It's the Money Market Funds That Will Hurt the Most

I'm increasingly convinced that when we, as investment pros, think back on the sub-prime debacle of 2007 in ten years, we'll think of trouble at money markets first. The CDOs that have blown up were more spectacular, but at least mezz and sub CDO investors were more prepared to take losses. The hedge funds that have fallen apart are a sexier story, with the complexity and egos involved, but again, those investors knew they were taking some degree of risk. The ABX will be a distant memory. Money market investors assumed they'd never take losses, and that's why it will hurt so much when they do.

You've heard by now that Florida has suspended withdrawals from their state-run "enhanced" money market fund. This isn't the first "enhanced" money market that has run into serious problems, for example General Electric cashed investors out of its enhanced fund at 96 cents on the dollar. Anyway, all of you can read the facts of this situation for yourself from main-stream sources. Here are a few insights I can give.

First of all, my firm has several municipal authorities as clients, so I know about these state-run funds first hand. They are normally set up by state Treasury offices and are open to local municipal authorities - anything from counties to school districts to transportation authorities etc. Ostensibly the idea is to pool the assets to realize economies of scale, but there is also the ironic fact that state officials always assume they are more sophisticated than the local yokels. Some were even set up to prevent another Orange County situation, figuring that a state-run fund would be safer. So much for that.

I've seen various types of state-run funds; some are basically private money markets, some are allowed to deviate from the 2A-7 rules. It's important to note that SIV-based CP was highly rated from the start, so there is no reason why any money market (other than government funds) couldn't have bought asset-based (AB) CP. In fact, I'd bet most money market funds did buy AB CP. The point here is that the "enhanced" nature of these funds didn't have anything to do with buying AB CP. More on this later.

I also run a few enhanced cash portfolios myself, several of which are for municipal authorities. The ones I manage are for the municipal agency itself, not a pool for smaller groups. The restrictions I face are usually pretty strict in terms of credit quality. Typically the credit restrictions are based on either state laws or the charter of the municipal agency. Maturity restrictions tend to be looser; how long I'm allowed to go depends more on the purpose of the asset pool than anything else.

I never bought SIV or ABS-backed commercial paper in any of those funds. Not that I wouldn't have been allowed, per above. In fact I wasn't buying CP of any kind since 2005. I had found other short-term paper, even agency discount notes, offered yields that were about the same. I also bought a lot of taxable municipal demand bonds, which are essentially like state and local government CP. Furthermore, that stuff was higher-yielding than corporate or asset-backed CP. More recently I had been buying longer-term paper than money markets are typically allowed: 18-24 month maturities, which has performed very nicely.

Anyway, the point is that "enhanced" cash is fine, but you must know what your enhancement is. I know first hand that there are so-called short-term bond/enhanced cash funds out there that bought CDO pools and floating-rate RMBS pools. Even if they bought only Senior tranches of these securities, they are looking at much bigger losses than they would have ever figured. And remember that anyone, governmental authority or otherwise, usually invests in a short-term portfolio because they expect to need the money on short notice. Now the CDO and RMBS pools have poor liquidity. Sizable losses + poor liquidity is exactly the opposite of what the client signed up for.

Back to money markets, enhanced or otherwise. Money market funds are often run by relatively inexperienced people. Not always, but often. I mean, many firms view their money market as something they have to offer, but not a driver of asset growth. So they aren't really willing to spend money on experienced people. Again, not all firms are like this, so if you are a 20-year veteran of money markets, don't write me a scathing comment.

Anyway, so the money market traders are usually working from a list of "approved" credits. So what do you think happens? Of course, the traders just buy CP in the highest yielding "approved" names. After all, the money markets trader is probably some young moisture farmer trying to make a name for him/herself. So s/he wants to generate as much yield as possible. And remember that up until now, someone with less than 5 years experience has never seen a bear credit market. So buying the highest yielding stuff has been rewarded over and over.

Also consider the sales pitch on asset-backed CP: you get a couple of extra beeps over corporate CP, plus you have high quality assets backing your paper directly. You aren't subject to any sort of corporate event risk. For anyone who remembered the 2001-2002 period, that was a strong pitch. Plus a lot of AB CP was (and still is) bank guaranteed. So I'm sure some investors started buying only the bank guaranteed stuff, and after a while started dabbling in the non-bank paper.

Anyway, so how does this play out?

• We'll probably see most large bank money markets get bailed out by their sponsors. We've already seen this from Bank of America (BAC) and Legg Mason (LM) among others. I've argued that this breaks recourse, but I've also argued that there isn't anyone to complain, so what the hell?
• I'd suspect that there will be some money markets forced to break the buck. There is too much SIV debt out there that is likely to pay less than 100% principal for every money market to emerge unscathed. How big is the loss? Who knows. But remember that people buy money markets with the idea that they never lose money. If a regular Joe investor lost even a small amount, 2%, 3%, 5%, whatever, that'd probably turn him off from money markets forever. If regular Joe's neighbor or sister or uncle loses 5% on his money market, that too might change his investing habits permanently.
• News reports of losses in money markets will cause "runs" on sound money markets. While the sound money markets may be perfectly able to meet redemptions, the result will be rising yields on all types of CP. We've already seen this, with pretty much all money market eligible instruments other than governments widening substantially.
• The taxpayers of Florida will probably have to bail out their state-run fund. We don't know what the losses are right now, but even if they are relatively small, I'd expect the state to make up the loss. If other states wind up in the same boat, expect bail-outs there too. If you doubt this, consider the press coverage if some rural school district in Florida couldn't pay its teachers because of incompetent state employees...
• Finally, government money market funds will likely become permanently more popular. For now, that will make T-Bills expensive as hell. If you buy Treasury bonds directly, it may be that coupon-paying bonds are significantly cheaper than T-Bills. For the long-term, this might make the slope from 0-18 months in Treasuries and Agencies unusually steep.