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Comment by pg | Hacker News Reader

This is fascinating. It helps explain why the savings rate in the US has gone down so much since the 1980s. People didn't suddenly become financially irresponsible. There was demand for debt, because it was the raw material debt-backed securities were made of. So companies were working much harder to convince consumers to get into it.

Incidentally, though no doubt debt-backed securities will be demonized for a while, I suspect they're useful with proper regulation. Market crashes often turn out to be due to the appearance of some new economic phenomenon that people get over-excited about initially, causing a boom-bust wave, but which in the long term turns out to be good.

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There's nothing inherently wrong with debt-backed securities. They can be a very healthy part of an economy. Variations of debt backed securities have been around for centuries.

The real problem is the maturity mismatching, which in this case was fraudulent.

Here's how it works:

I put cash in a money market fund. The fund promises me that it only invests my money in very safe short term debt, It promises I can get my money back at any time, on demand. The Sentinel money market fund - to pick a random example - promised that 50% of its investments were overnight loans.

The trouble is that Sentinel lied. It turned out that 80% of their holdings were in long term bonds, and only 8% were in overnight loans. The average maturity date of their holdings was an astounding 32 years. Other money market funds had their money invested in securitized student loans, mortgages, corporate bonds etc.

When you mismatch maturities like this, it becomes a license to print money. The fund accepts my investment. It then loans my dollar out to someone who wants a mortgage. That person pays the builders of the home, who then deposit the money back in the money market fund. The money market fund then loans the money back out again. The cycle keeps repeating, like a great big money printing machine.

This manufacturing of money is what caused gold prices, oil prices, stock prices, and real estate prices to take off over the past five years. More dollars floating around chasing the same quantity of assets causes prices to rise. It also explains the rise in consumer debt. With high inflation and low interest rates, borrowing lots of money is rational. This also explains why the financial industry was responsible for 50% of all American corporate profits in 2006.

At some point, some event causes depositors in the money market fund to get spooked. Perhaps information comes out that a money market fund has too many defaulting loans. The CFO of a VC backed startup is counting on that money to meet payroll in the next few months. He can't afford to accept any risk, nor any delays in redemption. So he decides to withdraw from the fund immediately. Except the CFO of many other companies have the same idea. The money market fund does not actually have the money to pay them. All the fund has is a bunch of IOU's saying, "we will pay you back with interest in 30 years." But the CFO's need the money now, not 30 years. The money market fund is forced to liquidate the IOU's for pennies on the dollars. Everyone loses their shirt. Worse, many businesses were counting on the low interest rates created by maturity mismatching. As people withdraw from money funds, the loan market dries up, and debt financed businesses start to go bankrupt.

This hardly is some "new economic phenomenon". Maturity mismatching has been at the heart of every single systematic financial crisis in the history of the Anglo-American financial system. The most notorious case was the Great Depression.

In the current crisis, the last step - the liquidation of the money market funds - has not happened. That's because Ben Bernanke is a student of the great depression, and recognized what was happening. When the bank run on the money markets began a few months ago, he decided to guarantee all the money market funds with full faith and credit of the government. He was basically saying, "We know that financial industry has been counterfeiting for decades. Unfortunately, now everyone is holding these counterfeit notes, including good, solid businesses. So instead of considering these bills counterfeit and allowing to a financial apocalypse, we're just going to consider these notes legitimate legal tender."

Vanguard sends me a report containing all the securities involved in my money market funds (which, by the way, have prevented me from losing anything in the late stock crash). Are you saying that these reports (or reports like it) are commonly fraudulent?

In the case of Sentinel, it was in their investment objects and allowed investments ( see this article for more info - http://seekingalpha.com/article/44695-duration-mismatch-at-s... ). If you paid close attention to what they were actually investing in, you might have seen that the prospectus wasn't telling the right story.

In all honesty though, I don't think people would have invested that much differently had they known. People are so used to FDIC insured bank accounts, they don't realize that maturity mismatching in an uninsured account will always lead to bank run. Of course, because of the perception that the government was going to insure the accounts, the government actually did have to insure the accounts. So no one has actually lost money in the money market funds. It was all paid for by the inflation tax.

There was demand for debt, because it was the raw material debt-backed securities were made of. So companies were working much harder to convince consumers to get into it.

Is that really a revelation?

Financial firms have been doing this for years now (debt-backed securities were originated in the 1980s), and the pitches to consumers have been incessant, just look at all the credit card and loan offers people get every week.

It was news to me, actually. I thought the credit card companies just wanted to get lots of nearly insolvent customers because they were old fashioned loan sharks, not because they wanted to resell their debt as securities.

If you're interested in that period on Wall Street (i.e., when debt-backed securities came into vogue), Michael Lewis wrote an interesting book about it: http://www.amazon.com/Liars-Poker-Rising-Through-Wreckage/dp...

pg, you are applying technology industry lessons to finance here. The phrase "financial innovation" has a long history of being very destructive to people's well-being. At the root of it, financial innovations turn out to be sophisticated ways of applying leverage (i.e debt).

The Federal Reserve also was massively complicit in the emergence of debt, so it is not a free market phenomenon. The Fed, in an attempt to fight the last bubble burst, kept interest rates low, and armed the speculators (hedge funds) with easy credit.

Basic ratios like debt to GDP have exhibited a strong long term tendency towards mean reversion. If that history proves right, we are in for one heck of a ride.

And, in turn, the demand for securities is coming from countries such as China that are becoming richer, and people there want a place to invest their money where they will get a good return.

The global pool of money doubled from about $36 trillion in 2000 to $72 trillion, explaining the greater demand for "safe" investments with good returns.

Numbers from "The Giant Pool of Money" episode of This American Life. Transcript: http://www.thislife.org/extras/radio/355_transcript.pdf.

I don't think boom-bust is a bad thing, it's a strategy more than anything else. The other day I ran-walked a half-marathon, first time I'd tried that strategy. Set a new PB and finished in the top 10% by a decent margin. Boom-bust economies massively outperform planned ones too.

I think it's more that genuine economic growth is a stick-slip phenomenon.

There are financial dis-incentives to saving cash, like taxes on the interest and low rates of return on your money. At least if you spend it right away, you get something neat in return.

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