TOPICS IN POLITICAL ECONOMY

REAL REGULATORY REFORM: FOR MONEY MARKET FUNDS

 

The Securities and Exchange Commission is supposed to look out for the small investor.  So, how did it end up precipitating the collapse, last September, of the entire money market fund (MMF) sector and the need for the U.S. Treasury to step in and guarantee $3.4 trillion in shares?

 

Take a look at Joe Nocera's outstanding piece, "The Risk in Money Funds," in today's New York Times business section, (normally not a solid source for economic and financial analysis). The massive run on all MMF shares was precipitated by The Reserve Fund's "breaking the buck" (marking down the value of its shares from $1.00) because of its holdings of $785 million in bankrupt Lehman Brothers' commercial paper. The run was aborted by the U.S. Treasury Department's guarantee of the $3.4 trillion in outstanding shares last September. 

 

The SEC Sponsors a Shadow Banking System. Originally, MMFs were not allowed to design and market their shares around a stable $1 @ share net asset value.  However, in the late 1970s the investment companies persuaded the SEC to let them follow accounting rules and marketing pitches that permitted them to do so under almost any conditions - and sell them, in effect, as alternatives to bank checking accounts, complete with check writing features - "turbocharged" bank accounts, as Nocera describes them. 

 

In the high interest rate environment of the 1980s, the MMFs prospered mightily. By the 1990s, they had become a parallel banking system, providing billions of dollars of short-term credit in competition with commercial banks. To further confidence in MMFs, the SEC started, with industry support, to mandate investments only with top credit ratings from the likes of Moody's and Standard & Poor's. Then, during the subprime mortgage boom, they plunged, indirectly, into that lending business, too, which the credit rating agencies facilitated with plenty of AAA marks on mortgage-backed securities.

 

In short, the MMFs had everything but FDIC insurance - and now, as a result of last September, they have demonstrated that Washington will guarantee $1 @ share if another run threatens.

 

Now What?  We can't rewrite history - but we can rewrite regulation so that the true riskiness of MMFs is transparent to investors, and reduce the likelihood of another government bailout.  As Nocera points out, the single best way to do that is to undo the SEC regulations that let them price and market their shares under almost any conditions at $1.00. Insist that MMF shares trade the way all other mutual fund shares trade.

 

Another action to make investors more conscious of risk would be to remove the mandate that MMFs invest only in SEC-defined "eligible" securities, and force fund managers to pay more attention to the creditworthiness of their investments. (S&P gave Lehman Brothers' short-term paper their highest credit rating until the day before that firm declared bankruptcy.)

 

Real reform of the money market sector means it will not enjoy all of the SEC-bequeathed competitive advantages they have had in the past.  But if the agency is more concerned about investor protection than the MMF's market share of  deposits v.v. commercial banks and savings institutions, it will take the steps advocated above. Otherwise, we might just as well force the conversion of MMFs into FDIC-insured banks (as Paul Volcker, for example, has advocated).

WHOLE FOODS AND HEALTHCARE: REALITY V. IDEOLOGY

There is a wonderful tempest in an (organic) teapot currently swirling around Whole Foods, the leading purveyor of organic products and assorted liberal bloggers.  It demonstrates clearly the yawning gap between knee-jerk, ideological thinking and the way the world is actually made a better place.

The CEO of Whole Foods, John Mackey wrote an op-ed for the Wall Street Journal describing his company's high-deductible health insurance plan.  He also suggested various ways in which less government and more individual choice could result in a fairer, less costly system for everyone. The Wall Street Journal's headline writer entitled the piece, "The Whole Foods Alternative to ObamaCare."

Mackey pointed to his own Company's plan, developed painfully over the past six years, as a example of what could be done under existing federal and state  law to maximize choice and employee satisfaction. (See his 2004 talk to the State Policy Network for illuminating details, including about how employees votes help to define the benefit package.)

For the cardinal sin of doubting that the federal government is the solution to health care's problems, the liberal blogosphere has descended upon Mackey with an outpouring of nastiness and a call to boycott the leading purveyor of granola to the literati of the left. At last count, his company's website forum on the issue had over 14,000 posts. 

By all accounts, Whole Foods treats its generally younger workers very well, as its low employee turnover rate would suggest. Its high deductible plan is something that many organizations have been moving towards in recent years, with generally positive results for both employees and employers. It would be nice to think that such facts should help shape the debate about how to reform health care.  

Read Mackey's op-ed  - and go buy a few granola bars from the nearest Whole Foods.

 

TIER 1 AND "TOO BIG TO FAIL" - BEWARE THE LAW OF UNINTENDED CONSEQUENCES

 

The problem of how to deal with very large and failing financial firms is as old as the privately-owned Bank of England’s problems in 1797, when it prevailed upon the British government to permit it to suspend payments in specie (coin) to its note holders.  It was carefully analyzed by the British economist Henry Thornton in 1802.  He saw a role for central bank "bailouts" so long as the rescued institution was solvent (e.g. facing a depositor panic that was based on erroneous fears).   

The bailout problem has bedeviled banking regulators in the United States for decades, most prominently (before the current financial cycle) in the case of Continental Illinois in 1984.   Only 10% ($4 billion) of its funding base was in insured deposits. But everyone, including bondholders, got all their money back.

