The Federal Reserve Board released a paper in its "Finance and Economics Discussion Series" entitled, "The Cross Section of Money Market Fund Risks and Financial Crises" written by Patrick McCabe from the Fed Board of Governors's Division of Research & Statistics and Monetary Affairs. The paper's Abstract says, "This paper examines the relationship between money market fund (MMF) risks and outcomes during crises, with a focus on the ABCP crisis in 2007 and the run on money funds in 2008. I analyze three broad types of MMF risks: portfolio risks arising from a fund's assets, investor risk reflecting the likelihood that a fund's shareholders will redeem shares disruptively, and sponsor risk due to uncertainty about MMF sponsors' support for distressed funds."
McCabe's Abstract continues, "I find that during the run on MMFs in September and October 2008, outflows were larger for MMFs that had previously exhibited greater degrees of all three types of risk. In contrast, as the asset-backed commercial paper (ABCP) crisis unfolded in 2007, many MMFs suffered capital losses, but investor flows were relatively unresponsive to risks, probably because investors correctly believed that sponsors would absorb the losses. However, the consequences of MMF risks were quite costly for some sponsors: Using a unique data set of sponsor interventions, I show that sponsor financial support was more likely for MMFs that previously earned higher gross yields (a measure of portfolio risk) and funds with bank-affiliated sponsors. Funds' gross yields and bank affiliation (but not funds' ratings) also would have helped forecast holdings of distressed ABCP. This paper provides some useful lessons for investors and policymakers. The significance of MMF risks in predicting poor outcomes in past crises highlights the importance of monitoring such risks, and I offer some useful proxies for doing so. The paper also argues for greater attention to the systemic risks posed by the industry's reliance on discretionary sponsor support."
The Introduction explains, "Money market funds (MMFs or 'money funds') have an impressive record of price stability. From the introduction of the rules specifically governing these funds in 1983 until the Lehman bankruptcy in September 2008, only one small MMF lost money for investors, and that loss, in 1994, had little broader impact on the industry. Although MMF prospectuses and advertisements must warn that 'it is possible to lose money by investing in the Fund', investors virtually never lost anything. Indeed, the perceived safety of MMFs typically prompted inflows to the funds during periods of heightened uncertainty and motivated some academic researchers to suggest that money funds might function well as 'narrow banks' that provide liquidity services."
It says, "However, two crises in the MMF industry during the financial turmoil that began in 2007 underlined the importance of money fund risks for MMF investors and sponsors, as well as for the broader financial system. The meltdown of the market for asset-backed commercial paper (ABCP) that began in August 2007 caused capital losses for many money funds that held ABCP, but the losses were absorbed by MMF sponsors (that is, asset management firms and their parents and affiliates), so MMF investors lost nothing. In contrast, losses on Lehman Brothers debt following that firm's bankruptcy in September 2008 caused the Reserve Primary Fund to 'break the buck' -- its share price fell below $1 -- and cost its shareholders liquidity as well as principal (as of this writing, the assets of the fund still had not been completely distributed). Moreover, the damage quickly spread beyond Reserve and its investors amid a broader run on MMFs. Other money fund investors were put at risk as concerns about the funds' vulnerabilities prompted a vicious cycle of redemptions, efforts by MMFs to sell assets, declines in prices for money market instruments, and the possibility of capital losses that motivated further redemptions. A broader liquidity crisis developed as MMF managers, facing enormous redemptions, curtailed their lending to firms and institutions. The run on MMFs appears to have been slowed only by announcements on September 19 of unprecedented government interventions to support MMFs and short-term funding markets."
McCabe writes, "The two crises I study provide different perspectives on the importance of MMF risks. The run on MMFs in 2008 was not indiscriminate; I find that redemptions from prime MMFs marketed to institutional investors were correlated significantly with ex ante indicators for each of the three types of risk. For example, outflows were larger for MMFs that had paid higher gross yields in the previous year and thus were likely carrying greater portfolio risks, for funds with larger pre-crisis flow volatility that signified greater investor risk, and for funds that had sponsors with wider credit default swap (CDS) spreads and hence greater sponsor risk. Meanwhile, net redemptions from retail prime MMFs during the run varied with investor risk proxies but not significantly with portfolio or sponsor risk measures, perhaps because retail investors -- who generally did not redeem shares en masse -- were less cognizant of MMF vulnerabilities and posed lower investor risk for the funds. Indeed, one lesson from the distinction between institutional and retail investors' behavior during the run is the interactions among fund risks: MMFs with greater investor risks were also more sensitive to portfolio and sponsor risks."
He adds, "Interactions among fund risks were also consequential during the ABCP crisis, as widespread sponsor support absorbed funds' losses. With sponsor risks apparently dormant, other MMF risks -- at least as perceived by fund shareholders -- also remained latent, and the funds saw only modest net outflows that exhibited little cross-sectional correlation with ex ante risks. However, MMF risks were consequential for money fund sponsors; their financial support for their funds reflected concerns about actual or expected losses in funds' portfolios as well as concerns about investors' potential responses to those risks. Using a unique data set of sponsor support actions in the wake of the ABCP crisis, I show that portfolio risks, as measured by gross yields in the year prior to the crisis, are useful for predicting whether sponsors intervened to support their funds. A separate analysis of MMFs' holdings of distressed ABCP corroborates this result. Interestingly, sponsor risk played a more complex role in ABCP crisis than during the run in 2008. MMFs with bank-affiliated sponsors, which presumably had particularly deep pockets with which to support ailing money funds, were more likely both to hold troubled ABCP and to receive financial support to absorb losses. However, controlling for bank affiliation, riskier sponsors (those with higher pre-crisis CDS spreads) were more likely to experience problems."
Finally, McCabe adds, "My findings provide some useful lessons for MMF shareholders and policymakers alike. The significance of MMF risks in predicting poor outcomes in past crises underscores the importance of monitoring these risks, and this paper offers some useful proxies for doing so. For example, shareholders and regulators might track funds' gross yields for early signs of undue portfolio risks, particularly in light of asset managers' incentives to take on risks to boost yields. This paper also shows that MMF risks are broader than the portfolio risks that are the focus of the current regulatory framework for money funds. The importance of investor risk during the run in 2008 lends some support for the Securities and Exchange Commission's (SEC's) 2009 proposals to require additional liquidity for funds that are marketed to riskier investors, such as institutional investors, and the proxies for investor risk that I employ may be useful for identifying funds with riskier clienteles. The link between sponsor risk and holdings of distressed paper during the ABCP crisis indicates that the sponsor-support option may distort incentives for portfolio managers, and the role of sponsor risk in channeling concerns about financial institutions to their off-balance-sheet MMFs during the 2008 run suggests that expectations for such support may contribute to transmission of financial shocks. These concerns at least warrant greater attention to the systemic risks posed by the MMF industry's reliance on sponsor support."
