Marco Cipriani, Michael Holscher,* Antoine Martin, and Patrick E. McCabe**
On September 16, 2008, Reserve Primary Fund, a money market fund (MMF) with $65 billion in assets under management, announced that losses in its portfolio had caused the value of shares in the fund to drop from $1.00 to $0.97. The news that an MMF had “broken the buck” spread panic quickly to other MMFs. In the two days following Reserve’s announcement, investors withdrew approximately $200 billion (10 percent of assets) from so-called “prime” MMFs, which, like Reserve, mainly invest in privately issued short-term securities. The massive redemptions and resulting strains on MMFs contributed to a freezing of the markets that provide short-term credit to businesses and financial institutions and a sudden spike in short-term interest rates. Responding to these severe disruptions, the Treasury Department intervened on September 19 with a government guarantee of the value of MMF shares, and the Federal Reserve announced on the same day a facility designed to provide liquidity to MMFs. These unprecedented actions stopped the run on MMFs (for more analysis of the run in 2008, see McCabe, 2010). In this post, we discuss why MMFs are a source of financial fragility and the need for reforms to mitigate the risks they pose to the financial system and the economy.
Since 2008, policy makers, MMF industry participants, investors, and academics have considered options for reducing the vulnerability of MMFs to runs and limiting their contribution to systemic risk. Developments since the crisis have heightened the importance of these objectives. For example, Treasury’s authority to provide a guarantee to MMF shareholders—which was critical to stopping the run in 2008—was eliminated by legislation later that year. The European fiscal crisis has highlighted the need to mitigate MMFs’ vulnerabilities, as European holdings made up more than half of prime MMFs’ assets at times in early 2011. Meanwhile, institutional investors’ heightened responsiveness to MMF risks since 2008 probably has exacerbated the susceptibility of MMFs to runs.
The Popularity, and Vulnerability, of MMFs
Both the popularity of MMFs and their vulnerability to runs traces back, in large part, to their defining feature: MMFs usually maintain stable net asset values (NAVs), typically at $1 per share. Like other mutual funds, MMFs are regulated under the Investment Company Act of 1940. But MMFs also must follow SEC rule 2a-7, which imposes strict guidelines on their assets, while allowing them to employ pricing methods that help hold NAVs steady even when there are small changes in the values of MMFs’ underlying assets.
The resulting stability of MMF share prices, combined with the liquidity investors enjoy in a product that allows redemptions (at least) daily, has made U.S. MMFs a very popular financial product for institutional and retail investors alike. Investors use MMFs for cash management, and with $2.7 trillion in assets under management at the end of 2011, MMFs represent about a quarter of all U.S. mutual fund assets. MMFs deploy investors’ cash to provide short-term funding for financial institutions, other businesses, and governments, and the funds play key roles in short-term credit markets. For example, MMFs owned over 40 percent of U.S. dollar-denominated financial commercial paper outstanding at the end of 2011 and about one-third of dollar-denominated negotiable certificates of deposit.
But MMFs’ stable NAVs and the methods used to keep them steady in normal times also make the funds susceptible to runs in unusual times, and these runs pose broad systemic risks. In part, these risks arise because the historical record of MMFs keeping NAVs steady (only two money funds have “broken the buck” since 1983, when the SEC adopted rule 2a-7) has attracted a large, highly risk-averse shareholder base that includes many institutional investors. These shareholders reportedly place great value on principal stability and are prone to fleeing money funds quickly at any sign of trouble. Importantly, because of the sheer size of the money fund industry and its importance in providing short-term funding to financial institutions, MMFs’ vulnerability to runs not only puts their investors at risk, but also poses considerable systemic risk to the U.S. financial system, as was observed in the fall of 2008.
Although the stable NAV is critical for many MMF investors, no capital buffer protects a money fund’s $1 share value. Instead, MMFs usually have relied on the SEC’s risk-limiting rules for portfolio holdings and on rounding of their NAVs to the nearest cent, as permitted under those rules. But NAV rounding can create dangerous dynamics when a fund is in trouble: If a MMF has incurred a small loss (less than 0.5 percent of assets), it can continue to redeem shares at $1 apiece. However, by doing so, the fund concentrates the loss over a shrinking number of shares. Redeeming shareholders get $1 per share, while those who stay invested see their potential losses grow. Clearly, under such circumstances, shareholders have strong incentives to run.
