 | | The Daily Reckoning | Wednesday, June 29, 2011 |
- Money market risk and the road to the next "Lehman moment,"
- Government assurances: The real root of today's ongoing crises,
- Plus, Bill Bonner on what could be Mr. Market's biggest trap, the Bonners' "Rocking Chair Syndrome," and plenty more...
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|  | | | Uncharacteristically Risky | | Money Market Funds No Longer the World’s Safest Investments | |  | | Eric Fry |
Reporting from Laguna Beach, California...
"The world is full of banana peels, that goes without saying," the insightful financial writer, James Grant, observed last week. "The difference today, across a range of markets, is you're not getting compensated for the risks you face."
Without knowing the context of Grant's observation, most investors might imagine he was referring first and foremost to the stock market. But he wasn't. He was referring to money-market mutual funds, or what most folks consider "cash."
To be sure, Grant is no fan of the volatile, richly priced stock market; nor the bouncy, low-yielding bond market. But it is the utterly placid, zero-yielding "cash market" that seems to concern him the most. The world's "safest" investments are, suddenly, among the world's riskiest.
Money market funds have always been rather boring, but they were trustworthy. They paid an acceptable annual yield with no significant risk. These things weren't supposed to be exciting and sexy. They were supposed to do a single job and to do it reliably, like Wonder bread, drywall or toilet paper.
But now that money market funds are yielding zero...or close to it, they seem to have slipped into a kind of financial torpor. They just sit there, lifeless, yielding nothing. When you scratch below the surface, however, you discover that these funds are much more exciting than they ought to be. They are incurring lots of risk for very little reward.
Somewhere along the way, the money market funds lost their way. These nerds of the financial world started acting like playboys...or at least trying to.
The fund managers started taking bigger and bigger risks for smaller and smaller rewards. Not content to receive respectable yields by buying commercial paper from the likes of Johnson & Johnson and Dupont, the managers started reaching for a few extra basis points by buying heavily processed and re-packaged asset-backed securities from Wall Street.
That episode did not end well. The crisis of 2008 erupted, causing widespread panic and capital loss in the global financial markets.
But the US government saved the day and the money market fund managers learned their lesson. Oh wait; those last two things didn't actually happen. The money-market fund managers learned nothing, except that the US government will clean up whatever financial Superfund sites they create.
Thus, less than three years after nearly dooming the US financial system by buying American asset-backed garbage, the money funds are at it again, buying European PIIGS-backed garbage.
"US regulators are worried about the 'systemic risk' posed by the exposure of American money-market funds to European bank debt," The Wall Street Journal reports. "That's right, nearly three years after the panic of 2008, our all-seeing regulators have somehow not fixed what was arguably that biggest single justification for government intervention at the time.
"In 2008," the Journal continues, "the feds felt obliged to guarantee all money-fund assets after they let the Reserve Primary Fund pile into bad Lehman Brothers paper, Reserve broke the $1 net-asset-value, and in the following days some $400 billion fled prime money funds. We'd have thought our regulatory wise men would have fixed this systemic risk before all others.
"Yet now we learn that since 2008 US money funds have been allowed to pile into European bank debt, even as everyone knew those banks had stocked up on bad European sovereign paper. The Treasury is even saying privately that the US needs to support the European bailout of Greece, lest European banks fail, US funds take big losses, and we get another flight from money funds.
"Can this possibly be happening?"
Yes, is the short answer. Here's the longer answer:
In a zero-percent world, one would imagine that cash managers would resign themselves to earning nothing for clients when nothing - approximately - is what the market is offering. One would imagine that cash managers would be busy improving their golf games. But one would be wrong. Instead of playing golf, the cash managers are busy "groping for yield."
Yield-groping, despite its provocative name, does not elicit any harassment lawsuits, nor even a censure from the Human Resources Department. But it is a very questionable practice, nonetheless...and it usually ends badly.
Yield-groping, loosely defined, is the tactic of pursing a small amount of incremental yield in exchange for a large amount of incremental risk. Think of it as tight-rope-walking across Niagara Falls to get a free ice cream cone. As long as you make it, you get your reward.
But it's a bad bet, no matter the outcome.
The nation's largest money market funds are busy shimmying across Niagara Falls. As Grant observed in a recent edition of Grant's Interest Rate Observer, these bellwether money market funds hold an average of 41% of their assets in European debt securities.
Most of these European borrowers are large banks that have loaned tens of billions of dollars each to the governments and corporations of Portugal, Ireland, Italy, Greece, and Spain (PIIGS). At some banks, loans to the PIIGS countries are so large that they total more than half of the bank's net equity.
