As we mentioned in our Oct. 15 Link of the Day, the Investment Company Institute published "The Impact of COVID-19 on Economies and Financial Markets. Last week, we quoted from the press release, "ICI: Pandemic and Economic Shutdown Drove Financial Turmoil in March," but today we excerpt from the full report. The ICI writes "The Report of the COVID-19 Market Impact Working Group is being issued under the auspices of the Investment Company Institute's COVID-19 Market Impact Working Group. This group of senior industry executives is examining the causes of the 2020 market turmoil and the experiences of regulated funds. The report is intended to provide a sound, data-based foundation for any future regulatory discussions or other responses that could affect regulated funds and their investors. The report was written by a team from ICI's Research, Law, Industry Operations, and ICI Global groups." Among the "Forthcoming Publications of the Report of the COVID-19 Market Impact Working Group," is one named, "The Experience of US Money Market Funds." (See also the FT's "EU sets sights on money market fund reform".)

ICI's Introduction tells us, "The key to understanding financial market developments in early 2020, and in turn to understanding flows to RICs, is to recognize that the COVID-19 pandemic is first and foremost a public health crisis. Governments sought to contain the spread ... through massive, mandated social distancing that effectively shut down a large portion of economies across the globe.... In the aftermath of the COVID-19 crisis, policymakers will no doubt consider whether and how to bolster the financial sector's resilience to massive shocks. But solutions must be relevant to the problems they seek to address. Reforms relevant to the global financial crisis -- which stemmed from a credit crisis caused by the collapse of a housing market bubble -- may or may not be appropriate for a financial crisis that stems from a global pandemic."

Discussing the "Reaction of Money and Bond Markets," ICI explains, "The early effects of the COVID-19 health crisis, and of shuttering parts of the economy, were reflected most dramatically in the bond and short-term credit markets in March. These markets came under severe stress, which resulted in widespread dislocations, beginning in the Treasury market -- normally a safe haven in times of market stress. These pressures migrated to mortgage backed securities (MBS) and short-term funding markets, and finally spilled over into the other credit markets (commercial paper, investment grade bonds, municipal securities, securitized debt, and high-yield bonds)."

They continue, "The impetus for these stresses was a tremendous demand for liquidity -- cash -- in the face of uncertainty about how devastating the virus would be and how the economy would fare. Short- and long-term credit markets froze. Sellers seeking liquidity found it difficult, if not impossible, to find buyers in any reasonable size for even very high-quality credits. At root, these developments were a reaction to the pandemic and the strains that social distancing and government mandates put on the real economy. Market observers correctly note that these strains were amplified by varied and complex interactions and factors in the financial markets. This section reviews factors that are especially germane to the experiences of RICs in March."

The report states, "As the COVID-19 crisis progressed, questions naturally arose about whether businesses, households, and municipalities would be able to pay their bills. Commonly, during financial or economic crises, investors seek to counterbalance uncertainty by flocking to 'cash.' Businesses, households, and municipalities are more likely to pay their bills if they have a reservoir of cash. In March, therefore, 'cash was king.' Normally, Treasury securities -- even longer-dated ones -- would be considered safe investments from a credit perspective, and investors generally are more willing to hold them during a crisis. But longer-dated Treasuries are not cash; their value will fluctuate with changes in interest rates. When interest rates on longer-dated Treasuries rose in early to mid-March, the value of these Treasury securities fell, which may have prompted selling by some market participants looking to lock in profits."

Then the "Crisis Spread to Short-Term Credit Markets," says the publication, commenting, "Dislocations in the Treasury market spread to the interbank lending, commercial paper, wholesale deposits, and short-term municipal debt markets. Once again, the fundamental reason was the virus and the fear and uncertainty it created. As noted earlier, when investors are fearful, they flock to cash. In normal times, high-quality investments -- consisting of short-term Treasury and agency debt, commercial paper, and other instruments with a maturity of less than 90 to 360 days, in addition to some overnight holdings—are often considered to be sufficient to maintain appropriate levels of liquidity. During March, however, investors' perceptions of what constituted liquid investments were far narrower: only true 'cash' -- securities that mature overnight, or perhaps within seven days -- was acceptable. This posed additional challenges for borrowers in terms of 'rollover risk,' especially in the commercial paper market."

