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Nicola Cetorelli, Fernando Duarte, Thomas Eisenbach, and Emily Eisner
On December 9, 2015, Third Avenue Focused Credit Fund (FCF) announced a “Plan of Liquidation,” effectively halting investor redemptions. This announcement followed a period of poor performance and large outflows. Assets at the fund had declined from a peak of $2.5 billion in May of 2015 to $942 million in November. Investors had redeemed more than $1.1 billion in shares since April 2015, and the fund’s year-to-date performance as of November had fallen below -21 percent. The FCF “run” highlights the need to quantify the potential for systemic risk among open-end mutual funds and the potential for contagion in the event of more widespread runs on other vulnerable funds. In this post, we first characterize open-end mutual funds that seem vulnerable to redemptions in much the same way as FCF. We then analyze the potential for fire-sale spillovers to other mutual funds if large redemptions in “at-risk” funds were to occur.
Nicola Cetorelli, Fernando Duarte, and Thomas Eisenbach
Update: A technical appendix has been added to the post.
According to conventional wisdom, an open-ended investment fund that has a floating net asset value (NAV) and no leverage will never experience a run and hence never have to fire-sell assets. In that view, a decline in the value of the fund’s assets will just lead to a commensurate and automatic decline in the fund’s equity—end of story. In this post, we argue that the conventional wisdom is incomplete and then explore some of the systemic risk consequences of investment funds’ vulnerabilities to fire-sale spillovers.
One of the lessons from the recent financial crisis is the need for securities dealers to have durable sources of funding. As evidenced by the demise of Bear Stearns and Lehman Brothers, during times of stress, cash lenders may pull away from firms or funding markets more broadly. Lengthening the tenor of secured funding is one way for a dealer to mitigate the risk of losing funding when market conditions are strained. In this post, we use clearing bank tri-party repo data to examine the degree to which dealers are lengthening the maturities of their sources of funding. (Aggregate statistics using these data are available here.) We focus on less liquid securities because it is for these assets that the durability of funding matters the most. We find substantial progress overall, with the weighted-average maturity (WAM) of funding of the less liquid securities more than doubling from January 2011 to May 2014. Nevertheless, there is currently a wide dispersion in dealer-level WAM, raising questions as to whether all dealers have enough durability in their funding of risk assets.
in the euro area periphery such as Greece, Italy, Portugal, and Spain saw
large-scale capital flight in 2011 and the first half of 2012. While events
unfolded much like a balance of payments crisis, the contraction in domestic
credit was less severe than would ordinarily be caused by capital flight of
this scale. Why was that? An important reason is that much of the capital
flight was financed by credits to deficit countries’ central banks, with those
credits extended collectively by other central banks in the euro area. This balance of payments financing was
paired with policies to supply liquidity to periphery commercial banks. Absent
these twin lifelines,
periphery countries would have had to endure even steeper recessions from the
sudden withdrawal of foreign capital.
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