The 2008 money market crisis

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The 2008 financial crisis triggered a money market crisis that included the failure of the original and oldest U.S. money fund, the $62 billion Reserve Primary Fund, which broke the one dollar net asset value mark (known as breaking the buck) in September 2008. An ensuing net redemption of prime money market funds[note 1] by both institutional and retail investors was counterbalanced by an inflow of funds to treasury/government money funds. Government action during the crisis included the formation of emergency measures designed to support and stabilize money markets. Subsequently, money market fund reform measures were instituted in 2010, with a second round of reforms added in 2014.

Historical background

September 2008 Timeline[note 2]

9/7 Fannie Mae and Freddie Mac placed in conservatorship[1]
9/10 Korean Development Bank ends investment talks with Lehmann Brothers.[2]
9/12 Lehmann considers asset sales[3]
9/12 Moody's and S&P downgrade Washington Mutual[4]
9/14 AIG capital injection announced[5]
9/14 Bank of America agrees to buy Merrill Lynch[6]
9/15 Lehmann files for bankruptcy[7]
9/16 Reserve Primary Fund breaks the buck[8]
9/17 Federal Reserve lends to AIG for 79.9% company ownership[9]
9/17 Barclays buys Lehmann's North American operations[10]
9/19 AMLF announces Treasury guarantees $1 NAV[11]
9/19 SEC issues temporary ban on short selling financial issues[12]
9/21 Goldman Sachs and Morgan Stanley convert to bank holding company status[13]
9/24 Central banks coordinate currency swap facility[14]
9/25 Ireland becomes first Eurozone country to announce recession[15]
9/26 JP Morgan Chase purchases Washington Mutual[16]
9/28 Congress approves $700 billion financial rescue plan[17]
9/29 Citigroup purchases Wachovia assets[18]
9/29 Global central banks inject credit market liquidity[19]

In August 2007, widening spreads in the commercial paper market, combined with mortgage security losses, resulted in the default of several structured investment vehicles.[note 3] These defaults included Cheyne Finance[20] and Axon SIV.[21] Additional problems with subprime mortgages surfaced in August as two Bear Stearns’s hedge funds filed for bankruptcy, and a third Bear Stearns’s hedge fund suspended investors’ redemptions. On August 7, 2007 the French bank BNP Paribas halted withdrawals from its three investment funds and suspended calculation of their net asset values. These actions resulted in lower demand for asset-backed commercial paper[22] and a movement of institutional money from unregulated liquidity pools to money market funds.[23][note 4]

Financial difficulties continued into the spring of 2008, with the failure of auctions for auction-rate securities.[24][25] In March 2008, Bear Stearns, a global investment bank and securities trading and brokerage firm, became insolvent. Intervention by the Federal Reserve, first with a bridge loan to the firm, and then with an arranged merger/acquisition of the firm by JPMorgan Chase and Co.[26] managed to avoid outright bankruptcy.

The 2008 financial crisis reached its climax during the month of September (see accompanying table for a timeline of September events).

On September 7, the large U.S. mortgage Government Sponsored Enterprises, Fannie Mae and Freddie Mac, were declared insolvent and placed in conservatorship. On September 14, the Bank of America bought the insolvent Merrill Lynch brokerage. On September 15, Lehmann Brothers, a global financial services firm, declared bankruptcy. Investors began selling prime money market funds on Friday, September 12, and continued selling them on Monday, September 15.[27]

On Tuesday, September 16, the Reserve Primary Fund, holding $785 million of defaulted Lehmann Brothers commercial paper, announced that, due to the default, the net asset value of the money fund had broken the 1.00 net asset value mark and was now valued at 0.97.[28] Over the next four days investors withdrew $23 billion and made redemption requests of $60 billion from the $62 billion dollar fund.[note 5] In addition, a number of money funds received sponsor support, by means of either capital infusion or purchase of discounted paper at book value, during this period.[note 6]

During the calendar week of the crisis institutional prime funds had large net outflow every day while retail prime funds had net outflow Wednesday through Friday. Institutional government and retail government funds received large daily net inflow during this period. Over the 9/2/2008 to 10/7/ 2008 time frame, government money market fund assets increased by $409 billion (44 percent) as prime fund assets fell by $498 billion (24 percent).[27]

At this point, the market for commercial paper became illiquid. Issuers generally issued, and buyers generally were only willing to buy, overnight issues of commercial paper. Longer maturities did not trade.[29]

