Bailout Part III Money Fund Guarantee

5 Community Comments, Facebook Comments

  1. Danny the Red (hair) says:

    Coming to the rescue of a key piece  the financial system, the government took some big steps Friday to shore up the $3.3 trillion U.S. money-market fund industry.

    This is a difficult one for me.  I managed money funds for years.

    First it is useful to explain what a money fund is and what it is not.

    A MMF is not a debt instrument, it is an equity that buys debt instruments.  MMFs pay dividends not interest.  They are designed to have a stable Net Asset Value ($1) by buying high credit quality paper that has a duration under 13 months that will not result in high volatility of the underlying assets.  Its pretty much worked for the last 36 years, with a couple of hiccups.  The problem is with how the financial press has described them:  substitutes for insured bank savings.  They have never been this and no Mutual fund presents them this way.  Though stable and low risk, they are never presented as no risk.

    The Reserve Fund, which failed to keep its stable $1 NAV (broke the buck) last week, was the first money fund invented in 1972 when they received an Exemptive Order from the SEC to used amortized cost in their accounting as long as the mark to market deviation was de minimus.  After 36 years it lost 3% for holders at liquidation though it reported positive returns everyday for the last 36 years: low risk, but not no risk.

    The Reserve Fund broke the buck because it held enough Lehman paper that when Lehman failed the funds amortized cost deviated from the mark to market as the Lehman paper now had little or no value.

    The loss would not have been enough in and of itself of to prompt government action, but the markets are a web.

    Because of limitations on checking interest for corporations, institutional money is a dominant force in MMFs.   Institutional money runs for the exit on any bad news.  I spoke with some former collogues on Friday and 1/3 of my former fund’s shareholders ran for the exits after the Lehman collapse.   My former fund held no Lehman paper, no AIG paper, but shareholders run and then investigate.  Which is prudent for the individual, but bad for the system.

    The collective redemptions resulted in the single worst week for MMF flows, which is shocking considering that after 9-11 we couldn’t even value assets or determine who was holding them due to certain issues related to custody.

    After a run began on Lehman Reserve fund dumped $40 billion of securities on the market.  The rumor is that they did this purposely to spark a crisis.  You are in trouble if you screw up on your own, but it’s the industry’s fault if everyone else comes with you.  

    $40 billion is a lot of securities for the market to absorb in the best of times, in times of crisis the street goes “no bid”.  Unlike equities that always have a 2 sided market (Bid/Ask) in all but the most thinly traded stocks, fixed income often has trouble finding a bid because the brokers hold the paper they buy in their inventory rather than passing it through to a buyer on the other side.

    Otherwise creditworthy MMFs getting hit with redemptions need to raise cash go to the B/Ds to sell securities, but because Reserve dumped a ton on the market, other MMFs are getting pounded as well and the B/Ds risk managers have tightened the trading books of their traders, no one is making markets any longer.

    This also served to depress the value of asset on the balance sheets of  banks and B/Ds because of Mark to Market accounting and further hammering the book capital of the banks and B/Ds

    Most insolvencies are actually liquidity crises, not credit crises.  Reserve Fund was a credit crisis, but it was causing a liquidity crisis in the entire industry.  Because my old team had liquidity management built into their DNA, they did just fine, but other funds were not in the same position.  Others were hitting their credit lines (many of which were put in place after 9-11) or force selling securities onto the B/Ds by using Puts.

    To stem the panic, the Treasury did two things: 1. insure up to $50 billion in money-market fund investments at financial companies that pay a fee to participate in the program to guarantee that the funds’ value does not fall below the standard $1 a share.  2.  Allow the banks and B/Ds to post ABCP (asset backed commercial paper) as collateral to the Fed.

    The first measure is designed to return confidence to the retail and institutional  customers.  The second is more important.  It creates liquidity in the ABCP market by creating a funding source that market makers can use to keep the market functioning.

    Verdict

    The government providing insurance may or may not be a good idea, but insurance is a good idea.  My funds used to have private insurance, but after the collapse of one large short term issuer, the insurance companies realized that any failure wouldn’t hit one policy holder, but many of them (like hurricanes in the P/C business).  Private Money Fund insurance quickly went away after that.

    If a program could be created that in essence similar to Government terror, Catastrophe, or Flood insurance for MMFs where the industry itself bore the costs, that would be ideal and something I would promote.

    On the second point allowing the market makers to post collateral to the Fed is absolutely critical to getting the markets moving again and to allow for real pricing to occur.  If the government didn’t do this, the run on the MMFs would continue and they would be forced to dump more paper on the street further depressing prices and depressing the capital of the Banks.

    A final word

    I have decided to “out” myself.  I am giving too much specific information to remain responsibly anonymous.  My name is Dan Schoen, I worked at Janus for 11 years 9 years of it as a fixed income analyst, trader or portfolio manager.  I am a Chartered Financial Analyst in addition to being an attorney.

  2. Ray Springfield says:

    If both parties do not act soon another large institution will fail.

    The domino effect has been slowed by speculation. If legislation is not enacted almost immediately, the general crisis will deepen.

  3. ClubTwitty says:

    allowing the Sec’t to spend $700 billion with no judicial review ever and no administrative oversight is a terrible idea.

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