Friday, June 24, 2011


My eye was caught by this story this morning regarding the potential risk US Money Market funds have to Greek and European defaults.  Please view the story here by right clicking and hitting "open in a new window" (don't click away from the blog!).

Why in the world do US money markets have exposure to the Greek debt bomb?  Well, the easy answer is that if it weren't for the Fed and Ben Bernanke, they probably wouldn't.  How is that you ask?  Well see, since short term rates are artificially low in the USA, investors must find alternative investments to find yield.  Great Grandma, Baby Boomers, Money Market Funds, and investors that are risk averse are being forced into investments they normally wouldn't ever consider in an effort to receive just compensation for their investment dollars.  While the Fed's plan has been all along to make money markets unappetizing, there are some investors that have no choice and must use them as an asset class.  The problem is that money market fund managers have this problem too.  They can't buy treasuries or mortgage backed securities anymore because yields are being manipulated lower by QE II and other invisible hands in the market.  They can't buy commercial paper, because that doesn't pay enough since everyone is competing for the same investments and prices are bid up.  They must find enough yield to earn enough to pay their fund expenses and then deliver some sort of return back to investors.  What is a money market to do?  The managers turn to buying paper across the pond and buying high rated bank and insurance company short term paper.  These funds are yield seeking and are probably taking more risk than they should due to the interference in the markets by the Fed. 

During the press conference, Ben Bernanke added to fears that we could be in a situation similar to the Lehman Brothers/Bear Stearns debacle where liquidity in the financial system simply froze up.  In situations where no one trusts each other, no one is willing to lend to one another, unless it is at astronomical prices.  This is a fear that is actually one based on truth - that if Greece defaults, European banks will be hurt financially, and that could impact other institutions.  The freeze could impact the banks and their lenders in several ways.  First, money markets and lenders could see those banks with Greek holdings as a perilous risk, one that perhaps shouldn't be traded with or one who should not receive favorable terms.  In that credit evaluation process things either slow down where lenders take a lot of time to make investment and lending decisions or they stop all together.    Second, if you are the bank on the receiving end of the freeze, you might consider holding on to money that has been lent to you and not returning it on time as you need to keep capital in house as long as possible.   As you can see, a simple default event in one insignificant country could end up being one big problem on a global investment stage.

Now let's simply dream a little here and simply make up a fanciful situation where there actually was a default in a small island nation that didn't really matter.  (I know, I know, it could never happen with all powerful institutions like the Fed, IMF, and ECB making sure that all risk is taken only by the tax payer, but run with me on this).  As a risk manager for an investment company, the first thing you do is run a counterparty report to see who you are exposed to once you learn of the default.  You do a little bit of digging and you find out that one or two of the banks you lend money to overnight have significant exposure to Greece.  (Mind you, you don't have direct Greek exposure, you just do an overnight repo or reverse repo with them).  Upon reading the report you quickly fire off an email to your money market traders and portfolio managers directing them to immediately cease all investing in those bank names and put them on a credit black list.  As soon as all outstanding investments (short term loans, repos, swaps, commercial paper) to these banks are paid back to you, your desks will not buying their issues again no matter what the yield.  As this process is repeated, the cascade of capital starvation sets in on the offending banks and they quickly die.  The death of those banks causes waves that destroy other banks because they have long term risk outstanding to the banks at ground zero and now are in jeopardy of not getting paid back.  Sound familiar?  Of course, it is what happened in the financial crisis of 2008.  And yet, here we are again, facing the exact same set of problems, yet this time we are looking at it on a global scale.  We are taking about nations defaulting and being the genesis for the financial tsunami that will swallow the gigantic ponzi-scheme that has captured the world. 

I feel so much better after reading the article where Mercer Bullard (professor) assures us that everything would be great if the SEC would just step forward and tell us it will all be okay.  There are a couple of problems with Mr. Bullard's statement. 

First, although money market funds can only hold short term investments there is no guarantee that a bank or company will actually return those investment proceeds on time if they are in financial trouble.    Banks in crisis don't always play by the rules and if they are dying they could care less if you are a money market fund, a church, or the US government.

Second, the notion that anything the government tells me will make me feel better is simply nuts!  Do you  think the SEC, the Fed, Treasury, or the Administration would tell me if things were really bad?  During the financial crisis did they tell us to get out of Washington Mutual, Lehman Brothers, Wachovia, Citibank, or a host of others?  No, if anything they came out to say that those institutions were fine and stable.  The FDIC said INDYMAC was great, only to find out they were completely insolvent.  Isn't that where we are with Fannie and Freddie too?

The SEC is too busy trying to find some small time trader that made $20,000 for insider trading when there are HFT (co-located high frequency trading computers that step in front of each trade and give you bad execution) that are ripping off investors every day to the tune of millions.  The SEC is too busy watching porn to worry about actually enforcing rules to protect shareowners of fake Chinese companies that don't actually do any business aren't they?  Suddenly the SEC is going to step in and reassure us that money market funds are just great and this will mean anything?
 Despite the stupidity of the professors comments, I am struck by the idea that we are two and a half years removed from the pit of the financial crisis and nothing has changed.  We have systematic risk embedded into the system and we have money market holdings that are still at risk of seizing up and collapsing the financial scheme.  What have we learned?  NOTHING!