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From: Brookings Papers on Economic Activity
Spring 2013
pp. 211-278 | 10.1353/eca.2013.0009

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Comment by Martin Neil Baily

Money market funds (MMFs) currently play an important role in providing liquidity to financial intermediaries. At the end of 2012, these funds accounted for over one-fifth of all U.S. mutual fund assets, with $2.7 trillion in assets under management. MMFs typically provide a higher yield than bank deposits, and before the recent financial crisis they were widely thought to be as safe as insured deposits, at least by retail investors, although their value was not in fact guaranteed by the government. As the crisis unfolded, wholesale investors began to doubt the stability of the funds and started to withdraw their shares. As Patrick McCabe and his coauthors point out in this paper, under the current rules governing MMFs, investors who are quick to redeem from a troubled MMF are able to protect both their liquidity and their principal, shifting the risks onto less savvy investors. This problem, inherent in the incentive structure of these funds, provides the context for the authors' proposed reform of MMFs.

The first MMF established was the Reserve Fund, which opened in 1971. From there the number of MMFs grew quickly, as they offered a way to avoid interest rate regulation on bank deposits (Regulation Q) and so reap higher returns. This is an important point, indicating that MMFs are a reflection of regulatory arbitrage, and since Regulation Q has now disappeared, the rationale for the continued existence of MMFs has come into question.

MMFs are regulated under the Investment Company Act of 1940 and under rule 2a-7 of the Securities and Exchange Commission (SEC), adopted in 1983, which allows MMFs to use a variety of procedures to maintain a stable net asset value (NAV) of $1 per share. In only a few cases has an MMF's NAV dropped below this $1 level ("broken the buck"): the authors report only two instances since 1983. Yet there have been other cases where runs on MMFs resulted in portfolio losses, and in some of these the MMF would have broken the buck but for the support of its sponsoring financial institution. The authors note that since the birth of the MMF industry in the 1970s, sponsors have intervened to support an MMF in over 300 instances.

The vulnerability of MMFs to runs results in part from the fact that they generally hold similar portfolios. The restrictions they face—MMFs can hold only assets with the highest short-term ratings—coupled with their need to maintain a stable NAV, severely limit the diversification available to MMF portfolios. The authors point out that as of September 2012, 50 private issuers accounted for 91 percent of all MMF investments in private entities, and that of these 50, all but 4 were financial firms. Because the portfolios of different MMFs have a significant degree of overlap, trouble at one MMF very often has direct implications for others. The authors identify this as a "contagion risk among MMFs," whereby a surge in redemptions from one or more troubled MMFs can depress asset prices and put other MMFs with overlapping portfolios at risk. This gives investors an incentive to redeem preemptively from those MMFs as well.

These concerns became acute during the financial crisis, especially in 2008. In the weeks following the collapse of Lehman Brothers in September 2008, prime MMFs experienced an outflow of $400 billion. During 2008 the Reserve Primary Fund lost 1.6 percent of its value. Almost all of this run behavior was on the part of institutional investors, whose holdings account for over 65 percent of all MMF shares. Retail investors, in contrast, displayed a great deal of inertia, in that they were significantly less likely to run from their MMFs.

In September and October 2008, more than two dozen MMFs received contributions from their sponsors in order to avoid breaking the buck. On September 19, 2008, the U.S. Treasury extended a guarantee to MMF investors that they could withdraw their funds without breaking the buck; that guarantee stayed in place until September 18, 2009. However, the Economic Stabilization Act of 2008 outlawed similar guarantees in the future. Thus, without a change in the law, the Treasury will...

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