The following is an extended version of an article recently published in the Australian Financial Review (firewalled sadly) , but I have also included some longer discussion about the role of Money Market Funds in transforming a ‘normal’ financial market crisis in 2008 into an economic one. A reader had recently asked for a link to an article I had previously published on the role of Money Market Funds in the Global Financial Crisis, which sadly neither one of us could locate. This is a subject that I have written on on numerous occasions since 2008 but in the absence of finding any of the originals (must get better at tagging) I thought it worth setting out the case afresh. A more detailed discussion is therefore included at the end of the AFR article

The Fed’s main job now is to manage the monster it has created.

Every year at the end of the summer in the US, the Federal Reserve Bank of Kansas City hosts an economic symposium for the assorted Federal Reserve Banks of the United States that is attended by many of the great and the good in economics. Unlike Davos, the winter festival for the networking private jet crowd, this is a select event, with media attendance strictly controlled, but it is nevertheless seen by much of the economic commentariat as setting the scene for the year to come. And yet, Fed watching has become such a strange pastime. Back in the days of Paul Volker, when the event first began, concepts such as the Output Gap and the Phillips curve were central to discussions, linking Fed Policy on interest rates to real world variables such as employment and prices. Indeed, in the early 1990s, Stamford Economist John Taylor created a model known as the Taylor Rule that formally linked economic variables such as real incomes and employment to ‘target’ levels of interest rates. Unfortunately, almost as soon as the model started to be widely adopted by Fed watchers in the late 1990s, it stopped working, as interest rates were manipulated for other, largely financial market related, reasons.

Bloomberg even have a function of the Taylor Rule, showing you where interest rates ‘should be’. The chart illustrates how accurate it has been since 1995, showing that except for a brief period in 2006/7, it has been either much lower or much higher than the actual Fed funds rate.

Taylor Rule basically doesn’t work, so Fed watching simply a ‘Sports Bet”

And yet, every month the high frequency economic data is pored over by traders in financial markets for signs of what the Fed will do next. The non farm payrolls has become like a sports betting event, with the tipsters (economists) predicting whether the latest number will come in above or below consensus and the punters (traders) effectively making and laying off ‘bets’ on the outcome. There is a flurry of activity around the data release, then it’s all back to normal. The Fed doesn’t actually do anything and the real world isn’t affected and the traders tear up their equivalent of the betting slip and move on to the next event.

Indeed, so irrelevant have economics become for Fed watching that we stopped the graph at September last year, not only because according to the Rule, rates should have been 5.5% at the start of this year, but apparently they should have gone to minus 7% in April!

This doesn’t mean that the Fed isn’t important. It is, but just not for the reasons we pretend. The real role of the Fed nowadays is not to pursue the twin targets of price stability and full employment, but rather to try and manage the monster that it, and Wall Street, have created over the last 20 years, the US Shadow Banking system. Following the repeal of the Glass Steagall Act in 1999, US Retail and Investment Banking effectively merged, with Fed money being increasingly channelled into higher margin leveraged shadow banking structures.  One important , but largely overlooked, example was the way the traditional role of banks in providing savings deposits and corporate cash flow lending was usurped by Wall Street in the mid 2000s with  Money market funds competing for savings by offering a higher rate for overnight money and in turn squeezing out traditional corporate overdrafts by buying up and funding a market for short term 30 day commercial paper. This worked fine until one major Money Market Fund called Reserve National was forced to write down all its commercial paper associated with Lehman Brothers to zero in September 2008. As such, it ‘broke the buck’ and announced its Net Asset Value had fallen below par. Cue the equivalent of a Bank run as savers took their money out. This in turn meant that the Money Market Funds were unable to buy up the next round of commercial paper so that effectively the multi-trillion dollar working capital line to the world economy froze overnight. * This, more than anything else, was the reason that a ‘normal’ financial market crash became a major economic event. With no working capital, inventories had to be run down, new orders stopped and assets shifted at fire sale prices. All the economic indicators (and the economists) screamed recession and yet we bounced back rapidly, for the simple reason that the Fed stepped in and bought the commercial paper. Buyer rather than lender of last resort.

