Unless you think that Ben Bernanke and Hank Paulson were just engaging in a shock-and-awe sales pitch for the TARP plan when they spoke to legislators on Friday, September 19th about such things as "martial law" and "the end of our economic system and our political system as we know it", you have to take very seriously the story told in my friend Magnifico's diary last night regarding how we as a nation were three hours away from a economic core meltdown because of a run of hundreds of billions of unexpected withdrawals from U.S. money market funds.
To review the basic course of events of that week: Lehman Brothers had failed the previous weekend. On September 16th (Tuesday), a story developed about a large money market fund, the Reserve Primary Fund, breaking the buck as the result of a $785 million investment in Lehman Brothers debt that was now worthless. A staggering $40 billion was withdrawn from the fund between the open of business Monday and 3pm on Tuesday, before the fund basically put a halt on redemptions. As this news spread, other money market funds, even those with no exposure to Lehman Brothers whatsoever, began experiencing unusually high levels of redemption orders from jittery investors.
So who withdrew all that money from the money market funds? And where did the money go?
As pointed out by economist Brad Setser, the primary goal of central banks and sovereign funds is to not lose money-- and he reported evidence that massive amounts of foreign-held dollars were pulled out of money market funds in September in a flight toward lower-risk assets. Around $100 billion in foreign central bank dollar reserves was plowed into Treasuries sometime between September 10th and the beginning of October, while dollar reserve amounts fell overall in nearly every country that reported such statistics. The dollars that foreign central banks were investing in Treasuries had to come from somewhere, and where it came from was likely in large part from withdrawals in money market funds.
And we know for a fact that at least one sovereign wealth fund was scrambling to get its money out of money market funds that week. Perhaps the party most burned by the events of that Tuesday was the China Investment Corporation (CIC), a sovereign wealth fund set up by China to invest a large chunk of its $2 trillion in foreign currency reserves. It turns out that CIC held an 11.1% stake in the Reserve primary Fund, and was likely the single largest bag-holder after the collapse, with up to $5.4 billion frozen in the fund.
So there's your run on the money markets-- whether Kanjorski got his numbers mixed up and it was only $150 billion in withdrawals over two days and not "$550 billion being drawn out in an hour or two", foreign central banks and sovereign wealth funds played a huge part in it.
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So because a money market fund held Lehman Brothers debt, our entire financial system almost collapsed. But why did this money market fund have Lehman debt in the first place?
The Wall Street Journal had a story a couple of months ago about the Reserve Primary Fund and its co-founder, a Republican named Bruce R. Bent who once had John McCain tape a campaign commercial for him in a failed run for county executive. Mr. Bent, for all intents and purposes invented the money market mutual fund. The idea was to pool the money of small investors, invest the money in higher interest rate investments like treasuries that required a large minimum investment that was out of reach of the typical small investor, pay the small investors more than they would get in a savings account, and keep the difference.
Bent refused to invest in anything but the safest, highest quality assets. From the fund's inception in 1972 until 2006, Bent adamantly refused to invest in commercial paper such as Lehman's debt, which it consistently deemed too risky.
But sometime in the latter half of March 2006, Bent's greed apparently got the best of him and he abandoned a core principle he had held for nearly 35 years:
Reserve had told the Securities and Exchange Commission in September 2005 that "to further minimize investment risk, the Funds do not invest in commercial paper." In another federal filing on March 15, 2006, Reserve said its funds had "slightly underperformed" rivals, owing to a "more conservative and risk averse manner" of investing, and noted: "For example, the Funds do not invest in commercial paper...."
A week later, Reserve amended its prospectus, deleting a line that said the Primary Fund couldn't buy commercial paper.
Within two months, such paper made up 5.7% of the fund's assets. The percentage soared tenfold in two years. The result was that by this September, the Primary Fund's 12-month yield was the highest among more than 2,100 money funds tracked, according to Morningstar -- 4.04%, versus an average of 2.75%. With this stellar yield, the fund's assets tripled in two years to $62.6 billion.
Wall Street Journal
Since this story was written, evidence points to the fact that the Reserve Primary Fund is not merely guilty of investing foolishly... it also lied in an ill-fated attempt to cover up it's losses:
State regulators in Massachusetts have accused top executives of the Reserve Fund of lying to shareholders about the safety of their investments hours before the firm’s largest money fund disclosed that its share price had fallen below a dollar — and then giving big shareholders first crack at avoiding losses.
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The Reserve Primary Fund held about $785 million in Lehman notes at the time of the bankruptcy filing, or about 1.2 percent of its portfolio. When shareholders raised questions about the Lehman stake, Reserve fund executives assured them that the fund would not break the buck and that redemptions would be honored on a "first-come, first-served" basis.
Those assurances, according to the Galvin complaint, "contained outright falsities which the principles of Reserve Management knew at the time were not true."
New York Times
I'm not sure whether it's fair to lay so much of the blame for this near-catastrophe on this one man. But I am sure that in a world where one man and one company can, through reckless and fraudulent acts, bring the world financial system to its knees, the punishment for this kind of white collar crime has to be swift, severe, and sure in coming.