- Mid-September money market mutual fund troubles spurred by the Lehman bankruptcy contributed to major problems in the commercial paper market.
- Previously considered safe, investors fled money funds for other, even "safer" investments.
- The Fed created two new facilities backstopping commercial paper markets. And to further aid faltering funds, the Fed recently offered up to $540 billion in loans.
- The situation is still by no means rosy, but we're reassured the Fed remains willing and able to administer first aid where needed.
Two weeks ago, we wrote about commercial paper and the Fed's efforts to bolster liquidity in that key market. Perhaps at the root of the commercial paper trouble, another story had developed weeks earlier. In mid-September, a major prime money market mutual fund, the Reserve Primary Fund, made headlines as commercial paper losses tied to the Lehman Brothers bankruptcy forced it to "break the buck" (the one-to-one ratio between fund shares and dollars money funds maintain). Until that point money funds were considered very safe investments.
But following the announcement, investors fled so-called prime money funds—to the tune of approximately $500 billion in assets. Trouble in commercial paper was thus transmitted to money funds, cycled, and fed back worse than before. Commercial paper markets dried up.
But what is a money market mutual fund and who invests in commercial paper? New investors might be surprised to learn that just about anyone with a brokerage account has likely invested in commercial paper. When investors keep cash in a brokerage account, it's not cash in the ordinary sense of the word. Brokerage accounts don't store crisp stacks of newly minted bills ready for redeployment. Rather, cash is another word for "money market mutual fund," a fund that invests in the very shortest duration debt instruments available. Investors benefit by holding a very liquid instrument, redeemable like cash but with a higher return on their holdings. Money market mutual funds invest in various forms of commercial paper, but also in other safe investments like government treasuries.
Thus, when Lehman went bankrupt, large amounts of commercial paper went up in smoke, money market funds felt the pinch, and the pain fed back into commercial paper. To tackle the problem head on, the Fed created the Commercial Paper Funding Facility (CPFF) and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility to lend to corporations directly and back one form of commercial paper (the safest asset-backed variety). Though helpful, markets continued to suffer.
So recently the Fed made up to $540 billion available to the money market mutual fund industry. The Fed will take certificates of deposit, bank notes, and commercial paper purchased from money funds by five "special purpose vehicles" as collateral in exchange for Fed loans. The agreement seeks to provide money funds a source of quick cash to better cope with increased redemptions, and hopefully safeguard other investors' savings.
Significantly, the moves attempt to address frozen credit markets and investor confidence at the same time. Though some pain continues, signs of life have been exhibited of late. The situation is still by no means rosy, but we're reassured the Fed remains willing and able to administer first aid wherever and whenever it's needed.