Thursday, February 12, 2015

Run-Free Funds Expand

Louise Bowman at Euromoney reports
Fidelity Investments has announced plans to convert up to $125 billion-worth of prime US money market funds (MMFs) into government-only funds –
Meaning, funds that invest only in government securities.
...a move that is a direct consequence of the new SEC regulations covering this business that were announced in July.
...From October next year, MMFs must hold at least 99.5% of total portfolio assets in cash or government securities and repos collateralized by such instruments to be exempt from new regulations imposing fees and gates on such funds in times of stress. The rules are designed to slow deposit runs and reduce systemic risk
In case you missed it, in the financial crisis the Reserve Fund, which held a lot of Lehman debt, suffered a run, and too big to fail quickly expanded to money market funds.

What are they invested in now?


Of the $125 billion in the three Fidelity funds, only 22% is currently invested in government fund-eligible assets, according to BAML. That means $97 billion (78%) now invested in CDs, CP, non-government repo and other instruments will need to be rolled into government holdings. Of this, $9 billion is bank CP, $2 billion non-financial CP and $15 billion non-government repo....less than 10% of the $97 billion in short-term unsecured bank paper held by the three Fidelity funds marked for conversion was issued by US institutions.
This is, in my view, great news. Money market funds were promising complete safety -- you can take your money out at any time -- and lending it, unsecured and uninsured, to banks. Not just too big to fail American banks, but (say) Greek banks.

I thought this would be more of a challenge. You can always promise greater yields during good times and hope for a bailout in bad. Or, each investor hopes to get out ahead of the others. Apparently not,
"Many investors have told us that they want access to money market mutual funds with a stable NAV that will not be subject to liquidity fees or redemption gates," stated Fidelity when news of the conversion became public. 
Though to some extent that's because the temptation is low right now.
With credit spreads on non-government funds as low as they are, the returns are simply not attractive enough versus government funds ... 
Louise worries that this spread will rise.  
The expectation is that...unsecured funding costs for the banks will rise. This has particularly serious implications for non-US banks, as they are far greater users of this market than their US counterparts, which have ready access to cheap deposits.
It will. It should. But paragraph 1 should inform paragraph 2. A higher rate will induce people to take the risk and hold commercial paper directly, or suffer the indignities of the fees and gates in return for higher yields. Supply does equal demand!

Like the other Squam Lakers, I think that floating values are a better solution for non-government funds. But I like emergence of run-free, treasury-backed money market funds!

(This is "narrow banking" but I try not to use that word. The point is not to "narrow" banking. Using that word reinforced the fallacy that the size of credit creation must contract. The point is that risky investments should have floating-value or run-free liabilities, and fixed-value liabilities should be backed by government securities. For more, "Toward a run-free financial system")

9 comments:

  1. Why would they suddenly be run free?

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    1. For the following reasons. Where any bank or bank like entity like an MMF promises to return $X to a depositor for every $X depositied, and it looks like the MMF might not be able to meet its commitment, the depositor might as well “run” and put their money in a safer institution. In contrast, if stakes in the bank like entity FLOAT in value, those stakes are essentially shares, not deposits. And we don’t see a run on the shares of an entity funded by shares when there’s a bit of bad news.

      When BP made a nasty mess in the Gulf of Mexico, it was obvious they’d have to pay out billions. But that didn’t mean BP went INSOLVENT – anywhere near. All that happened was the value of its shares declined a bit. No sweat. Yawn yawn.

      Delete
    2. Baconbacon,

      John uses the term "run free" loosely. What he means is that a fall in the value of shares does not trigger a legal bankruptcy proceeding.

      A "run" is any attempt by a large group of people to exit a financial arrangement - could be a run on deposits, could be a run on debt, or it could be a run on shares.

      A run on debt can trigger a bankruptcy (especially if the issuer uses a lot of short term debt that must be rolled over). A run on shares cannot trigger a bankruptcy.

      Insolvency is a different matter. The solvency of a company is a measure of it's assets and liabilities. If the value of a company's liabilities exceeds the value of it's assets, then the company is insolvent (though perhaps not bankrupt).

      Insolvency is a balance sheet position. Bankruptcy is a cash flow position.

      Delete
  2. UST Bills are considered cash equivalents and are accepted in most places with <1% haircut. As a result, liquidity in the bill market never really disappears. Even if there were a temporary gap, where it became difficult to sell bills (and the Fed didn't step into buy bills), most funds could meet redemptions by just letting existing holdings mature. Large money market funds have to buy billions of dollars a day in short-term instruments just to stay invested in something other than cash (which, of course, earns 0% return).

    ReplyDelete
  3. UST Bills are considered cash equivalents and are accepted in most places with <1% haircut. As a result, liquidity in the bill market never really disappears. Even if there were a temporary gap, where it became difficult to sell bills (and the Fed didn't step into buy bills), most funds could meet redemptions by just letting existing holdings mature. Large money market funds have to buy billions of dollars a day in short-term instruments just to stay invested in something other than cash (which, of course, earns 0% return).

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  4. This is still not an honest stable NAV fund, or narrow bank. That would require holding only overnight repos, and whether the collateral is government bonds or not doesn't matter. There's no need for a rule that privileges government bonds (of course, the funds prefer such a rule to one that requires repos, since they don't want to run a real narrow bank).

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  5. Prof Cochrane says that using the phrase narrow banking reinforces “the fallacy that the size of credit creation must contract.” Actually I think lending WOULD CONTRACT a bit under narrow / full reserve banking. But that’s no problem at all.

    The REASON lending contracts is that under full reserve, ALL SUBSIDIES for lending institions are removed: no lender of last resort on favorable terms, no deposit insurance (unless you want to organize your own insurance). I’m all for that. But removing a subsidy inevitably raises the price of the subsidised item. But of course it’s fatuous to argue that “removing a subsidy isn't justified because the price of the subsidised item rises”.

    Another APPARENT problem with less lending is that all else equal GDP declines. Well the simple answer to that is that any such decline in GDP can be countered by standard stimulatory measures: interest rate cuts, QE, a bigger deficit, or whatever. Thus the NET EFFECT of full reserve would be a decline in lending based activity and a rise in non-lending based activity.

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    Replies
    1. Ralph,

      How do you finance a bigger deficit with less lending?

      Delete
    2. Frank,

      I was referring to lending by one private sector entity to another private sector entity (e.g. mortgages), rather that government deficits. As to whether a bigger deficit is possible without more lending to government, that question was answered by Keynes when he said that a deficit can be funded by borrowed or printed money. Of course governments can’t literally print money, but IN EFFECT they can: it’s called QE. I.e. if government borrows and spends $X and the central bank then prints $X and buys those government bonds, that comes to the same thing as “the state (or government plus central bank considered as a single unit) simply printing $X and spending it”.

      Delete

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