Governments’ Fiat “Cash” Funds Do Not Merit Public’s Trust; Demonstrate Need For Sound Money Options

by Aaron Krowne

To this day, governments (and banking lobbyists) insist that the short-term “cash” funds that they park public funds in are safe.  In the modern era, this is done instead of simply holding these funds in sound money or precious metals equivalents.  This is unusual when you think about it, since the dollar had some measure of a gold backing until 1971.  Therefore, one would think that at least the core of such holdings would be held in hard money equivalents for safekeeping.  But despite the recent history of the subprime crisis, credit crunch, and economic downturn, most government officials don’t seem to care, and still not more than a fraction of a percent of public funds are in classic sound money equivalents.

Below I provide a brief history of money market/cash fund crises in the US, which undermines this insouciant attitude.  And the evidence becomes more compelling as we get closer to the present economic crisis — suggesting the problems aren’t just off the distant past.

• 1994:  “On December 6 1994, Orange County, a prosperous district in California, declared bankruptcy after suffering losses of around $1.6 billion from a wrong-way bet on interest rates in one of its principal investment pools. The pool was intended to be a conservative but profitable way of managing the countys cashflows, and those of 241 associated local government entities. Instead, it triggered the largest financial failure of a local government in US history.”  NOTE THAT THERE WAS NO REAL ECONOMIC REASON FOR THIS TO HAPPEN — A MUNICIPAL OFFICIAL IN CHARGE OF OC’s MONEY FUND INVESTMENTS SIMPLY MADE A BAD BET, SOMETHING FIAT-BASED MONEY MANAGERS ARE ETERNALLY SUSCEPTIBLE TO.

  http://www.erisk.com/LEARNING/CASESTUDIES/ORANGECOUNTY.ASP

• 1994: “The first money-market fund to “break the buck” was the Community Bankers Mutual Fund in Denver, which had $82.2 million when it was liquidated in 1994 because of losses on interest-rate derivatives.”

  http://www.bloomberg.com/apps/news?sid=aLwxHK3Ygc8s&pid=newsarchive

  [This was a US GOVERNMENT Money Market fund; issuers included “familiar names like the Federal Home Loan Bank, Federal Farm Credit Bank, Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Student Loan Marketing Association.” See for more info and analysis: http://www.questia.com/googleScholar.qst?docId=5000266354 (“Arsenic is low-fat too: lessons from the demise of Community Bankers U.S. Government Money Market Fund.” by Nicholas Betzold and Richard Berg, ABA Banking Journal, 1994).

  This article explains how the source of the error was simply a mistaken judgment of how to abide by policies to limit volatility in the fund (an easy mistake to make when sophisticated, arcane yet attractive paper-money investments are floating around, offered by Wall Street bankers who may be able to offer nice sinecures to public money managers).]

• 2007-11-14: Financial institutions moved quickly to shore up their money market funds in the face of downgrades of subprime (and other shaky mortgage debt) and resulting panicked withdrawals. This move included Bank of America, Legg Mason, and SunTrust, none of whom wanted to “break the buck” like the Community Bankers fund mentioned above.  (Luckily the banks were able to do this — ultimately, relying on further Fed and Treasury bailouts to shore themselves up.  Will they (and we) be so fortunate next time?)

  http://www.usatoday.com/money/industries/banking/2007-11-13-bank-america-writedowns_N.htm?loc=interstitialskip

• 2007-11-29: Florida’s Local Government Investment Pool is frozen in the face of mass withdrawals, due to downgrades of subprime-linked debt held by the fund.  Local governments who did not get out early enough lose access to their “cash.”

  
  http://www.bloomberg.com/apps/news?pid=newsarchive&refer=special_report&sid=aDdJ4GDZ6eao

• 2007-11-30: E-Trade is bought out by hedge/private equity fund CITADEL in a $2.55 , .27-cents on the dollar “firesale”, after various E-Trade money funds linked to subprime and other bad debt take big valuation hits.

  http://www.nytimes.com/2007/11/30/business/30citadel.html

• 2007-12-05: The scare spreads to other government funds, including Orange County (again, 14 years later!), which faced $460 million of SIV funds at risk of downgrade out of its $2.3 billion Extended Fund.  The county subsequently had to hire the financial firm BlackRock to save its finances.

  http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a3r_IRjU20O0&refer=us
  

• 2008 (mid-year): Funds run into more trouble on continuing debt losses; “Evergreen [owned by parent Wachovia] liquidated the $403 million Ultra-Short Opportunities Fund in June after it fell 20 percent this year. San Francisco-based Charles Schwab Corp. is being sued by investors over losses in its Yield-Plus Fund, which is down 30 percent.”

  http://www.bloomberg.com/apps/news?sid=aLwxHK3Ygc8s&pid=newsarchive

• 2008-09-16: After The Lehman collapse, even more funds are hit, and some do break the buck, including the Reserve Primary Fund.  Also the Colorado Diversified Trust broke the buck (this one is another state and local government pool fund).  Wachovia, the parent of Evergreen (mentioned above), is forced to bail 3 impacted funds out.

  http://www.bloomberg.com/apps/news?sid=aLwxHK3Ygc8s&pid=newsarchive

  http://www.marketwatch.com/story/second-money-fund-breaks-the-buck

• 2008-09-20: Money Market funds in general are bailed out by the Fed and Treasury on September 20, 2008.  In a panic, the $3.4 trillion money market fund sector was subject to $144.5 billion of withdrawals in the week prior to the bailout.   The blanket action by the monetary authorities ceases the money market/cash fund exodus and buck-breaking… for now.

  http://online.wsj.com/article/SB122186683086958875.html

While the central government’s monetary authorities ultimately appeared as the “knights in shining armor” preventing wider calamity in money funds than collapses highlighted above, it is now becoming clear to even the dullest observer now that even they do not have the money to back all of this country’s ailing fiat-based funds and financial institutions.  They have simply “printed” the money, and committed to more printing in the future (should fund and bond guarantees be invoked).

This simply means that the crisis has been pushed into the future, and has become a threatened dollar crisis, as well as Federal Reserve and federal government financing crisis.

In light of this, I think that most reasonable people would agree that state and local governments should make it priority #1 to save (in the true meaning of the word) tax monies entrusted to them in classical sound money options (and equivalents).

While sound money-encouraging  legislation such as Utah’s (which appears on the verge of becoming law) is nice, legislation is needed which actually forces the states to adhere to their still-in-force Constitutional requirement to only deal in lawful monetary gold and silver form.  Georgia’s proposed Constitutional Tender Act is one of these.  It also takes the useful (and very practical) step of requiring banks in the state to provide gold and silver-backed accounts, which would allow gold/silver-backed commerce to take place in an identical (cashless) manner as today, eliminating concerns of any added hassle (indeed, banks would likely compete with each other to provide options to “fund” such accounts automatically, without requiring depositors to visit coin shops or make other special arrangements to acquire the necessary monetary gold/silver).

Any states implementing such a system would find their funds automatically coming in in a form that is inherently safe and stable, lacking the currency risk or counterparty risk of fiat-based investments.  And any need to expend precious overhead on sophisticated “management” of government cash funds would immediately be eliminated — providing an instant savings to state and local governments.