As we wrote yesterday, the Federal Reserve Bank of New York recently published "The Federal Reserve's Commercial Paper Funding Facility," a paper authored by Tobias Adrian, Karin Kimbrough and Dina Marchioni, which "examines the creation and performance of the CPFF, while simultaneously outlining the evolution and importance of the commercial paper market before and during the CPFF (which expired February 1, 2010)." We summarized the article yesterday, but today we excerpt highlights from the "Background on the Commercial Paper Market" and "Lenders in the Commercial Paper Market" (including of course money market mutual funds).
The New York Fed authors write, "The commercial paper market is used by commercial banks, nonbank financial institutions, and nonfinancial corporations to obtain short-term external funding. There are two main types of commercial paper: unsecured and asset-backed. Unsecured commercial paper consists of promissory notes issued by financial or nonfinancial institutions with a fixed maturity of 1 to 270 days, unless the paper is issued with the option of an extendable maturity. Unsecured commercial paper is not backed by collateral, which makes the credit rating of the originating institution a key variable in determining the cost of issuance. Asset-backed commercial paper (ABCP) is collateralized by other financial assets and therefore is a secured form of borrowing. Historically, senior tranches of asset-backed securities (ABS) have served as collateral for ABCP.... While the underlying loans or mortgages in the ABS are of long maturity (typically five to thirty years), ABCP maturities range between 1 and 270 days."
The paper continues, "Commercial paper is held by many classes of investors. The largest share of ownership is by money market mutual funds, followed by the foreign sector, and then by mutual funds that are not money market mutual funds. Other financial institutions that hold commercial paper include nonfinancial corporations, commercial banks, insurance companies, and pension funds. The creation of the Commercial Paper Funding Facility is closely tied to the operation of money market mutual funds. Money market funds in the United States are regulated by the Securities and Exchange Commission's (SEC) Investment Company Act of 1940. Rule 2a-7 of the Act restricts investments by quality, maturity, and diversity. Under this rule, money market funds are limited to investing mainly in highly rated debt with maturities of less than thirteen months. A fund's portfolio must maintain a weighted-average maturity of ninety days or less [soon to be 60 days], and money market funds cannot invest more than 5 percent in any one issuer, except for government securities and repurchase agreements (repos). Eligible money market securities include commercial paper, repos, short-term bonds, and other money market funds."
It explains, "Money market funds seek a stable $1 net asset value (NAV). If a fund's NAV drops below $1, the fund is said to have 'broken the buck.' Money market funds, to preserve a stable NAV, must have securities that are liquid and have low credit risk. Between 1971 -- when the first money market fund was created in the United States -- and September 2008, only one 2a-7 fund had broken the buck: the Community Bankers U.S. Government Money Market Fund of Denver, in 1994. In light of disruptions to the sector in 2008, the SEC is currently reevaluating 2a-7 guidelines and considering the mandating of floating NAVs and the shortening of weighted-average maturities.
The NY Fed paper says, "Considerable strains in the commercial paper market emerged following the bankruptcy of Lehman Brothers Holdings Inc. on September 15, 2008. Exposure to Lehman forced the Reserve Primary Fund to break the buck on September 16. As a result, money market investors reallocated their funds from prime money market funds to those that held only government securities."
It explains, "This reallocation unleashed a tidal wave of redemption demands that overwhelmed the funds' immediate liquid reserves. In the week following the Lehman bankruptcy, prime money market mutual funds received more than $117 billion in redemption requests from investors concerned about losses on presumably safe investments, possible contagion from Lehman's bankruptcy, and financial institutions with large exposures to subprime assets. As a result, 2a-7 money market mutual funds were reluctant, and in some cases unable, to purchase commercial paper (or other money market assets with credit exposure). Any purchases made were concentrated in very short maturities; shortening the duration of their asset holdings made it easier for money market funds to manage uncertainty over further redemptions."
Finally, it says, "As demand by money market funds shrank, commercial paper issuers were unable to issue term paper and instead issued overnight paper. Thus, with each passing maturity date of commercial paper outstanding, an issuer's rollover risk increased sharply. Banks bore the increasing risk of having their credit lines drawn by issuers unable to place commercial paper in the market precisely when the banks themselves were having difficulty securing funding from the market and were attempting to reduce risk."
