Money market funds pose risk during crisis

There are two potential big problems:

  • If a big dealer has to dump a bunch of securities, it will flood the market, which decreases the price of those securities. Other investors who also own those securities will see their account values go down, potentially triggering margin calls, which initiates another round of sell-offs, pushing the price down further.
  • If a money market fund has loaned money through the tri-party repo market and the counterparty to the transaction stumbles and can't repay, the money market fund has to sell the securities. Money market funds are barred from owning long-dated securities or risky investments, so they can't hang onto the collateral in the deal.

"You may not have an option. You would have to fire sale them unless you have a different source of funding. That is another source of fire sale risk," says Duffie.

Money market funds bridge 2 worlds

In 2008, money market funds ran into trouble on both ends, with investors in the funds and with their investments. On the wholesale side, exposure to bad commercial paper from Lehman Brothers sparked the fire sale. As the crisis unfolded, institutional investors rushed to take their investments out of money market funds. In order to meet the massive amount of redemptions, money market funds had to sell more securities, adding to the fire sale dynamic already in progress.

One money market fund went under -- Reserve Primary Fund -- but it wasn't the only money market fund affected. Recent reports by Moody's and the Federal Reserve Bank of Boston have found that at least 21 and as many as 36 prime money market funds were in danger of breaking the buck but were propped up by their sponsor or parent company. For the first time ever, the U.S. Treasury stepped in to guarantee the value of money market funds at $1 per share. U.S. taxpayers essentially insured $2.4 trillion in money market funds.

"It was the first time in the history of the country that the Treasury put the full faith and credit behind a single product and single industry and it did it within 48 hours of the problem appearing. That is because the money market fund industry, along with the repo market, funds so much of the short-term financing market for the big dealer banks and the commercial paper markets," says Kelleher.

To prevent this from happening again, the FSOC report recommended that money market funds institute floating net asset values rather than hewing to the artificial but stable $1 per share. The funds should also be required to have capital buffers to absorb redemptions and could impose a delay on redemptions over a certain dollar amount in a crisis.

The Securities and Exchange Commission, or SEC, recently proposed several measures in line with those recommendations but they fall too far short of the mark to be useful, according to critics.

For instance, the goal behind the stable NAV is to recast the way investors consider the risk of investing in money market funds, but it won't make the system more stable.

The limits on redemptions, or gates, in a crisis could be useful but, "It's discretionary. It's based on a vote of the board. By the time they get together the run will be over," Kelleher says.

The most effective answer to stopping runs was a political nonstarter.

"Deposit insurance: It has stopped runs since the 1930s by 100 percent. If you want to stop a run in the money market fund market, let's do what we know is 100 percent effective," says Kelleher. "The industry fought that because the few basis points' advantage they have over bank products would be erased and the product would die."

The system failed in spectacular fashion during the financial crisis. New rules and regulations have tempered the most dangerous aspects of the financial markets to some degree, but more work lies ahead.


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