Tuesday, August 28, 2012

Why Cheaters Prosper

Now there’s something you don’t see every day.

If I told you that the Wall Street Journal ran no less than 3 articles in the last week promoting more regulations, you’d think I was crazy. But it’s true. And, for once, the WSJ is right.

Last week, the Securities and Exchange Commission (SEC) voted down a proposal for rule changes that would have helped to avoid another financial meltdown like 2008. The vote was 3 to 2 and– as the editors of the WSJ opined– it illustrates the degree to which government regulators are captured by the industry.

“Captured”? Industry “slaves” is more like it.

Here’s the story: When Lehman Brothers failed in September 2008, there was a run on Reserve Primary Fund, a money market mutual fund that had a paltry 1.2% of its $63 billion in Lehman financial assets. Even so, when Primary “broke the buck” (and could no longer pay back its investors 100 cents on the dollar) panic spread through the market triggering a bank run. Prime money-market funds lost $310 billion or 15%  in less than a week. The panic put stocks into a nosedive which didn’t stop until the Fed extended a blanket taxpayer-funded guarantee on all money market funds.

Four years have passed since the money markets blew up and still nothing has been done to fix the problem, which means that it’s only a matter of time until the next meltdown.

Now, there are a couple of very easy ways to make the system safe again. Either the SEC can require the funds to have enough ready cash on hand to pay investors off “in full” if they want their money back on short notice or financial institutions can explain to investors that there are risks involved when they put their money into money market mutual fund accounts. (and that the value of their investment can go up or down) These aren’t FDIC-guaranteed depository accounts, even though everyone seems to think they are.

Both of these are straightforward solutions that would remedy the situation and assure that the financial system would not suffer another massive heart attack if one of these funds were to dip below 100 cents per dollar.

So why did 3 of the 5 SEC board members vote the measures down?

Well, because the banks don’t want to hold any additional capital to pay off investors in the event of a run. And, because the banks don’t want investors to know that they are actually taking a risk by putting their money in money market mutual funds. (They want to preserve the illusion that these are standard-issue checking-savings accounts) And, finally, because the banks know that if the system goes haywire again, the Fed and US Treasury will ride to rescue with more taxpayer-backed bailouts. So, why would they want to pay when Uncle Sam will cover their losses anyway? That’s how the banks see it.

Here’s a little more background from the Wall Street Journal:
“The industry notes that only two funds have ever broken the buck—and argues this is much ado about nothing. Yet that doesn’t mean other funds didn’t come close. A Boston Fed study—unchallenged by the industry—found “frequent and significant” cases in which companies that sponsor money funds had to bail them out. At least $4.4 billion was provided between 2007 and 2011 to at least 78 funds.”….
…the Treasury’s Office of Financial Research found that in April 2012—after those SEC changes had been implemented—there were 105 money-market funds with combined assets of more than $1 trillion that were at risk of breaking the buck if any of the top 20 outfits in which they invested defaulted. Of those, 14 were at risk of breaking the buck if any of the top 30 outfits in which they invested did so.
In ordinary times, that may be OK. In a crisis, it spells trouble, particularly since the funds tend to invest in the same securities.” (“SEC Can’t Agree on a Fix For Money-Market Funds”, David Wessel, Wall Street Journal)
So the idea that “only two funds have ever broken the buck” is pure baloney. These funds get into trouble all the time, which is why they need to be fixed, so the banks that run them provide the resources necessary to make them safe. At present, the financial institutions are getting a free ride, which is to say, they are recipients of an implicit government subsidy by virtue of the fact that the Fed will be forced to backstop their crappy mutual fund if the there’s another panic. That’s free insurance and, in 2008, it cost taxpayers a bundle.

This whole money market fracas is just like the regulatory issues surrounding securitization, which is the bundling of loans into securities.  Dodd-Frank is supposed to require originators of these garbage products to retain a portion of them for their own accounts. It’s called “risk retention” and it’s no different than an insurance company being required to keep some money on hand in case your bloody house burns down.

Fair enough? Well, of course, the banks don’t want to have skin in the game, not unless it’s your skin or my skin. So, they are fighting risk retention tooth and nail.

And they’re probably going to win that fight, too, because in the good old USA, cheaters always prosper. Just ask a banker.