CASH, The Red Headed Stepchild is King . . . or Queen!

by Michael Matheron · October 6, 2008

The red headed stepchild is that member of the family who is immediately obvious at family get togethers. Often given the most suspiciously lacking holiday present or the least raucous birthday party, he or she often develops an understandably underwhelming personality fraught with self esteem deficits. In the financial world, cash is the almost perpetual red headed child at the party. Derivatives and highly leveraged financial products like mortgage backed securities, until recently the family scions, cavorted and pranced merrily though the last decade, while poor cash languished. “Why does cash stand aside? It’s positively embarrassing to the nearest and dearest, particularly Uncles Merrill and Lynch.”

Well, perhaps the red headed one, being nearly always shunted to the side, has been at an advantage after all. The dear red head is out of the way as the other loved ones rush to leap off the roof as their world collapses. Cash may once again be King or Queen of the realm, particularly, as hinted, the other kin have taken unceremonious swan dives from the battlements. The house suddenly kinfolk free, cash has the place to itself.

During the 2000-2006 run up, with high returns on invested dollars seemingly guaranteed from the leveraged and derivative driven markets, housing prices that defied laws of economic gravity, and low interest rates on those safe investments like bank deposits, holding cash in deposits of money market funds was viewed as a wasted asset. Indeed, could one call recumbent cash an “asset” at all, or was it somewhat akin to the red headed stepchild’s provenance.

Cash, however, is where most financial high flyers now want to be, if only they could unleverage some. The step child is embraced again, perhaps even deified. How this turnabout? It’s because of what’s called “unwinding” of leverage, or the “credit crunch,” or in old-fashioned terms “good old-fashioned deflation.” It’s due to a reassertion of the laws of economic gravity which brought an enormous amount of market securities (strange moniker that now), once valued in the many trillions of dollars, falling to earth. As this continues to occur in an often disorderly fashion prices attempt to seek a level at which there will be buyers to peg a price. In the present climate, however, there are very few buyers and as we have seen governments must enter the market to attempt what few private players other than Warren Buffett will do, put a financial floor under panicky deleveraging by paying a price for presently seemingly worthless assets. What those prices will be, we have yet to see clearly as the Rescue/Bail Out Plan is many weeks from its start. But note, the price may be high: AIG has blown through $68 Billion of its $85 Billion Treasury rescue already . . .

In this environment, for example, the United States has enacted a Rescue or Bail Out Plan (the once named Paulson Plan) in an attempt to provide some price for the so-called “troubled assets” like mortgage-backed securities (MBS) and insurance schemes that sought to guarantee those MBEs, the so-called credit default swaps (CDS). Other governments are following suit but more on a case-by-case method. The hope is that by governmental purchase of these insecure securities enough public money will be injected into the banking system so as to reflate balance sheets, and thus (hopefully) free up the fractional lending system once again. And lending is how we create money in the economy. Loans being repaid without new loans being made cause a contraction in money and a deflation of prices everywhere and that is where the high and mighty encounter Main Streeters. Thanks for the picture to Phreak 2.0

So, back to our little red headed one. These days there are actually incentives being offered to hold cash. One of the primary additions to the original Paulson Plan and the bill that initially failed to pass the House last week was providing a statutory basis for the FDIC to increase its coverage of deposits from $100,000 to $250,000. Overseas, Ireland, England, Germany, and Greece have put in place similar increases in deposit insurance with Ireland virtually insuring all deposits of any size for the next two years. In addition, the U.S. Treasury has also taken the unprecedented step of guaranteeing investments in most money market funds. This is also very interesting in that there is still no monetary reason to plunk one’s cash in a bank account given the almost non existent interest rate being offered on deposits; however, these are times where safety is paramount, not investment results.

Another place that one turns to to raise cash is the still liquid stock market. Even today’s plunge in the Dow didn’t dry up its liquidity — the real nightmare has been in Russia, for example, where their stock market often cannot even open. Yet, liquidity is relative. If everyone tries at some point this week to leave the equity markets at once, price instability will be rampant, and we may see some illiquidity in our own markets at least for certain stock issues like financial sector stock. We also need to realize that, as mentioned earlier, the higher guarantees on bank deposits being offered in the U.S. and in other countries offers incentive to move one’s cash out of equities, into cash, and then — Plunk! — into the bank, or into what many consider the best way to hold cash, short term Treasury securities even though now, due to the so-called “flight to quality” effect, these securities are offering a negative interest rate, i.e. you are paying a small premium to own these T-Bills . . . I believe that this incentive to hold cash will continue as deflation becomes the lead story in the news, and as more incentives are offered to bank one’s money.

And read what small businesses are being advised: remain debt free (as if there is a choice): “But there’s more: now is actually a time for you to thrive. If your small business runs debt-free, the turmoil of the last year and a half is truly an opportunity. Why? Because cash is king for the next few years. And so if your lack of debt gives you the ability, for example, to extend limited but scarce and therefore valuable credit to customers, then that could be the factor that puts you on a fast track for growth.” Growth is a bit of a dream in a deflationary environment, but you can see the point: go to cash, pay off debt. When that occurs on a national basis among small businesses, the money supply contracts and prices fall.

On the other side, though, let’s not forget that world governments are literally printing money and pumping it wildly into the financial system through deficit spending in an attempt to soften and make somewhat orderly the macroeconomic (Main Street) effects of the present deflation. Given, however, that the amount of money the U.S. must print to continue our massive deficit spending will become ever more massive since the Rescue/Bail Out bill’s passage last week, there is a real down-the-road possibility that the deflation of assets will be rather short-lived. The massive reflation attempt that is underway may actually work its wonders, with bank balance sheets growing quickly, and lending unplugged. The recovery that might occur after such a spectacular influx of printed mone would ordinarily lead to an inflation-fueled recovery. But not now. Now we’re at the deflation fork in the road, and as Yogi Berra said, “When you come to a fork in the road, take it.”

For the present, cash, that often under appreciated but always irrepressible red headed step child, is King or Queen. Perhaps inflation will follow, but not for now. Not for now “Apres moi, le deluge.”