What happened last week to make the US Treasury abandon its "case-by-case" approach to the credit crunch? What was the most significant initiative to come out of the Treasury Department over the past few days?
The answer to the first question is, "Panic withdrawals by investors in a number of major money market funds" (MMFs). The answer to the second is, "Treasury's guarantee for money market fund investors," not the contentious one-shot $700 billion buyout of toxic financial assets from the private sector.
Over the past twenty years, a $3.4 trillion "shadow banking system" has grown up inside the U.S. financial system. An old-fashioned panic-driven "bank run" has now fully revealed its dimensions - and vulnerabilities.
How the Panic Started. The die was cast when investment bank Lehman Brothers went into bankruptcy on Monday, September 15. A major money market fund, the $64 billion Reserve Prime Fund held $785 million of Lehman's short-term debt. Institutional investors quickly took note: in two days, $38 billion went out that fund's door. When its managers had to suspend redemptions and revalue its shares from the sacred $1.00 to 97 cents, the game was over and the panic was on.
As this blog suggested ten months ago (10/18/2007) as the credit crunch developed, financial regulators have long feared that if a major MMF ever had to "break the buck," a general run on all similar MMFs would likely take place - with consequent major disruptions in all financial markets and international repercussions as foreign investors took fright. This came to pass last week.
An increasing number of investors in a growing number of MMFs decided that US Treasury bills, not money market funds loaded with private sector debt, was the place to be: T-bills yields fell to less than 1/2%. Total MMF outflows for the last two weeks amounted to $206 billion, and this doesn't count the probable massive switch by investors from commercial paper-heavy MMFs to those that invest only in US government securities.
Where did the cash come from to pay off the fleeing MMF investors? In the first instance, it came from very short-term (1-3 day) "repo" loans the funds make to investment banks to finance their inventories of securities. These loans were not renewed, creating major problems for those banks. The cash from maturing commercial paper helped too - at the expense of firms that had borrowed this way in the past. (At the end of June 2008, the MMFs held $525 billion in repos and $700 billion in commercial paper.) And some funds, no doubt, sold securities to or borrowed cash from commercial banks to meet redemption demands.
Both investment banks and commercial banks borrowed by the billions from the Federal Reserve to try to replace the rapidly-shrinking MMF funding and meet the needs of their customers. At the close of business yesterday (September 24), more than $72 billion had been advance to banks so they could buy commercial paper from MMFs. But there is no way to deflate rapidly a $3.4 trillion shadow banking system without causing true financial chaos.
Ending the Run on MMFs. As the potential scale of the emerging run on the MMFs became apparent, the Treasury turned to its traditional in-house honey pot, the Exchange Stabilization Fund, to establish a "temporary" MMF investor $50 billion guaranty program. The stated objective is to insure that MMFs "will not 'break the buck'." This appears to have halted the panic in its tracks.
The establishment of the fund does not require any Congressional action or further review. As the press release accompanying its announcement simply states, the President "approved the use of existing authorities" by Treasury Secretary Paulson.
Beware the Law of Unintended Consequences. This $50 billion guaranty program is a work in progress. The Treasury appears to be trying to limit its scope (only amounts at risk as of September 19 will be covered) and duration - the program is supposed to last only one year. However, MMFs that invest in tax-free securities were included in the first "clarification" of the orginal Treasury proposal (a $1.2 billion default by Jefferson County, Alabama is looming up the road, but it has nothing to do with subprime mortgages).
But, who ever heard of a $50 billion US government program that lasted only one year? Once such a program is established, it creates economic dependents and a political constituency that will strive mightily to keep it in existence - and expand it. Case in point: government terrorism insurance for property developers.
Commercial bankers see an immediate, heightened threat to their ability to attract deposits from their traditional customers. The primary advantage they have had ever since the MMFs appeared on the scene is federal deposit insurance from the FDIC. (And the de facto extension of this umbrella to all depositors, including foreigners, at the largest banks, despite the official $100,000 per account limit). No doubt the bankers will strive mightily to make sure the guaranty program is terminated at the end of one year, but I suspect they will lose the battle.
In the meantime, the Treasury will be forced to issue a stream of interpretations and regulations as the complexities of operating such a massive program become clear. Coordinating its actions with the Securities and Exchange Commission is likely to become a sore point. The money fund sector will need to be integrated into the promised full-scale overhaul of the entire financial regulatory apparatus.
Bottom Line. The financial playing field is being radically reshaped "on the fly." Let's just hope that the designers and engineers keep focused on making sure that the proper "risk v. reward" incentive structures for both borrowers, lenders and intermediaries are not buried in the urge to protect, coddle or punish the principal actors in this decade's premier financial bust.
If they don't, the next exciting financial cycle won't be long in coming.
[For a diagram showing how toxic mortgages penetrated the financial system in general and money market funds in particular, please go to: Download toxic_mortgages_schematic.pdf ]
