On Friday in a speech entitled, "Our Financial Structures -- Are They Prepared for Financial Instability? in Amsterdam, new money fund industry nemesis Eric Rosengren, President of the Federal Reserve Bank of Boston, proposed yet another half-baked idea for monitoring money fund risk. This time Rosengren focused on stress-testing banks affiliated with money fund sponsors. He says, "Since the severe financial stresses of 2008, a variety of actions have been taken to strengthen the financial infrastructure and make banks more resilient in the face of adverse shocks. While many banks have improved their capital and liquidity positions since 2008, we still see in the headlines of newspapers around the world that financial stability remains very much an issue.... Today I want to highlight an area where remedial action is still required. My goal is to focus more attention on financial structures that by design or reality reduce or avoid capital charges.... Such structures are vulnerable to stresses that can have destabilizing effects on financial markets and the broader economy.... I will touch on two specific areas that merit consideration -- money market mutual funds sponsored by banking organizations, and broker-dealer financing."
He explains, "I will discuss the possibility of using stress tests to illuminate the impact of various scenarios on fund sponsors, many of which are banks or financial institutions. My primary focus will be on prime money market mutual funds, with approximately $1.41 trillion in total assets as of May 31. Prime funds invest in a variety of securities that carry more credit risk than traditional U.S. Treasury securities. Money market mutual funds allow investors to potentially earn a higher return on short-term investments in part because -- unlike banks -- money market mutual funds are not required to hold capital. As a result, they often pay a competitive rate relative to bank deposits, and they provide investors many features similar to traditional bank deposits -- for example, immediate availability of funds as well as a fixed net asset value that does not fluctuate when the value of assets held by the money fund changes."
Rosengren continues, "So money market mutual funds provide investors with an investment vehicle with features like bank deposits -- but the funds do not hold capital. The problem is that a financial intermediary -- which has no capital, but takes credit risk, and provides under normal circumstances immediately available funds at a fixed net asset value -- may be inviting trouble. Such a fund can be susceptible if the credit risk of the assets it invests in were to rise, causing investors to become concerned about the fund's ability to sell its assets, meet redemption demands, and maintain a stable net asset value. Consequently, the implicit expectation of a bank-deposit-like investment can unravel, and the incentives to redeem could be strong."
He shows some charts of the asset swings from Prime and into Government money funds in 2008, and says, "While the funds may remain in the same fund family with this shift, investors who do not exit from the prime money market mutual fund could be financially impacted, and the prime fund might need to engage in a fire sale of assets to meet investor demands. Furthermore, firms counting on money market mutual funds to provide funding (for example by buying their debt -- their commercial paper) can suddenly find that the primary purchasers of their paper are no longer active in the market."
He adds, "Our concerns should be amplified by the fact that many prime funds are sponsored by depository institutions or their affiliates.... Just under half the assets are held in funds sponsored by an asset manager not affiliated with a depository institution. But domestic (U.S.) bank holding companies, foreign bank holding companies, and savings and loan holding companies (in other words companies affiliated with depository institutions) combined serve as the sponsoring organizations for a bit more than half the prime fund assets, and more than half of the number of funds."
Rosengren also opines, "While SEC regulations restrict the credit risk and maturity risk of prime money market mutual fund investments, these funds nonetheless can and do invest in risky assets. An example is provided by the number and value of Dexia obligations held by money market mutual funds at the end of 2010, less than one year before the Belgian and French governments needed to bail out the bank. As Figure 3 shows, a large number of money market mutual funds with various types of sponsors held Dexia paper at the beginning of the year in which Dexia failed. However, funds sponsored by banks or bank affiliates were over-weighted relative to funds sponsored by asset management firms not affiliated with a bank, both in the number of funds invested in Dexia and the value of Dexia assets."
He says, "As recent studies have highlighted, it is quite common for money market mutual funds that have impaired assets to obtain support from their sponsors. Whether this is a cash infusion or a purchase at face value of an impaired asset, this support can represent draws on capital at times when the sponsoring organization is facing other capital pressures. Figure 4 shows support-related losses by fund sponsors, using data provided by Moody's and broken down by sponsor type."
Rosengren explains, "While most of the losses were during stressful times, even during non-stressful times there are some losses. Figure 5 sums the losses recognized over the five-year period of 2007 to 2011. The degree of sponsor support is substantial. Support has been quite large and particularly prevalent for prime money market mutual funds which have depository institution or depository institution affiliated sponsors. Over this period, Moody's reports almost $9 billion in losses associated with money market mutual funds by depository institution or depository institution affiliated sponsors."
He tells us, "The SEC has been working on reform proposals that would provide several measures to reduce the risk of stresses during times of financial market crisis and provide some capital support. I am very supportive of the current push within the SEC for additional reforms, which have the potential of mitigating many of the concerns I am sharing today. As the primary regulator of money funds, the SEC is in a position to adopt rules that would address the vulnerabilities of those funds more comprehensively, effectively, and efficiently than other approaches. However, at this time it is unclear what the final proposal will be, or whether the SEC's final proposal will be adopted."
Then, Rosengren threatens, "In the absence of such reforms for all money market mutual funds, an alternative for funds with depository institution or depository institution affiliated sponsors would be to include likely money market mutual fund support in the sponsor's stress tests. Based on the historical experience of their money market funds, the historical experience of similar funds, and their money market funds' exposures, sponsors could calculate the likely capital support needed from the organization in a stress scenario."
He says, "Again, this is an admittedly partial approach, in the absence of more comprehensive reforms that I hope will occur. But this approach would at least make more banking organizations more resilient (it would not be just money market mutual fund structures that would need capital -- any financial structure that broke down during stress would need more capital) but it would also make clearer to money market mutual fund investors that banks had capital that could support funds during stressful periods. It would thus make clear that money market mutual funds with well capitalized sponsors are likely to be less risky than those that do not have well capitalized sponsors."
Finally, Rosengren adds, "Similarly, other financial products that circumvent standard capital requirements -- such as non 2a-7 "money market like" funds, stable value wrap products, and asset-backed commercial paper -- could lead investors to expect that the sponsor holds capital for the support that these products could need in times of stress. While some firms are likely to argue they would not provide support for so-called capital efficient products, the high frequency of support of money market mutual funds and other off-balance-sheet items during the crisis makes such claims dubious. In fact, this support might be encouraged by regulators during a crisis, in order to avoid broader problems of financial instability."