Money Market Mutual Funds and Shadow Banking

Wednesday, the Securities and Exchange Commission cancelled a plan to vote on imposing new regulations on money market mutual funds.  Although SEC Chairwoman Mary Schapiro, with the backing of the Federal Reserve chairman and the Treasury secretary, supported new measures, she backed off from actually holding the meeting when the swing vote stated that he could not, at this time, support the new regulations. 

Money market mutual funds are not banks, but account holders can write checks against their accounts.  Account holders are promised that they will get $1 back for each $1 share that they own.  However, there is no deposit insurance connected with the accounts.

Money market mutual funds can invest in risky securities and need hold no capital on their balance sheets to absorb any losses that the fund may experience.  In 2010 the SEC introduced new rules to achieve more stability in the industry, the most important one being a rule that required fund managers to hold more assets that could be easily sold so as to be more liquid in the case there was a significant increase in withdrawals from the funds. 

Money market mutual funds evolved from the 1970s and are part of the shadow banking system.

The attempt to increase regulations on money market mutual funds is just one effort being made to regulate the shadow banking system.  The Dodd-Frank bill is, of course, the driving force behind most of these efforts.

The industry fought a hard battle against Schapiro, and, for the time being, has stemmed the tide of new regulation.

On the industry side, the argument is that the rules introduced in 2010 have proved sufficient and are enough to protect the industry from future problems.

The other side argues that since most money market mutual funds lend to the same borrowers, the industry is subject to systemic risk because of the failure of one or more borrowers.  The concern over the possibility that something like this could happen increases the probability that in a time of financial stress, account holders could get “spooked” and this would cause a run on these institutions.

Ms. Schapiro had suggested that the SEC impose one of two possible options.  First, let the value of the accounts vary with the market value of the funds’ holdings.  Or, two, require the funds to hold capital to absorb losses.  In other words, she wanted to make these institutions into something out of the past.   

The private-side backup to the problem of capital is that the “sponsors” of these money market mutual funds will provide money to the funds should the assets of the funds be threatened.  In fact this is what happened in the recent financial crisis where, according to the article referenced above, companies that sponsored money funds had to help the money funds out: “At least $4.4 billion was provided between 2007 and 2011 to at least 78 funds.”

The question then becomes: will the sponsors always be there?

Although helping the funds out would seem to be in the interest of the sponsors over time…no one can really claim to know the answer to this question.

But, the discussion surrounding this issue for the money market mutual funds can be extended to almost any area of the banking industry as well as to the shadow banking industry.  Let me just take up another subject for a minute, the trading of swaps.  We are told that: “When US regulators, (thanks to the Dodd-Frank Act) led by the Commodity Futures Trading Commission, move to vote on swap execution rules later this year, the industry fears an overly prescriptive approach that could push trading towards that of listed futures or equities. In these largely electronic markets, trading is more frequent and the size of trades is much smaller than the notional hundreds of millions transacted in OTC derivatives.”

“In anticipation, the banks that act as big swap dealers are tackling their cost base, investing in more technology and adjusting to the prospect of using less leverage, taking less risk and by extension harvesting smaller bonuses.”  These changes will tend to raise costs, reduce revenues, and change the way that business is done.

However, the technology in this area is already changing with the leaders being Goldman Sachs, Morgan Stanley, and UBS.  The resulting model will be more like an exchange-traded model.  The instruments traded will be more homogeneous and, as one analyst stated, “we’ll employ our equity tools and slice and dice orders, so they’ll become smaller” and traded more rapidly and will spread to more firms and smaller firms.  That is, financial innovation will adapt to the situation.

This kind of world, as we have seen, becomes more complex, more interactive, and moves at faster and faster speeds. 

As I have written many times before, the regulators cannot keep up with this world, the regulators cannot fully understand what they are dealing with, and the regulators will not be able to prevent the next…or, any future…financial crisis.

The world we are in…and the world we are moving into…cannot be comprehended at this stage because we cannot predict what the evolution of electronics and information technology will bring.  What we can say about this future is that the private sector institutions will find the incentives and invent the ways to get around just about anything that the regulators want to place in their path. 

I believe that in the case of money market mutual funds, causing these institutions to either allow their accounts to vary with the market value of their assets or to impose capital requirements on the institutions will result in customers moving elsewhere in large numbers to institutions that will guarantee them the value of their initial deposits or will cause firms to find another way to do their business because the capital requirements raise the cost of doing business too much.

If rules like these are imposed on the industry, then another kind of financial institution will evolve to provide customers with the account guarantee they want as homogenously as possible.  That is, as with the potential future of the swap market, financial institutions will evolve that will employ equity tools to “slice and dice orders” into any form the customer wants...at the cheapest cost. 

The regulators, in my mind, still don’t understand the environment they are working within.  The modern credit engine can turn a cash flow into almost anything imaginable.  After all, finance is just information.  Applying alchemy to the finance system to make it into something the regulators want, will not work.  The regulators must “get real” and accept the world for what it is.  The regulators must attempt to build processes that help the system adjust and focus less on outcomes, which cannot be achieved.    

The financial world is changing.  Electronics and information technology is going to allow finance to do things we can’t even imagine.  Efforts by the regulators to force people and institutions into something that used to exist will not work, yet, they will keep on trying.  Since the regulators will not change, what we need to do is to look for opportunities that take advantage of the dislocations that the regulators create and take advantage of them!         

