Wells Fargo Money Market Funds' latest "Portfolio Manager Commentary" looks back at the financial crisis and what has changed in the decade since. Jeff Weaver, et. al., write "'Surveying [what's left of] the landscape,' That's how we titled the overview section of our September monthly commentary published 10 years ago. September 2008 was a seminal moment in the money markets. Following months of stresses in various sectors of the financial markets, the crisis hit home with a vengeance when Lehman Brothers declared bankruptcy on Monday, September 15, 2008. In its wake, a run began on money market funds, culminating with the Reserve Primary Fund, the nation's first and oldest money market fund, breaking its one-dollar net asset value (NAV), becoming only the second to do so since the Community Bankers money market fund in 1994. What began as a credit crisis quickly transformed into a crisis of liquidity and confidence, with markets seizing up and issuers unable to roll their maturities."
They explain, "By month-end, we noted that: '[t]he financial landscape ... was barely recognizable after the bankruptcy of Lehman Brothers; the rescue of AIG; government aid to Fannie Mae and Freddie Mac; sales of Merrill Lynch to Bank of America and Washington Mutual to JPMorgan; and the reformation of Morgan Stanley and Goldman Sachs as bankholding companies.... The Federal Reserve, along with other central banks, actively deployed a veritable cornucopia of acronyms in an effort to inject liquidity into the system and shore up investor confidence.'"
Wells says, "While we suspected it would take some time for the markets to stabilize and heal, in retrospect we did not really expect the process would last as long as it did. The global financial crisis, as it is sometimes called, ushered in an era of regulatory reform affecting issuers and investors alike. In response, the U.S. Securities and Exchange Commission (SEC) amended the rule governing money market funds twice -- the first in 2010 and the second in 2014 (with an implementation date of 2016). These amendments fundamentally altered the structure of money market funds; at the same time, regulatory efforts affecting issuers led to changes in the composition of investable assets. The end result is that the landscape as we knew it is markedly different today."
On the government sector, they tell us, "Although it seems odd to suggest it, at the most basic level the U.S. government money markets function in much the same way as they did prior to the financial crisis. They continue to provide a forum for investors seeking short-dated, historically stable investments to transact with the U.S. government (and its agencies), which need to borrow to finance their operations. In addition, the money markets facilitate the government's longer-term financing by providing a way for broker/dealers and other investors to finance their purchases of U.S. Treasury securities in the repurchase agreement (repo) market. That said, while the basics remain the same, many of the market's particular features have changed at least a fair amount."
Wells' latest update comments, "The backbone of the money markets is the U.S. Treasury bill (T-bill), the rates on which are the starting point for everything else. Ten years ago, there were $1.5 trillion in T-bills outstanding, as the amount issued was in the process of roughly doubling during the heat of the crisis as the government funded its various rescue programs. Today, there are just over $2.2 trillion outstanding, with much of that increase having taken place in the past two years."
It tells us, "Some of the consequences of the crisis took a while to arrive. Money market fund reform was riding in the back of the reform family's van asking, 'are we there yet?' seemingly forever. Finally, eight years after the crisis erupted, the final round of money market fund reform took effect in 2016, with one result being the wholesale transfer of assets from the prime and municipal spaces into government money market funds. Although higher T-bill balances boosted supply, the increased demand due to the growth of government and Treasury money market funds from around $1.2 trillion at the beginning of 2016 to over $2.2 trillion today represents probably the single biggest impact on the government money markets from the crisis. For comparison, before the crisis, in mid-2007 those funds' assets totaled about $450 billion."
Regarding the prime sector, Wells states, "There are many factors that led to the global financial crisis, and where you sat likely influenced what you felt was the overriding cause. Among those advanced, either individually or in some combination, are: Consumers over-levered their homes; Investment banks packaged these loans and sold them as short-term securities; Banks financed illiquid loans in the unsecured markets; Ratings agencies rated the securities AAA; Banks used repos to increase leverage and improve profit margins; and, Shadow banking systems operated outside regulatory frameworks. These are only a few of the commonly reported causes and there are undoubtedly far more. The bottom line is the financial crisis highlighted how interconnected the financial markets are and how a credit event like the bankruptcy of Lehman Brothers morphed into a liquidity event that shook all financial markets and shaped regulatory reform for the next decade."
The monthly outlook adds, "The structure, size, and stability of prime funds has changed dramatically since the financial crisis. Prime money market funds had always been categorized as cash for reporting purposes and carried a stable Net Asset Value (NAV). Prior to the financial crisis, the portfolio characteristics of prime funds varied greatly by fund family as the SEC guidelines offered only a generic framework within which to manage funds.... Prime money market funds were not required to publicly disclose portfolio holdings outside of semi-annual reports and only reported a shadow NAV twice per year to the SEC. There were no requirements to perform stress tests or to conduct a know-your-customer review to better manage shareholder and market risk."
It also says, "The 2010 amendment to Rule 2a-7 -- the rule governing money market funds -- addressed many of the pressing issues resulting from the credit crisis. The reform made wide-sweeping, industry-changing requirements that were aimed at addressing the portfolio construction and risk management processes for money market funds and changed the management of such funds. It required money market funds to maintain specific daily and weekly liquidity targets to ensure adequate coverage for possible redemptions. In order to shorten credit exposures and reduce portfolio risks, the SEC reduced the maximum allowable WAM to 60 days and introduced the WAL, limiting it to 120 days."
Wells explains, "While market participants largely considered these measures successful in addressing some of the issues leading to the 2008 financial crisis, the SEC felt they had not gone far enough. In 2014, they amended Rule 2a-7 again to require certain money market funds to trade at a four-digit NAV and to take specific action in the event their liquidity was impaired. These additional reforms were put in place to remove the stable NAV for institutional nongovernment funds and to reduce the incentives for a run on money market funds if a credit issue occurred. While prior to these reforms money market funds always had the ability to halt or delay redemptions in case of a negative event, now a specific trigger and decision tree around it was introduced for these funds. The SEC also gave funds the option to impose a redemption fee instead of gating a fund during a crisis. Shareholders reviewed this new rule and decided to transfer roughly $1 trillion from prime money market funds to government money market funds, which still offered a stable NAV and did not have a fees or gates requirement."
They add, "The decision for investors to switch strategies from prime to government and adopt a wait-and-see outlook was fairly easy at the time. With the Fed's extremely accommodative monetary policy maintaining debt markets in a zero rate environment, the incremental yield differential between the two types of funds was minimal. But, as the FOMC began removing accommodation, the yield differential between government and prime money market funds widened and the four-digit NAV volatility remained muted, leading potential shareholders to begin reexamining the prime product."
Finally, they tell us, "Investors reexamining this product are realizing the changes from the 2010 reform have made a material difference in the construction of prime money market fund portfolios. The added liquidity requirements and maturity restrictions have had a beneficial impact on dampening NAV volatility even as the FOMC continues to raise rates, as well as in the face of widening credit spreads in March resulting from additional T-bill supply and possible repatriation of offshore assets. In addition, the transparency of holdings provides a daily view of the portfolio construction process and allows shareholders to assess the risks in the portfolios."