A little problem in Athens, therefore, could become a big problem in Paris...and in Boston, where the Fidelity money-market funds are loaded up on commercial paper from European Banks.
Source: The Wall Street Journal |
Who could have imagined that the dismal finances of the Greek government might someday impact the "cash" in your American brokerage account? Who could have imagined that an insolvent Greek butterfly, flapping its wings in Athens, might cause a tsunami of redemptions from American money-market funds in Boston?
We did not imagine it before now...but now our imagination is running wild.
As the chart above clearly shows, fear is ascendant on the European continent. Bond yields in the PIIGS countries are soaring, relative to the AAA-rated bonds of the Swiss government. These soaring bond yields testify to the genuine distress that is already besetting the credit markets of Europe. Perhaps conditions will improve, but we wouldn't bet on it.
Fidelity's money market fund managers are betting on it, and receiving about 20 basis points per year for the bet. Seems like a bad bet to us, but then again, we aren't professional money managers. Maybe they know something we don't, like how a government with a debt-to-GDP of 150%, annual deficits equal to 10% of GDP and a 200-year history of chronic default is going to pay its bills.
The world is, indeed, full of banana peels. In the column below, guest columnist, Charles Kadlec, explains how they got there...
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| | The Daily Reckoning Presents | | Governments are the Primary Creators of Systemic Risk | |  | | Charles Kadlec |
The greatest lesson of the still young 21st century is proving to be that governments are the primary source of systemic risk to the economy, our standard of living, and our liberty.
The latest case in point is the European government debt crisis, with Greece once again running out of money and threatening to trigger yet another financial crisis. The government's debt now totals more than 150% of its GDP, and continues to grow. Last year's bailout by other European governments was supposed to give it the time needed to reduce its budget deficits so that next year Greece could roll over its maturing debts, as well as finance additional deficits at interest rates under 6%. However, the government's austerity plan of tax increases and budget cuts has not reduced current or projected government deficits because the economy in 2010 contracted by 4.5% and the unemployment rate jumped to 15%.
The combination of a contracting economy and rising debt levels has driven the market yield on Greek two-year notes to near 25% and on its 10-year debt to around 15%. Since these loans are in euros, rates this high reflect the growing risk the people of Greece will not be able to make good on their collective debts. They also effectively shut the government out of the capital markets. Last week, S&P downgraded its rating on Greek debt to B from BB-, well into junk bond territory.
The downgrade reflects the increasing possibility that Greece will restructure its debt by forcing current debt holders to accept longer maturities, or do what demonstrators in the streets of Athens are demanding, which is to force its creditors to take a loss on their loans.
Normally, this would be a matter between a debtor and its creditors. However, European Central Bank (ECB) Executive Board Member Juergen Stark warns that the effects of restructuring "could overshadow the effects of the Lehman bankruptcy," which is associated with the beginning of the 2008 financial crisis.
At the heart of that financial crisis were government policies including Federal Reserve efforts to manipulate the economy by keeping interest rates artificially low and a weak dollar policy that fueled the housing bubble, federal government rules and regulations that de facto required banks to make loans to high risk borrowers, and two government sponsored enterprises, Fannie Mae and Freddie Mac, who stood ready to purchase hundreds of billions of dollars of sub-prime mortgages if only Wall Street could figure out how to turn them into high grade bonds.
In the case of Greece, government actions and regulations also lie at the heart of what threatens to be a European financial crisis.
Greek social security funds hold nearly two-thirds of their liquid assets in government bonds. Thus, any default would undermine these funds' ability to meet their obligations to pay promised health and pension benefits. Such an outcome understandably would create massive political unrest that could reduce government revenues and the government's ability to make good on its debts.
This risk is amplified by special rules created by politicians that encourage banks to lend freely to governments.
Here's how it works. Governments require banks to hold capital against the loans that they make, anticipating that in the normal course of business, some of the loans will not be repaid. The riskier the loan, the more capital that needs to be held in reserve.
However, under international rules negotiated by government representatives through the Bank for International Settlements (BIS), government loans fit into a special category that has a 0% risk requirement. That means European banks do not have to hold any reserves against loans they make to European governments. That's right, politicians implicitly promised banks that governments would never default. And, given the opportunity to make "risk free" loans that require no capital commitment, bankers purchased mountains of government debt.
According to Reuters, Greek banks own nearly 60 billion euros ($84 billion) of Greek government debt, and would almost certainly need additional capital and potentially a government bailout in the event of a government default.
In addition, the European Central Bank has increased the risk of systemic failure by becoming one of Greece's largest creditors. As reported by The New York Times, J. P. Morgan estimates that the ECB owns 40 billion euros of Greek debt. In addition, it has lent 91 billion euros to Greek banks, with much of that backed by Greek government bonds.
