Second Order Effects: Money Funds Cascade

A year or so ago when the sub prime crisis was still new we started to see "The Tentacles of the Credit Beast" extending into places that were unexpected. As we have all witnessed, in the last week or two the credit beast that looked like maybe it was being vanquished, came back with a vengeance, bigger and stronger than ever. It tore through Fannie, Freddie and Lehman, it scared Merrill off and then devoured AIG in one bite. With each feast it seems to get bigger and stronger. Now it's getting to where it appears that the government is literally having to make a last stand to stop it. As noted in my recent piece Post Modern? Bank Run, I was worried that with AIG evaporating in the course of a couple of days and the possibility of Washington Mutual - with it's branches on every corner - going under, consumers could get the hint and start to really worry about their savings. A bank run is what government officials are most worried about because it's a panic in which all confidence falls away and things run amok.

We may have gotten closer to a bank run than people realize. But it's not your corner bank where the run is happening. It's money market mutual funds and in some ways it's worse than a bank run....where at least their is FDIC insurance in place. Now, I want to state upfront, as I am sure you all know, the US government has announced that it is taking steps to backstop money market funds. The following quote was made Friday by the Federal Reserve according to Reuters.

One initiative will extend non-recourse loans at the primary credit rate to U.S. depositary institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper (ABCP) from money market mutual funds, This should assist money funds that hold such paper in meeting demands for redemptions by investors and foster liquidity in the ABC market and broader money markets.

Additionally, the treasury had already announced that it would use the SEC's Exchange Stabilization Fund, which had assets of about $50B to help prevent any money market fund from breaking the $1.00 per share mark. Recall that money funds always trade at $1.00 per share. They normally hold super safe short-term paper and only a once has a money market mutual fund "broken the buck", in other cases where funds were likely to the fund company has put its own money in to shore up the fund, as not doing so would be a huge black mark to their brand. These funds are supposed to be as safe as a bank account. In fact, they are so safe that Americans and U.S. companies have about $2 - $4 trillion sitting in these funds, depending on how you count it. (Please note that the ratio of money market assets to the stabilization fund is about the same as the ratio of bank deposits to the FDIC insurance fund today....not that that gives a lot of confidence.

So why did the government immediately run out to back up money market funds after the Primary Fund, the oldest money market mutual fund broke the buck? A run on the funds began. The number of redemptions at Putnam Investments $12.3 billion Primary Fund was so great, that they were forced to liquidate the fund, rather than stabilize it with their own money. This was unprecedented! Legg Mason stepped up and injected $630 million into three of its money market funds. This brings the total they have pledged to support their money market funds this year to $2B.

According to Reuters:

Since Tuesday, money market funds have faced heavy withdrawal from jittery investors who favored short-term funds that own only Treasuries. "As a result of this shift, other money market mutual funds have apparently attempted to sell large volumes of agency discount notes, further reducing liquidity in this market,"

Money market funds reportedly saw record redemptions this week of $42.2 billion. So why is this such a big deal? A few points.

If a fund falls from $1.00 to 93 cents, your loss is small. But if everyone tries to get out at once, it can further weigh down the value of the securities they are having to sell into the currently illiquid markets and the last people redeeming can lose a lot more.

As I just learned today, in many cases, like the municipal money market fund I own, the borrowers actually have letters of credit with banks backstopping their ability to pay back short-term funds. If the system grinds to a halt due to liquidations, banks may be severly hurt in addition to the likely defaults by borrowers.

Additionally, most of the paper that money funds buy is short-term debt used by corporations to run their everyday business. If this market shuts down, perfectly good companies could be hit with a liquidity crisis. Many corporations also keep their cash in money market or money market like institutional funds - one of which run by Bank of New York "broke the buck" this week. Corporations reportedly have a couple of trillion dollars in these funds and if they pull this money it could have equally horrible ramifications.

Bond kings Pimco had this to say about the situation and government response:

``They're putting up a firewall,'' said Paul McCulley, managing director at Pacific Investment Management Co., which oversees $830 billion including money funds. ``It's the ultimate nightmare to have a run on the money markets -- that is truly the Armageddon outcome -- and they're not going to allow that to happen.''

How do ya like them apples?

Hold onto your hats! and please don't run out and redeem those money funds.

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