On September 19, the U.S. Treasury announced the establishment of a temporary guarantee program to protect shareholders of money market mutual funds.[note 7] Three additional programs were initiated in September and October:

  • Money Market Investor Funding Facility (MMIFF)
  • Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF)
  • Commercial Paper Funding Facility (CPFF). [note 8]

The programs were aimed at increasing liquidity within the commercial paper market. The intervention moves succeeded in halting the run on prime money fund assets, and unlocked the commercial paper market.[note 9]

Explanations for money fund redemption

Prime money fund assets [30]

The September 2008 run on prime money market funds (see figure to the right for a chart of prime money fund asset levels over the period; click table to enlarge) has led investors, academics and financial market regulators to seek plausible explanations for investor conduct. The most commonly cited investor motivations include investor flights to quality; flights to liquidity; flights to transparency; and flights to performance.

Flight to quality.

During the crisis period, investors shifted from money funds that held securities subject to default to treasury/government funds that possess low default risk. Both Wermers (2012)[23] and McCabe (2010)[30] also point out that investors shifted funds to prime funds that were judged capable of providing sponsor support if needed. (See table three in figure to the right; note that of 116 institutional prime money funds, ten saw assets shrink by more than 50 percent during this period and another twelve lost between 40 and 50 percent of assets, but 20 had net inflows over the same period.)[note 10]

Flight to liquidity.

Institutional investors demand having immediate access to their cash holdings. The most liquid money market securities are treasury bills and other government securities. The shift to treasury/government funds during the crisis is an indication of investor preference for liquidity.

Flight to transparency.

With the risk of default rising, investors sought funds with the highest levels of portfolio transparency. Since treasury/government funds, by prospectus policy, hold at least 80% of the portfolio in treasury securities, they offer reliable transparency. The crisis also encouraged prime money market managers to release current information on fund holdings and issue statements to investors.[31]

Flight to performance.

The SEC's RSFI cite academic research that provides evidence that higher performance attracts additional flows. [27]

The 2010 money market fund reforms

The 2008 money market crisis provided an impetus to both industry and regulators to produce reform measures.

On November 4, 2008, the mutual fund trade organization, the Investment Company Institute (ICI), announced the formation of a panel of fund industry leaders with a mandate "to develop recommendations to improve the functioning of the money market and the operation and regulation of funds investing in that market." The panel was chaired by former Vanguard CEO John Brennan.[32].

The panel presented its completed report to the ICI's Board on March 17, 2009. The report offered 24 recommended actions for improving fund safety.[note 11]

On February 23, 2010, the SEC adopted three amendments to rule 2a-7 which governs money market funds. The rules were effective June 30, 2010.[27] The changes to existing rules are as follows:

  1. The Weighted Average Maturity (WAM) for money market funds is reduced from 90 days to 60 days.
  2. Liquidity buffers are introduced for taxable money market funds (a minimum 10% of assets must be cash, treasury securities, or securities that convert to cash in one day; a minimum 30% of assets must be cash, treasury securities or certain government securities with remaining maturities of 60 days or less, or securities that convert to cash within one week.)
  3. Tighter restrictions on the amount of higher risk second-tier securities a money fund can hold (now a maximum limit of 3% from the former limit of 5%; and a maximum limit of 0.5% to any single issuer, from a prior limit of 1%.) Investment in second tier securities is restricted to maturities of 45 days or less.[33]

The 2014 money market fund reforms

On July 14, 2014 the SEC issued final rules that "... make structural and operational reforms to address risks of investor runs in money market funds, while preserving the benefits of the funds."[34]

The SEC’s final rules[35] "... require a floating net asset value (NAV) for institutional prime money market funds, which allows the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets and provide non-government money market fund boards new tools – liquidity fees and redemption gates – to address runs."[34] The Internal Revenue Service is formulating a simplified aggregate method of accounting applicable to investors in floating NAV money market funds.[36]

