Subscribe: RSS Feed | Twitter | Facebook | Email
Home | Contact Us

The Wall Street “Sausage-Making” Process

Posted by Larry Doyle on June 20, 2009 9:01 AM |

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.


  • OMG

    Update from industry “inhouse’ bulletin..Tame inflation data helped mortgage rates move lower early in the week, but stronger than expected economic data turned them higher later in the week, leaving mortgage rates nearly unchanged from last week. The announcement of larger than expected Treasury auctions next week ($104 billion) also was negative for mortgage rates.

    · This week’s Consumer Price Index (CPI) and Producer Price Index (PPI) data indicated that inflation is not a concern in the short-term. A significant decline in energy prices from one year ago resulted in a very low overall annual inflation rate. Even Core CPI, which excludes food and energy, rose at a tame 1.8% annual rate. However, the benefits from the favorable inflation news was offset by stronger than expected economic growth data. In particular, the Philadelphia Fed manufacturing index showed surprising improvement. In addition, May Housing Starts rose 17% from April, while Building Permits, a leading indicator of future activity, also exceeded expectations. This week’s data sets the stage for next week’s Fed meeting. With inflation currently low but at risk of increasing if the economy continues to improve, the Fed may be reluctant to introduce more stimulus, opting instead to wait and see how the economy performs.

    White House administraton this week proposed broad new rules for regulating the financial system. One proposal under the plan would create a consumer protection agency which would have the authority to set rules for the mortgage industry. The details may not be known for quite a while, as the plan now faces a lengthy debate in Congress.

    Week Ahead ….

    With major economic data, Treasury auctions, and a Fed meeting, next week will be a busy one.

    · Existing Home Sales and New Home Sales on Tuesday and Wednesday will provide a look at activity in the housing sector. Also on Wednesday, Durable Orders will be an important indicator of overall economic activity.

    · There will be large Treasury auctions on Tuesday, Wednesday, and Thursday.

    · Personal Income and the Core PCE inflation index will come out on Friday.

    · The announcement from the Fed meeting will be released around 2:15 et on Wednesday.

    · Investors are divided about whether the Fed’s next move will be to increase or decrease the level of stimulus. Even if the Fed takes no action next week, the wording of its statement will be likely to have a significant impact on mortgage markets.

  • OMG

    Also Notable:

    The -1.3% decline in CPI from one year earlier was the largest annual decline since 1950
    Continuing Jobless Claims fell for the first time in twenty weeks
    The Fed’s Bullard predicted that the economy will begin to improve during the third quarter
    The Fed purchased $20 billion in agency MBS during the week ending 6/17

    • OMG…thanks very much for providing this comprehensive review and preview.

  • TeakWoodKite

    LD, is there any way to track where the origination of these “sausage parts” come from?

    If they are laundered debt instraments, how can an investor ever gauge the actual quality of

  • TWK…well, the sausage that I am referring to here are Money Market Funds. The bonds that go into them are of a wide variety. Certain tax-free money market funds will clearly have these lesser creditworthy x-Tender ‘pigs’ in the fund.

    If there is some sort of criminal activity ongoing within the municipality (and to some degree there will be, as municipal finance is rife with ‘pay to play’) an investor will likely never know.

    The point I want to emphasize is that prior to buying a money market fund, an investor needs to make sure that there are none of these ‘piggies’ in the fund.

  • Pingback: contemporary home()

Recent Posts