Ensuring that the government is not again required to stabilize money market mutual funds thus remains a vital priority for regulatory policy and crucial unfinished business from the financial crisis.

Unfinished business from the financial crisis

by Phillip Swagel

Amid a flurry of five-year retrospectives came a news item reflecting unfinished business from the financial crisis: the breakdown of settlement talks between the Securities and Exchange Commission and managers from the Reserve Primary Fund, a money market mutual fund whose problems in September 2008 helped transform the failure of Lehman Brothers — by itself a major jolt — into a global financial crisis.

The Reserve Primary Fund owned $785 million in Lehman Brothers debt when Lehman filed for bankruptcy on Sept. 15, 2008, and “broke the buck” as the loss it suffered from this debt reduced the fund’s assets to less than the $1 per share that investors counted on. Money market funds are not guaranteed by the government, but are nonetheless widely seen as providing a stable investment vehicle with ready access to cash and a yield slightly above that for bank deposits (which are covered by government insurance through the Federal Deposit Insurance Corporation). Investors rushed for the exit as they realized the losses taken by the Reserve Primary Fund, which in turn put limits on withdrawals.

Investors in the Reserve Primary Fund have since received nearly all of their money back, more than 99 cents on the dollar, but this outcome was not known at the time and, in any case, investors expecting ready access to their money could not get it. The travails of the Reserve Primary Fund led to a panic of withdrawals from similar money market funds — so-called prime funds that invested in short-term debt from supposedly high-quality corporate borrowers.

Faced with huge redemptions from investors seeking cash, money market funds reduced their purchases of commercial paper, which are the short-term debt obligations used by many corporations to generate cash for their day-to-day needs. Corporations that could not float commercial paper turned to their standby bank lines of credit — something no one had anticipated would happen en masse. As documented by two Harvard Business School professors, Victoria Ivashina and David Scharfstein, this huge involuntary expansion of bank lending led to a reduction in banks’ provision of credit to other firms, especially by banks without stable deposit bases that thus themselves relied on short-term debt markets for financing.

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