Notes

  1. Prime money market funds invest in a large gamut of money fund instruments: treasury bills, CD's, Yankee CD's, Eurodollar CD's, commercial paper, and banker's acceptances. These funds are usually heavily weighted towards the non-treasury instruments.
  2. The time line follows the page 13 chart in Response to Questions Posed by Commissioners Aguilar, Paredes, and Gallagher, RSFI, November 30, 2012.
    RSFI is an acronym for the Division of Risk, Strategy and Financial Innovation, a segment of the Security and Exchange Commission's Division of Economic and Risk Analysis, (DERA) established in 2009.
  3. Investopedia defines structured investment vehicles (SIV):
    A pool of investment assets that attempts to profit from credit spreads between short-term debt and long-term structured finance products such as asset-backed securities (ABS). Funding for SIVs comes from the issuance of commercial paper that is continuously renewed or rolled over; the proceeds are then invested in longer maturity assets that have less liquidity but pay higher yields. The SIV earns profits on the spread between incoming cash flows (principal and interest payments on ABS) and the high-rated commercial paper that it issues. SIVs often employ great amounts of leverage to generate returns.
    Definition of Structured Investment Vehicle (SIV), investopedia
  4. Actions taken by money fund sponsors in 2007 to ameliorate losses on asset-backed commercial paper (ABCP) by either purchasing securities out of their funds at above-market price or by entering capital support agreements to guarantee securities still in the funds shored up investor confidence in money market funds. The SEC reported that sponsors intervened to support at least 44 money market funds because of exposures to distressed ABCP, and no money market fund broke the buck. See McCabe, Patrick E. (2010). "The Cross Section of Money Market Fund Risks and Financial Crises". FEDS Working Papers. 2010-51. p.8
  5. The Reserve Fund received permission from the SEC to suspend redemptions from its money market funds on September 22, 2008 (Press release, September 23, 2008.) The actual liquidation and dispensing of the Reserve Fund's family of money market fund assets took years to complete. On January 26, 2010, with the sixth distribution of fund assets, the fund had returned $55 billion dollars, or 99% of fund assets. A record of the funds' liquidation is preserved in The Reserve Fund Archive.
    In addition to the Reserve Fund, two other smaller funds also "broke the buck" due to holdings of defaulted Lehmann Brothers commercial paper: the Reserve Yield Plus Fund, classified as a short-term bond fund, saw its net asset value drop to $0.97 a share: (See press release); and the Reserve International Liquidity Fund, which had a drop in net asset value to $0.91: (See Breaking The Buck: Why Low Risk Is Not Risk-Free, investopedia)
  6. Brady, Steffanie A; Ken E. Anadu, and Nathaniel R. Cooper (August 13 2012). "The Stability of Prime Money Market Mutual Funds: Sponsor Support from 2007 to 2011". Federal Reserve Bank of Boston (Working Paper No. RPA12-3) report that:
    Large sponsor support (in aggregate) representing over 0.5 percent of assets under management (AUM), occurred in 31 money market funds, and the primary reason disclosed was losses on Lehman Brothers, AIG, and Morgan Stanley securities.
  7. Although the U.S Treasury deposit insurance program for prime money funds instilled confidence in money fund investors and stemmed the outflow of investor assets, the funds continued to sell commercial paper and buy treasuries. Within one month after Lehman’s bankruptcy, money market funds' commercial paper holdings fell from 24.2 to 16.9 percent of fund assets. Over the same period, money market funds increased government debt holdings from 36.7 to 44.5 percent of assets. See Kacperczyk, Marcin T. and Schnabl, Philipp,, 2010. "When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009," Journal of Economic Perspectives, American Economic Association, vol. 24(1), p.19.
  8. Each program had a specific purpose and a finite life span:
    • Treasury Guarantee Program for Money Market Funds provided insurance for investor money fund accounts. The program was initially in effect for three months, beginning September 19, 2008, but was later extended through September 18, 2009. Treasury did not extend the program beyond September 18, 2009.
    • Money Market Investor Funding Facility (MMIFF) provided liquidity to U.S. money market mutual funds in order to increase their ability to meet redemption requests and to enhance money market investors' willingness to invest in money market instruments, particularly for terms longer than overnight. The facility was announced on October 21, 2008, and was closed on October 30, 2009.
    • Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) provided liquidity that allowed money funds to sell asset-backed commercial paper. The facility was announced on September 19, 2008, and was closed on February 1, 2010.
    • Commercial Paper Funding Facility (CPFF) allowed the Federal Reserve to directly purchase commercial paper, providing liquidity to the market. The facility was announced on October 7, 2008, began purchases of commercial paper on October 27, 2008, and was closed on February 1, 2010.
    Further details on the programs are available at:
  9. The following charts show the amount of commercial paper outstanding over the 2000 - 2013 period.

