On Friday, Eric Rosengren, President & Chief Executive Officer, of the Federal Reserve Bank of Boston gave a speech entitled, "Defining Financial Stability, and Some Policy Implications of Applying the Definition, which contained a section on money market mutual funds. Rosengren reviews the crisis, discusses current options and risks, including heavy European holdings of money funds, and urges action to address future threats. (See also, Bloomberg's "Fed's Rosengren Says Money Funds May Be Vulnerable to Europe".)
In the section "Examples of financial instability (and possible causes)," Rosengren says, "I have been arguing here that there are examples of serious financial problems and dislocations that I would not consider examples of financial instability, as I define it. But there are, unfortunately, examples of financial instability that occurred recently, during the financial crisis and recession. As I mentioned in my introduction, the Dodd-Frank legislation seems primarily focused on addressing the failure of large financial institutions and payments systems -- which certainly warrants attention. But a large interconnected failure is only one of several ways that a systemic problem can emerge. The first example I would offer involves the experience of money market mutual funds (MMMFs) during the financial crisis, and it demonstrates that even a small financial intermediary can create financial instability."
He explains, "As of August 2008 MMMFs had $3.5 trillion of assets, and funds had been flowing into MMMFs, as a result of problems at a variety of banks and other factors. But Figure 6 shows the daily change in money market fund assets in prime funds in the latter portion of 2008, and notes some of the key events of that era. In the wake of the failure of Lehman Brothers, a relatively small MMMF called the Reserve Primary Fund experienced very substantial outflows due to investor concerns about its credit exposure to Lehman. While money market funds are highly regulated by the SEC and are supposed to hold high-quality liquid assets, investors were concerned that losses from Lehman would cause the Reserve Fund to 'break the buck' (that is, redeem shares for less than one dollar)."
The Boston Fed President continues, "The problems at the Reserve Fund not only caused funds to flow out of that fund, but also triggered large withdrawals from other money market mutual funds as well.... Over the course of the week, over $300 billion was withdrawn from prime MMMFs, forcing the funds to try to quickly sell assets to meet redemption requests. Note that there are three major types of money market funds ... funds that invest in tax-exempt securities, funds that invest in government securities, and prime money market funds that purchase a wide variety of debt instruments. It was the prime money market funds that posed the most severe problem during the crisis -- and which still pose a problem today (as I will discuss in a moment). While some of the assets in the prime funds, such as Treasury securities, could be readily sold, others such as asset-backed commercial paper (ABCP) were not easily sold given the prevailing harsh market conditions."
He adds, "The rapid withdrawal of funds from prime money market funds not only represented a crisis of confidence, but also began seriously disrupting credit markets where MMMFs were the major buyers. Interest spreads on asset-backed commercial paper ... rose dramatically. The bottom panel shows that asset-backed commercial paper could only be issued in very short maturities. The percent of issued paper maturing in one to four days leapt from roughly half to over 90 percent. In response to these short-term credit disruptions, the U.S. Treasury announced a plan to insure MMMF shares, and the Federal Reserve System announced an asset-backed commercial paper MMMF liquidity facility. The facility, operated for the System by the Boston Fed, allowed money market funds to sell asset-backed commercial paper to banks -- the MMMFs could use the sale proceeds to meet redemption requests -- and the asset-backed commercial paper was pledged by the banks to the Fed as part of a loan from the Fed, which was ultimately paid back with interest. In addition, over time other facilities were created to address disruptions in short-term credit markets."
Rosengren says, "The money market problems that disrupted short-term credit markets highlighted that financial instability could be created by even a small money market fund if its problems created doubts about other funds' ability to redeem investors' funds at stable net asset value. In a situation like this, we should note, the weakest link in the financial stability chain might be small, rather than large, financial intermediaries. This problem with promising stable asset values despite some credit risk was what in this example impaired financial intermediaries (the MMMFs), seriously disrupted short-term credit markets, and had a large impact on the ability of firms to acquire short-term debt financing."
He continues, "The Securities and Exchange Commission has tightened requirements on money market funds. While this represents an important step forward, I will digress for a moment on this issue as it relates to our topic today, financial stability. Despite the regulatory changes that have occurred, MMMFs still remain vulnerable to an unexpected credit shock that could cause investors to doubt the ability to redeem at a stable net asset value. I am certainly not predicting such an outcome, but I believe we all do well to recognize and address this vulnerability."
Rosengren also says, "I do think it would be particularly prudent to address this issue now, as money market mutual funds have the potential to be impacted should there be unexpected international financial problems emanating from Europe. Consider that many (but not all) MMMF's have sizeable exposures to European banks, by virtue of holding the banks' short-term debt. This means some MMMFs are potentially sensitive to a disruption in the European banking system, should one arise from the fiscal and sovereign-debt problems we are seeing in some European countries. Conversely, I would note that European banks are reliant on the MMMFs -- which are a major source of their dollar-funding needs. This latter point is worth noting as we carefully and responsibly examine this set of issues -- because it means, for instance, that a regulatory change that reduced the debt holdings of European banks by prime money market funds could (as an unintended consequence) necessitate corresponding changes in European dollar-funding strategies."
Finally, he adds, "While there have been various proposals to address this issue -- for instance allowing the asset values of the funds to float, or requiring capital be set aside in the event of a credit shock, or requiring a source of strength from a parent company or an insurance contract -- no one solution has been settled on that would cure the type of problem that occurred with the Reserve Primary Fund in the last financial crisis. So in my view, any solution needs to address the potential impact of unexpected credit losses, the risk that investors might rapidly withdraw their funds to avoid any loss, and the operational convenience that MMMFs provide as a transactions account vehicle. Despite these challenges, the set of issues surrounding MMMFs is in sum a vulnerability that needs to be addressed. Forums like this one serve an important role in allowing us to underline issues like this that need focused and constructive attention."
