How safe is safe?

Consider the plight of Raymond Przybilinski...

by Mike "Mish" Shedlock, editor of the Global Economics Analysis blog...

POOR Raymond Przybilinski.

   "He socked away $521,000 from a lifetime of driving trucks, working overtime when he could, and playing the piano or accordion late into the evenings at weddings, hotel bars, and social clubs...

  
"The money was destined for his five children. But that was before more than half of the family nest egg disappeared on Feb. 2 as state banking regulators seized Metropolitan Savings Bank in Lawrenceville, citing 'unsafe and unsound' operations. When Mr. Przybilinski tried to take his money out, the man in charge of Metropolitan Savings' assets informed him that there was only $200,000 left to withdraw – the amount protected by the federal government."

  
Here are some school-of-hard-knocks lessons from Raymond Przybilinski's misfortune:

1. If a bank is offering above market rate interest on CDs and deposits, there is a reason behind it. That reason is risk. And with excessive risk comes eventual disaster.
2. With credit spreads widening, margin calls being issued, and absurd lending to build condos in Florida and other places smack in the face of record inventories, there are going to be more bank failures like this.
3. Know and understand the FDIC limits, or your life savings can be wiped out.
4. If you have money in a bank in excess of the FDIC limits, do something about it now, while you can.

  
The above material was written on Aug. 8. Flash forward to Tuesday, Aug. 14, 2007, and the USA Today headline reads "Sentinel Freezes Assets of $1.5 Billion Fund".

  
What the headline does not say is that Sentinel is a money market fund. On Tuesday, Sentinel Management Group froze assets in a $1.5 billion fund, saying too many investors are trying to withdraw their money. "We have never experienced a situation quite like this one," Sentinel Management said. "Liquidity has dried up all over the Street."

  
If you're looking for the source of the problem, here it is: "We have never experienced a situation quite like this one...Liquidity has dried up all over the Street." What happened is that Sentinel thought that just because it has not seen something yet, it could not happen. This is, in essence, the same thing that happened to the models at Moody's, Fitch, and the S&P, and various quant models. On Tuesday, Sentinel asked the U.S. Commodity Futures Trading Commission for permissions to halt redemptions. The request was denied.

  
Check out Sentinel's letter to clients:

"Dear Client:

  
"As you undoubtedly know, the credit markets, along with most other markets, have experienced a liquidity crisis in the past several weeks. Investor fear has overtaken reason and has induced a period in which most securities have simply ceased to trade. We've all read the stories about one hedge fund or another suffering losses related to subprime exposure and closing down or being rescued. This fear, while warranted in some cases, has spilled over into the rest of the credit market, and liquidity has dried up all over the Street...

  
"This liquidity crisis has caused bids to disappear from the market and makes it virtually impossible to properly price securities or to trade them. High-grade securities are trading like junk bonds as panicked investors dump names like General Electric at Tyco-like prices.

  
"We had previously thought that the market would return to some semblance of order and that our clients would not join in the panic. Unfortunately, this has not been the case..."

  
There were some interesting frequently asked questions on Sentinel's website. They may have been yanked by the time you read this:

1. "How can Sentinel consistently earn high yields on short-term investments without taking excessive risk?"
2. "How can I be sure my money is safe at Sentinel?"
3. "That is history. How can Sentinel ensure that such a record will continue?"
4. "Exactly what happens to the cash invested by Sentinel?

Proposed New Answers

1. We can't. No one else can, either. That is what risk is all about.
2. You can't. Liquidity has dried up and we just got caught. That's why we halted redemptions.
3. Part of our original answer was: "Sentinel is registered with three regulatory agencies: the Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Congressionally chartered self-regulatory body, the National Futures Association (NFA)." You can easily see that now does not mean much.
4. "Sentinel clients have an indirect, undivided pro rata ownership interest in a pool of high-quality, liquid securities. Sentinel's Treasury Only Portfolio (TOP) consists of direct obligations of the U.S. Treasury. The 125 Portfolio and Prime Portfolio consist of money market securities issued by U.S. government agencies, corporations, or short-term bank time deposits, all of which meet Sentinel's requirements for liquidity and low risk." Those most at risk put their faith in the "125 Portfolio," and that's where the big problems are.

  
One part of the Sentinel letter complained: "We are concerned that we cannot meet any significant redemption requests without selling securities at deep discounts to their fair value and therefore causing unnecessary losses to our clients."

  
Excuse me, but doesn't the market determine "fair value"? Apparently, Sentinel thinks it knows what fair value is, but the market doesn't. Recall that Bear Stearns thought the same thing. Bear Stearns locked out clients who wanted to redeem all the way back in January. Those investors would have gotten something back, perhaps as much as 70 cents on the dollar. Bear Stearns locked those clients in, and the hedge fund went to totally worthless.

  
While Sentinel does not like the current offer for those assets, there is no guarantee (or even likelihood) that the market is going to think more of those assets tomorrow than it thinks of them today. Should Sentinel have seen this coming? I think so, or at least it should have been alert to the possibility.

  
Instead, it stuck with a now failed model that offers these excuses:

• Investor fear has overtaken reason
• The market would return to some semblance of order
• Our clients would not join in the panic
• Securities are at deep discounts to their fair value.

  
Some may be shocked by this, but readers of the Survival Report were prepared for it. The difference between shocked and prepared is, of course, paramount. In preparation of a "liquidity crunch" and a continued housing tsunami, we recommended leap puts on Countrywide Financial (CFC: NYSE) when it was trading near $36 and Lowes (LOW: NYSE) when it was trading in a range near $31-$32.

  
Both options are doing extremely well as CFC is now trading near $22 and LOW is trading near $28.

Individual investors need not buy put options, of course. But they do need to examine the safety of the investments that they believe to be safe. They need to read the fine print on their "guaranteed" investments. They need to read (or, at least, to understand) the statements on their money market accounts that stipulate in their prospectus very clearly that they can LOSE money and that NAVs (net asset values) can fall below a dollar.

Unfortunately, most folks don't care about "the fine print" until it's too late.

Free Tips

• Make sure you do not exceed the FDIC limits in any account. Just ask Raymond Przybilinski about the consequences.
• Do not panic over this. Just calmly make sure you know where your money is and that it exceeds no limits.
• Also make sure that any money markets you are in are not heavily invested in "junk-rated" securities.
• The higher the yield, the more excessive the risk is.

  
In short, don't become another Sentinel victim...