*See below for more detail

Of course the reason for the collapse of Lehman in the first place was another part of the shadow banking system, the Credit Default Swap (CDS) market. While technically banks can’t lend for high risk speculative activities, they simply lend to ‘low risk structures’ that do so instead, usually avoiding the relevant regulator along the way and so it was with the CDS market which by using volatility as a proxy for risk offered global pension funds and insurance companies a ‘low risk’ way to lend to high risk customers. Until that was someone wanted to get their money back when the reality of highly correlated but illiquid assets proved to be far from low risk. Here too, the Fed had to be the buyer.

The response of the regulators to that debacle was to allow the same pension funds and insurance companies to invest in new, ‘low risk’, structures provided by Wall Street instead, the so called ‘alternative assets’ like private equity, private credit, leveraged loans and Real Estate Investment Trusts, where once again a lack of liquidity was overlooked and the leveraged nature of the structures was ignored. This too almost collapsed in March of this year until the Fed stepped in to effectively underwrite the US corporate bond market. This time around it was the big Exchange Traded Fund (ETF) providers that were ‘too big to fail’ and yes, yet again it fell to the Fed to be the buyer or last resort.

So ultimately Fed watchers looking at indicators such as employment and inflation are looking in the wrong place and statements about whether the Fed is targeting either are missing the point. The Fed’s role now is one of damage limitation. It can’t shut down the Shadow Banking system as it is simply too big and has basically replaced the traditional banking system. It can’t set interest rates to efficiently allocate investment capital because it would bankrupt the existing debt holders. Interest rates therefore are stuck and the ability of the Banks to channel almost free central bank money into structured products remains unhindered. Ultimately it needs to collapse the leverage in the shadow banking system for which it needs legislative help. Reducing the incentive for leverage as well as the ability to offer such products for sale as ‘low risk’ would be a start, but whether the Fed has the courage or the politicians the will remains to be seen.

* The Role of Money Market Funds in the Global Financial Crisis.

The essence of the story is the nature of the US capital markets, which are in a seemingly constant state of evolution as participants try to re-invent old products in new guises in order to either evade controls and restrictions on the existing products or to try and push up margins that had collapsed under the force of competition. This ‘Shadow Banking System’ of in the US is thus remarkably similar to the widely derided Shadow Banking System in China, except of course having been invented by Wall Street it is ‘a good thing’. There is an old expression of putting Old Wine in New Bottles but in this case, given the higher margin on old wine, it is more a case of putting New Wine in Old Bottles.

Back in the mid noughties, as interest rates remained suppressed and regulators forced traditional Banks to hold more capital against traditional lending on the one hand while encouraging them and other financial institutions to hold bonds rather than equities on the other hand, Wall Street and the capital markets expanded the shadow banking system through a variety of ‘new’ products. Chief amongst these of course was the Credit Default Swap (CDS) which was really an insurance product that facilitated the securitisation of, largely mortgaged backed, loans, but which became a product that was traded in its own right. Except it wasn’t really traded, it was largely bought and held to maturity by insurance companies and pension funds attracted by the combination of a ‘high’ yield, a lack of volatility (that actually disguised a lack of liquidity) and a label that said AAA rated which meant that the regulator was happy, as were their internal risk controllers. As such the CDS was a Wall Street solution to investors looking to circumvent the regulations and challenges resulting from Wall Street’s previous Big Idea of the dot com bubble.

As with most of these initiatives, it was to end in tears when the one way directional bet of buying illiquid assets and watching the prices rise inevitably flipped when someone started to sell. However, what was different about this event was that unlike previous booms and busts, from emerging market debt to junk bonds to LTCM and even the dot com bubble, it became the Global Financial Crisis because it spread from the Financial Markets to the real economy. And that was because of another piece of the Shadow Banking System. The US Money Market Funds.

The US Money Market Funds had evolved into a nice fee earner for the big fund management groups who were effectively charging fees on cash, but whose product was attractive because it offered a higher return than simply holding this as cash itself. In the noughties, when a combination of regulatory pressure and residual risk aversion meant that institutional cash holdings in the US were in the trillions, this was big business. In order to achieve this spread over normal cash while still remaining acceptable as near cash to regulators, the Money Market Funds (MMFs) resorted to the oldest banking trick in the book, duration mismatch, otherwise known as borrowing short and lending long. The mismatch was not massive however, it was mostly for 30 days and the MMFs were primarily involved in buying another ‘new’ Wall Street product, Commercial Paper.

