Guarantee All Bank Deposits - A Cautionary Note

Jeremy J. Siegel, in an editorial titled Guarantee All Bank Deposits, (WSJ, Sep 20, 2008), makes an excellent case for having the government guarantee all deposits, including money market funds, to avert the sort of panic that threatened us over the past week. Speaking as one who told friends a couple of months ago that it was probably time to stash cash in a safe deposit box (I didn't, but perhaps should have), I can appreciate the urgency of doing something along the lines suggested by Mr. Siegel.

The Cautionary Note

However, while Mr. Siegel covered a lot in his short editorial, he left out one crucial matter that any law authorizing the U.S. Government to guarantee all money market and savings deposits absolutely must address or we will risk creating a FNMA-like risk all over again. Simply put, if an investor desires the safety of a government guarantee, then that investor must also accept the level of interest paid on short-term government securities, i.e., on U.S. Treasury Bills. If this is not part of the package, a tremendous arbitrage opportunity is created, one that puts the taxpayer at risk yet again, for then money market managers will be free to invest in the riskiest of assets without fear of immediate consequences. Those investing in the highest yielding (riskiest) paper will be able to offer the most attractive yields and attract the most investors. Investors, knowing that their deposits are guaranteed, will have no incentive to assess the risk of the underlying investments going sour, just as investors in CD's currently scour the countryside looking for the highest yields in the riskiest banks as long as they keep their balances under $100,000 per bank.

A Tentative Answer

So, what's to be done? Well, one possibility is to turn this problem into an opportunity for the government (actually, for the taxpayers, for once.) How? By giving investors several choices up front.

The First Choice - Keep Today's Arrangement as One Option

If they choose to forgo the guarantee (and why should they not have that choice?) then they will be able to invest in non-guaranteed money market funds and buy CD's that are clearly named as such, for example a Citigroup 12-month NonGuaranteed CD, that bear the risk of the underlying credits going sour. In this investment category, banks and money market funds will compete for business on a yield basis as they currently do, but will always face the threat of massive withdrawals should they make poor investment choices. And these investors, of course, will bear the risk of a loss if they can't exit their investments at cost.

The Second Choice - Offering a Complete Guarantee

On the other end of the spectrum, banks and money market funds should be able to offer investments with a solid government guarantee, yielding the Treasury Bill rate for the respective maturities chosen, or some close approximation of it. However, to keep a viable short-term credit market functioning in the real economy (after all, the real economy should be the emphasis here, not government), those banks and money market funds should still be permitted to invest in non-government guaranteed paper. When they do so, however, the government (think taxpayers here) should get a cut of the action, and a substantial cut at that, in exchange for issuing the guarantee. For example, if a money market fund is buying commercial paper at a five percent yield and paying out only three percent (the T-Bill rate) to its investors, the two percent spread is available for some creative usage.

Remember now, the purchaser of the money fund only expects a 3% return, so what incentive does the money fund manager have to purchase commercial paper paying 5%? Well, that depends on what he's required to do with the extra 2%. Here's one possibility, among many. Set up three reserve accounts in which to accumulate the excess funds earned, as follows:

The Three Reserve Accounts

1. The Taxpayer Account - Place 50% of the excess earnings of the money fund into this account and rebate the balance directly to the U.S. Government (the taxpayers) quarterly to compensate them for taking on the risk of guaranteeing all such deposits.

2. The Risk Reserve Account - Place 50% of the excess earnings in an account similar to the current FDIC account that currently guarantees bank deposits under $100,000 and utilize this account first whenever a money market fund or savings institution is forced to call on the government guarantee.

3. The Excess Earnings Account - After a particular money market fund has deposited reserves equal to a certain percentage of its outstanding assets in the Risk Reserve Account above, any amount remaining can be deposited in this Excess Earnings Account and will be available to pay out to depositors in the form of a higher interest rate.

Additional Considerations

1. The percentages listed above are obviously arbitrary and are highly subject to lobbying efforts by affected parties. Hopefully, our future leaders will have been sufficiently traumatized by current events to put the taxpayer first when designing any plan similar to the one being discussed here.

2. When some money funds and banks begin to accumulate funds in their Excess Earnings Accounts they will then be able to offer a higher yield to depositors. This will draw more deposits to those institutions, but those will be the very institutions that have a) most rewarded the taxpayers and b) filled their Risk Reserve Accounts, so the best-managed institutions will be attracting the additional funds.

3. A flood of funds into one institution due to its sudden ability to pay a "bonus rate" will result in a need to once-again replenish the Risk Reserve Account, so this will be a limiting factor on any one fund gaining undue advantage.

The Third Choice - In Between

This is the messy one, but a third possible option would be to place a government guarantee on a percentage of the assets invested, say 80%, with any excess earned over the relevant T-bill rate to be shared between the government (again, the taxpayers) that is offering the partial guarantee and the investors. The first payments to the government could be allocated to the FDIC-like institution until any particular money fund or bank had contributed sufficient funds to cover a significant percentage of any future losses by the fund. After that contribution limit is reached, the government would get the use of any additional funds.

Meanwhile, the investor would enjoy a somewhat higher return for taking the risk of losing 20% of his assets in any particular institution, but the security behind those assets would continue to increase as the Reserve Fund grows.

Conclusion

However it is accomplished, any law authorizing the guarantee of all deposits, including money market deposits, must deal with the risk discussed at the outset of this commentary. Offering investors three distinct choices would enable them to choose the risk/reward trade off that best suits their needs and individual personalities. They could go it alone without the government guarantee while earning the maximum income, or they could cut risk to near zero by accepting a T-Bill rate in return, or they could take a middle path and earn a greater return by taking on a reasonable risk. In the meantime, the taxpayers would be receiving a significant return in exchange for issuing the guarantee and FDIC-like reserves would be building to mitigate the impact of a future meltdown in the short-term financial markets.

Is this exactly what should be done? Probably not, but something does need to be done along these lines because just guaranteeing all deposits will be another disaster waiting in the wings. It might take years to materialize, but materialize it most certainly will.