How Two Guys in a Room Invented a New Kind of Money
Here is the standard story of the 2008 financial crisis:
Shady lenders gave ridiculous mortgages to unqualified buyers of overpriced houses.
The ridiculous mortgages were then bundled together, sliced up, and sold off to investors.
When housing prices started to fall, the unqualified buyers couldn’t pay back the ridiculous mortgages.
The investors who bought the bundles of ridiculous mortgages blew up and took the economy down with them.
This story has the virtues of being true and dramatic. But it is incomplete. It is only part of the story of the crisis. The ridiculous mortgages alone would not have been enough to blow up the entire economy. There is a whole other part of the story that’s almost never told.
The other part is a story about money itself—a new kind of money that started flowing through a new kind of banking system that nobody quite knew was a banking system. This new kind of money drove the bananas rise of finance in the late twentieth and early twenty-first centuries. Also, this new kind of money helped a relatively small corner of the US mortgage market blow up the global economy. And there is a fundamental problem with this new kind of money that nobody has entirely fixed, and unless it gets fixed, it could blow up the world again.
This chapter is that part of the story.
The Two Guys
“I always had an attraction to money,” Bruce Bent said. He started collecting empty soda bottles and turning them in for the deposit money when he was an eight-year-old kid in postwar Long Island. He tried being a paperboy, but the math just never made sense. “Delivering papers was a crap job: too much work, not enough pay.” So he got a job at the grocery store. “I was making $70 a week when I was 14. Outstanding money.”
After high school he became a mailman, like his dad. He spent six months in the Marines as a reserve, went on to graduate from St. John’s University, and, like lots of people who are attracted to money, found his way to a job in finance. “I went down to Wall Street and was the flunky to the managing partners.”
A few years later, he got a job in the investment department at an insurance company. He started on the same day as the man who would be his boss, Harry Brown. Brown was a Harvard graduate and the grandson of a federal judge and just a very different kind of guy than Bent.
They met for the first time on their first day, in the office of Harry’s boss (Bent’s boss’s boss). A few minutes later—which is to say, a few minutes after they’d met—Harry looked at Bruce and said to the big boss: “I don’t like him. I don’t want him working in my department.”
“Why not?”
“He’s a New York City wiseass and I don’t want him in my department.”
“Deal with him.”
In the end, Bent and Brown loved working with each other. A few years later, they left their jobs to start their own company: Brown and Bent. They thought they would match insurance companies that had money to invest with companies that needed to borrow. But business was slow.
Bent had a wife and two kids and two mortgages. He bought a thrift-store bike to save on bus fare. He rode his bike to the train and rode the train to work and sat across from Brown in the office, where they kicked ideas back and forth. “We were trying to find something that was a money-earning experience,” Bent said.
After a few years of this marginal existence, Bent and Brown saw an opportunity. Federal regulations put in place in 1933 capped interest rates on bank savings accounts and prohibited banks from paying any interest at all on checking accounts. But people who had lots of money and were willing to tie it up for a few weeks or months could get more interest from opening savings accounts of at least $100,000 or buying short-term government debt known as Treasury bills (or T-bills).
Bent and Brown decided to figure out how investors who didn’t want to tie up their money, or who couldn’t make such a big investment, could get the higher interest rates offered by T-bills and jumbo savings accounts. One afternoon, Bent had an idea. “I looked up at Brown and said, ‘Why not a mutual fund?’” Bent said. “He said he didn’t know anything about mutual funds. I said, ‘I don’t know anything about mutual funds either, but I think it would work.’”
Mutual funds are pools of money that typically are invested in stocks or bonds. If you have a retirement account, there’s a very good chance that you are an investor in one or more mutual funds. When investors buy shares in a mutual fund, they are actually buying an ownership stake in all the stocks or bonds (or both) that the fund owns. The value of the mutual fund shares rises and falls every day with the value of the stocks and bonds in the fund.
Brown and Bent wanted to create a mutual fund that would feel like money in the bank—not like an investment in stocks or bonds. They wanted it to have all the convenience of a checking account, but with a higher interest rate for savers. So they made a few tweaks to the mutual fund model.
Investors would buy shares in their fund. The fund would then take investors’ money and lend it out—to the government, in the form of Treasury bills, and to banks, in the form of big savings accounts. These were short-term, ultra-safe investments. So safe, in fact, that the price of the mutual fund shares didn’t need to fluctuate every day like funds that owned stocks or riskier bonds. Brown and Bent decided to set the share price at $1 per share. And they were able to use an accounting system such that, outside of some catastrophe, they would be able to leave the price at $1 per share. Just like money in the bank.