That means any Greek default would cost the ECB billions of euros in losses and potentially impact the value of the euro, disrupting European and international financial markets, and the conduct of European monetary policy.
In a television interview last Friday, ECB Vice President Lucas Papademos warned: "...the adverse consequences both on the banking system in Greece as well as on financial stability in the euro area as a whole can be far reaching and undesirable. So all in all, I think that Greek debt restructuring should not be on the agenda."
One possible "far reaching and undesirable" consequence of such a disruption to European financial markets would be follow-on defaults by Ireland, Portugal, Spain and Italy. According to AEI Scholar Desmond Lachman, the combined debt of the first four countries alone is about $2 trillion, a large portion of which is held by European banks. As a consequence, a write-down of 30% of that debt could lead to a European financial crisis not unlike that which struck the US banks from subprime mortgages.
Thus, the systemic risk created by the political class has put the citizens of Europe on the hook for irresponsible levels of government spending. Wealth producers are faced with the lose-lose choices of bailing out governments, bailing out bankers who were induced into buying government debt, or suffering the economic consequences and losses associated with widespread bank failures.
The brewing European debt crisis demonstrates again that the greatest source of systemic risk is believing politicians when they promise government guarantees are costless, and that elite public servants are capable of protecting us from systemic risks in the first place. The lesson is that giving governments more power over the economy and financial system is itself a source of potentially catastrophic financial and economic instability.
Regards,
Charles Kadlec,
for The Daily Reckoning
Ed. Note: Mr. Kadlec is a member of the Economic Advisory Board of the American Principles Project, an author and founder of the Community of Liberty.
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| | | | Bill Bonner | | Bear Traps in the Bond Market | |  | | Bill Bonner |
Reckoning from Delray Beach, Florida...
Fat guys can surprise you. They don't move very fast. But they can be very agile intellectually.
That was how G.K. Chesterton was. Laurence Lindsay, former assistant to George W. Bush for economic policy, seems to be the same way. Slow on his feet, perhaps. But quick in his mind.
Writing in The Wall Street Journal, Lindsey delivers thoughts that might have come fromThe Daily Reckoning. First, he notes that the budget problems faced by Washington are larger than generally reported. Growth rates have been overestimated, he says, while interest costs and deficits have been grossly underestimated. When more realistic assumptions are plugged in to the numbers it adds more than $4 trillion in 'budget costs' over the next four years. He concludes:
Underestimating the long-term budget situation is an old game in Washington. But never have the numbers been this large.
There is no way to raise taxes enough to cover these problems. The tax- the-rich proposals of the Obama administration raise about $700 billion, less than a fifth of the budgetary consequences of the excess economic growth projected in their forecast. The whole $700 billion collected over 10 years would not even cover the difference in interest costs in any one year at the end of the decade between current rates and the average cost of Treasury borrowing over the last 20 years.
Only serious long-term spending reduction in the entitlement area can begin to address the nation's deficit and debt problems. It should no longer be credible for our elected officials to hide the need for entitlement reforms behind rosy economic and budgetary assumptions. And while we should all hope for a deal that cuts spending and raises the debt ceiling to avoid a possible default, bondholders should be under no illusions.
Under current government policies and economic projections, they should be far more concerned about a return of their principal in 10 years than about any short-term delay in a coupon payment in August. Yesterday, stocks rose. The Dow was up 145 points. Oil increased a little too. Gold stayed at $1,500.
Still no clear direction.
But the direction of the bond market for the last few months has been up. This appears to contradict Mr. Lindsey. QE2 is ending. Everybody knows it. The Fed was the world's biggest customer for US debt - in some months buying two times as much debt as the US government issued. Now that the Fed's buying program is coming to an end, shouldn't bonds go down?
If the economy sinks the way we expect, Lindsey will appear to be a fool - for a while. That is, the Great Correction will intensify rather than go away. Bond yields will fall, not rise. Lenders will make money as bond prices go up, while stocks, employment, commodities, houses and almost all other assets go down.
People will say:
"See, everybody wants the US dollar. Everybody wants to buy US Treasury debt. It's the only thing you can trust. Debt is not the problem. The problem is growth. That's why we need QE3."
This is probably the trap Mr. Market is setting. The Great Correction will prove to be more bad news for investors - except for those who have put their money in 'safe' US dollars...and US treasury debt. Gradually, investors will move more and more of their money out of 'risky' assets and into bonds. Then, Mr. Market can spring his trap. As Lindsey warns, that is when they will stop worrying about debt ceilings and Congressional budget talks. That is when they will realize that it is too late. That is when bond yields shoot up and bond prices fall. That is when investors regret having lent money to Washington.