    <gallery widths=400px heights=400px perrow=2 caption="U.S Commercial Paper"> File:Financialcommercialpaper.png| Financial Commercial Paper File:Domesticnonfinancialcommercialpaper.png| Non-financial Commercial Paper

    
    
  10. McCabe examines three risk factors faced by institutional money fund investors: (1) portfolio risks arising from a fund's assets, (2) investor risk reflecting the likelihood that a fund's shareholders will redeem shares disruptively, and (3) sponsor risk due to uncertainty about MMF sponsors' support for distressed funds. He finds that funds that had provided higher gross yields (holding higher risk securities), showed higher pre-crisis volatility of fund flows (indicating higher investor risk), and funds with sponsors with higher default/swap spreads (indicating less likelihood of offering support) all experienced outflows during the crisis.
  11. The ICI’s Money Market Working Group recommendations are summarized in this Factsheet>

References

  1. Statement by Secretary Henry M. Paulson, Jr.
  2. Korea Development Bank Ends Talks For Stake in Lehman, September 10, 2008, Bloomberg
  3. Lehman Said to Be Looking for a Buyer as Pressure Builds, September 10, 2008, New York Times.
  4. WaMu lowered to junk by S&P, September 15, 2008 CNN
  5. AIG Set to Announce Asset Sale or Capital Injection, September 14, 2008, CNBC
  6. Bank of America to Buy Merrill,September 15, 2008, Wall Street Journal
  7. Lehman folds with record $613 billion debt September 15, 2008, Marketwatch
  8. Reserve Primary Money Fund Falls Below $1 a Share, September 16, 2008, Bloomberg
  9. U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up September 17, 2008, Wall Street Journal
  10. Barclays announces agreement to acquire Lehman Brothers North American investment banking and capital markets businesses, September 17, 2008 press release
  11. AMLF press release, September 19, 2008
  12. SEC Issues New Rules to Protect Investors Against Naked Short Selling Abuses, September 19, 2008, SEC press release
  13. Goldman, Morgan to become holding companies, September 21, 2008, Market Watch
  14. FRB press release, September 24, 2008
  15. Ireland falls into recession, September 25, 2008, theguardian
  16. WaMu Is Seized, Sold Off to J.P. Morgan, In Largest Failure in U.S. Banking History, September 26, 2008, Wall Street Journal
  17. Bailout is law, October 3, 2008, CNN
  18. Citigroup buys Wachovia bank assets for $2.2B, September 29, 2008, CNN
  19. FRB press release, September 29, 2008
  20. Cheyne Finance SIV Won't Pay Debt as It Falls Due (Update2, October 17, 2007), Bloomberg
  21. Moody's slashes Axon SIV as capital NAV plummets, October 23, 2007, Reuters
  22. Kacperczyk, Marcin T. and Schnabl, Philipp,, 2010. "When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 29-50, Winter. pp.15 - 16.
  23. 23.0 23.1 Wermers, Russ R., "Runs on Money Market Mutual Funds" (March 15, 2012). Available at SSRN: http://ssrn.com/abstract=2024282 or http://dx.doi.org/10.2139/ssrn.2024282. p.9.
  24. Florida Schools, California Convert Auction-Rate Debt (Update5, February 22, 2008, Bloomberg
  25. Auction Rate Securities: What Happens When Auctions Fail, FINRA
  26. Bear Stearns, JPMorgan Chase, and Maiden Lane LLC, Federal Reserve Board
  27. 27.0 27.1 27.2 27.3 Response to Questions Posed by Commissioners Aguilar, Paredes, and Gallagher, RSFI, November 30, 2012
  28. Reserve Primary Money Fund Falls Below $1 a Share (Update4), September 2008, Bloomberg
  29. Report of the Money Market Working Group, ICI Money Market Working Group, March 17, 2009], p.60
  30. 30.0 30.1 McCabe, Patrick E. (2010). "The Cross Section of Money Market Fund Risks and Financial Crises". FEDS Working Papers. 2010-51.
  31. Money Market Funds Enter a World of Risk , New York Times, September 17, 2008
  32. CI Establishes Money Market Working Group
  33. Amended Rule 2a-7 (2010)
  34. 34.0 34.1 SEC Adopts Money Market Fund Reform Rules , press release
  35. Money Market Fund Reform; Amendments to Form PF, full SEC final regulations
  36. Internal Revenue Bulletin: 2014-33

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