Thus in effect Wall Street and Capital Markets had disintermediated the traditional Banking system by firstly diverting all the cash deposits from traditional bank customers into (modestly) higher yielding mutual fund structures that offered daily liquidity and then using that liquidity to usurp the traditional working capital lending that banks would make to their corporate customers with fees for the Investment Banks and asset managers all the way.

This all worked perfectly well until the CDS structures started to unwind and liquidity suddenly became the key risk to markets – except none of the regular risk management systems were looking at liquidity, they all remained obsessed with volatility. MMFs were seen as ‘fine’ because there was no volatility, until that is Lehman Brothers went bust in early September 2008 and the regulators, suddenly awakened, declared that all bonds issued by Lehmans had to be marked to zero. The problem was not immediately apparent to most people in markets until it came time to roll the 30 day commercial paper in October. The catalyst was the Reserve Primary Fund, which with over $60bn in assets, was one of the largest of the MMFs. On 16 September, a week after Lehman, it announced that it had, to use the expression “Broken the Buck’, meaning that a $ invested in their MMF was now worth less than a $ as their Net Asset Value (NAV) had to be written down to allow for the Lehman issued Commercial Paper now being officially valued at zero. Although the actual position was less than $1bn, the reaction was immediate, as investors rapidly moved to sell their MMFs, not just in Reserve Primary but across the board replicating all the aspects of a classic ‘Bank Run’.

This of course meant that come the October refinancing round for Commercial Paper there were no buyers as the MMFs, concerned about liquidity in the event of redemptions, could not tie their capital up – even for 30 days. The effective result was that the Fortune 500 and many companies beyond suddenly lost their working capital. It was as if the entire corporate sector had its overdraft pulled. The only solution at the company level was to stop. Stop making anything new and try and shift the stuff in inventory. The Chart illustrates this, with the orange line as the Year on Year change in US nominal GDP and the white line showing the change in inventories.

In 2008 dumping inventories due to a cash flow crisis drove GDP down sharply. And then back up in 2010

To put it in context, US GDP in 2008 was around $14.7trn, or around 3.7tn a quarter. Because inventories fell rapidly from $1.5trn, to around $1.3tn due to the liquidity crisis, that alone would have registered as around minus 5% on a quarterly basis – which is how the numbers are usually reported.

We knew this was going on for two reasons; first, as investors talking to corporates they were telling us first hand about the situation, in many cases they were providing liquidity to their suppliers, but second, because in early October the Fed, having already undertaken to buy up all the CDS paper that the banks could no longer hold, suddenly announced that they were also going to step in and buy up the next round of commercial paper. Rather than act as a lender of last resort, the Fed had one again been forced to be the buyer of last resort for a product that the Shadow banking system couldn’t, or wouldn’t, take.

There was never “A great Recession’, it was simply the great Inventory liquidation.

Of course there were another knock on effects; dumping inventory meant slashing prices and of course nobody put in new orders while dumping existing stock so industrial production also came to a temporary halt, with a resultant drop in demand all the way down the supply chain. The economists saw falling GDP and falling prices and the role of housing as the underlying asset in the CDS market and concluded (as usual) that this was the recession that they personally had predicted for the last decade. All caused by the housing ‘crash’ when in fact it was really a liquidity crisis caused by the modern equivalent of a bank run, although this time it was a run on the shadow banks.

The flip side of course was that as soon as inventories were gone, everything, both the technical calculation of GDP and the industrial activity (as well as prices) started to rebound while the great and the good of the economics profession continued to go on about ‘the Great Recession’ – and their role in predicting it. The natural result of this of course was that nobody dealt with the actual problem, which was the shadow banks. Indeed, they simply made the situation worse. Far worse. Quantitative Easing and other abnormal monetary policy channeled even more long term investment capital into fixed income and structured products ‘to reduce risk’, replacing CDS with a whole raft of illiquid and unquoted products including private equity, private credit, leveraged loans and real estate. Described as ‘alternative’ they are in fact mostly illiquid, which gives them the low volatility that is falsely regarded as low risk and far from being good for diversification, the reality is that they are often all connected into very similar if not identical underlying economic entities.

The Fed meanwhile can do little to unwind this situation. As we saw with the so called “Taper Tantrum’ of 2013, any attempt to unwind QE causes markets to panic and central bankers to back off. Back in 2009 there was much use of the phrase ‘kicking the can down the road’. While the expression seems to have fallen out of fashion, the policy remains basically that.

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