They wanted to call their fund the “Savings Fund,” but the Securities and Exchange Commission (SEC), which regulates mutual funds, wouldn’t let them. So they called it the “Reserve Fund,” similarly boring, which is what they were going for.
The Fund opened for business in 1972. By the end of 1973, they were managing $100 million. Within a few years, a bunch of competing funds had sprung up. This new kind of fund came to be called a money-market fund. Pretty soon, you could write checks against your money-market fund—which is to say, you could use your money-market money to buy stuff. Just like money in the bank!
The Big Banks Get In on It
Corporations with extra cash on hand started parking hundreds of millions of dollars in money-market funds. By 1982, ten years after Bent and Brown came up with the idea in their tiny office, money funds had more than $200 billion, with billions more flowing in every year.
The funds suddenly had more cash than they knew what to do with. Bent and Brown stuck with investing in large bank deposits and government debt, but other fund managers started looking for new options. Some funds started buying something called “commercial paper,” which was basically a way to make short-term loans to safe, stable companies. In the 1980s, money-market funds became the biggest buyers of commercial paper.
Vast flows of money were now shifting from banks to money funds. So Citibank, one of the biggest banks in the country, figured out how to do the thing banks do: get in the middle of a vast flow of money. With a bunch of complicated legal and financial maneuvering, Citi invented something called “asset-backed commercial paper.” It was a new way for money-market funds to lend money to companies that weren’t safe enough to issue commercial paper.
Soon other banks jumped in. By the early ’90s, billions of dollars were flowing into asset-backed commercial paper, and banks were selling more every month.
Bent, who’d started it all, thought commercial paper was too risky for money-market funds. “Commercial paper is anathema to the concept of the money fund,” he told a reporter in 2001. “People prostituted the concept by putting garbage in the funds and reaching for yield.”
Bent’s Reserve Fund still invested only in government-backed debt and certificates of deposit from old-fashioned banks. “We consider it prudent rather than plain,” Bent’s son, who was president of the family business by this point, told the Wall Street Journal.
In a few years, the Bents would quietly abandon this worldview at exactly the wrong time.
The Money Boom
The last decades of the twentieth century were an extraordinary financial boom, and lots of rich people and corporations and pension funds and foreign governments found themselves with the pleasant problem of having more cash than they knew what to do with.
This wasn’t money they wanted to invest. This was money that they essentially wanted to put in their checking account. Money they would need to make payroll next week, or cover the retirement checks sent out next month, or whatever. Since government insurance on checking accounts topped out at $100,000, there wasn’t an obvious place to put this cash. The classic thing to do in this setting is to buy very short-term Treasury debt, but there was so much cash to park that there just weren’t enough Treasuries to go around.
A lot of these people invested in money-market funds; some imitated the funds and invested on their own. The money-market funds, with more money than they knew what to do with, turned around and started lending huge amounts of money to investment banks on Wall Street. (Investment banks, despite their name, aren’t like regular banks; they’re not really in the business of taking deposits and making loans, and they don’t have the government guarantees that regular banks have.) All this money innocently looking for a safe, short-term home was the air that inflated the great finance bubble of the early twenty-first century.
The aughts come. The housing boom is booming. Wildly unqualified borrowers are taking out absurdly large mortgages on overpriced houses. But in this version of the story we are starting a step earlier. We are looking at where the money that is being loaned to the unqualified buyers of the overpriced houses is coming from. The answer, as you have already guessed: money-market mutual funds! Pension funds and corporations that needed to park their cash! This new kind of money flowing in vast sums through money-market mutual funds and asset-backed commercial paper and investment banks was the money that inflated the bubble.
In late 2006, home prices stopped rising and corporate treasurers and money-market funds started getting nervous. So they started asking for their money back from some of the investment funds that had borrowed money (via asset-backed commercial paper) to invest in mortgages. In a few cases, the investors couldn’t come up with the money. When that happened, lots more people started asking for their money back.
To the outside world, this looked like some super-wonky thing going on in some arcane corner of the financial world. But to Paul McCulley, it looked like something else—something much more worrying.
Shadow Banking
McCulley was an economist who worked at a giant investment firm called PIMCO. He looked out across this world of money-market funds and asset-backed commercial paper and said: this is not just a bunch of arcane investment vehicles. It’s an entire banking system that nobody quite recognizes as a banking system.
