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Generational Dynamics Web Log for 15-Aug-07
Redemptions of money market funds now fully in doubt

Web Log - August, 2007

Redemptions of money market funds now fully in doubt

Wednesday is the deadline for 3Q redemption of many hedge fund shares.

Wall Street was running about even on Tuesday, until around 10 am. European Central Bank President Jean-Claude Trichet said that we'd gone through "a period of market nervousness" that was now ending, and "financial markets in general are going back to normal functioning." In fact, the ECB was pouring billions more into the money markets to prop them up, so everything was good. More than good. Everything was swell.

At 10 am, CNBC reported that an obscure Illinois money market firm, Sentinel Management Group Inc., had asked permission of a regulatory agency to stop redemptions -- meaning that clients would be unable to get their money back.

The market immediately fell 100 points (Dow). There were ups and downs for the rest of the day, and the Dow ended up 200 points down. Other markets in Europe and New York all ended down 1.5-2%. And as I write this (around noon, Asian time), the Asian markets are down by the same amount.

So I guess Trichet must have been wrong, huh? The "market nervousness" hasn't ended after all, and "normal functioning" hasn't returned.

I was listening to pundits today on CNBC. They don't have the vaguest idea what's going on.

"You just have to ride it out."
"Investors are nervous and irrational."
"The Fed has to cool things down -- relax all the animal spirits out there."
"The underlying economy is one of the strongest in history."
"Everyone's waiting for fundamentals to come back in line."
"There's still plenty of money sitting on the sidelines waiting to come back into the market."
"Things will be back to normal in the fall."
"It's just like 1998 or 1987 - it will pass quickly."

Sentinel is a relatively small firm, and this kind of failure would never have caused this kind of reaction a few years ago. We're finally beginning to see real generational panic -- something that no one alive today, under age 80, has seen before.

As I've been writing a lot in recent articles, everything about what's going on today happened in 1929. Anyone doubting this should order a copy of John Kenneth Galbraith's book, The Great Crash - 1929, originally written in 1954, a time when the 1929 crash was still fresh in people's minds.

Sentinel Management's web site seems to be down this evening ("Under construction," it says), but on Tuesday afternoon I did grab a copy of their FAQ (no longer available). It had some mighty interesting things in it. I'm not surprised they've taken the web site down.

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Sentinel is in the business of managing disposable cash for large institutions. Suppose that you have a few million dollars lying around, and you'd like to earn some interest on it -- this is the kind of thing that Corporate CFOs do all the time. You can put the money into a bank, but banks don't pay all that much interest these days.

So you hire Sentinel to manage your money for you. Here's what the FAQ says (or said):

"Sentinel buys only the highest quality and most liquid securities (unless specifically directed by a client to seek higher yield in somewhat lower quality issues). Sentinel will not use derivatives, options, or any other 'financial engineering' techniques to enhance the yield on its portfolios. Sentinel's objective is to achieve the highest yield consistent with preservation of principal and daily liquidity, not simply 'the highest yield'.

Sentinel deals only with investment firms of the highest standing in the industry. Further, it buys from no fewer than four different dealers, both to ensure fair pricing, but also to diversify counterparty risk. ...

Finally, Sentinel's custodian, The Bank of New York, is one of the three top ranked custodians in the U.S. Its size, reputation, and concentration on custody and clearing provide additional assurance to Sentinels' clients that their liquid investments are being serviced by the highest quality professionals in the business. And because they are held in custody, these assets are protected by federal fiduciary law from any third party claims against the bank. Unlike FDIC insurance for bank deposits, there is no limit on the amount of protection this federal law can provide."

Wow! Sentinel protects your money better than the Federal government agency, the FDIC, does.

So, now let's see what Sentinel said on Tuesday, in a letter to its clients:

"As you undoubtedly know, the credit markets, along with most other markets, have experienced a liquidity crisis in the past several weeks. Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade.

