Breaking the Buck—Reducing Systemic Risks Posed by Money Market Mutual Funds

By Jeanne Gobat

The breakdown of the short-term funding markets was one of the most striking features of the global financial crisis. Equally astonishing, and unexpected, was the central role that U.S. money market mutual funds played in contributing to this wholesale shut-down.

In our chapter on systemic liquidity risk in the October 2010 Global Financial Stability Report, we describe this aspect of the financial crisis and propose some concrete recommendations on how to fix it.

Following the bankruptcy of Lehman Brothers in the fall of 2008, financial institutions suddenly found it extremely difficult, if not impossible, to borrow short-term cash, even against assets that had relatively low risks. Some of the key investors into this short-term funding market—money market mutual funds—started leaving the market. Suddenly, these funds wanted higher margins on repurchase transactions and they wanted their asset-backed commercial paper to be backed by more secure collateral (i.e., cash reserves or other assets).

The source of these difficulties

This was because money market mutual funds were being squeezed as investors tried to withdraw funds en masse following Lehman Brothers’ bankruptcy. These withdrawals or redemptions were triggered in turn by the failure of the Reserve Primary Fund to maintain its “net asset value” (NAV) at par, or above the US$1 per share price. (Share prices falling below US$1 ―known as “breaking the buck”―can trigger massive redemptions (a run) as money market mutual funds are forced to sell their underlying assets at increasingly lower prices and realize losses.) These disruptions also affected many non-U.S. banks that relied heavily on the U.S. wholesale market to fund their dollar-denominated assets.

Almost overnight, it became painfully clear that no one really understood the central and systemic role of money market mutual funds in the financial system; not the market participants, nor the regulators. The U.S. government was forced to respond, taking extraordinary steps to stabilize the money market mutual fund industry.

Since then, a number of reforms have been put in place. These focus primarily on minimizing the risk of another run by investors. Money market mutual funds in the Unites States now face new rules designed to increase their ability to withstand redemption pressures. More specifically, the U.S. Securities and Exchange Commission modified Rule “2a-7 Funds” that governs mutual funds to impose constraints on asset quality, new liquidity rules, and restrictions on collateral acceptable for their repo operations.

While we believe that these measures will indeed lower the risk profile of the industry in the short term, they do not mitigate sufficiently the system-wide risks posed by this sector. As a general principal, we believe that financial institutions that contribute to systemic liquidity risk, and that offer typical banking services, should be set up and regulated as banks.

Options for addressing industry risk

One option would be for money market mutual funds to retain their bank-like business activity, but be re-licensed as banks. This would clearly require a substantial change in their structure, capitalization, and regulation.

An even better option, in our view, would be for these funds to move, over time, to a floating NAV. This would be a less fundamental change, and have several clear advantages.

  • First, it would make it clear to everyone that market risks are borne by the investor, in contrast to a bank deposit where there is a guaranteed return of principal, underpinned by public deposit insurance.
  • Second, this would remove any special treatment favoring money market mutual funds in the United States relative to commercial banks, thereby address concerns about a “level playing field.”
  • Third, it would help eliminate the “first-mover advantage”—a key factor behind destabilizing runs—whereby early redemption requests are paid at par, even if actual asset values are lower, leaving investors that do not rush for the exit bearing disproportionate losses.

The key idea is to provide a clear signal to investors that placements in money market mutual funds are different than deposits in banks. Armed with more accurate information about the risks, this should help ensure that money is not allocated to these funds under false pretenses. It would also reduce a systemic component of bank funding—posed by these funds—the next time a system-wide funding problem emerges.

One Response

  1. I agree with the recommendation, but differ on some of the facts.

    This problem did not occur suddenly when the Reserve Fund broke the buck, it was obvious since August 2007, more than a year earlier, when enhanced cash funds (which do have floating NAVs) were hit. The mystery is why no one prepared for the money fund crisis, just as no one prepared for the Lehman failure even after Bear went.

    Next, the federal government did not “have” to bail out money funds. They could have frozen them and liquidated them as Canada did with similar vehicles. At the very least, they could have offered to buy shareholders out at $0.95 on the dollar (calling back only a little over one year’s interest at the time) to make the point that these funds were not federally insured.

    On a related point, people were not fooled into thinking these funds were guaranteed. Everyone knew you could get an FDIC-insured account or get a higher rate in a non-insured money-market account. That was the deal and, by breaking it, the government destroyed any incentive for prudence.

    Finally, there were two different problems. There was a liquidity problem for funds with large investments in SIVs and conduits, and other structures packaging long-term risky assets into short-term, low-risk investments. Virtually all of these eventually paid off. You can argue they were imprudent for a money fund to hold, but the alternative was direct financial institution paper (there is negligible supply of non-financial money market paper other than T-bills, and investors always had the choice of treasury funds) which was objectively less safe.

    Anyway, right or wrong, that problem should not be confused with the wildly irresponsible purchase of Lehman Brothers commercial paper at 600 bp over LIBOR. No one can claim that was a reasonable investment at the time for a money market fund under any logic. It was a highly speculative yield play, betting the federal government would bail Lehman out (and it worked out for fund holders who got the benefit of the high yield, then had the government bail out their investments when they lost).

    The new rules for money market funds all address the first issue, which did not cause systemic problems, and fail to address the second, which did.

    A floating NAV goes a long way toward making things better. Since no one (including me) will believe a government declaration that money funds won’t be supported in future, the best alternative is to offer a voluntary government insurance program that pays off at $0.95 on the dollar. Most funds would elect not to pay the premium, which would be set at market rates, but the existence of the program would put a ceiling on bailout expectations.

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