Monday, December 03, 2007

Money Markets: And I thought they smelled bad... On the outside!

I'm increasingly convinced that when we, as investment pros, think back on the sub-prime debacle of 2007 in ten years, we'll think of trouble at money markets first. The CDOs that have blown up were more spectacular, but at least mezz and sub CDO investors were more prepared to take losses. The hedge funds that have fallen apart are a sexier story, with the complexity and egos involved, but again, those investors knew they were taking some degree of risk. The ABX will be a distant memory. Money market investors assumed they'd never take losses, and that's why it will hurt so much when they do.

You've heard by now that Florida has suspended withdrawals from their state-run "enhanced" money market fund. This isn't the first "enhanced" money market that has run into serious problems, for example General Electric cashed investors out of its enhanced fund at 96 cents on the dollar. Anyway, all of you can read the facts of this situation for yourself from main-stream sources. Here are a few insights I can give.

First of all, my firm has several municipal authorities as clients, so I know about these state-run funds first hand. They are normally set up by state Treasury offices and are open to local municipal authorities. Anything from counties to school districts to transportation authorities etc. Ostensibly the idea is to pool the assets to realize economies of scale, but there is also the ironic fact that state officials always assume they are more sophisticated than the local yokels. Some were even set up to prevent another Orange County situation, figuring that a state-run fund would be safer. So much for that.

I've seen various types of state-run funds, some are basically private money markets, some are allowed to deviate from the 2A-7 rules. Its important to note that SIV-based CP was highly rated from the start, so there is no reason why any money market (other than government funds) couldn't have bought asset-based (AB) CP. In fact, I'd bet most money market funds did buy AB CP. Point here is that the "enhanced" nature of these funds didn't have anything to do with buying AB CP. More on this later.

I also run a few enhanced cash portfolios myself, several of which are for municipal authorities. The ones I manage are for the municipal agency itself, not a pool for smaller groups. The restrictions I face are usually pretty strict in terms of credit quality. Typically the credit restrictions are based on either state laws or the charter of the municipal agency. Maturity restrictions tend to be looser, as how long I'm allowed to go depends more on the purpose of the asset pool than anything else.

I never bought SIV or ABS-backed commercial paper in any of those funds. Not that I wouldn't have been allowed, per above. In fact I wasn't buying CP of any kind since 2005. I had found other short-term paper, even agency discount notes, offered yields that were about the same. I also bought a lot of taxable municipal demand bonds, which are essentially like state and local government CP. That stuff was higher-yielding than corporate or asset-backed CP as well. More recently I had been buying longer-term paper than money markets are typically allowed, 18-24 month maturities, which has performed very nicely.

Anyway, point is that "enhanced" cash is fine, but know what your enhancement is. I know first hand that there are so-called short-term bond/enhanced cash funds out there that bought CDO pools and floating-rate RMBS pools. Even if they bought only Senior tranches of these securities, they are looking at much bigger losses than they would have ever figured. And remember that anyone, governmental authority or otherwise, usually invests in a short-term portfolio because they expect to need the money on short notice. Now the CDO and RMBS pools have poor liquidity. Sizable losses + poor liquidity is exactly the opposite of what the client signed up for.

Back to money markets, enhanced or otherwise. Money market funds are often run by relatively inexperienced people. Not always, but often. I mean, many firms view their money market as something they have to offer, but not a driver of asset growth. So they aren't real willing to spend money on experienced people. Again, not all firms are like this so if you are a 20-year veteran of money markets, don't write me a scathing comment.

Anyway, so the money market traders are usually working from a list of "approved" credits. So what do you think happens? Of course, the traders just buy CP in the highest yielding "approved" names. After all, the money markets trader is probably some young moisture farmer trying to make a name for him/herself. So s/he wants to generate as much yield as possible. And remember that up until now, someone with less than 5 years experience has never seen a bear credit market. So buying the highest yielding stuff has been rewarded over and over.

Also consider the sales pitch on asset-backed CP: you get a couple extra beeps over corporate CP, plus you have high quality assets backing your paper directly. You aren't subject to any sort of corporate event risk. For anyone who remembered the 2001-2002 period, that was a strong pitch. Plus a lot of AB CP was (and still is) bank guaranteed. So I'm sure some investors started buying only the bank guaranteed stuff, and after a while started dabbling in the non-bank paper.

