As the U.S. Congress heads towards what may be yet another standoff over the Treasury's "debt ceiling" this fall, a new research paper, entitled, "Money Market Funds and the Prospect of a Treasury Default," examines the impact this could have on money market funds. Authors Emily Gallagher, an ICI Economist who did the study while at the Paris School of Economics, Sorbonne, and Sean Collins, ICI's Senior Director of Industry and Financial Analysis, look at past debt ceiling crises in 2011 and 2013 to evaluate the "behavior and motivations of investors redeeming from MMFs during these crises." The debt ceiling battle and possibility of a "technical" Treasury default takes on added significance going forward, given the potentially massive migration to government assets (or not) as a result of money market reforms and other regulatory changes.
The abstract says, "U.S. debt ceiling crises in 2011 and 2013 were marked by significant outflows from money market funds (MMFs). This study evaluates the behavior and motivations of investors redeeming from MMFs during these crises. We find that the majority of redemptions reflect a generalized flight-to-liquidity and are, therefore, primarily a function of the liquidity needs of a fund's investor base. Funds holding Treasury securities at greatest risk of default or with market values below their $1 share price experience flows that are insignificantly different from other funds, all else equal. We also find evidence that a significant portion of the outflows stem, not from liquidity concerns, but from an opportunistic yield play on the repo market created by the crises. Finally, we offer anecdotal evidence that the government's guarantee of bank deposits had the perverse effect of encouraging outflows from MMFs during the 2011 crisis." (Note: The Government terminated its unlimited deposit account guarantees at the end of 2012.)
The introduction of the 44-page paper explains, "A cornerstone of international financial markets is the notion that debt issued by the U.S. Treasury is essentially credit-risk-free. This perception of safety is based on the strength of the U.S. economy as well as on its government's ability to raise taxes, borrow, and print money to meet its obligations. However, the U.S. Treasury's authorization to borrow is subject to a statutory limit. Often referred to as the "debt ceiling," the U.S. Congress sets a limit on the amount the Treasury can borrow. Debt limit increases, once routine, have recently become a bargaining chip in negotiations for spending cuts. Uncertainty over whether last-minute budget negotiations might end in a federal default rattled financial markets in 2011 and, to a lesser extent, in 2013." (Note too: The Treasury is expected to hit the ceiling again in October 2015.)
It continues, "Short-term markets, whose participants are often highly risk averse and value liquidity, were particularly affected. If, as appears to be the case, debt ceiling crises become more frequent, it will be important to understand the factors motivating investors in short-term markets to react during these periods of stress. Money market mutual funds (MMFs), which invest in a mix of high-quality, short-term securities issued by banks, corporations, municipalities, and the U.S. government, provide an ideal setting to examine these reactions. In this study, we identify several possible motivations for investors to redeem from MMFs during U.S. debt ceiling crises and examine whether and to what degree these motivations contribute to outflows."
Collins and Gallagher explain, "We begin by establishing that outflows from prime and government MMFs during the 2011 and 2013 crises were indeed notable in aggregate. We, then, analyze differences in aggregate flows across the two fund categories and the two crises. Next, we test several possible motives to redeem from MMFs. We explore the possibility that investors may redeem from MMFs during debt ceiling crises, not out of fear, but out of profit opportunities. Investors, confident that the debt ceiling would be lifted, may have shifted assets out of MMFs and directly into repo markets to take advantage of higher overnight rates on repos caused by the crisis."
They add, "We also ask whether outflows from MMFs during debt ceiling crises are better described as a flight-to-liquidity or as a flight-to-quality.... Finally, we provide some evidence on whether outflows from MMFs during debt ceiling crises arise from a first-mover advantage derived from the stable $1 net asset values (NAVs) MMFs offer their investors. An analysis of this type could help regulators to better understand disruptions in short-term markets during debt ceiling crises. This analysis could also help money fund managers prepare for future debt ceiling events."
The paper continues, "Our results indicate that MMF investors treat the risk of a U.S. federal default differently than they treat private credit events. Prior studies show that, during the 2008 financial crisis, institutional share classes of prime MMFs with higher yields and larger exposures to troubled securities experienced greater outflows while institutional share classes of government MMFs experience inflows. Thus, during private credit events, sophisticated investors appear capable and willing to monitor their funds' holdings and impose discipline on fund managers. However, using cross-sectional regressions, we observe no targeted response by investors during debt ceiling crises. Instead, outflows from funds with large Treasury exposures were no greater than outflows from other funds."
It tells us, "Funds' investments in Treasuries maturing near the date when a Treasury default would most likely occur (i.e., the "default window") had no significant effect on flows. Instead, redemptions were concentrated in funds with a higher proportion of institutional investors and a history of large flows (i.e., funds serving large-balance investors with greater liquidity needs). In other words, a fund's outflows during debt limit crises seem to be primarily a function of the liquidity needs of the clientele it serves. This result supports the theory that a substantial portion of the outflows were motivated by a flight-to-liquidity. Ironically, though, the flight was from the Treasury market, rather than to, as would normally be expected. This result also indicates that efforts by fund managers to reduce exposures to a potential Treasury default could be less effective than might be presumed."
The authors comment, "Investors also appear to have acted opportunistically during the 2011 and 2013 debt ceiling crises. Investors in MMFs took advantage of yield differentials between repos and MMFs during the debt ceiling crises. Simulations indicate that a quarter of the outflows from prime MMFs during the two crises can be attributed to yields available in repo markets, as opposed to direct concerns about the impact of a federal default. Thus, by shifting assets into overnight repos (which are often collateralized by Treasury securities), a non-negligible portion of investors may have wagered that the debt ceiling crises would be resolved without a default.... Finally, we observe no significant relationship between a fund's flows and its market valuation. This finding indicates that investors are motivated to redeem during debt ceiling crises primarily by the desire to maintain the liquidity of their principal rather than by concerns about the actions of other investors. This result has policy implications since it suggests that, even in a variable NAV setting, MMFs would experience outflows during debt ceiling crises."
In their conclusion, they write, "In both 2011 and 2013, the U.S. faced the very real prospect that a legislative impasse on the federal debt ceiling could lead to a federal default. During both crises, short-term market participants reacted. Treasury yields and repo rates moved upward while corporate bond spreads fell. Investors also reduced their investments in prime and government money market funds.... Our study, the first of its kind, focuses on U.S. debt ceiling crises and evaluates the factors motivating investors to redeem from both prime and government MMFs during these periods."
Finally, Gallagher and Collins add, "Our results illustrate how uncertainties generated by U.S. debt ceiling crises drive investors with substantial liquidity needs to redeem from MMFs. These redemptions cannot be fully explained by differences in fund portfolio holdings, fund market values, or by other contemporaneous macro-financial changes. Thus, our findings are consistent with the theory that investors are primarily motivated to redeem by concerns that a Treasury default might temporarily limit access to their liquid balances. Large institutions with the greatest liquidity needs appear to gravitate toward those investment types they perceive to be most liquid. Evidence suggests that these results are not unique to stable value short-term investments pools, like MMFs. Since MMF investors must essentially choose each day whether to rollover their shares (i.e., continue to invest in the fund) or not (i.e., redeem), the reactions of MMF investors may speak to the broader behavior of short-term market participants."