In addition, MMFs’ liquidity management practices, while they contribute to principal stability, also increase investors’ incentives to run from the funds. MMFs meet redemptions by selling their most liquid assets, rather than selling a cross-section of all of their holdings. This practice allows an MMF to avoid realizing losses from sales of less liquid securities and, as long as all investors do not redeem at once, effectively provides shareholders with more liquidity than they would have individually. But during periods of market strain, when less-liquid assets may sell at deep discounts, redeemers who receive $1 per share bear none of the implicit liquidity costs of their redemptions. Rather, remaining investors are left with claims on a less-liquid portfolio. For this reason, shareholders have an incentive to run from troubled money funds as they leave behind risks and costs to be borne by those who remain invested in the fund.
Historically, when all else has failed, MMF sponsors (asset management firms and their affiliates) have voluntarily provided support—when they have had the wherewithal to do so—to prevent shareholder losses. Indeed, sponsor support has been crucial for MMFs’ apparent price stability. For example, the SEC documented 100 cases in which MMFs received support from sponsors during the 2008 crisis alone (see “Money Market Fund Reform: Proposed Rule“). Notwithstanding language in MMF prospectuses stating that the funds’ shares are risky, sponsor support probably has led many investors to view MMFs as safer than their underlying assets and thus has attracted highly risk-averse investors. Yet, sponsors are not required to demonstrate an ability to support MMFs, and no capital requirements or other rules ensure that money will be available during crises to hold NAVs at $1. So, if investors doubt the ability of a sponsor to prevent losses, they have strong incentives to redeem shares before others do. In September, 2008, Reserve’s announcement that its MMF had broken the buck evidently undermined investor confidence that sponsors would provide support and sent MMF shareholders running for the exits.
In a run, investors who are left behind are most likely to suffer losses, so the first sign of serious strains for an MMF or its sponsor—or worries that other shareholders think there is a problem—may be enough to trigger a run. Moreover, retail investors, who historically have been slower to redeem shares than institutional shareholders during crises, may be at risk of shouldering a disproportionate share of any MMF losses. During the run in 2008, redemptions by institutional investors accounted for over 90 percent of outflows from prime funds. For further discussion of the vulnerability of MMFs to runs, see the Report of the President’s Working Group on Financial Markets-Money Market Fund Reform Options.
How to mitigate the vulnerability of MMFs to runs? In January 2010, the SEC strengthened rule 2a-7 by requiring that MMFs hold substantial amounts of highly liquid assets, shortening the maximum average maturities of MMF portfolios, limiting holdings of certain risky assets, and mandating monthly disclosure of portfolio holdings. The new rules made MMFs more resilient to strains, including heavy redemptions and changes in interest rates. But SEC Chair Mary Schapiro made clear in a speech, even as the new rules were announced, that more was needed. In particular, MMFs can still take risks similar to those that destroyed the Reserve Primary Fund and triggered the damaging run in 2008: MMFs still use the same set of tools, including rounded NAVs, to maintain principal stability; and investors still have ince
ntives to run at the first sign of trouble. Thus, the SEC’s current efforts to modify the structure of MMFs to reduce incentives to run may be essential not only for protecting MMF investors—especially retail investors—but also for protecting the stability of the U.S. financial system and maintaining the access of businesses, consumers, and governments to credit. In a future post, we intend to describe a proposal for improving the stability of MMFs by making them less vulnerable to runs.
*Michael Holscher is an officer in the Markets Group.
**Patrick E. McCabe is a senior economist with the Board of Governors of the Federal Reserve System.
The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.
Your post focusses exclusively on money market funds (MMFs) without proper context of all the upheavals in the markets. Much of your blog repeats the myth that a run on MMFs was the proximate cause of the crisis. Treasury Strategies believes this is incorrect and misdirects focus away from more significant causal factors. A $1.2 trillion run on non- MMF asset classes had already occurred during the 15 months preceding the chaos of mid-September 2008. Close examination of asset flows for the week of September 15 shows the firestorm was not triggered by the failure of MMFs, as is being widely cited. The firestorm was actually triggered by the surprise, late-night $85 billion government rescue of AIG. On the morning of September 15, Lehman Brothers declared bankruptcy. That evening, aware of AIG’s Lehman exposure, all three major rating agencies nonetheless issued investment grade ratings on AIG. Thus the 9 p.m. September 16 surprise $85B rescue of AIG (more than 100X the loss in the Reserve fund) sent global markets into a tailspin. Investors were shocked, not only by the sudden collapse of AIG but also by the fact that all three rating agencies had been completely wrong, just 24 hours earlier. Hence, they assumed problems lurked around every corner. That AIG rescue announcement panicked investors around the world, who then immediately fled all non-government guaranteed asset classes for the safety of government securities/government guarantees.