The Danger Lurking in the Shadows

Cash funds have taken on much of the banking system's real estate risk
May 22, 2018 Updated: May 22, 2018    

Since the financial crisis of 2008, the official banking system has reduced leverage and has stayed away from lending to low-quality borrowers, at least directly. However, there are other non-bank lenders, the so-called shadow banks which have been piling up risk, largely unseen from the public.

This is a topic few if any understand fully due to its complexity, but the rough contours are clear. First, some history. The 1920s bubble was virulent because (like today) banks were allowed to fund long-term mortgages with demand deposits.

The Glass-Steagall banking reform prevented banks from paying interest on deposits in order to discourage large cash balances from accumulated in demand accounts. Large companies with large cash balances did not like leaving their funds completely idle, especially since their balances exceeded FDIC insurance limits. So, the market developed money market funds which took corporate cash and deployed it into highly liquid, short-term government debt and overnight, senior loans to only the most highly rated banks and corporations.

The funds were called “shadow banks” because they performed the same function as banks: accepting demand deposits
(characterized as “investments,” but demand liquidity made them effectively the same as a deposit) and investing in safe debt, except without being subject to banking regulation.

Breaking the Buck

By convention, market money funds are valued a $1 per unit and pay interest daily. The tiny duration, senior position, and credit-worthiness of the borrowers make the loans have no possibility of loss, at least theoretically. But theory and practice rarely match fully, and in the panic of 2008 one of the major money market funds “broke the buck,” meaning its Net Asset Value per share went below $1.

The Fed was terrifed this would lead to a run on the money market funds, which would freeze the cash large corporations use to make payroll, pay suppliers, etc., so they bailed them out. The Securities and Exchange Commission (SEC), wishing to prevent a repeat of such an occurrence, changed the rules as of 2016 to force money market funds to allow their NAVs to float and required them to gate investors in the event of a liquidity panic.

Well, the whole point of the funds is to house ready cash, so the prospect of a gate completely undermined their function. When the rule change came into effect, about $1 trillion of money market funds moved into government bond money market funds, which (of course) are exempt from the rules, and around $350 billion moved into lightly-regulated, so-called “cash funds.”

Whereas government money market funds were shooting for a 0.6 percent return in early 2017, cash funds were promising 2 percent returns. This is a low figure from a total return perspective, but very high when earned on “risk-free” cash.

No Free Lunch

But, how could these cash funds achieve this risk-free return when the Treasury bond had barely any return at all?
In fact, the would buy not cash obligations but tap the commercial real estate market. Whereas Mortgage Backed Securities (MBS) contain residential mortgages, implicitly guaranteed by the government, Commercial Mortgage Backed Securities (CMBS) contain commercial mortgage-backed securities: malls and office buildings.

For example, this was typical transaction from early 2017. JP Morgan and Deutsche Bank made (or acquired) $1 billion of commercial loans yielding 4.5 percent with maturities of around 10 years. The owners of the real estate took the loans out against their existing assets, perhaps, to help finance construction of some new office towers in Manhattan.

The banks securitized the loans such that 95 percent of the loan pool was put into slices of short maturities (meaning they get the payments first) which get a AAA rating, and 5 percent was put into a B-piece, which has the longest maturity and is first to absorb defaults.

Who were the buyers? The insurance behemoth MassMutual (with $675 billion under management) issued a $475 million 60-year bond paying 4.95 percent fixed rate at the same time of the real estate transaction. It used some of this capital to buy the B-piece, priced to yield 13.9 percent. Meanwhile the cash funds took the AAA-pieces, priced to generate yields ranging between 1.2 percent and 3.7 percent.

Everyone was a winner: the banks made a fortune selling 95 percent of 4.5 percent yielding assets at an average yield of around 2 percent; MassMutual locked in a 9 percent spread for ten years, and the cash funds could offer three times the yield of government money market funds.

Let us distinguish, again, between default risk, interest rate risk, and bubble blowing risk. The cash funds would say that the AAA tranches have almost no risk of default. In addition, the interest rate risk is low: presumably, investors will not transfer their funds back into bank deposits unless the deposit rate jumps above the CMBS yield before the AAA tranches mature, and these tranches are fairly short term—even if final maturity is 18 months out, the buyer is getting 5.5 percent of its capital back per month.

The insurance company has long-term liabilities, so it is happy to take the long piece, the return is so high it can absorb some defaults, and the debt is collateralized in any case: having 60-year capital means it can foreclose and ride out the cycle if it has to. This seeming lack of risk is why corporations have been putting their cash into cash funds and why regulators are unconcerned.

Blowing Bubbles

But what about bubble-blowing? No matter how the banks slice and dice the debt instruments, corporate cash—not assets, not investments, not savings, cash, of the overnight kind—is being used through this Byzantine system to finance the construction of office towers, which are long-term, interest-rate sensitive, illiquid assets. The system as a whole is borrowing short to lend long.

Missing from the calculation is what happens when the over-capacity that results from building assets not in accordance with consumer demand but instead on the basis of bank credit creation causes severe shortfalls in cash flow. How many investors—or even policy makers—understand the structures described above? The Federal Reserve clearly thinks asset market are too high and is raising interest rates to control them (as it did in 1920 and 1928 and 2006), but what happens
when the rising rates do tip over the credit pyramid (as happened in 1921, 1929, and 2008)?

Yes, when the next crisis hits the Fed can print and print, and they will to extend this madness as long as they can. But there are real world consequences—ever more economic is spent building long-term physical capital for which there is little demand.

In a historic example, as the German economy during the hyperinflation in the 1920s devoted ever more of its resources to expanding fixed capital well beyond that demanded by the market, it became ever harder to find additional capital to fund more malinvestment.

Terrified at the consequences of a thorough liquidation, however, the central bank through the currency became the
ultimate source of financing. All of this malinvestment comes at the expense of the production of consumable goods for the lower classes.

Is it any wonder that Bernie Sanders and even Marx himself have large and growing numbers of followers? More statism is the not answer, of course. Rather, the solution is to allow free markets to flourish, to remove the state-granted subsidies to the banking sector by abolishing too-big-to-fail, FDIC insurance, legal tender laws, and limited liability for
bank directors.

The banking lobby is far too powerful to allow any of this to happen, and so, as rates rise, the world waits for the end of the current credit cycle. The only question is whether the Fed can engineer another round. However, since this time the
bad assets sit directly on central bank balance sheets, the end of this cycle may also be the end of the credit-super cycle that began in 1981 or, by some measures, 1934.

Dan Oliver is the principal at gold mining fund Myrmikan Capital.

Views expressed in this article are the opinions of the author and do not necessarily reflect the views of The Epoch Times.