Money market funds invest heavily in commercial paper, making them an important source of short-term funding.
When Lehman Brothers went bankrupt last fall, investors panicked and bailed out of money market funds.
To stem the panic, the Treasury cobbled together an emergency insurance program to back money funds.
The program expired last Friday—another sign financial markets continue strengthening.
· The SEC has proposed several regulatory changes to avoid another run, but now the panic's passed, we hope they take plenty of time and care.
Last Friday, the Treasury boarded up its money market fund insurance program—another link in the lengthening chain of emergency measures made obsolete by strengthening financial markets. Bank runs aren't uncommon during financial panics, but FDIC insurance and other features have made traditional bank runs scarce since the 1930s. Money market funds haven't enjoyed (or paid for) the same guarantees as banks, so after Lehman Brothers' collapse sparked a panic, investors rushed to redeem money market shares—the 21st century equivalent of an old-fashioned bank run.
Money market funds invest in short-term government, corporate, and municipal debt. As proof of their stability, virtually all money market funds maintain a $1 share price with interest paid at regular intervals. Money market funds are considered ultra-safe and liquid, so investors (businesses, individuals, municipalities, etc.) tend to park cash in them. Today, about 80% of US firms keep at least part of their cash reserves in money market funds.
Competition between funds inevitably resolves to basis point yield advantages, and even minute return enhancements can come at a price. To achieve higher yields, some money market fund managers invest in riskier or less-liquid investments. In the case of money markets, government debt is on the safe side—commercial paper (short-term corporate debt) is on the risky side. Increasingly, money market funds viewed highly rated commercial paper a safe way to squeeze a few extra points of yield. Eventually money funds grew to control 40% of the commercial paper market, making them an important source of short-term capital for many businesses, especially financial firms that often used short-term funds (commercial paper) to buy long-term investments (structured debt vehicles, among others).
When Lehman Brothers collapsed in September, confidence in money market funds evaporated. Not only did some suffer losses on Lehman's debt, fearful investors also redeemed shares at breakneck speed. Investors pulled $40 billion (50% of assets under management) from one of the then-largest money market funds, the Reserve Primary Fund, in less than 40 hours, causing Reserve Primary to drop its share price or "break the buck" on September 16th (although the share price only fell by 3% to $0.97/share). A panic ensued. Within the week, $230 billion was yanked from money market funds nationwide. Suddenly, the main source of funding for the commercial paper market, the lifeblood of many firms' everyday functioning, was at risk, instantly transmitting the financial panic into the broader economy.
Within days, the Treasury formed a $50 billion emergency money market insurance program, like the FDIC's bank deposit guarantee. Demonstrating just how ethereal a panic is, withdrawals slowed and the Treasury fund was never once tapped (though it gathered $1.2 billion insurance fees). As ever, the panic's cure was confidence. To get the corporate paper market moving again, the Fed created the Commercial Paper Funding Facility a few weeks later—buying hard-to-sell commercial paper and injecting liquidity where needed.
In response to the turmoil, the SEC has proposed some regulatory changes for money market funds. Some may prove beneficial—perhaps bringing regulation in line with 21st century realities. But now the panic's passed, we hope regulators take their time to carefully consider action, avoiding misplaced restrictions.
Blame the crisis on the feds if you like—they played a significant part—but quick action to stem the money market fund panic was among the most important in the long line of emergency actions pulling financial markets and the economy back from the brink.