Many investors question the role that government played in stabilizing the economy, but the alternatives would have been impossible to sell to the American public. To put things into perspective, the CEO of PIMCO, the largest bond fund manager in the world, called his wife in 2008 and told her to withdraw as much money as she could because he feared the banking system was on the verge of collapse. We may never admit that the treasury saved the day for the time being because we like to think of ourselves as pure capitalists who never benefit from government interference. Nevertheless, the under-reported shadow banking system still remains a threat to a stable economic environment.
The traditional banking system allows consumers to deposit their savings in a bank, who in turn lends this money to another household so they can purchase a house or start a business. The bank may charge five percent for the loan, give the depositor two percent and keep three percent for themselves as profit. The deposit is known as a demand deposit because consumers have unrestricted access to their money. Should depositors come to believe that the money can be withheld; they will demand their funds immediately and cause a run on the bank, which is why the FDIC plays such an important role in guaranteeing the return of deposits from failed banking institutions.
The advent of deregulation created a fertile environment for a shadow banking system, one in which the deposit is not lent to other households, but is invested in mortgages, credit card debt and other liabilities that have been packaged into fixed income instruments. What was once a plain vanilla savings account is now parked in short-term bonds. The reason money markets pay a higher interest rate than savings accounts is to compensate investors for the increased amount of risk they incur. The minute investors think they don’t have access to their money, they’ll demand its return whether they need it or not and begin a run on a bank, whose own assets would be tied up in the same illiquid investments that caused the problem in the first place. Unfortunately for the public, money markets do not guarantee the return of principal, only sound management of the funds as described in the prospectus.
When the liquidity crisis hit in 2008, there was a run on the banks because investors knew their deposits were not guaranteed by any regulatory agency. It was reported by the Wall Street Journal that 36 of the 100 largest U.S. prime money markets had to be propped up in order to survive the financial crisis. It seems that an exodus had begun on $3.4 trillion of money market investments and the system couldn’t withstand that type of trauma. In fact, the only thing that stopped the run on the banks was the extension of FDIC insurance to these so-called cash alternatives and the Federal Reserve’s willingness to lend money to the banks so they can buy hard-to-value securities from illiquid funds and free up cash for distributions. More evidence of potential exposure came in May 2010, as the European debt crisis roiled the markets. After all, $500 billion of U.S. money market investments were invested in European debt instruments.
Most Americans save money in a system that is essentially supported by a housing market that experienced a 35 percent increase in foreclosures during the first quarter of 2010 and foreign coffers depleted by social programs they can no longer afford. Even the U.S. government is out of bullets, as interest rates are historically low, mortgages were modified, home purchases have been subsidized, roads are being built, states were provided with aid packages and the Fed’s balance sheet has grown from $850 billion to $2.3 trillion to buy worthless toxic assets from the large banks to free up liquidity. Should the economic recovery fail to materialize, trillions of dollars that Americans consider to be cash may at some point become frozen. The discussion of a state controlled economy is so explosive because it sparks emotional reactions, the sort of thing that sounds good on TV and sells lots of advertising, but the alternatives are unbearable to the majority of Americans who would suffer the consequences of poor decisions and an unsophisticated knowledge of the financial markets. Enjoy the assistance while you can; the government can’t support a failed economy forever.