Despite the Continental precedent, up until recently the Federal Reserve, the FDIC and other U.S. banking regulators have been careful to ensure that a reasonably high degree of “constructive ambiguity” existed to try keep bankers and creditors focused on sound banking practices.  Lehman Brothers was allowed to fail.  In the past 12 months, however, all the old rules have been thrown out and replaced with massive bailouts and federal guarantees on nearly every kind of short-term borrowing that exists.

Now comes the Obama Administration's proposal for another way to deal with the problem - and it's a very flawed approach: establish a "Tier 1" category of very large regulated financial firms.

 Such firms would be chosen by the Federal Reserve Board on the basis of their potential to “pose a threat to global or U.S. financial stability or the global or U.S. economy during times of economic stress.”  They would be subjected to more stringent standards than other financial firms.

The Tier 1 concept would apply to any “financial company” with more than $10 billion in assets, $100 billion in assets under management or $2 billion or more in gross annual revenue. In other words,  very large insurance  and investment companies, finance companies, and hedge funds, among others,  are to be herded into the Tier 1 corral. 

In effect, Tier 1 firms would be designated “too big to fail” and become a protected class. All their liabilities (except the shareholders’ investment) would be guaranteed by the Federal government.  Depositors, bondholders, and transaction counter-parties need not concern themselves with the financial stability of the Tier 1 firms they are doing business with.  “Let the regulators worry about that” is the message.

 The proposed legislation tries to inject a shred of uncertainty by requiring a bankruptcy hearing if a firm becomes “critically under-capitalized.”  But the whole purpose of the Tier 1 concept is to make sure this never happens and, even if it does, the only parties at risk are going to be shareholders.

Why “Tier 1” is Bad Policy.  Maintaining a sufficient degree of uncertainty about government support for specific financial institutions (“constructive ambiguity”) is a critically important  incentive for financial firms to act prudently –  historically, even more important than regulatory restrictions on capital and bank operations.

When the uncertainty level is low, e.g. government bailout probabilities are high, we end up with imprudent lending  (the “moral hazard” problem) and massive government bailouts – Fannie Mae and Freddie Mac being today’s prime examples.

By making it 99.9% certain that creditors of the largest financial firms will not be allowed to lose their investment, smaller firms will suffer an even greater  competitive disadvantage. (Small banks are already seriously disadvantaged by the largest banks' free ride in the deposit insurance system - as in the case of Continental.) 

Tier 1 makes analytical sense only if the promised “more stringent” standards on capital and liquidity ratios cost Tier 1 firms more than they gain in lower funding costs. Trying to make the cost of such standards equal to the value of the funding subsidy – across a myriad number and variety of financial institutions via regulatory fiat  - will only result in a massive and counterproductive web of paperwork and bureaucratic intrusions.  And it will lead to the establishment of a lobbying powerhouse (“The Tier 1 Toughs”?) that would make sure their clients came out ahead.

A Better Way Forward.  While there are many debatable aspects to the Administration’s package of financial reform regulation, the Tier 1 concept has the highest probability of major, adverse and unintended consequences.

Already the working assumption in financial markets today is that every “very large” financial institution will be supported.  While the Administration’s recent refusal to assist CIT Financial (a $75 billion finance company) helps to distinguish “large” from “very large,” the Tier 1 concept needs to be totally abandoned. 

Instead of Tier 1, all banking firms (including finance companies and government-sponsored agencies, such as Fannie Mae) should face a relatively seamless series of increasingly higher capital requirements as they grow in size.  Regulators should continue using “constructive ambiguity” (e.g. the possibility of large firms' bankruptcy and losses to their creditors) as a way to encourage prudent management - and to offset any tendency by managers to invest in increasingly risky assets as their capital requirements grow.

Nonbanking institutions, such as insurance and investment companies as well as hedge funds, should be excluded from the new regime.  No substantive evidence has been advanced that demonstrates these institutions, as a group, need to be included;  AIG was an outlier, already subject to federal regulatory oversight.

Final Note.  Unfortunately, rather than focusing on the implications of Tier 1, Congressional and media attention has been directed at relatively minor turf fights among federal regulatory agencies  -  and Treasury Secretary Geithner’s irritation about what is going on in the back of the bus. 

It's time for all the players to pay attention to the dangerous economic and political consequences of establishing a "protected class" of mega financial firms.

MAN-MADE CLIMATE CHANGE: THE CASE FOR SKEPTICISM

If you think there is a "consensus" among scientists regarding human responsibility for climate change, read the letters to the editor in the July 27 issue of Chemical and Engineering News, published by the American Chemical Society.

Members of the Society were incensed by a June 22 editorial, written by the editor-in-chief, asserting that

The science of anthropogenic climate change is becoming increasingly well established. The scientific consensus on the reality of climate change has become increasingly difficult to challenge, despite the efforts of die-hard climate-change deniers.

Nearly all of the correspondents attack the editor-in-chief (of a scientific society's publication) for condemning skepticism - a critical driver of scientific discovery.

A substantial majority of the letter writers are quite open to the possibility of global warming, but highly doubtful of the assertion that it is primarily driven by man-made activity. The summaries of the scientific basis for skepticism are highly readable and strongly recommended.

Yet another reason to oppose the massive energy bill winding its way through Congress (see "The Big, Bad Energy Bill, June 12).