How close was the financial system to melting down?

By Megan McArdle

I do not work for the Treasury, the Fed, or an investment house, so take this for what it's worth.  But my understanding is really, frighteningly close.  Remember the monster that lived under your bed when you were five?  Actually, mine lived in the closet.  But that's not the point.  The point is, that monster was loose on the financial markets last week.

Last week I explained what a money market fund is.  This week, I explain what they invest in. The money market is the market for short-term debt, which companies use to smooth out mismatches in their cash flows:

  • Commercial paper:  unsecured debt issued by corporations, with a duration of under 270 days, which avoids certain kinds of SEC paperwork. 
  • Repos:  aka Repurchase agreements.  Basically, the holder of a security sells that security to someone with an agreement to buy it back at a later date, usually measured in days rather than months.
  • Banker's agreements:  basically, a short-term financial instrument created by a non-financial firm, but guaranteed by a bank.
  • CD's:  You know what these are; you probably have one.  CD's are what paleolibertarians would like the entire banking system to look like:  you loan money at a guaranteed interest rate for a set period of time.
  • Treasury bills:  Government securities.

Money market funds are heavily regulated as to what sort of securities they can buy.  These kind of short term debts were widely believed to be as safe as . . . er . . . something other than buying a house.

What happened last week is that one money market firm advertised its entire portfolio, including a large chunk of Lehman paper worth slightly less than 2% of the total fund assets.  Spooked investors, who did not want to lose out if the fund "broke the buck" started withdrawing as fast as their little fingers could punch the buttons on their phones.  Now, this money market fund had tens of billions worth of assets; if it started dumping them on the market, it would drive the price down, leaving them even less money to hand back to their shareholders.  But there's a reason investors herd in a bank run:  the first people out get all their money back. The rest get trampled in the stampede.  The fund--incidentally, the same company that founded the money market industry--"broke the buck"; that is, its shares became worth less than a dollar.  It's as if the value of your bank account suddenly dropped below the amount you'd put in.

This, by the way, is probably not the only fund this happened to, but it was the only fund that a) advertised its holdings and b) was not attached to an institution large enough to easily make good the loss.

Thus was touched off a general run on money market funds that held money for institutions--the kind that require buy ins of a couple million or more.  Institutional managers have a strong incentive to do stupid, destructive things, as long as everyone else is doing them.  It's the same reason that IT managers used to buy IBM--not because it was necessarily the best solution, but because as long as you did it, no one could blame you when things went south.  "I bought IBM!" troubled CTOs would say when the server crashed.  "The whole market is down!" cry money managers when the financial system crashes.

Investors were particularly worried about any exposure to financial paper.  So, frankly, were the managers of money market funds.  From Lehman, the worries spread to Wachovia, Washington Mutual, and beyond.   Suddenly, said one source, no one could sell two-week Wachovia paper at 30% yield-to-maturity--which in layman's terms means they were offering a hell of a discount on a loan that was pretty likelyt o pay off.  Some funds bragged they didn't have Wachovia, which only made the others seem ominously silent in comparison.  The fund runs started to hit money markets that had no obvious problems (Putnam, BKNY/Mellon, American Beacon) causing them to shut down or redeem the shares in kind. Investors began worrying State Street's massive short-term investment fund complex was holding Lehman, which whipsawed its stock price 50% in one day.

Money market funds are generally designed to be the functional equivalent of a bank account:  short-term vehicles where you park cash you aren't using at the moment.  Investors are supposed to be able to pull their money out at any time.  That meant that all the funds, sound or not, were vulnerable to a run.  And virtually any fund that experienced a run would "break the buck" because while these funds are perfectly safe and liquid in normal circumstances, no one could dump a billion dollars worth of securities on the market without seeing the price of those securities plummet.  Since funds definitionally try to hold their asset base near a dollar a share, and distribute the yield, there was no gigantic cushion to pad the sales.