A bank borrows money from depositors, who can ask for their money back at any time. Then the bank turns around and makes long-term loans. The fundamental bank thing that the bank is doing is borrowing short-term and lending long-term. The money-market funds and asset-backed commercial paper markets were doing the same thing: taking money that investors could demand at a moment’s notice and turning around and lending it out. In the shadows of the regulated banking system, a whole new system of quasi-banks had sprung up. And now there was a problem.
“What’s going on is really simple,” McCulley told a room full of central bankers at a meeting in the summer of 2007. “We’re having a run on the shadow banking system.” It was the first time anyone had used that term to describe this new universe: shadow banking.
Everybody thought we had solved bank runs in the Depression. The government started guaranteeing the money people deposited in the bank so people didn’t need to rush to the bank at the first sign of trouble anymore. The Fed stood ready to lend to sound banks that were in a temporary crunch. The government stood behind everybody’s bank account. Our money was safe.
But without anybody really realizing it, a parallel banking structure had sprung up. It was massive, and it was global. It allowed hedge funds and investment banks to borrow more and more and more money, to make bigger and bigger bets. It provided a lot of the money to people buying homes in the United States. It had all of the risk of traditional banking—the potential for a run that could wreck the entire economy—with none of the safety net.
“The short-term IOUs that are issued by shadow banks… are called cash equivalents,” Morgan Ricks, a trader turned law professor, wrote later. “Corporate treasurers and other businesspeople just call them cash.” In other words, shadow banks were creating real money.
By 2007, shadow banking was bigger than traditional banking. And the depositors in the shadow banks—the corporate treasurers and money-market funds and pension funds that had trillions of dollars of cash—were starting to demand their money back. It was the start of the biggest bank run in history.
The run hit Bear Stearns first. Bear was a small, risk-loving investment bank that borrowed tons of money from money-market funds and used it to buy mortgage-backed bonds. In March 2008, the funds decided the risk of lending to Bear was no longer worth it. Fidelity, the biggest money-market fund manager in America, had been lending Bear nearly $10 billion. In a single week, they demanded every penny of it back.
This is the moment in the bank run when all the depositors line up outside the bank to withdraw their money. It’s the moment when the British navy official says these notes are not money. But instead of 5,000 people with deposits of a few thousand dollars each, it was 50 institutions with deposits of hundreds of millions each. Bear had taken the borrowed money and used it to buy billions of dollars in mortgage-backed bonds. Now nobody wanted to buy those bonds. Bear Stearns’ depositors—including the money-market funds—wanted their money back, and Bear Stearns didn’t have it.
Bear Stearns wasn’t a commercial bank. It didn’t hold deposits for regular people and wasn’t supposed to be able to borrow from the Fed. But the Fed invoked a legal provision that said it could lend to anyone in “unusual and exigent circumstances,” and loaned $13 billion to Bear. The Fed was following Walter Bagehot’s nineteenth-century advice to “lend to merchants, to minor bankers, to ‘this man and that man.’” The central bank was pouring money into the shadow bank run, acting as lender of last resort.
The loan allowed Bear to open for business on Friday. That weekend, in a shotgun wedding, JPMorgan Chase bought Bear Stearns outright. As part of the deal, the Fed agreed to buy $30 billion in mortgage bonds from Bear Stearns. And then Bear Stearns ceased to exist. The bonds, in the end, were fine. The Fed eventually got its money back, with interest.
A few months later, the bank run came for another investment bank: Lehman Brothers. Lehman was Bear Stearns but bigger. The company owned an enormous quantity of crappy mortgage-backed securities. It had borrowed so, so much money. In September 2008, approximately everybody who had been parking their money with Lehman decided they wanted it back. Lehman didn’t have the money. It had a bunch of mortgage-backed bonds that nobody wanted to buy. Early in the morning on Monday, September 15, Lehman declared bankruptcy.
Bruce Bent Breaks the Buck
Three days before Lehman filed for bankruptcy, the Wall Street Journal ran a small story, deep inside the paper, about an obscure regulatory question in the money-market fund industry. The story quoted Bruce Bent, inventor of the money-market fund, arguing once again that other money fund managers were taking too many risks. “Lest we forget, the purpose of the money fund is to bore the investor into a sound night’s sleep,” he said.
