Wednesday, October 1, 2008

a 21st century run on the bank.

Remember the run on the bank scene in It’s a Wonderful Life? That was a dramatization, with a happy ending, of what happened 75 years ago. However, 75 years ago the happy ending didn't always happen in real life.

Two weeks ago another run almost happened. Before I go on, you may want to refresh your classic-film-scene memory:

The Bailey Building & Loan was not strictly speaking a bank, but it was a middleman between depositors and borrowers. That is what banks and other financial firms generally do. A modern version of this is a Money Market Fund (MMF). With MMF accounts, people deposit cash with an investment company who then buys short-term government bonds and corporate debt. (This deposit is NOT to be confused with a type of deposit with banks. Those are just bank accounts with a deceptive name to make you think it is a MMF account.)

MMFs are an important source of funding for corporations. (Like in the Home Depot example from yesterday’s post.) Two weeks ago there was the beginning of a run on these accounts, accounts that held over 3 trillion dollars.

What happened? Just like in the movie scene, depositors were afraid of losing their money: money that was backed by short-term corporate debt, also known as commercial paper. Going back to yesterday’s post, the price of this debt was falling due to fears of AIG failing and credit swaps in general possibly failing. So, MMF assets were approaching the point where they were worth less than the value of their deposits, to where they did not have the means to back all the deposits. In the case of one fund, it did “break the buck,” meaning a dollar of deposits being worth less than a dollar.

If you had a deposit in a MMF, what would you do? If you were on the ball, you’d try to get your money out while you could. You'd want to be first in line too! Just like in the movie scene above. To pay off deposits, the MMF would have to sell their commercial paper. Who would buy it? The other MMF’s are in the same situation. With everyone selling and no one buying, commercial paper prices will crash. MMF deposits would be paid back at less than a dollar, if at all.

Let’s reimagine the scene from It’s a Wonderful Life. Do you think even Jimmy Stewart would be able convince people to keep their money on deposit if they knew that Joe's house, the Kennedy house, and Mrs. Macklin's house, houses that their money was in, had been hit by a tornado and there was no insurance?

That is why after the AIG deal two weeks ago, the federal government insured MMF accounts for a year. They weren’t bailing out anyone so much as they were stopping a 21st Century run, a present day panic.

What if our government hadn't decided to "bail out" the MMFs with federal guarantees? MMFs are a major source of short-term corporate financing. If that financing dries up, we are back to the big fat hairy recession scenario mentioned yesterday.

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