Connect the Dots Before Financial Depressurization
Let’s start with the conclusion – The ability of retail investors to trade or short during market freefalls may be limited in the near future, even without changing any rules related to trading or shorting.
Dot #1 – Suspension of the mark-to-market FASB rule in April 2009. Old news, but the starting point of this line of dominoes. Suspending the mark-to-market rule allows assets that are “temporarily impaired” (owner intends to hold most of them until their value is restored in the market) to remain on the balance sheet without writing them down to current market value. The rule was enacted by a 3-2 vote.
Dot #1.a. one year later – The Fed’s flood of liquidity has temporarily reinflated the stock market, but not reinflated impaired real estate. Markets are showing signs they will be stagnant-to-down during 2010. The FASB rule change (if changed at all) should have allowed averaging of asset values over many quarters, rather than locking in inflated values near the top of the market. Averaging impaired assets to their markets over time would have eased balance sheets toward true market value with each quarterly report, whether the market remains weak or is in recovery. Instead, asset values were hard-coded at their frothy levels, NINJA fraud premiums included.
Dot #2 – SEC rule 22e-3(a) allows money market funds to suspend redemptions if “the fund’s current price per share is less than the fund’s stable net asset value per share”, commonly referred to as “breaking the buck”. This allows money market managers to invest / speculate in riskier financial products and not be forced to sell into a panicked market at a loss when customers’ use of cash surges. The potential loss will now be transferred to retail customers in the form of opportunity cost. Retail customers will still get their full dollars back, but maybe not when they would have been of the most use to them. The yield curve for managers supersedes the need curve of account holders according to 22e-3(a). This rule, passed 4-1, allows money market managers to chase yield while transferring risk elsewhere. The perennial institutional warning to retail customers is “don’t chase yield”, but with the safety net of 22e-3(a) in place, institutions themselves can now chase yield with impunity.
Dot #2.a. corollary – for all who skimmed this recent news and thought “I have no intention of withdrawing cash from my money market fund so this is no big deal”, reread the reports and substitute “use” wherever “redemption” appears. This is one reason why your statement is in units or shares, not dollars. The sole reason for this rule change is so money market managers can count on the dollars being there when they need them, not you. Now that money market managers are protected from being forced to sell assets like reverse repurchase agreements to raise cash in a panicked market, they are more likely to buy higher-yielding instruments in exchange for your liquidity.
Dot #3 – Three-party reverse repurchase transactions where the repo dealer is allowed to transfer and hold impaired mortgage-backed assets from the Fed without recording them on their balance sheet. By bypassing this core accounting requirement, the assets would not need to be written down upon transfer and the repo dealer would be exempt from normal capital reserve requirements. As reported by Kristina Cooke of Reuters in November, 2009, the Fed, SEC, and FASB have been discussing a rule change that would allow this sacrosanct accounting element to be legally bypassed.
Implementing Dot #3 would be really bad. Imagine a going concern intent on disposing of a bad investment for which selling at a loss is not an option, yet the organization is systemically unable to perform to the goal using established practices. Imagine also, the operation wants to reach their goal so quickly that very difficult, long-term solutions are not acceptable to current management. Further, imagine they are given the legal power to sell assets at their target price, shielding all involved in the process from prosecution, and where the normal steps between raw materials and final sale need not be documented. Elements of cost of sales are not separated. Selling price and incentives for buyers are not recorded as separate line items. The only remaining obligation after the sale is to buy back the instrument at a predetermined price and date in the future. This is the rule change the Fed is requesting.
Last week, twenty-two indictments were issued by the FBI in a sting that caught executives paying bribes in a fake international arms deal. The cost of the bribe was added to the cost of the product. Dot #3 would essentially perform the same function for reverse repo dealers, only with no recorded inventory, no audit trail, and no indictment. The incentives and discounts needed to convince money market managers to back the Fed’s impaired mortgage assets with their customers’ money market cash will need to be substantial. Repo dealers, of course, will take their normal fee, or perhaps more. With no audit trail, even the Fed may never know. As long as the Fed’s mortgage assets get backed by real dollars, they probably don’t really care.
If this hole (Dot #3) is allowed in the dike of our financial system, another flood is assured because it will continue to be allowed in other circumstances, by precedent.
What to do:
Thank God for the two FASB standards board members and one SEC member, who, like the general public, are often on the losing end of votes, but do their job with integrity. Thank you for your continued career-limiting votes. Thank God again that some of the seven colleagues who allowed Dot #1 are having greater issues approving Dot #3 that would complete an unbroken line of dominoes. As we all know, an unbroken line of dominoes can be completely toppled from any point along the series. In brokerage accounts, or any account for which you depend on immediate access to your dollars, expect low returns. If those accounts generate higher than average returns, learn why. Make it clear to your brokerage that if they ever limit your access to funds or restrict your ability to trade, they will lose your account. This will force your institution to balance the gain from backing your money with heavily discounted reverse repos against the permanent loss of the commissions you generate. Read your money market prospectus when it comes in the mail. Look for high-yield instruments that reduce the liquidity of the fund, and thus your liquidity.Shortcuts beget more shortcuts. This series of rule changes is evolving because the attempt to reinflate impaired assets is failing. Dot #1 begat Dots #2 and #3. We the people are already on the hook for the troubled assets mess. As soon as the Fed made large banks whole, taxpayers owned the damage. Let’s not tolerate rule changes that attempt to cover up the damage and will lead to new unintended consequences like the loss of quick access to money market cash. Sell the underlying distressed assets and total the bill now.
As with straightening our children’s teeth, we may have to pay it over time, but we understand we were going to pay for it anyway. You bet we’ll be angry. We’re in our second year of being angry. Don’t prolong the pain with more poor decisions. We know mortgage-related failed bets were made on our dime. Stop painting over peeling paint, start scraping, and do it with some transparent-C, as promised. Return troubled assets to the market to begin the recovery. By dealing with these assets truthfully, there is no need to pursue changes to financial rules that have made this country a safe haven for international investment in a world where untrustworthy balance sheets are common. We would no longer be tempted to trash our own currency, the lifeblood of secure commerce, in an attempt to inflate the market to match unjustified balance sheet asset numbers.
Repo dealers normally get 2-5 percent, but for troubled assets, expect at least 5%. Money market managers would want at least 10% per year to cover the possible damage they would do to their core business if they ever need to invoke a redemption suspension. These reverse repos are expected to have a pretty long required holding period - long enough that the underlying assets can recover their value. Money managers have to consider the extended holding period when deciding how much to pay. Note, these reverse repos are backed by assets that the source banks they originally came from are not likely to bid for. So, if large, in-the-know banks don't want these, how deep a discount will money managers require to take the bait? This scheme would add billions to the cost of working off the troubled assets portfolio while adding more risk to an already fragile system.
Connect the dots. When the economy was starved for liquidity, the Fed provided capital infusion at the top of the economic food chain. The flood of money went directly to the largest institutions with the most recent trend of misapplying capital and destroying middle class wealth on the most massive scale in human history. When the recovery takes hold, the Fed’s plan is to drain liquidity from the bottom of the system targeting small savers and investors who managed to act prudently before and during this crisis. Dot #3 is all that is needed to complete the plan. Don’t let it happen.