We've all read the stories about one hedge fund or another suffering losses related to subprime exposure and closing down or being rescued.

This fear, while warranted in some cases, has spilled over into the rest of the credit market and liquidity has dried up all over the street. In addition, investment banks and securities firms are stuck with LBO deals they've already entered into but cannot find buyers for the bonds so must inventory them themselves.

This liquidity crisis has caused bids to disappear from the market and makes it virtually impossible to properly price securities or to trade them.

High grade securities are trading like junk bonds as panicked investors dump names like General Electric at Tyco-like prices.

We have carefully monitored this situation for the past several weeks and have met regularly to discuss the potential impact it may have on our clients.

We had previously thought that the market would return to some semblance of order and that our clients would not join in the panic.

Unfortunately, this has not been the case. We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

"Now, how is this possible?" you may well ask. How is it possible for a company that invests in "only the highest quality and most liquid securities," a company that "will not use derivatives, options, or any other 'financial engineering' techniques" -- how is such a company in a situation where "we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

That IS a good question, isn't it.

Of course, Sentinel says it's not their fault: "Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade."

But that can't be the real reason.

We've been talking about collateralized debt obligations (CDOs), based indirectly on mortgage loans. I think I'm finally getting to the point where I understand how these CDOs work, and here's a summary: You take a bunch of mortgage loans, say $100 billion worth, and break them up by rating level, with AAA being the highest rating (for the most creditworthy borrowers), and BBB- being the lowest rating (for the subprime borrowers). Each rating defines a slice or "tranche" of this group of loans.

Now the problem is that the BBB and BBB- tranches are bad news, because they're so low-rated. There are many institutions that are not even permitted to invest in such securities, even for very high returns, because it's against their charter or even against the law, depending on the type of institution. So these institutions have to get rid of the lowest-rated tranches.

But who wants to buy low-rated tranches? Not too many people. It's too risky.

So the financial geniuses of a few years ago got the idea that you can turn BBB- securities into AAA securities. You do this by taking the low-rated tranche, and break these up into low-rated to high-rated tranches. These are the CDOs. Set up the returns so that if everyone makes their mortgage payments, then all the CDO owners will get paid; but if homeowners start defaulting on their mortgages, then the lower-rated CDO tranches will get nothing, and the the upper-level tranches will get whatever money is available. Therefore, the highest rated CDOs will almost certainly get paid. So the ratings agencies (Moody's, S&P, Fitch) say, "OK, that sounds good to me. We'll rate them AAA for you."

So now you've got huge numbers of AAA-rated CDOs that are based on subprime mortgages. But of course they're "safe," because their owners get paid no matter what happens.

How do you determine the value of these CDOs? There's no market for them, so you can't price them on the market -- i.e., you can't use "mark-to-market." Instead, you write a computer program that performs some complicated algorithm that comes up with a value. That's called "mark-to-model" or, as some people are saying, "mark-to-myth."

Anyway, to make a very long story short, you now have these AAA-rated securities (CDOs). Since they're AAA rated, they can be traded like commercial paper at the safest level, and lowest risk. Since they're AAA-rated, they can be treated as almost as safe as government Treasury bonds. That's what AAA means.

So there you are. That's how these CDOs got into everyone's portfolio. Tens or hundreds of trillions of dollars worth of these are everywhere -- in the portfolios of mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, so everyone is at risk, not just large financial institutions.

For example, a college endowment or a pension fund might be precluded by law or by charter from investing in risky securities, but these weren't risky securities -- these were rated AAA -- the safest rating possible. So they invested in them, paying for them the price computed by somebody's computer software.

Now, hedge funds are the most vulnerable, since they're the most aggressive in investing in risky securities. That's why hedge funds have been imploding every week. But everyone else has been investing in the AAA-rated CDOs as well, and now they're turning out to be not worth the paper they're written on.