Anyway, so how does this play out?

  • We'll probably see most large bank money markets get bailed out by their sponsors. We've already seen this from Bank of America and Legg Mason among others. I've argued that this breaks recourse, but I've also argued that there isn't anyone to complain, so what the hell?
  • I'd suspect that there will be some money markets forced to break the buck. There is too much SIV debt out there that is likely to be pay less than 100% principal for every money market to emerge unscathed. How big the loss? Who knows. But remember that people buy money markets with the idea that they never lose money. If a regular Joe investor lost even a small amount, 2%, 3%, 5%, whatever, that'd probably turn him off from money markets forever. If regular Joe's neighbor or sister or uncle loses 5% on his money market, that too might change his investing habits permanently.
  • News reports of losses in money markets will cause "runs" on sound money markets. While the sound money markets may be perfectly able to meet redemptions, the result will be rising yields on all types of CP. We've already seen this, with pretty much all money market eligible instruments other than governments widening substantially.
  • The tax payers of Florida will probably have to bail out their state-run fund. We don't know what the losses are right now, but even if they are relatively small, I'd expect the state to make up the loss. If other states wind up in the same boat, expect bail outs there too. If you doubt this, consider the press coverage if some rural school district in Florida couldn't pay its teachers because of incompetent state employees...
  • Finally, government money market funds will likely become permanently more popular. For now, that will make T-Bills expensive as hell. If you buy Treasury bonds directly, it may be that coupon-paying bonds are significantly cheaper than T-Bills. For the long-term, this might make the slope from 0-18 months in Treasuries and Agencies unusually steep.


Anonymous said...

"Moisture farmer"?

I am probably revealing myself as the least cool person on the entire internet, but what is a "moisture farmer"?

Sivaram V said...

Anyone interested in the money market fund problems should also check out the problems with the ABCP (asset-backed commerical paper) market in Canada.

When it's all said and done, it is quite possible those investing in low-risk ABCP or some sort of money market fund may end up taking a worse beating than those who went into CDOs and subprime debt. Anyone dabbling in subprime-related stuff probably knows the risk in some sense. Even if the rating agencies gave a high rating, subprime basically implies high risk. After all, these are people who can't get a loan (prime) at a normal bank.

But those investing in money market funds probably can't tolerate any losses. I'm just a small invest with a tiny portfolio but I really feel bad for the money market investors. People like me who invest in stocks know that everything could blow up (i.e. Merril Lynch, MBIA, C, etc--I don't own these but just listing them). But I suspect a lot of those in money market funds are truly shocked. On top of school districts and the like, I wonder how many elderly pensioners and others have been hit...

Accrued Interest said...

Not many have been hit so far, but I think it may be coming.

Moisture farmer... don't worry about it. Its a running gag.

Anonymous said...

Hello Accrued,
Good site..
Could you provide some of your insights for HRB. Looks fishy... and can be a good short candidate with their Dec11 earnings call ( I am hoping it will go like.. "Earnings what Earnings !?!" )

Any commets from your research.

Also abt PNC.. looks like it is still around its 52 week high.. but it acquired a CA based mortgage company early this year... still no impact on the stock ! wonder why!

Thanks for the website. First timer. Will be back time and again.

Best Regards,

Anonymous said...

What an incredible post!

This post makes the MSM (Mainstream Media) look positively sick. Sick.

What a post!


Will all banks bailout their money market funds. Specifically, will Citi be able to bailout its funds?

I suppose the answer is yes. But recourse will have to be twisted into a pretzel, right?

Anonymous said...

Another question/comment.

The villains of the piece?

Well, as one would have expected if one had thought about it, the show trials will belong to the rating agencies.

After all, Chuck Prince didn't do anything he wasn't allowed to do, did he? Yeah, he will be driving the Beemer for a few more years than he planned, but the guy's not going to jail.

But those rural municipalities who are going to have to give up their football teams over this, are going to say, "This stuff was AAA. Who screwed up, and where do they live?" Right?

Anonymous said...

I have learned a TON from your blog. Who knew the fixed income markets were so interesting; they have been this year no doubt! If you get a chance I would like to read your views on the CDO market for student loans and credit cards. I am long FMD; they did a large securitization in September but were unable to sell a BBB trance; CCRT has had some problems but the market is pricing massive losses in their credit card portfolio.

