Fed Prepared to Prop Up Money-Market Funds
Wednesday, October 22, 2008
The Federal Reserve yesterday created a program to provide cash to money-market mutual funds, the latest step in a vast expansion of the government's safety net for the financial system.
The Fed will make up to $540 billion available to buy assets from money-market mutual funds -- in which pension funds, university endowments and millions of Americans stash money -- if they need it. The measure is intended to keep the funds from experiencing cash crunches.
Money-market mutual funds invest by lending money on a short-term basis to companies, banks and other financial institutions, as well as the government. They are normally considered safe places to park cash because they buy only debt that is highly likely to be paid back.
But from early September to mid-October, nervous investors pulled about $480 billon out of a particular class of money-market funds. If that run on the funds had continued, it could have forced them to sell assets into an already troubled market, potentially causing a cascading series of losses to investors, more fund redemptions, more forced selling and further losses.
Whereas a Treasury Department initiative announced last month protected investors in money-market funds against losses, yesterday's action was designed to ensure that a run on the funds would not prove devastating; government officials hope the action will also help ensure that lending remains available to banks and other financial institutions.
But the new program is a vivid example of how the government's rescue of the financial system has raised new questions about long-term policymaking.
For example, though the new Fed lending is designed to be temporary -- it is scheduled to begin winding down in April -- the central bank has continued renewing other emergency lending programs that had been scheduled to expire. The Fed will have to decide by April whether the "unusual and exigent" circumstances that permitted the bank to set up the new facility have persisted. If they haven't, it must close the program by law.
Moreover, now that the Fed has taken extraordinary action once, investors in money-market funds will assume that it could do so again in a crisis. That might lead them to take inappropriate risks, counting on a government bailout if things go awry, analysts said.
"It's going to be difficult for the funds to wean themselves off of this," said Peter G. Crane, president of Crane Data, which collects information on money-market mutual funds. "It wouldn't be shocking to see an FDIC-like system put in place for money-market funds. At some point, a big strategic discussion will have to take place."
Inside the Federal Reserve, leaders are only beginning to grapple with the longer-term implications of their actions after weeks of round-the-clock work designing a series of novel actions to try to keep the global financial system from spiraling into chaos. Fed Chairman Ben S. Bernanke and his colleagues intend to be as aggressive in removing the government interventions in the economy when things turn better as they have been in creating them. But that might prove difficult, as it could be hard to tell when the financial system is back on solid footing for good.
To ease the current crisis, the Fed already has said it will help the banks and other financial institutions that normally rely on this funding by standing ready to lend them money directly. Now it is also offering to be a backstop for the other side of the transaction, the funds themselves.
In early September, there was $2.2 trillion invested in "prime money-market funds," the term for the funds that invest in those short-term loans to all manner of companies. That figure had been reduced to $1.7 trillion by Oct. 15.
Two things changed in mid-September. The bankruptcy of the investment bank Lehman Brothers made investors worry about the safety of their investment in money-market funds. And on Sept. 16, the Reserve Primary Fund, a $62.5 billion fund, "broke the buck," meaning that its share price fell below its normal $1 level.
In the weeks that followed, investors -- especially large institutions like pension funds and college endowments -- pulled cash out of money-market funds that lend to companies and banks, redirecting most of the money to funds that buy Treasury bonds. In the past two weeks, conditions have stabilized, but Fed officials believe the new program could help head off future disruptions.
Since mid-September, the Fed has been searching for new ways to backstop money-market funds. The problem: Under the Federal Reserve Act, the Fed can lend only against solid collateral. Therefore it couldn't simply accept mutual fund assets that were not backed by collateral.
The mutual fund industry and J.P. Morgan Chase found a way around that restriction. The central bank will lend up to $540 billion to five specially created entities, managed by J.P. Morgan Chase, that will buy up to $600 billion of assets from money-market mutual funds. The first $60 billion in any losses would be incurred by the mutual funds themselves, which offers the Fed some measure of protection.
"The government has encouraged the private sector to think hard about sensible ways to address the difficulties we see and to find measures that would help restore normal functioning," said Paul Schott Stevens, chief executive of the Investment Company Institute, the trade group for mutual fund managers. That group, and many of its members, were involved in designing the plan, senior Fed officials said yesterday.
As for the longer term? "There's a lot for us to ponder and to think about," Stevens said. "I'm sure we will be doing that at the institute, and undoubtedly the Fed, Treasury and Congress will be thinking a lot about it, as well."