Money Market Funds Were a Victim, Not a Cause, Of the Financial Crisis
As in medicine, the wrong diagnosis of a policy issue can lead to the wrong prescription. A good example is the persistent argument by the Financial Stability Oversight Council (FSOC) and the editorial pages of the Wall Street Journal that a stable $1 net asset value (NAV) for money market mutual funds (MMFs) is somehow a threat to the taxpayers or the stability of the financial system. The error, I believe, comes from a mistake about the facts.
For some reason, the idea has become embedded in the lore of the financial crisis that the Treasury was required to set up a special insurance fund for MMFs after the bankruptcy of Lehman Brothers because one fund, the Reserve Primary Fund, "broke the buck" -- that is, was unable to redeem all its shares at the stable NAV price of $1 per share. Therefore, runs the argument, the government will have to do the same thing the next time a MMF breaks the buck, and that puts the taxpayers at risk.
This claim led the FSOC-an organization of federal financial regulators set up by the Dodd-Frank Act-to push the SEC for a change in the accounting rules for MMFs, so that they could no longer set their net asset value (NAV) at a stable price of $1. The proponents of change want the NAV to float, believing that this will eliminate the possibility that MMFs will break the buck in the future. The MMFs, on the other hand, argue on the basis of surveys that their customers prefer the stable NAV and many will abandon the MMF structure if a floating NAV is adopted.
It was always a bit implausible that Treasury would set up an insurance system just to protect the shareholders of MMFs against what many were calling a "run." What interest could Treasury possibly have in whether MMF shareholders suffer losses? Clearly, when the Reserve Fund broke the buck, some of its shareholders were hurt; eventually their losses were somewhere between 1 and 2 cents on the dollar. But at that time shareholders all over the market were taking a severe beating, far larger than the losses suffered by the shareholders of the Reserve Fund. Even if shareholders of other MMFs, frightened by redemptions in the Reserve Fund, sought to redeem their shares, why should Treasury care, or risk taxpayer funds to keep those shareholders from converting their shares to cash?
One possibility is that the Treasury simply panicked. The market's reaction to the Lehman failure was devastating, and-as shown by the subsequent rescue of AIG-the Treasury and the Fed were now going to rescue everything that moved. The Troubled Asset Relief Program, a huge rescue fund in which the Treasury and the Fed asked for and received $700 billion from Congress, followed soon after. So panic is certainly one conceivable reason for the Treasury's action.
But there's another and more plausible reason for what Treasury did. By the mid-2000s, MMFs were a major financing source for $1.3 trillion in commercial paper that had been issued by off-balance sheet entities established and guaranteed by the largest U.S. banks. These entities, known as asset backed commercial paper conduits (ABCP conduits) had been set up with the approval of the Fed and had invested in prime and subprime mortgage-backed securities. Supporting long term assets like mortgages with short term commercial paper is profitable, but risky. If the mortgages begin to lose value, the financing sources may not roll over, and what would the banks do then?
Beginning in 2007, this is exactly what happened. As the mortgage market began to weaken, the funding sources for these ABCP conduits began to dry up, requiring the banks to pick up more of the funding themselves or to take the assets back onto their balance sheets. By early 2008, the conduits' commercial paper outstanding had been substantially reduced, but largely because the original bank sponsors had been compelled to furnish their own funding. This had substantially weakened the banks' capital and liquidity positions, well before the financial crisis began in September 2008. That the Fed allowed the banks to set up such a risky structure off their balance sheets-avoiding the Fed's own capital requirements-is something that Congress should investigate, but its role in the financial crisis seems clear.
By the time Lehman failed and the Reserve Primary Fund broke the buck, the banks were already weak and strapped for cash; they were in no position to take on more of the commercial paper issued by their off-balance sheet conduits. But things only got worse for the banks. When Lehman failed, there was a wholesale rush to quality by investors. Almost all the nongovernment MMFs, like the Reserve Primary Fund, were hit by redemptions as investors moved their funds to MMFs that invested principally in government securities.
This was dangerous for the banks, since the MMFs were not going to roll over their loans to the banks' conduits if most of the non-government MMFs were losing shareholders in the flight to quality. It was essential, accordingly, to keep those shareholders in place so the MMFs would continue -- relying on bank liquidity guarantees -- to roll over the commercial paper of the conduits. The way to keep funds in the nongovernment MMFs was to insure them against losses. In that way, many of their shareholders would stay where they were and the MMFs would, or at least could, continue to support the conduits, reducing the pressure on the banks.
These facts provide a completely different perspective than the conventional view of the of the Treasury's action. It was not to save the shareholders of the MMFs -- there was literally no reason for the Treasury to do that -- but to ease the financial pressures on the banks that had guaranteed the commercial paper of their off-balance sheet conduits. It follows that in any future crisis -- unless the banks are again allowed by the Fed to establish ABCP conduits -- there is no likelihood that the Treasury will seek to use taxpayer funds to protect the shareholders of MMFs, even if one or more of those MMFs break the buck.
Blaming the creation of Treasury's MMF insurance fund on the so-called "run" on the Reserve Primary Fund distracted many -- apparently including the Wall Street Journal -- from the real reasons the Treasury's insurance system was established. The fact that these real reasons were not immediately recognized is only one of the many errors about the causes of the financial crisis that remain to be corrected. This particular error, however, has led to unnecessary pressure on the SEC to change a system of accounting for MMFs that --in light of the success of the product -- clearly meets the needs of their retail and business consumers. In this sense, MMFs were a victim -- rather than a cause -- of the financial crisis.