Anonymous said...

The more things change. . .I remember this happened in Texas in the early '90s. The state sponsored fund had solid investments but made the classic mistake of extending its maturities. Rates went up, values went down, and redemptions broke the fund.

I don't know if this problem can be fixed. The local governments are often constrained by resources and political favoritism. All too often their only gauge is price and performance--promise a better yield at a lower price and you get the business. Talk about matching maturities with expected spending requirements and you are out of contention.

Anonymous said...

Excellent blog--one of the best on the web, and i have read a lot.

I am a 20 year professional, and spent several sleepless nights in August going through my clients' money fund holdings. I didn't recognize half the names, and promptly pulled out of it back then.

Since then, I have been telling anyone who asks that money funds WILL BE the big catalyst for a real bear market. Though I don't think any major firms will break the buck [SEI has also put money in btw], the loss of confidence will lead to serious problems.

Anonymous said...

I tried to find your contact information but it is nowhere to be found on your blog. Please send me an email at Vitaliy AT my blog is (I'll keep your identity private).



Anonymous said...

So the conspiracy theorists are already blogging that Jeb Bush was apparently "on" the SBA committee in Florida until last January, and therefor he is singularly responsible for all the troubles that FL now faces. And of course, this means Doubya is directly responsible.

I certainly don't want to argue that Doubya doesnt have a laundry list of faults; I would even question if some of his behavior would be considered legal if judged by a court he didnt appoint. But lets be honest here: the guy isn't competent enough to have screwed up everything he gets blamed for.

More importantly, we as voters need to think about the long term effects of our witch hunts.

Anyone who is a candidate for one of these boards is going to be human, and have made errors at some point in their lives (except maybe the news media-- they seem to have led perfect lives). Forget about having a shred of privacy: everything from your finances to your wife's underwear selection suddenly becomes part of the public's "right to know".

Guess what? Honorable decent people don't want to be assumed guilty until proven guilty. A honest person could make his/her best effort, and still make a mistake -- it really could be a mistake, and not part of some grand crime.

When we subject our "leadership" to these unreasonable tests, is it any wonder we end up with losers like Bush, Kerry, Guliani and Clinton? Who is going to want to run the Federal government, much less the state money funds?

Answer: people who don't mind being treated like the incompetent / crooks they are. People who think the best way to enhance their own image is to fling mud at their opponent's image.

When sports figures spend their whole time trash talking, we call them bad sports (or worse). Sports leagues that encourage 100% trash talking, and 0% talent generally have TV ratings in the toilet.

But for some reason, we not only accept this from politicians-- we insist on it.

And then we wonder how public finances could get as messed up as they are

Anonymous said...

You know, I read the post by Anonymous-6:02, sighed, and considered myself fortunate not to live in such an outrageously politicized and polarized country.

And then I read this amusing tid-bit:

Coleman Stipanovich, the head of an agency managing a troubled $14 billion Florida investment pool for local governments, quit as officials approved a plan by BlackRock Inc. to salvage the fund.

Stipanovich, whose brother J.M. ``Mac'' Stipanovich is a Tallahassee lobbyist and Republican strategist who ran former Governor Jeb Bush's campaign for governor in 1994, was appointed executive director of the state board in 2002.

In the late 1990s, Coleman Stipanovich worked as a lobbyist for PaineWebber Inc. in Florida and was paid $7,500 per month to help the firm win municipal bond business.

Stipanovich, a Vietnam veteran, has a master of science degree in criminal justice administration from Michigan State University and a bachelors of science in criminology from Florida State University.

Impressive credentials for running a $184-billion asset management firm, eh? I really, really hope that Bloomberg forgot to mention quite a few other accomplishments.

Anonymous said...

Conspiracy is one thing. The fact that what the Bush's touch turns to [rhymes with sit] seems easier to prove.

Anonymous said...

I thought I was being smart when I moved my 401k out of stocks and into money markets and treasuries 16 months ago. I'm beginning to think I should have put it all into my Mattress Fund.

I work as a property searcher in the title business. You'd think I'd know better...

F-Trader said...

I thought the entire last correction we saw WAS a fire sale at Citi.

Anonymous said...
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