ICI tells us, "The commercial paper market is an important source of short-term credit for a range of financial and nonfinancial businesses. Commercial paper is generally very high quality and can either be unsecured or, in the case of asset-backed commercial paper (ABCP), secured with other debt such as credit card receivables or auto loans. At year-end 2019, commercial paper outstanding in the United States totaled a little more than $1 trillion.... The ... four main issuers of commercial paper [include] Nonfinancial firms [and] Financial firms such as banks, especially foreign banks doing business in the United States.... Financial issuers also may issue commercial paper to fund auto, credit card, or home-equity lending to US consumers. A range of entities purchase commercial paper.... Nonfinancial corporations are the largest single holders at $246 billion (24 percent). Money market funds hold $237 billion (23 percent), and other open-end funds (mutual funds and ETFs) hold $103 billion (10 percent). Thus, RICs (money market funds, mutual funds, and ETFs) in total account for about one-third of the market. Other large holders include foreign entities (rest of the world, $130 billion, 12 percent), and other financial businesses ($101 billion, 10 percent). Municipalities (state and local governments) and state and local retirement plans hold a combined $128 billion (12 percent)."

The report comments, "As in other fixed-income markets, intense pressures arose in the commercial paper market in March.... Dislocations in the Treasury market seem to have spilled over into the commercial paper market.... Concerns about investors' willingness to buy newly issued commercial paper added to pressures in the commercial paper market. Most commercial paper is of very short maturity, typically 90 days or less. When these short-term loans mature, issuers often replace, or roll over, the maturing paper with newly issued commercial paper. This generally works well in normal times. During periods of stress, however, if there are no buyers for newly issued commercial paper, the issuer may have to tap bank lines of credit, issue term corporate bonds -- which have higher interest expense than commercial paper -- or even sell assets in order to have an appropriate level of cash on hand."

It adds, "Market participants' concerns were evident in March. Discussions with ICI members indicate that RICs holding commercial paper maturing in more than seven days could not find buyers for that paper, even if the issuers were of the highest quality. At the same time, issuers could only roll over overnight or perhaps seven-day commercial paper, adding to the mounting pressure in the commercial paper market. In such circumstances, it would not be surprising for investors (including RICs) to demand higher yields on longer-dated commercial paper.... In addition, ICI member firms believe that banks' needs to preserve their own cash may have contributed to difficulties in the commercial paper market.... Banks' actions are understandable, given the stresses they faced, notably the need to preserve cash to support draws on credit lines. But difficulties in the commercial paper market in March reflected complex interactions and interconnections in the financial system, rather than the actions of any particular group of market participants."

ICI also writes, "Like the commercial paper market, dislocations occurred in the market for short-term municipal debt.... Dealers' holdings of VRDNs, like their increased inventories of Treasury securities, may have added additional market stress. When an investor puts back a VRDN to a bank, or its dealer subsidiary, the bank may seek to resell the VRDN to another investor. If it cannot find a buyer, it will take the VRDN into its inventory. Federal Reserve data indicate that primary dealers took large amounts of VRDNs onto their balance sheets in mid-March as investors exercised demand features."

The report also explains, "Recognizing that further measures were necessary to provide liquidity to the short-term credit markets, on March 18 the Federal Reserve established the Money Market Mutual Fund Lending Facility (MMLF). This facility, which began operating on March 23, would lend to banks that acquired US Treasury and agency securities and highly rated commercial paper from money market funds, including those that banks purchased beginning on March 18.... The terms of the MMLF were flexible, increasing the chances that the facility would strongly supplement the PDCF and CPFF.... Additionally, on March 19, the Federal Reserve provided relief from certain regulatory capital requirements to banks that borrowed under the MMLF, indicating that the Federal Reserve recognized that bank capital standards were indeed restricting the flow of credit."

Finally, the ICI writes, "The Federal Reserve's actions were timely, creative, flexible, and necessary. The probability was high that had the Federal Reserve (with the support of Congress and backing from the US Treasury) not undertaken these actions, the financial markets, and thus, the economy would have collapsed. In recent remarks, Federal Reserve Bank of New York President and CEO John C. Williams underscored this very point [saying], 'Despite our best efforts, we should not fool ourselves that we can design a system that is bulletproof against every circumstance. The events of the past year have demonstrated the critical role central banks can and must play in extraordinary times when market stress and dysfunction threaten to spill over into the economy. No private institution has the ability to provide liquidity at the speed or scale that the Federal Reserve and other central banks have this year. [T]he Federal Reserve System was originally created to ensure the stability of the financial system. That role is as relevant today as it was 107 years ago and will continue to be in the future.' Under the circumstances -- namely the widespread dash to cash sparked by concerns about the economy and the vast uncertainty about how events would progress -- the Federal Reserve (in conjunction with other major central banks) was the only entity capable of providing the necessary liquidity."

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