Bent loved this theme, and he was hitting it hard. In the Reserve Funds’ annual report a few months earlier, he had written:
One year has passed since the… [subprime] crisis shook the foundation of our markets, which has investors questioning the safety of their money funds. Good! We are pleased to report that you, and the markets in general, have embraced the very concept and foundation on which The Reserve was founded, an unwavering discipline focused on protecting your principal…
But readers who looked past Bent’s letter and into the details of the report would have noticed something surprising. The Reserve Primary Fund was no longer the “prudent rather than plain” fund that limited itself to investing in boring bank deposits and government-backed bonds. Now the firm was taking investors’ money and buying tens of billions of dollars of commercial paper—just the sort of riskier investment Bent had once said money-market funds should avoid.
On the morning of September 15, 2008, the Bents’ Reserve Fund (now technically called the Reserve Primary Fund) owned $785 million in commercial paper issued by Lehman Brothers. Which is to say that Lehman Brothers, which had just declared bankruptcy, owed the Reserve Fund $785 million. It represented a little more than 1 percent of the total amount of money in the fund. That is just a tiny sliver! Even if the Primary Fund could recover no money at all from Lehman—and they could almost certainly recover something—the other 99 percent of the fund would be fine. If the Reserve Fund were a normal mutual fund, this would have been a nonevent. Mutual funds lose or gain 1 percent all the time.
But the Reserve Fund was not a normal mutual fund. It was a money-market fund. Despite the standard warnings that the fund might lose money, people did not think of their money in the fund as an investment. They thought of their money in the fund as their money. You put in a dollar, you get back a dollar whenever you want it. If the fund were to lose 1 percent of its value, investors wouldn’t get all their money back. This, for a money-market fund, is a disaster known as “breaking the buck.”
The savvy institutional investors who knew what was going on rushed to pull their money out of the Reserve Fund. By midmorning, just hours after Lehman declared bankruptcy, investors had redeemed $10 billion—ten times as much as in a typical morning. Like a bank, the Fund didn’t have that cash on hand. It had a bunch of bonds and commercial paper it had to sell to get the money. So, at 10:10 a.m., the bank that managed redemptions for the Reserve Fund stopped giving investors their money back.
Over the next few hours, depositors tried to withdraw another $8 billion. But the Reserve Fund couldn’t sell assets fast enough to come up with the money. The shadow bank run was hidden from the public, but it’s audible in the internal phone calls fund executives were having that day. (The calls were later made public in court records.)
“We’re in the hole for about eight,” one executive says. (Terrifyingly, he’s speaking in billions of dollars.)
And then a minute later:
“How much have we raised?”
“We’ve raised about a billion. That’s all we’ve been able to raise…”
“Oh, my gosh.”
“Yeah.”
“Well, that’s really bad.”
This is the morning Lehman went bankrupt. The biggest financial crisis in seventy years. Everybody is demanding their money back everywhere. All of the shadow banks are suddenly trying to sell all of their assets. But nobody’s buying!
As these two guys are talking on the phone, they actually see the run happening in front of them. Giant companies that have parked their cash with the Reserve Fund are calling and asking for their money back. One of those companies was ADP, which does HR-type stuff for other companies.
“Oh, fuck.… frickin’ ADP just took out fucking 213,” one of guys on the call says. He means $213 million.
“It’s not going to—nothing’s going to go,” the other guy says.
This is the part of the bank run where the teller puts down the glass in the window and walks away while depositors frantically scream for their money.
“Those customers are not going to get their money tonight.”
“That’s going to be the kiss of death.”
All that day and into Tuesday morning, the Bents tried to borrow money. They tried to sell a chunk of their firm. But it didn’t happen. They couldn’t come up with the money. Tuesday afternoon, the fund announced: “The value of the debt securities issued by Lehman Brothers Holdings, Inc.… and held by the Primary Fund has been valued at zero effective 4:00PM New York time today. As a result, the NAV [net asset value] of the Primary Fund, effective as of 4:00PM, is $0.97 per share.” The Reserve Primary Fund had broken the buck.
As the news spread, investors started pulling hundreds of billions of dollars from other money-market funds. To meet the redemptions, the funds had to sell their assets—including their commercial paper. But nobody wanted to buy commercial paper. Nobody wanted to lend, even to sound borrowers.
“Suddenly GE and Caterpillar and Boeing were having trouble borrowing money to make payroll and pay suppliers.… Everybody is running from all forms of commercial paper,” a lawyer who worked at the New York Fed told me. “One of our senior economists said, ‘Well, that’s not rational behavior.’ I ran into the bathroom and dry heaved.”
Shadow Money Is Real Money
On Friday, three days after the Reserve Fund broke the buck, President George W. Bush gave a speech at the White House Rose Garden. “The Department of the Treasury is acting to restore confidence in a key element of America’s financial system: money-market mutual funds,” the president said. Then he said the government was going to offer insurance for money-market funds.