How far ahead will that be? We wish we knew. But Bill Gross, who famously sold US bonds, could turn out to be years early.
Then, Mr. Market - the joker - will have such a laugh. All those people who tried to get away from risk...by moving to the dollar and US Treasury bonds...will get whacked.
And more thoughts...
Most of the Bonner clan is shy. Has been for generations. When visitors would drive up to the family farm in the '20s or '30s, for example, they would find an empty front porch...but a rocking chair still in motion.
Whoever was on the porch had beaten a retreat...trying to avoid company.
"The rocking chair syndrome," the family called it.
An uncle, a local farmer, went to church regularly. But he snuck into the assembly by a side door at the last minute...so as to avoid the usual pleasantries. Then, he left the same way...
Shy people are usually considered to have a problem. They are 'socially dysfunctional,' widely believed to lead lonely, barren lives, trapped in their own prisons.
Various remedies have been proposed. Alcohol is an ancient elixir, prized by shy people. More recently, they are given drugs to loosen them up.
But maybe shyness isn't such a bad thing, after all. Maybe we're not sick. Maybe we're 'normal' after all. Here's The New York Times on the subject:
BEAUTIFUL woman lowers her eyes demurely beneath a hat. In an earlier era, her gaze might have signaled a mysterious allure. But this is a 2003 advertisement for Zoloft, a selective serotonin reuptake inhibitor (S.S.R.I.) approved by the F.D.A. to treat social anxiety disorder. "Is she just shy? Or is it Social Anxiety Disorder?"
It is possible that the lovely young woman has a life-wrecking form of social anxiety. There are people too afraid of disapproval to venture out for a job interview, a date or even a meal in public. Despite the risk of serious side effects - nausea, loss of sex drive, seizures - drugs like Zoloft can be a godsend for this group.
But the ad's insinuation aside, it's also possible the young woman is "just shy," or introverted - traits our society disfavors. One way we manifest this bias is by encouraging perfectly healthy shy people to see themselves as ill.
This does us all a grave disservice, because shyness and introversion - or more precisely, the careful, sensitive temperament from which both often spring - are not just normal. They are valuable. And they may be essential to the survival of our species.
Theoretically, shyness and social anxiety disorder are easily distinguishable. But a blurry line divides the two. Imagine that the woman in the ad enjoys a steady paycheck, a strong marriage and a small circle of close friends - a good life by most measures - except that she avoids a needed promotion because she's nervous about leading meetings. She often criticizes herself for feeling too shy to speak up.
Before 1980, this would have seemed a strange question. Social anxiety disorder did not officially exist until it appeared in that year's Diagnostic and Statistical Manual, the DSM-III, the psychiatrist's bible of mental disorders, under the name "social phobia." It was not widely known until the 1990s, when pharmaceutical companies received F.D.A. approval to treat social anxiety with S.S.R.I.'s and poured tens of millions of dollars into advertising its existence. The current version of the Diagnostic and Statistical Manual, the DSM-IV, acknowledges that stage fright (and shyness in social situations) is common and not necessarily a sign of illness. But it also says that diagnosis is warranted when anxiety "interferes significantly" with work performance or if the sufferer shows "marked distress" about it. According to this definition, the answer to our question is clear: the young woman in the ad is indeed sick.
But shyness and introversion share an undervalued status in a world that prizes extroversion. Children's classroom desks are now often arranged in pods, because group participation supposedly leads to better learning; in one school I visited, a sign announcing "Rules for Group Work" included, "You can't ask a teacher for help unless everyone in your group has the same question." Many adults work for organizations that now assign work in teams, in offices without walls, for supervisors who value "people skills" above all. As a society, we prefer action to contemplation, risk-taking to heed-taking, certainty to doubt. Studies show that we rank fast and frequent talkers as more competent, likable and even smarter than slow ones. As the psychologists William Hart and Dolores Albarracin point out, phrases like "get active," "get moving," "do something" and similar calls to action surface repeatedly in recent books.
Yet shy and introverted people have been part of our species for a very long time, often in leadership positions. We find them in the Bible ("Who am I, that I should go unto Pharaoh?" asked Moses, whom the Book of Numbers describes as "very meek, above all the men which were upon the face of the earth.") We find them in recent history, in figures like Charles Darwin, Marcel Proust and Albert Einstein, and, in contemporary times: think of Google's Larry Page, or Harry Potter's creator, J. K. Rowling.
In the science journalist Winifred Gallagher's words: "The glory of the disposition that stops to consider stimuli rather than rushing to engage with them is its long association with intellectual and artistic achievement. Neither E=mc2 nor 'Paradise Lost' was dashed off by a party animal." Regards,
Bill Bonner,
for The Daily Reckoning
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