Cast your minds back to August 2007, when money market funds were experiencing their first major crisis. It was far less sexy than what was to follow in September 2008 — when Reserve Primary notoriously broke the buck and sent money markets into panic — but it was one of the earlier manifestations of the credit crunch.
In 2007, as demand for Asset-Backed Commercial Paper (ACP) rapidly dissipated, the money market funds (MMFs) which invested in ABCP were rocked by credit and liquidity issues.
Both those MMF crises are the subject of a new Federal Reserve discussion paper, which takes a look at the relationship between the funds’ risks and “outcomes” during the turmoil.
Unsurprisingly perhaps, author Patrick McCabe finds that funds that earned relatively higher gross yields (an indicator of portfolio risk) were more likely to experience trouble during that 2008 MMF crisis. Reserve Primary, for instance, used to earn a yield lower than its average competitor. Once it began buying Lehman Brothers paper in the summer of 2007 however, its yield jumped to about 0.3 per cent above competitors’. These are big differences for the relatively conservative MMF industry, and investors did not fail to notice Reserve’s outperformance. Between August 2007 and August 2008, the fund’s assets more than tripled.
But back to those “outcomes” — the author has put together a data set of funds that received support during the crisis. That is, the funds’ sponsors (often banks) eventually absorbed MMFs’ losses to keep Net Asset Values from plunging below that all-important, “buck-breaking”, $1 level.
This support data is a rather nifty thing as a lot of it is currently confidential. Under SEC rule 2a-7 MMFs have to notify the Commission in the event of a default of any security representing more than 0.5 per cent of the fund’s assets, and they have to describe how they intend to respond to the default. McCabe has managed to get hold of an SEC list of support pledges, and added them to publicly-available records. According to him, it’s “the most complete available record of [recent] sponsor support for MMFs.”
Part of it looks like this:
Of the 249 funds in the sample then (these are funds with at least $100m in assets and 12 months of history in the iMoneyNet database) 39 funds, or 16 per cent, had records of sponsor support due to their holdings of busted-ABCP. Funnily enough, funds that eventually received sponsor support were more likely to have had AAA ratings. A third of all MMFs had triple-As, but AAA funds accounted for about half the funds that received support. Whoops.
Anyway, you can probably see where McCabe is going with this. There’s a complex interplay between support actions, portfolio risk, and shareholder behavior taking place here. Not to mention a looming, overarching spectre of moral hazard.
As he puts it:
This paper provides some useful lessons both for policymakers and investors. The significance of MMF risks in explaining poor outcomes in past crises highlights the importance of monitoring these risks, and I offer some useful proxies for doing so. For example, shareholders and regulators might track funds’ gross yields for early signs of problematic portfolio risks, particularly given asset managers’ incentives to boost yields. My indicators of investor risk may be useful in the SEC’s ongoing efforts to reflect such risk in setting liquidity requirements for MMFs.
This paper’s findings also raise concerns about the systemic risks associated with sponsor support actions for MMFs and the expectations of safety that these actions have fostered among investors. Clearly, sponsor support of MMFs was critical in helping funds weather the ABCP crisis in 2007 and the run in 2008. But the extensive record of sponsor support has probably attracted many highly risk-averse investors who would not hold MMFs without the conviction that the funds are effectively (privately) insured. Hence, sponsor support has likely increased investor risk for MMFs. The fact that funds with bank sponsors were more likely to have held distressed ABCP and to have received sponsor bailouts in the wake of the ABCP crisis also suggests that the possibility of sponsor support may undermine incentives for prudent asset management.
It wasn’t until 2008 of course, when sponsors like that of Reserve Primary were genuinely unable to support their funds, that investors got scared — and promptly pulled back from the market.
As far as we can tell, the new SEC rules for money market funds haven’t really done much to address the issue of sponsor support.
Or, as McCabe puts it:
… despite the apparent importance of sponsor support for MMFs, the practice is discretionary, unregulated, and opaque, and it is probably most unreliable when systemic risks are most salient.
Related links:
Moody’s on breaking the buck – and 208 near misses - FT Alphaville
Repairing the buck - FT Alphaville