Much has been written about President Obama’s implementation of the “Volcker Rule“.  That is, a rule to prevent commercial banks from getting too large.  Basically, the rule will place restrictions on banks that take government-backed deposits.  I have no disagreement with that rule by the way.  If a bank wants to offer deposits guaranteed by you and me, then we should have a say in how the bank is run.  If the bank doesn’t want restrictions or input, then they need to take that FDIC badge off of their bank.  Let’s see what interest rate they have to pay on their deposits to get uninsured deposits, and then see if a real free market delivers the gigantic profits they earned in 2009.  [That's one of the problems with the current crop of executives at the money-center bankers.  They don't realize the profit subsidy the FDIC insurance provides them.]

The purpose of this post is to show that focusing on deposits is not the only thing that needs to be done.  Because banks have another source of funds.  In fact, in 2008, it wasn’t deposits that were fleeing the banking system.  It was commercial paper!

Folks, LEHMAN DIDN’T TAKE DEPOSITS!  Their source of funds was the money market.

On August 9, 2007 (before I had this blog), after the Bear Stearns hedge funds first blew up, I advised people to switch out of regular money market funds and into Treasury-only money funds (see below).  The reason I did that is because when I looked at the composition of Fidelity’s Cash Reserves fund, I noticed that they had a ton of money invested in Countrywide short-term debt.  Back then, I had no idea things would get so bad.  But I also knew that if something bad did happen, the money market industry was not prepared.  And at the time, the yield on a money fund was 5%; the yield on a T-bill was about 4.75%.  I figured why not take the sure thing for just a 1/4% less.

A little over a year later, Lehman collapsed.  That was quickly followed by the consequential collapse of the Reserve Primary fund.  Things went from bad to worse.  Over the next four weeks, a total of $450 billion was withdrawn from money market funds that invested in commercial paper.  Nearly all of it was from institutional money market funds.  Most of the money these “professional” investors yanked out was put into money funds that invested in Treasury securities.  It was a run on the bank, only instead of individuals pulling deposits, it was a bunch of money managers selling bank debt.

And that’s the problem that the Volcker Rule doesn’t address: bank debt.  In the heat of the moment, the government did what was necessary.  The taxpayer guaranteed the principle of all money market fund assets purchased prior to September 19, 2008.  If they hadn’t done that–along with the Fed providing every financial institution (even non-banks) with cash to pay back their commercial paper loans–then it truly would have been a financial Armageddon (as if it wasn’t bad enough).

Now, more than one year after the crisis, that money market guarantee has passed.  But many other mechanisms that support bank profits and their ability to pay their debt (and their bonuses), haven’t.  What’s more, in this age of “too big to fail”, the precedent has been set.  Money markets were guaranteed against failure.  There is no way that the government is going to now let the multi-trillion dollar money market implode.  Which means there is another taxpayer-backed source of money for banks: implicitly insured bank debt.

What that means is, unless there is some mechanism that limits the leverage of financial institutions that use other sources of funding besides deposits, such as issuing debt to investment companies (money market funds, bonds funds and bond ETFs), hedge funds and private equity, then the Volcker Rule has a gaping loophole that financial entities will exploit.

– Don

P.S. – Not only is bank debt an alternative source of funding, international banking regulations state that hedged loans have a much lower capital requirement than unhedged loans (see page 263).  It’s one of the reasons that the government rescued AIG and paid out 100% of AIG’s obligations.  The banks were told by international regulators that buying CDS insurance from AIG was a good thing!  If AIG had subsequently welched on its CDS contracts, then you’d have seen Goldman and nearly every other investment bank and many money center banks in the same predicament as Lehman, with the same catastrophic consequences.  This is another a loophole that needs to be plugged.

From August 9, 2007:

I don’t want to be alarmist.  But I just moved some money from my Fidelity Cash Reserves money market fund (FDRXX) to the Fidelity Treasury Money Market (FDLXX), which holds 80% T-bills and 20% U.S. Treasury notes.  I also switched my corporate money market from a 5/3 commercial money market to a 5/3 Treasury fund.  The reason is that most of the stuff in money market funds is commercial paper.  That’s short-term corporate loans.  Money market funds are always priced at 1.00.  The way you make money by investing in a money market fund is that instead of increasing the asset value of the fund, you get more shares.  Let’s say you start with 100 shares at 1.00 and the fund pays 5% a year in interest.  At the end of the year, the fund price is still 1.00, but you’d have 105 shares.

In the money market world, that 1.00 is considered sacred.  They call it a “peg”.  That is, all money funds are pegged at 1.00.  I don’t remember EVER seeing a fund bust that peg.  Some fund companies that have had commercial paper blow up and have had the net asset value of their investments drop below 1.00.  But the fund companies have actually put the company’s money into the fund to make sure that the net assets in the fund stay where they need to in order to keep the peg.

It’s a trust issue.  If a money fund busts its peg, then cash is no longer considered safe, and there is a run on the bank.

Here’s the thing, Putnam (which is a huge fund company) has something in its money fund portfolio called a conduit, that is a derivative which is issued by a company.  In this particular case, the company issuing the conduit is called Broadhollow Funding.  A conduit is basically asset backed commercial paper.  Problem is, one of the conduits Broadhollow issued is somehow tangled up with AHM, which is the mortgage company that filed for bankruptcy a couple of days ago.  Broadhollow apparently can’t meet the due date of the note, so they are going to have to extend the maturity of the note.  That assumes they will be able to redeem the paper in the future.  If they can’t, then that paper becomes worthless.  That means the fund’s assets will decline by the face value of the conduit, which means the peg will drop below 1.00 unless Putnam puts up their own money to maintain the peg.  And I have to say, right now getting money right now is NOT easy.

In another situation, which is potentially more dire, Fidelity Cash Reserves has holdings is several different companies’ commercial paper.  Their largest holdings are concentrated in paper issued by Countrywide and companies affiliated with the country’s largest mortgage company. Late today, Countrywide issued a statement.  They said, CFC and other mortgage companies are facing “unprecedented disruptions” in debt and mortgage-finance markets that could hurt earnings and the company’s financial condition.

By switching from a commercial paper money market to a U.S. Treasury money market, I am giving up about 1/4% in yield, going from 5% to 4.75%.