Risks Associated with Investing in Commercial Banks

If I thought I was a “value investor” and that my investments should be held, at a minimum, for four or five years, I would not want to put any of my investment money in commercial banks at this time.

The primary reason for this is the uncertainty that envelops the banking industry at this time.

First, there is still, I believe, a great deal of uncertainty about the value of many of the assets banks are carrying on their balance sheets.  Let me just mention three areas of concern: commercial real estate loans; residential real estate loans; and anything connected with state and local governments. 

Commercial real estate loans have generally been granted with a five to seven year maturity with the principal of the loan coming due when the loan matures.  Many of these loans are coming due or will come due in the next 12 to 18 months.  Most of these loans will need to be refinanced.  A large number of the projects connected with these loans are not doing well.  It is uncertain what will happen here.

Current statistics on residential real estate loans indicate that about one in four of these loans have a mortgage value that is in excess of the market value of the underlying property.  The government would like to see many of these loans refinanced with the principle amount of the loan being reduced to a value below current market values.  This may help the borrower but it would require substantial asset write-downs for the financial institution holding them.

In terms of state and local governments very little needs to be said these days.  Every week it seems we learn more about the financial tricks these governments used and the unfunded pensions that exist, which cannot easily be covered.  No one seems to have an idea about how much these problems will impact our commercial banks.

Second, there is the uncertainty hanging over the banking system about the new rules system that is going to be imposed.  President Barack Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010.  That was two years ago!

And, banks still don’t know what some of the laws are and how they will be implemented.  One reason for this is that there are still a number of the provisions of the law that have not been fully written yet.  Dates still get postponed for when various provisions will actually be implemented.

Then we have the Basel III rules, imposed by international agreement, that remain to be implemented. 

I don’t know one banker that is happy with this situation. 

Third, there is the uncertainty with respect to the state of the economy.  Very little is happening in the economy.  Economic growth, year-over-year, remains around 2 percent and is not expected to get better in the near future.  The reports are growing about companies that are cutting back spending because of the uncertainty created by the “fiscal cliff” coming up. And, there is uncertainty about how the economic crisis in Europe is going to play out in America.

Finally, there is the uncertainty surrounding the future structure of the banking system.  Although there has been so much noise about banks that are “too big to fail”, the larger banks continue to dominate the banking scene and will continue to do so in the future. 

The largest 25 banks in the United States plus foreign-related financial institutions hold more than 70 percent of the banking assets in the country.  This number is only going to increase. 

Domestically chartered banks that are larger than $1 billion in asset size (there are 525 of them) hold more than 90 percent of the assets held by domestically chartered banks.  This means that there are about 5,700 banks in the United States that hold less than 10 percent of the banking assets in the country.

And, we hear and read about the pressure that the bad bank assets, the poor economic conditions, and the growing regulatory burden are putting on the smaller banks.  Take for example the Wall Street Journal article, "Small Banks Are Blunt In Dislike of New Rules".  This is an article about how these bankers are reacting to the proposed rules on capital levels related to Basel III. 

The most important, to me, paragraph in the whole piece is the last one.  “C. R. “Rusty” Cloutier, president and CEO of MidSouth Bancorp, Inc., of Lafayette, La., said the Basel rules won’t affect him as harshly as some smaller banks since he is on the big end of small—about $1.5 billion in assets—and publicly traded.  But his phone is ‘ringing off the hook’ for smaller lenders looking for an exit.” 

Everything today points to larger banks and fewer smaller banks.  And, it is not just the economics that is pointing this way but the actions of the politicians and regulators are also driving things in this direction as well.

But, there are two other major players that have to be contended with in the restructuring going on:  credit unions and “shadow” banks. The roles these two categories of financial organizations are going to play in the new structure are uncertain now, but they will be important players, I am sure of it.

For one, people needing “banking services” are going to divide into two sub-groups.  Those that don’t need “traditional” banks…like myself…who can do all they need electronically and interact with all their assets within the same institution.  And, those that basically only need a checking account, a safe deposit box, and maybe a savings account.  This latter group needs a “no frills”, low cost provider of basic banking services.  The credit unions may eventually satisfy this need. 

And, lending is going to change for small business.  Angel financing is going to grow.  Private equity is going to play more of a role in business lending and then there are other innovations like “peer-to-peer” lending and so forth.  No telling what is going to evolve from the Internet.  No telling what will come from the shadow banking system.  Depository institutions need not apply.

In five years, banking finance will be structured in a very different way.  Getting there will be the problem.  Because of the uncertainties mentioned above, investing in commercial banks will make it very difficult to pick winners.

At the start of the year, who would have picked out JPMorgan Chase as the institution that would “shock” the banking industry with trading losses?  Myself, I am not confident that any bank in the present environment is immune from such surprises.  Banks may have bad assets on their books that have not been recognized.  Banks may be unprepared for exactly how the banking regulations are going to work out.  Banks may not whether this period of slow economic growth well.  And, banks may not be fully prepared for the changes taking place in information technology and the new competition from shadow banking and beyond. 

These are new times.  There will be new “winners.”  And, there will be lots of losers.  Welcome to banking in the early twenty-first century!