In a speech Friday entitled, "Money Market Mutual Funds and Stable Funding," Federal Reserve Bank of Boston President & CEO Eric Rosengren unleashed a(nother) broadside against money market mutual funds at the "Conference on Stable Funding," sponsored by The Federal Reserve Bank of New York and the Fed's Office of Financial Research. His speech says, "As you all know, we recently passed the five-year anniversary of the failure of Lehman Brothers. This conference is particularly appropriate because many of the issues surrounding stable funding, so relevant in the crisis, sadly remain with us today. Indeed, one of the hallmarks of the 2008 financial crisis was the severity of runs on financial intermediaries that were not traditional depository institutions. During these runs, the inability to obtain short-term funding meant that broker-dealers could not finance their securities portfolios. Similarly, Structured Investment Vehicles (SIVs) and other structured financial entities could not obtain rollover financing. And as you well know, in the wake of the Lehman failure, the Reserve Primary Fund was unable to maintain a fixed net asset value (NAV). Investors who were concerned that other funds with exposure to Lehman might not be able to maintain their NAVs ran from prime money market mutual funds (MMMFs)."
Rosengren explains, "Many of the structural weaknesses that lie beneath these run episodes have yet to be fully addressed by market participants and policymakers. It is good that they will be discussed in various sessions at today's conference. Given that our time is limited, I will focus my remarks on MMMFs and, given the conference themes, the critical role that MMMFs play in short-term credit markets, providing funding to financial intermediaries. I will first describe how prime MMMFs contributed critically to the financial instability experienced in the fall of 2008 instability that necessitated substantial government intervention, including providing insurance for MMMFs, tailoring an emergency lending facility to provide liquidity for MMMFs, and providing a variety of other emergency liquidity facilities -- in part as a result of the "collateral damage" throughout the financial infrastructure stemming from the run on MMMFs. I would stress that these actions were taken not to prop up the financial infrastructure per se, but rather to ensure funding flows that are crucial to real economic activity."
He continues, "Second, I will describe some of the challenges posed by the structure of MMMFs, which necessitated the Securities and Exchange Commission's (SEC's) 2010 reforms to Rule 2-a7 as well as the Commission's current proposal on money market mutual fund reform. In this, I will draw heavily from the joint letter sent by all 12 of the Federal Reserve Bank presidents in response to the SEC's request for comment. I would like, however, to stress that while many of my comments will draw from that comment letter, my remarks today are my own and do not necessarily reflect the views of my colleagues at the Board of Governors, or the other Reserve Bank presidents who signed the letter."
Rosengren's speech adds, "Third, I will discuss what I see as some needed enhancements to the SEC proposal. I will conclude that the floating NAV proposal, properly implemented, would enhance financial stability; but the proposal to allow discretionary liquidity fees and redemption gates would not enhance financial stability -- and would likely be worse than the status quo."
He says of "Money Market Mutual Funds during the Crisis," "Figure 1 shows total MMMF assets under management, which currently total approximately $2.6 trillion. These assets are distributed across funds that buy short-term, tax-free municipal securities (approximately $265 billion in assets), funds that buy short term government and agency securities (approximately $890 billion in assets), and funds that purchase short-term corporate and financial debt instruments as well as government and agency securities. The latter, the so-called "prime" money market mutual funds, represent about 56 percent of total MMMF assets (about $1.5 trillion)."
Rosengren writes, "Figure 2 shows the assets under management for all MMMFs, and separately for just the prime money market funds. As you can see, MMMFs grew rapidly during the period leading up to the financial crisis, but experienced a significant outflow when the failure of Lehman Brothers led the Reserve Primary Fund to "break the buck" (becoming unable to maintain a fixed $1 per share net asset value). As it became apparent that some prime funds were exposed to non-trivial amounts of credit risk, and with investors in the Reserve Primary Fund unable to access their money and facing uncertain losses, investors in other prime MMMFs began to quickly redeem their funds. In the week after the Reserve Primary Fund announcement, more than $300 billion dollars "ran" from prime funds. At least some of the funds redeemed from prime MMMFs were reinvested into government MMMFs, as investors sought funds that did not take credit risk. Of course, others transferred deposits to insured depository institutions."
He says, "The run on prime MMMFs would likely have been much more severe and disruptive had the Treasury not announced a temporary guarantee program, which provided insurance to money fund investors, and had the Federal Reserve not set up an emergency lending facility that provided needed liquidity to MMMFs experiencing (or concerned that they might soon experience) significant withdrawals. These unprecedented government actions were designed to provide confidence to investors to stem the outflows from prime funds. But they were also intended to stabilize the short term funding markets, because the dramatic reduction in money fund assets meant that money market funds withdrew from their role as significant purchasers of short-term debt instruments -- an activity critical to the functioning of short-term credit markets and the provision of stable funding within the financial system."
