John Hawke of Arnold & Porter has penned another comment letter to the SEC and Chairman Mary Schapiro, which was posted to the President's Working Group Report on Money Market Fund Reform website late last week. Entitled, "Role of Federal Reserve in Supporting Short-Term Credit Markets File No. 4-619; Presidents Working Group on Money Market Funds, it says, "A recurrent theme raised by supporters of radical change to the regulation and structure of money market mutual funds (MMFs) is that the Federal Reserve lent money to MMFs to bail them out during the Financial Crisis, that Congress in the Dodd-Frank Act prohibited the Federal Reserve from ever doing so again, and therefore the continued existence of MMFs in their current form poses a grave financial risk to the world economy."
He explains, "The Federal Reserve did not lend to MMFs under the Asset-Backed Commercial Paper MMF Liquidity Facility (AMLF), it lent to banks, and it did so to address illiquidity in the commercial paper market, not to bailout MMFs. As discussed below, this is exactly the purpose for which the Federal Reserve was created in 1913. MMFs did not cause the recent financial crisis -- the crisis had been underway for 20 months before the Reserve Primary Fund "broke a buck" in September 2008 -- but MMFs were not immune from its effects. The AMLF program was one small part of a large number of credit programs put in place by the Federal Reserve and Treasury Department to deal with illiquidity during the recent Financial Crisis."
Hawke writes, "As you no doubt are aware, the history of the United States has included many financial panics characterized by sharp contractions in lending and the availability of credit, accompanied by economic contraction in the form of increased unemployment and decreased output of goods and services.... The Federal Reserve Act of 1913 created the Federal Reserve System, including the Federal Reserve Banks and the Board of Governors of the Federal Reserve System. The purpose underlying the Federal Reserve Act of 1913, as stated by Congress, was "[t]o provide for the establishment of the Federal reserve banks, to furnish an elastic currency, to afford a means of rediscounting commercial paper, to establish a more effective supervision of banking in the United States, and for other purposes." Of the four stated Congressional purposes behind the Federal Reserve Act, one is specifically to provide liquidity to the commercial paper market, and that purpose was listed by Congress ahead of regulation of banks."
He adds, "Sections 13 and 14 of the Federal Reserve Act ... contain the main provisions by which the Federal Reserve System provides liquidity to banks, through banks to the underlying short-term credit markets, and in some instances directly to the short-term credit markets. When the Federal Reserve extends credit, it does not provide a "bail out". Instead, it lends on commercially appropriate terms against sound collateral. The Federal Reserve extends credit to protect the short-term credit markets from seizing up, in order to protect the economy. Providing this short-term credit is the purpose for which the Federal Reserve was created. It is the reason the Federal Reserve is sometimes referred to as "the lender of last resort." The primary purpose and function of the Federal Reserve, the essential reason it was created by Congress, is to address financial panics by providing liquidity by lending into the short-term credit markets, when no one else will."
Hawke explains, "Similarly, during the recent Financial Crisis, there were a number of instances in particular credit markets becoming illiquid. These included the February 2008 freezing up of the auction rate municipal securities market, a tightening of the repo markets in 2007-2008, and a general tightening and illiquidity in the market for securitized assets beginning in 2007. Indeed, as early as August 2007, in recognition of banks' unwillingness to lend to each other and the deterioration of conditions in the financial markets, the Federal Reserve began taking extraordinary steps to inject liquidity into the market. In December 2007, it launched the Term Auction Facility, the first of over a dozen special liquidity programs. In September 2008, during the Financial Crisis, the market for commercial paper (including, in particular, asset backed commercial paper "ABCP")) became illiquid. This made it difficult to holders of commercial paper, including banks, MMFs and other investors, to sell commercial paper, which in turn made investors unwilling to roll over existing commercial paper or purchase new issues of commercial paper. The Federal Reserve responded very quickly with the creation of the AMLF, by which banks were able to borrow from the Federal Reserve against the collateral of performing ABCP purchased by the banks from MMFs. The collateral for the Federal Reserve loans was high-quality commercial paper, and the loans were all repaid with interest in full and on time at a profit to the Federal Reserve."
He adds, "The AMLF was one of the smaller and shorter-lived financing programs of the Federal Reserve and Treasury during the Financial Crisis of 2007-2009.... The AMLF balances represented less than 1% of the aggregate amount of the various emergency lending programs put in place by the federal government during the Financial Crisis. A larger lending facility, the Commercial Paper Funding Facility was put in place by the Federal Reserve in October 2008 to provide a liquidity backstop directly to commercial paper issuers, and the Money Market Investor Liquidity Facility was put in place for investors in money market instruments in October 2008 but was never called upon. These programs were terminated in 2009 and 2010."