The runs meant that all the money market funds were in the same boat:  everyone wanted to sell and hoard cash in case of a run.  No one wanted to buy.  Once busted funds had gotten rid of their very short paper, they were stuck with the weeks/months maturities, which were virtually unsaleable.  Unless the parent institutions make your investors whole the only thing you can do in that situation is distribute the assets in kind, to investors who can't sell them any more than you could.

Ultimately, despite last week's bailouts, no one wanted to hold financial company paper.  Unfortunately, as I understand it that paper made up the bulk of the money markets, which is hardly surprising given the volume of trades they do (did) every day. 

Banks have tens of billions of debt maturities to refinance in the coming months.  The overwhelming majority of it will be good even under distressed circumstances--unless they can't roll any of it over.  At that point, they experience the same problems you would if your credit card company pulled your credit line and demanded you pay back everything you owe them. 

No doubt some of my readers are rubbing their hands and saying "Exactly what should happen to people who carry credit card balances!"  And I'm sure that among you there are people who pay cash on the barrel for everything, having never taken out any loan for a house, an automobile, an education, a personal financial crisis.  These people never even use an American Express Card, which is, of course, a short-term loan.  They also do not work for companies that borrow money to buy capital equipment or finance expansion, and their firms do not experience any mismatch between their payables and their receivables.  Those people should stop reading now, because I'm pretty sure the Amish aren't supposed to use the internet.

The rest of us live in a world that is created and run by institutions that amass capital from millions of people and concentrate it in areas where it (usually) makes people better off.  I'm particularly confused by conservatives who claim to hate fractional reserve banking, duration mismatches in the financial system, and easy credit/bankruptcy.  If you think more deeply about it, there are three reasons why this opposition is silly:

1)  Outlawing it would require massive market interventions.  The vast majority of people want to borrow long and lend short.  Keeping them from doing so would mean not only outlawing the current banking industry, but giving the government sweeping powers and budget to make sure that no one synthetically recreates a duration mismatched position.  Human ingenuity on this front is endless--witness the acrobatic contortions of Islamic finance to get around the bans on, yes, lending money with interest.

2)  Credit and easy bankruptcy serve as a substitute for government intervention.  In a developed society that will not (however you personally may feel) stand by and watch its members starve, income fluctuations have to be dealt with somehow.  If people can't borrow money to smooth their consumption, they'll demand that the government provide that service instead.

3)  No country in the world, except Britain, has managed to industrially develop on retained earnings.  Which is why it took them twice as long as the rest of us.

Lefties overjoyed at the prospect of banks running out of cash should note that money markets also hold federal and local government securities.  What happens when Maryland doesn't have the cash in its coffers to make payroll, and the money market no longer exists?  What happens is they send the employees home and tell them to come back when they get more cash.  To the extent that you think a large and well paid civil service is a good thing, this should distress you. 

And if they simply carried big cash cushions to cover tax flow problems, that would mean either less spending, or more taxes.  Conservatives and liberals alike can reflect on the likelihood of getting whichever of those options you don't want.

If the FDIC hadn't stepped in to backstop the runs on the money market funds, it's not crazy to think that we might have seen a massive liquidation of huge portions of the banking system at fire sale prices.  That magnitude--one person I talked to before the bailout gave a wild-sounding estimate of $1 trillion worth of money market fund redemptions in the immediate offing.  With the money market essentially destroyed, the resulting bank liquidations would have been even worse, beyond even the ability of the US Government's borrowing power to pull back.  That would have touched the bank accounts, the investments, and the firms of even the hawkiest of credit hawks--unless you've actually got it buried in your back yard in tin cans, you'd lose something, and even then, who would buy whatever it is you sell to make a living?

Consider that the Great Depression came upon a society much less dependent on unsecured credit than we are.  Then count your lucky stars that our financial officials are moderately competent.

How likely was this doomsday scenario?  No way to know.  But it was possible.  That's quite scary enough.

This article available online at:

http://www.theatlantic.com/business/archive/2008/09/how-close-was-the-financial-system-to-melting-down/4150/