Without knowing the context of Grant’s observation, most investors might imagine he was referring first and foremost to the stock market. But he wasn’t. He was referring to money-market mutual funds, or what most folks consider “cash.”
To be sure, Grant is no fan of the volatile, richly priced stock market, nor the bouncy, low-yielding bond market. But it is the utterly placid, zero-yielding “cash market” that seems to concern him the most. The world’s “safest” investments are, suddenly, among the world’s riskiest.
Money market funds have always been rather boring, but they were trustworthy. They paid an acceptable annual yield with no significant risk. These things weren’t supposed to be exciting and sexy. They were supposed to do a single job and to do it reliably, like Wonder Bread, drywall or toilet paper.
But now that money market funds are yielding zero, or close to it, they seem to have slipped into a kind of financial torpor. They just sit there, lifeless, yielding nothing. When you scratch below the surface, however, you discover that these funds are much more exciting than they ought to be. They are incurring lots of risk for very little reward.
Somewhere along the way, the money market funds lost their way. These nerds of the financial world started acting like playboys… or at least trying to.
The fund managers started taking bigger and bigger risks for smaller and smaller rewards. Not content to receive respectable yields by buying commercial paper from the likes of Johnson & Johnson (JNJ) and Dupont (DFT), the managers started reaching for a few extra basis points by buying heavily processed and re-packaged asset-backed securities from Wall Street.
That episode did not end well. The crisis of 2008 erupted, causing widespread panic and capital loss in the global financial markets.
But the US government saved the day and the money market fund managers learned their lesson. Oh wait — those last two things didn’t actually happen. The money-market fund managers learned nothing, except that the US government will clean up whatever financial Superfund sites they create.
Thus, less than three years after nearly dooming the US financial system by buying American asset-backed garbage, the money funds are at it again, buying European PIIGS-backed garbage.
“US regulators are worried about the ‘systemic risk’ posed by the exposure of American money-market funds to European bank debt,” The Wall Street Journal reports. “That’s right, nearly three years after the panic of 2008, our all-seeing regulators have somehow not fixed what was arguably that biggest single justification for government intervention at the time.
“In 2008,” the Journal continues, “the feds felt obliged to guarantee all money-fund assets after they let the Reserve Primary Fund pile into bad Lehman Brothers paper, Reserve broke the $1 net-asset-value, and in the following days some $400 billion fled prime money funds. We’d have thought our regulatory wise men would have fixed this systemic risk before all others.
“Yet now we learn that since 2008 US money funds have been allowed to pile into European bank debt, even as everyone knew those banks had stocked up on bad European sovereign paper. The Treasury is even saying privately that the US needs to support the European bailout of Greece, lest European banks fail, US funds take big losses, and we get another flight from money funds.
“Can this possibly be happening?”
Yes, is the short answer. Here’s the longer answer:
In a zero-percent world, one would imagine that cash managers would resign themselves to earning nothing for clients when nothing — approximately — is what the market is offering. One would imagine that cash managers would be busy improving their golf games. But one would be wrong. Instead of playing golf, the cash managers are busy “groping for yield.”
Yield-groping, despite its provocative name, does not elicit any harassment lawsuits, nor even a censure from the Human Resources Department. But it is a very questionable practice, nonetheless… and it usually ends badly.
Yield-groping, loosely defined, is the tactic of pursing a small amount of incremental yield in exchange for a large amount of incremental risk. Think of it as tight-rope-walking across Niagara Falls to get a free ice cream cone. As long as you make it, you get your reward.
But it’s a bad bet, no matter the outcome.
The nation’s largest money market funds are busy shimmying across Niagara Falls. As Grant observed in a recent edition of Grant’s Interest Rate Observer, these bellwether money market funds hold an average of 41% of their assets in European debt securities.
Most of these European borrowers are large banks that have loaned tens of billions of dollars each to the governments and corporations of Portugal, Ireland, Italy, Greece and Spain (PIIGS). At some banks, loans to the PIIGS countries are so large that they total more than half of the bank’s net equity.
A little problem in Athens, therefore, could become a big problem in Paris, and in Boston, where the Fidelity money-market funds are loaded up on commercial paper from European Banks.
Who could have imagined that the dismal finances of the Greek government might someday impact the “cash” in your American brokerage account? Who could have imagined that an insolvent Greek butterfly, flapping its wings in Athens, might cause a tsunami of redemptions from American money-market funds in Boston?
We did not imagine it before now, but now our imagination is running wild.
As the chart above clearly shows, fear is ascendant on the European continent. Bond yields in the PIIGS countries are soaring, relative to the AAA-rated bonds of the Swiss government. These soaring bond yields testify to the genuine distress that is already besetting the credit markets of Europe. Perhaps conditions will improve, but we wouldn’t bet on it.
Fidelity’s money market fund managers are betting on it, and receiving about 20 basis points per year for the bet. Seems like a bad bet to us, but then again, we aren’t professional money managers. Maybe they know something we don’t, like how a government with a debt-to-GDP of 150%, annual deficits equal to 10% of GDP and a 200-year history of chronic default is going to pay its bills.
The world is, indeed, full of banana peels.
for The Daily Reckoning