Hawke's letter tells us, "Sections 214, 1101, 1306 and 1501 of the Dodd Frank Act placed restrictions on government lending to insolvent institutions or foreign governments, 5 and Section 131 of the Emergency Economic Stabilization Act of 2008 precluded the Treasury Department from creating future MMF guarantee programs similar to its 2008 MMF guarantee facility. Sections 1101-1109 of the Dodd Frank Act, however, which tightened somewhat the Federal Reserve's emergency lending authority, preserves the basic function and authority of the Federal Reserve System under Sections 13 and 14 of the Federal Reserve Act to provide liquidity to the financial markets. If needed tomorrow, the Federal Reserve could launch a program similar to the program it undertook to address the Penn Central crisis in 1970 or something very much like the AMLF (the fact that asset backed commercial paper -- a subset of the overall commercial paper market has shrunk in size is irrelevant). Although the Federal Reserve retains the authority under the Federal Reserve Act to make future extensions of credit to provide liquidity in the commercial paper market, changes in 2010 to SEC rules governing MMFs liquidity requirements make it unlikely that MMFs would need to rely on that source of secondary market liquidity in the future."
He says, "The SEC's 2010 amendments to Rule 2a-7 now require MMFs to hold massive amounts of short-term liquid assets in their portfolios (at least 10% overnight liquidity, 30% 7-day liquidity, plus additional amounts based on an assessment of their shareholders' liquidity needs and plans, with current liquid assets of MMFs estimated to exceed $1 trillion on $2.6 trillion in total assets). Moreover, MMFs currently hold very little ABCP, so it is unlikely that a facility similar to the AMLF will be needed in the future. A current example of an extraordinary short-term liquidity facility being provided by the Federal Reserve is the extension of over a trillion dollars in short-term dollar financing to the European banking system through the European Central Bank."
Hawke continues, "Our point is not to criticize the Federal Reserve for these programs, as many have done. Instead, in our view the Federal Reserve and Treasury did an extraordinary and highly effective job during the recent Financial Crisis to provide liquidity to various sectors of the economy. This was exactly what was needed, and this as precisely the role for which the Federal Reserve was created in 1913. The Federal Reserve and Treasury deserve praise, rather than criticism, for these extraordinary credit programs. Financial panics existed long before MMFs were invented. If the Federal Reserve and its supporters succeed in their efforts to do away with MMFs, financial panics will continue to occur. Whether they invest in MMFs or invest directly in commercial paper and other short-term credit instruments, lenders and investors will continue to withhold new loans and cease to roll over existing credit in the face of a financial crisis. There will continue to be a "flight to quality" in times of uncertainty. If MMFs no longer exist, the Federal Reserve will still be required, from time to time, to provide liquidity to short-term credit markets to resolve a financial panic."
Finally, he writes to Schapiro, "In your testimony on June 28, 2012 to the Senate Banking Committee, you did not accept the use of the term "shadow banks" for MMFs, noted that the Securities and Exchange Commission, rather than the federal banking agencies, is the appropriate regulator of MMFs, and stated that the Commission has taken strong steps through the 2010 amendments to Rule 2a-7 to address the liquidity issues in MMFs and to strengthen and improve the program of regulation and supervision of MMFs. We agree. We disagree, however, with concluding that because the Federal Reserve in September 2008 provided liquidity through the AMLF to the commercial paper market, MMFs are inherently unstable, that MMFs make the short-term credit markets less stable, that MMFs caused or worsened the Financial Crisis that began 20 months earlier and was brought to a head by the receiverships of two government sponsored enterprises, the forced sale of Merrill Lynch, and the bankruptcy of Lehman Brothers before the Reserve Primary Fund "broke a buck" and the bailout of AIG at about the same time. In uncertain times there is always a market flight to quality, a contraction of private credit, and a tightening of liquidity in the short-term credit markets. This will occur regardless of whether MMFs exist and regardless of the structure of MMFs. The purpose of the Federal Reserve is to provide liquidity to the short-term credit markets in uncertain times. It served that role for 60 years prior to the creation of MMFs. Changing the fundamental structure of MMFs or doing away with them entirely will not lessen the need for the Federal Reserve to serve as the lender of last resort to provide liquidity to the short-term credit markets."
