Tuesday, September 23, 2008

A Question for Secretary Paulson

I chose the wrong week to go on vacation and must now catch up with the unread papers of an eventful week.

The demise of broker-dealers was news only in the manner it played out. But the business model was doomed. I wrote on this blog that for broker-dealers “to function, the system has to be unstable”.

The wording was slightly imprecise. I meant that to function, the system needed to be balanced on a razor’s edge. And for over a decade it was. But the ongoing turmoil in money markets disrupted the shaky balance beyond any hope of restoration.

AIG, too, was an easy bet. You could see something was rotten in the state of the company from the vehemence that it attacked standard accounting principles.

What I did not know was the extent of AIG’s involvement in the troubled money market funds. Then, under the cover of arranging an $85 billion bail-out of AIG, the Treasury announced that it would also rescue money market funds regardless of their affiliation. This happened on Thursday, after several funds “broke the buck”, meaning that their investors would lose some portion of their principal.

The news came out on Friday and after a few comments about how unprecedented it was, disappeared. Count on the mainstream media to ignore important news.

Let us see now. The U.S. Treasury is handing out money to money market funds to ensure that these funds, many of them with absolutely no affiliation with banks, broker-dealers or other financial institution, would preserve their $1 net asset value. Why? Note that this is taking place in the midst of a blood bath that forced Merrill Lynch to sell some assets for as little as 22 cents on a dollar. Why would it matter then if a money market fund's NAV dropped by a penny, to 99 cents? And why would that concern the U.S. Treasury?

The answer is that money markets are the critical link between industrial and finance capital, or, as your economics professor would say, between the financial markets and the “real economy” – the “real economy” always in quotation marks because he cannot define the term but expects you to understand it, very much like pornography.

The relation between the industrial and finance capital is a chapter in Vol. 5 of Speculative Capital. Here, I will have to be brief.

Assume your business purchases a machine for $12,000. The machine has an average life of 5 years, after which you have to replace it due to either wear and tear or obsolescence.

It is an elementary principle of accounting and finance that, ignoring the price change due to innovation, you have to set aside $2,400 every year for 5 years to create a reserve fund for the replacement of the machine. It is this money – $2,400 the first year, $4,800 the second year, and so on – that is placed in money markets and never in capital markets, the latter having a completely different function.

Money markets provide an extra income to funds while funds are waiting to be employed. But that income is absolutely secondary to preserving the original sum. This sum, when called upon, must be available for turning into fixed assets. If it falls short, it could not purchase the assets and the process of industrial production would suffer. It might even come to a halt. That is how money market is “related” to the real economy.

One of the funds in trouble was the famed Reserve Fund. Here is its “inventor” in an August '07 interview with the Financial Times. The man must have seen what was coming.
Bruce Bent, the inventor of the money market fund, has criticised the “flagrant abuse” of the concept – which he introduced in 1970 – that has come to light in recent weeks.

Mr Bent, who established the world’s first money market fund, the Reserve Fund, says the original idea behind the fund is being ignored. His displeasure stems from a sense that many money market funds have exposure to sectors or securities they should not be in, claiming his original concept was not designed to give investors any headline risk and should give them immediate liquidity and safety above all else.

“The money market fund was created to provide effective cash management, to guarantee at least a dollar in and a dollar back and beyond that, a reasonable rate of return,” Mr Bent says.
Like all fund managers, old Bruce is a practical man and cannot exactly or convincingly explain the nature of the “flagrant abuse” he is complaining about; when it comes to matters of theory, the “sense” will take you only so far. But he is right on the mark in describing the characteristics of money market funds. All traders know that, which is why on Thursday, the rates on the 3-month T-bills dropped to 3 basis points, which is to say, zero. I even heard that the market ran out of the T-bills. Thus, through rates and prices, the only way they know how, traders defined money markets for us: a place where the safety of principal trumps the interest income at all costs.

What about the Treasury secretary? Does he know the relation between the money markets and the real economy?

I must say, Yes. His hurried response to the shortfall in the money market funds is not sufficient proof. You could argue that it was the practical reaction of officials deluged by panicked calls from bankers and fund managers; the back office of any clearing institution on that Thursday must have been a scene to behold.

So I have other evidence, thanks to Larry Summers whose picture made The New York Times the other day as a potential Treasury secretary in the Obama administration. I remember him speaking in his capacity as the Deputy Treasury Secretary (to Bob Rubin) of the “benefits” of the Southeast Asian financial crisis. The time was February 13, 1998. The Wall Street Journal reported it on page A2 under the heading “U.S. Presses Japan to Stimulate Economy”:
’There has been more progress in scaling back the industrial policy programs in these countries in the last several months than there has been in a decade or more of negotiations,’ Mr. Summer said.
So Larry Summers knows that a financial crisis can setback industrial output and boasts of having achieved just that in Southeast Asia. He no doubt passed this knowledge to the Treasury staff as part of the “knowledge transfer” initiative that any responsible technocrat would undertake.

That brings us to the question. If the Treasury secretary and his underlings knew of the relation between money funds and the “real economy”, why did he not interfere to prevent the perversion of money markets that I described in the Credit Woes series? The perversion was a long time in the making and took place in the plain view of everyone in the market.

For that matter, where was Larry Summers, as Deputy Treasury Secretary, as Harvard President, as an eminent Financial Times columnist, to raise the issue? After all, it was under his watch and that of his mentor, Consigliere Rubin, that the money markets began metamorphosing into trading places.

These are rhetorical questions; I gave the answer in Vol. 1 of Speculative Capital, in discussing the dynamics of speculative capital and the way it operates through human subjects. But they are still questions to ponder in the midst of this crisis where grave-looking men in dark suits who try to end it find themselves grossly out of their depth.

(The last entry on Lehman bankruptcy had several errors, typos and an incomplete sentence. Blame them on the slow and spotty Internet connection I was using at the time. All are corrected, with apologies.)

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