Rosengren also says, "Figure 3, which shows the current composition of prime money market mutual funds, highlights why these entities are so critical to the provision of stable funding. MMMFs continue to provide important liquidity for short-term debt instruments, such as commercial paper, asset-backed commercial paper, and short-term debt obligations. As I have suggested, one reason that short-term credit froze up in the wake of Lehman's failure was that money market funds were not able to continue purchasing such debt, which slowed the flow of critical stable funding within the "financial ecosystem." The result was that the Federal Reserve needed to provide liquidity not only to MMMFs directly, but also to markets where MMMFs were usually an important source of financing. By the way, it is worth noting that both the temporary guarantees provided by the Treasury and the type of liquidity facility run by the Federal Reserve are now essentially ruled out (by the Emergency Economic Stabilization Act, and by Dodd-Frank provisions). Thus, if MMMFs were to again experience a significant run, short-term credit markets could not rely on the same degree of government support, and might find the shock to stable funding to be even more disruptive."
He asks, "So where are we now? Currently we have new limitations on public-sector safety nets for MMMFs. We have the still-remaining risk of a significant disruption to short term credit markets, were MMMFs to again experience runs. As a result, there are reasons to remain concerned about credit risk some MMMFs may be taking. One possible source of risk is highlighted in Figure 4, which shows the European exposure of MMMFs. Roughly one-third of the assets held by prime MMMFs are related to European firms. Of course, there are many European firms with low credit risk, but if some MMMFs get more comfortable with riskier European exposures, the financial system becomes more susceptible to a financial shock emanating from Europe."
Rosengren adds, "Figure 5 shows the reduction in MMMFs' exposure to commercial paper and asset-backed commercial paper since the financial crisis. The decline, in part, reflects the low-interest-rate environment, which has led many firms to issue longer-term debt. It also reflects the fact that many markets that relied on asset-backed financing still have not recovered. However, money markets remain an important source of financing for these instruments."
He explains, "In summary, I would say that prime MMMFs remain a very important source of financing for short-term debt instruments -- and thus any disruption in the MMMF sector could again impede the provision of stable funding to financial intermediaries. Many of the tools used to offset the 2008 run by MMMF investors have been ruled out by legislation. And once again, some MMMFs are beginning to take riskier positions. Thus, the financial stability concerns surrounding MMMFs remain real, five years after the financial crisis."
On "Money Market Mutual Fund Reform," Rosengren writes, "Reform remains critical because MMMFs implicitly promise to return a fixed net asset value [sic], even as they take credit risks against which they hold no capital. A failure to keep this implicit promise during a future period of financial turmoil could risk once again freezing short-term credit markets. The Financial Stability Oversight Council (FSOC) has proposed three potential reforms, with the one requiring MMMFs to hold capital quite similar to proposals currently being considered in Europe. However, at this time the SEC has advanced only two proposals, only one of which was included in the FSOC proposals."
He continues, "The first SEC proposal, which was suggested by the FSOC, would treat institutional prime MMMFs like other mutual funds and allow the value of a share of the fund to float with the value of its underlying assets. But unlike the FSOC's proposal, the SEC's proposal limits this reform option to institutional prime MMMFs (funds serving institutional investors). The incentive to run on a MMMF stems from the concern that a fund could suffer credit or other losses and would be unable to redeem shares at its "fixed" net asset value. In that case, the first investors to ask for their funds back will get them, while later investors may not."
Rosengren writes, "The second SEC proposal, which was not suggested by the FSOC, would require the fund's directors to impose a fee of not more than 2 percent on all redemptions in the event that the fund's weekly liquid assets fell below a specified threshold. The proposal, however, gives the fund's directors discretion to impose a lower fee or no fee if they determine that such action is not in the best interest of the fund. This liquidity fee is intended to discourage investors from redeeming funds at a time when the MMMF is experiencing significant withdrawals. Additionally, under the proposal the fund's directors could, at their discretion, impose temporary "gates" to prevent redemptions for a time. These temporary redemption gates would, the proposal envisions, prevent investors from redeeming funds -- thus ending an investor run."
Finally, he says, "In summary and conclusion, I would stress that MMMF reform is overdue. However, it is important that the reforms actually reduce the financial stability issues that remain under the current structure. Promising a fixed NAV with no capital while taking credit risk is not sustainable -- especially in potential future crises where the response of the public sector will be substantially limited, compared to 2008. MMMF runs should not be allowed to once again impede the flow of stable funding within our financial system. The SEC proposal to allow funds to impose liquidity fees and redemption gates should be dropped. This particular proposal is, in my view, worse than the status quo. It would only increase the risk of financial instability. However, I strongly support requiring a floating NAV for all prime funds, both institutional and retail, which would treat these funds like other mutual funds. Investors who want a fixed NAV can keep their funds in government-only funds -- and those should have the vast majority of their portfolios invested in cash and government securities."
