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Friday, November 30, 2007

Policy change needed for state and local investment pools

The invasion of toxic paper into local and state investment pools, read government operated money market funds, has produced a great deal of hand wringing, blame sharing and head shaking, but not enough policy changing.

The federal government is restricted from this type of activity by the Treasury's tax and loan account program, which places federal taxes in commercial banks, but only in safe, liquid accounts. States are not following this model.

This is the policy that needs to be changed, with the object lesson so close at hand.

Two weeks ago we brought the fact that state money market funds, where state and local governments parked their tax receipts, were in jeopardy from the toxic paper purveyed by the financial sector. In the last two days more bad news has come out, focusing on Montana and Florida:
Here is our coverage. Notice that no state, or very few, are immune from the unsafe practice of self-operated money market funds. Also listen to the Tom Keene interview with Drexel's Joseph Mason on November 16.
State pension funds and general operating funds nationwide have apparently invested in the toxic paper produced by the unregulated financial markets, according to Joseph Mason, associate professor of finance at Drexel University.

On Bloomberg, Mason made some bone-jarring revelations.
  • The CDOs and structured debt for corporations that have similar weaknesses could plague the economy into 2012 and beyond.

  • Subprime mortgages are not the only debt with resets to be packaged and sliced (tranched) for the investing animal. Corporate debt, too, has resets coming due.

  • Why was the contagion in credit markets not confined to subprime? Corporate borrowers are on the hook for the same sorts of problems. This is not invisible to those on the inside. (That is three bullets on the same point. But it begins to reveal why credit markets are seizing up when the problem is advertised to reside only in CDO's holding subprime loans.)

  • $40 billion has been written down so far, out of at least $400 billion. These resets will be cleared by the end of 2009.

  • Not only is it your pension fund, it is in your state's general fund. State's run their own money market funds, and have been buyers of the toxic paper.

  • State money market funds do not have a parent bank to bail them out. They have only the taxpayer. It is the taxpayer's money that is in these money market funds. (Note: The federal government is restricted from this type of activity by the Treasury's tax and loan account program, which places federal taxes in commercial banks, but only in safe, liquid accounts. States are not following this model.)

  • The bind on state budgets is a direct line into the middle and lower income levels, where recessions are made. Demand Side perspective gives state budgets a full pass-through in the multiplier. That means a hit to the state government is a body blow compared to a hit on the financial sector, which is a jab.
The problem is not a liquidity problem. A liquidity problem is where an instrument has a price, but there is no money to buy it. These "credit market innovations" are opaque, so potential buyers guess at what they're worth and then discount the value for the risk of not knowing. Potential sellers don't like the prices. No market. But not because of liquidity.

While everybody who owns this toxic paper is blowing smoke to disguise their irresponsibility, it is coming clear that many states are in significant jeopardy. A short look at one example will also show how big $400 billion is, or $900 billion, or even $1,500 billion -- all figures that have been offered as costs for this debacle -- and what sort of fix they're in.
Florida has an annual budget of $50 billion, according to Mason. Its annual revenues are about $36 billion. (Notice, a large state's annual budget is small compared to the impending problem.) Imagine that Florida has invested in structured debt with tax money in a kind of self-sponsored money market accout. Maybe 4.37% of this debt is in instruments already downgraded to near zero, and maybe another 7.33% is in portfolio credit watch negative. That could be $2.2 billion in the first account, and $3.6 billion in the second account. Maybe this is 12% of the fund.

Consider further that, as Florida, your sales tax revenues are plummeting from the recession and you have no income tax. This is 12% of your annual revenue for 2006. The outlook for 2007 is worse. You have no big brother to bail you out, as the bank's money market funds do, or as the entire financial sector does with the Fed. You have mandated programs like food stamps, health and social services, etc.
Remember that in the Depression, some state's went bankrupt, closed universities and other operations, and paid remaining employees with IOUs.

Be glad you are not Montana, with possibly 20% of its fund in jeopardy.

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