That's why Sentinel can't sell their portfolio of "the highest quality and most liquid securities," and it's not because "investor fear has overtaken reason." It's actually because investor anxiety has overtaken giddiness. Investors are panicking because they don't know how to handle the situation.

It's worthwhile to write again how this ties in to generational theory.

The crazy situation that's come about was set up by the Boomer generation that survived the Great Depression and World War II. During the 1960s, these kids rebelled against their parents, and all the values that their parents had adopted. While the survivors of the Great Depression understood the meaning and danger of credit, the Boomer generation simply rebelled, and understood nothing. This was OK as long as their parents were still alive, since their parents would take care of them.

Today, the Boomers are in charge, and their parents are gone. And the Boomers have no idea what's going on, because they never learned.

They brought about the dot-com bubble of the late 1990s, then the housing and credit and stock market bubbles of the 2000s, thinking that everything would take of itself, not realizing that their parents had been taking care of everything behind the scenes.

This is the generational cycle, the generational saeculum, on which Generational Dynamics is based.

Generational panic is a unique smell, unique feel to it, and that smell and feel have been growing in the last few months, especially since the Bear Stearns announced that its hedge funds are almost worthless.

Now Boomers are wondering what to do and what's going to happen. They're getting desperate.

Wednesday will be a very important day, because August 15 is the day that investors have to inform their hedge funds that they want to get their money out in the third quarter (September 30). Those are the rules for many hedge funds, giving the managers 45 days to raise the cash that they'll need for the redemptions.

According to the Sentinel FAQ, their rules are different:

"Sentinel clients can withdraw 100% of their cash daily. Sentinel accepts deposits of any amount daily. A cutoff time of 4:00PM (eastern time) applies for notification of intent to redeem or make deposits same day."

That's what's no longer true, until further notice, and possibly never.

Here's another interesting paragraph from the Sentinel FAQ that caught my eye:

"A margin certificate protects traders in the OTC currency and bond markets against the failure of their trading counterparty. Instead of delivering margin to the broker/dealer, where they become general liabilities of the firm, traders deposit cash into a Sentinel account at The Bank of New York, where they are held in custody as margin for the benefit of the counterparty. By terms of the certificate, the counterparty can draw on them only to satisfy amounts the client owes. The assets used as margin are thereby protected against any third party claims against the counterparty in the event of the latter's failure or illiquidity."

This paragraph refers to money that an investor gives to a broker for margin calls. The Broker or Dealer holds the money in escrow until its needed, but this paragraph points out that if the Broker goes bankrupt, then you've lost your margin money, though you may get a little of it in bankruptcy court. The Sentinel FAQ says that Sentinel provides an additional service -- holding margin funds in escrow in such a way that a bankruptcy won't put them in danger to the investor.

This means that if you still own stocks, and you own them on margin, then you could lose your margin money if the broker goes under.

But what if you sell stocks short? Several web site readers have written to me asking about this option. (This means that you're betting that the value of the stocks is going to fall, and you make money in that case.)

The problem with short sales is that you have to put a lot of money into escrow with your broker, and there are going to be a lot of bankruptcies in the next few months.

For this reason, I recommend against short sales. It's possible that you'll lose your money if stock prices go up or go down.

As I've said many times before, from the point of view of Generational Dynamics, a generational stock market crash is overdue. If you go back through history, there are of course many small or regional recessions. But since the 1600s there have been only five major international financial crises: the 1637 Tulipomania bubble, the South Sea bubble of the 1710s-20s, the bankruptcy of the French monarchy in the 1789, the Panic of 1857, and the 1929 Wall Street crash. We're now overdue for the next one. It could happen next week, next month or next year, but it will come with absolutely certainty, and will come sooner rather than later. It's now beginning to appear that it's coming very soon. (15-Aug-07) Permanent Link
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Generational Dynamics Web Log for 15-Aug-07 Redemptions of money market funds now fully in doubt

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Generational Dynamics Web Log for 15-Aug-07
Redemptions of money market funds now fully in doubt