Why do pigs need to go through such a curing process before finding their way to market? The innards of a pig are filled with all sorts of waste. In the same vein, the new Wall Street pig, otherwise known as an x-Tender security (but hereby deemed Porky Pig at Sense on Cents), is also filled with similar “junk.” I will try to make this quick, but bring a mask as we navigate the Wall Street sausage factory.
Please recall from my post yesterday, “An Auction-Rate Pig by Any Other Name Is Still a Pig”, that this ‘new’ Wall Street product is merely a revised version of THE LARGEST fraud perpetrated in the history of finance. This “pig” allows municipalities to address long-term funding needs via the short term debt market. The arbitrage involved in that process is akin to slaughtering the pig and making sausage.
Given the stench surrounding this product, take a deep breath as we tip-toe through the pigsty and move into the sausage factory. The Wall Street Journal can serve as our tour guide as it writes, Belt-Tightening by States Squeezes Cities and Towns. Let me connect the dots.
As this article highlights, municipalities across our country are increasingly financially strapped by a combination of decreasing tax revenues and lessened state funding. Regrettably, these municipalities are forced to cut expenses via a reduction in services and layoffs. Additionally, it is only logical to expect that municipalities will increase taxes to bridge their financial gap.
Add it all up, though, and it is very clear that an overwhelming number of municipalities in our nation are not as creditworthy today as a year or two ago. When credit ratings decline, borrowing costs go up. Those increased borrowing costs further squeeze the municipalities. What to do? Let’s enter the sausage factory.
With the blessing of the SEC, and the wizardry of financial engineers on Wall Street, municipalities can address long-term funding needs by borrowing money via the short-term market with a ‘promise’ to repay the funds if the short-term market shuts down. These municipal deals, much like sausage, are packaged and distributed via money market funds that incorporate a variety of short term deals. As such, the poorer credit quality of the municipality is “processed” and sold without investors fully appreciating the contents of the money market fund.
This works, right? The municipality receives the badly needed funds and the Wall Street banks earn their fees. Meanwhile, investors – who by nature move in and out of money market funds expecting them never to “break the buck” (meaning the funds will always maintain a $1.00 net asset value) – are kept in the dark.
Investors should appreciate that money market funds will likely “break the buck” going forward. All one needs to do is review the fiasco involved with the longstanding money market fund, The Reserve Fund. Investors in that money market fund are now involved in a protracted legal dispute and the value of the fund is truly a great unknown. What happened? The fund took increased credit risk in a variety of products. Investors were clueless of these credit risks.
The same “sausage-making” is going on with this new x-Tender product. I exhort every investor to “check the contents” and ask the “butcher”, that being your broker or financial planner, as to what is going into that money market fund before you buy it.