In the 1930s, the government had put a fence around ordinary people’s bank accounts and said: Okay, what’s inside this fence is no longer a loan to the bank that you, the depositor, may or may not get back. Your bank deposit is your money. The government is going to insure the money inside this fence to make sure you get your money back. And we’re going to regulate the hell out of banks, and make them pay for the insurance, to keep that money safe.
Now, President Bush was essentially admitting that money—the thing the government had promised to keep safe—had jumped the fence. The dollars people had invested in money-market funds were no longer investments that people might or might not get back. They were now money, guaranteed by the United States, just like money in the bank or a gold coin in a locked box guarded by a soldier with a gun. “For every dollar invested in an insured fund, you will be able to take a dollar out,” the president said.
The president’s next sentence was boring but extraordinarily important: “The Federal Reserve is also taking steps to provide additional liquidity to money-market mutual funds, which will help ease pressure on our financial markets.” This was the other half of the money bargain, previously only available to banks: the Fed as lender of last resort. Now, the president was saying, the Fed stood ready to lend against the commercial paper that the money-market funds held and that nobody, but nobody, wanted to buy.
Two days later, Morgan Stanley and Goldman Sachs—the last two freestanding big investment banks—became bank holding companies. That meant they now got all of the delicious Federal Reserve lending of last resort that classic banks could get. Citibank and Bank of America, which had gotten into shadow banking by directing hundreds of billions of dollars into asset-backed commercial paper, would get bailouts in the form of hundreds of billions of dollars in government loans and guarantees in the months that followed.
Shadow banking, and the shadow money it created, managed to get all of the safety net, after going decades without paying any of the cost. Shadow money was now real money.
Money-market funds survived, but the Reserve Fund did not. It was wound down, and investors received 99 cents on the dollar.
Money and the Next Crisis
In 2009, the Group of Thirty—an absurdly elite organization whose thirty members include Nobel Prize–winning economists, people who have run every major central bank in the world, and the heads of several of the planet’s biggest banks—suggested a future for money-market funds. If it walks like a duck, swims like a duck, and quacks like a duck, they said, we should regulate it like a duck.
“Money market mutual funds wishing to continue to offer bank-like services…” a report from the group said, “should be required to reorganize as special-purpose banks, with appropriate prudential regulation…” If, on the other hand, money funds didn’t want to be regulated like banks, they could stop letting people write checks on their accounts and stop showing a constant value of $1 per share—in short, they could stop acting like banks that held people’s money for safekeeping.
The companies that ran money-market mutual funds wanted to keep acting like banks without being regulated like banks. “Fundamentally changing the nature of money market funds (and in the process eviscerating a product that has been so successful for both investors and the U.S. money market) goes too far and will create new risks,” an industry group wrote a few months later. (The use of “so successful” was an impressive show of chutzpah in 2009, less than a year after the run on money funds.)
The government insurance issued during the crisis was allowed to expire once the crisis passed. People argued for years over what to do about money funds. In the end, some new rules were put in place, but the industry got much of what it wanted.
Funds that are open only to big investors like companies and endowments do have to report daily swings in value, down to a fraction of a penny. But funds for ordinary investors still use the same accounting methods to show a constant dollar value for investors. People can still write checks on their accounts. Money-market funds are not regulated like banks, but for most people money in a money fund still feels like money in the bank.
In the spring of 2020, as the coronavirus pandemic spread around the world, people once again started frantically pulling billions of dollars out of money-market funds. And the US government once again rushed to protect the funds. “It’s just frustrating that we never really fixed this stuff to begin with,” Sheila Bair, a former regulator, said. “The industry lobbyists came in and persuaded regulators to do half measures. And we’re back in the soup again.”
***
One essential lesson of the Panic of 2008 is this: follow the money. Not in the traditional sense of looking for the place where the money is going, but in the shadow money sense of looking for the place where new kinds of quasi-money are being created. Look for the place where people are making loans that don’t feel like loans—they feel like money in the bank, which can be withdrawn at full face value at a moment’s notice.
What is the thing that is like a piece of paper from a goldsmith in 1690, or a deposit in a bank in 1930, or a money-market fund balance in 2007? When everybody who holds that thing decides to cash it in at once, the world will get very ugly very fast.
Source: Jacob Goldstein: Money: The True Story of a Made-Up Thing (2020)
Odd Lots: How A New Type of Money Caused The Financial Crisis (2020)
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