC is the same. SIPC is a guarantee on cash in brokerage accounts by the government, but fees paid by the industry keeps this funded.

      The same thing can be set up for the MMF industry; run by the government, funded by the MMF industry to protect the industry. This is sort of how insurance is supposed to work and for something as crucial as this, government insurance makes sense.

      The industry just doesn't want to be regulated and doesn't want to be charged fees. Noone wants their very own Sheila Bair, lol... With interest rates so low, they can't even charge management fees now let alone paying fees to the government.

      In any case, we shall see what happens.

    4. Oh, and by the way, if the MMF was going to be allowed to have a credit event, then I don't think you really have to worry about a 'run'. It would be no different, as you say, than short term bond funds now. If people know that the NAV can fluctuate and par is not guaranteed, then they will not freak out on a loss no more than short term bond fund investors would freak out about a decline in NAV etc...

      So the key issue is still going to be whether that should be allowed or not. I hope they do come up with something good, even though I am skeptical...

    5. Thanks. A variety of people have arisen to praise this, but when I tried to get the ICI & SEC to embrace this, it went nowhere. No one wants to compromise.

  2. Ha - yes, this post does smell and read like someone overly sympathetic to banks. I don't get the connection between $500bn leaving money markets and bond funds to that being a root cause of the financial crisis. Unless I'm missing something, if an institution got a redemption request for a money market fund, they'd be able to sell assets to facilitate that redemption (auction rate securities aside, it wasn't that hard to sell even then to make that redemption). And I could say the same for bond funds (HY, distressed and other illiquid funds aside).

    I'm sure MMFs played a role but I see other much bigger forces - and yes, the banks here were key players - that caused the crisis.

    Love your blog and thoughts/analysis (we overlap on many names).....

    1. Yes, I thought someone would say that. Yes, banks caused a lot of the problems; subprime, CDO-squareds and all that.

      But my point was really that things really got nasty after the Lehman collapse. And the point is that it wasn't necessarily Lehman collapsing that broke the camels back, it was the fact that there was trillions in money market funds that guaranteed principle with no FDIC-like insurance and no capital to support it that caused a huge 'run on the bank', as big as if there was a real, 1930s-type run on JPM or Citibank or something.

      That was really my point. If that $500 billion run didn't happen, I think the markets/economy could have absorbed a Lehman collapse.

      If you go back and look at the economic figures and the panic that led to TARP etc., it really does start after that 'run'.

      So yes, banks caused the bubble/collapse and all that, but the really big "shock", I think, was in fact something as simple as money market funds.

      That was really my point.

      And yes, either way, I do come across as a bank lover, lol... That's OK. I have already confessed to that...

  3. When money fled MMF, commercial paper market collapsed. Banks and many corporations rely on CP for short term funding needs, withdrawing $500bn from that market is a HUGE dislocation.

  4. I remember taking client's money out of Citi's SIV exposed MMFs in 2008. I never read prospectuses with more detail than late 2007 and early 2008. VRDNs and Senior Bank Loan funds were being used as cash substitutes. Interest rates were rising steadily back then and floaters were paying a good yield. All of that got crushed and liquidity was an enormous problem. I remember meeting with a PWC partner and discussing assets. He told me in 2007 that companies didn't know how to value those assets... if only I had more experience and knew what that meant...
    Great that you bring this up because I think MMFs are still a gaping hole in our system - the lure for yield is too great. David I like your plan, too, but wonder why individual funds can't get an insurance company to back up their investments and within certain parameters they can invest more or less aggressively.

    1. Financial insurance has always been a dodgy game. It doesn't work well, outside of bull markets, where it is not needed.

      Think about the recent crisis, and what has happened to the financial insurers. Some are dead, others are almost dead, and the rest are walking wounded.

      Here's the conundrum: in the bull market, financial insurers don't hold huge reserves, because they are looking through the rear-view mirror. In the bear market, they have no resources to meet clains.

    2. Good point about insurance. That's why in the case of MMF, I would support a government insurance plan. If the insurance is for the sake of the stability of the financial system (like what the FDIC is for), government backing makes sense. The private insurers (mortgage insurers, AIG etc...) were ridiculous; they charged the same fixed percentage, apparently, for any mortgage (or at least by broad categories).

      They were undercapitalized and went under. That's why it won't work (by the way, private insurers used to insure brokerage accounts above the SIPC maximum, but I think they stopped doing that as the risk/reward was not worth).

      This is why something like the FDIC makes sense. If they are undercapitalized and lose money, they can get funding from congress but that gets paid back in future, higher FDIC fees. A private insurer can't do that. If they go out of business, that's it. If they survive and try to make it back via higher rates, they might not get renewals.

      For some things, like terrorism insurance, it just makes sense for government involvement even though I am for less government, not more...

      Anyway, interesting discussion.

  5. I had never thought of this angle.

    But I wonder who controlled such massive amounts of capital and were able to pull them so quickly. There is some inertia in humanity...but not in computerized programs I suppose. And a small group of panicked individuals controlling huge pools of capital could turn on a dime.

    But what triggered the panic was derivatives...and one side was so unabalanced it could not settle.

    Nervous Nellies. And wasn't the initial request from Paulson for 800 billion...and then that guy at Bloomerberg later tallied the rescue money at something like 32 trillion, though some argue that was a smaller pool of money recycling week to week.

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  7. Can anyone please tell me how exactly did ''money markets'' responded to the financial crisis 2007-8

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