Policymakers Could Have Easily Predicted MMF Breaking the Buck

Virtually all the recent clamor for tough new restrictions on money market mutual funds is bottomed on the experience of September 2008 when one fund "broke the buck" after Lehman Brothers was allowed to fail.

The Reserve Primary Fund held an appreciable amount of Lehman debt, and after Lehman filed for bankruptcy that investment was written off, causing the Reserve Fund's net asset value to fall below one dollar a share. In the midst of uncertainty in the market, there was a wave of redemptions from prime MMFs, leading many to pronounce that MMFs are "susceptible" or "vulnerable" or "prone" to runs. 

What is not mentioned is that many months before Lehman failed, policymakers were keenly aware of Lehman's precarious financial position, and were clearly on notice of the Lehman holdings of a number of MMFs – in particular those of the Reserve Fund. Yet they took no steps to mitigate the impact of a Lehman failure on Reserve or other MMFs. 

To be sure, by September 2008 markets were in a meltdown that went far beyond Lehman and Reserve, and officials were struggling to contain a widespread disaster. But had actions been taken many months earlier, at a time when Lehman's condition was well known to them, the event that caused a run on MMFs and seized up short-term credit markets might well have been avoided. To argue now that MMFs are "susceptible" or "vulnerable" or "prone" to runs and thus should be subject to more stringent regulation, when appropriate government actions might have avoided a run that should have been anticipated, is disingenuous, to say the least.

As early as May of 2008, the Federal Reserve Bank of New York and the Securities and Exchange Commission, which had begun daily on-site monitoring of Lehman, knew that Lehman had failed at least three stress tests developed by the FRBNY to determine how Lehman would fare under the kind of circumstances that had earlier brought down Bear Stearns. That month the FRBNY had calculated that Lehman would need to raise some $84 billion to survive a run. Lehman's condition steadily worsened as the months went on.

While there were varying views among policymakers as to whether the government should step in to support Lehman, as it had earlier done with Bear Sterns, there was no doubt among them that a Lehman failure could have a catastrophic impact on financial markets, including MMFs.  Fed Chairman Ben Bernanke told the Financial Crisis Inquiry Commission in November 2009: "We never had any doubt about that. It was going to have huge impacts on funding markets. It would create a huge loss of confidence in other financial firms. . . . It would probably bring the short-term money markets into crisis, which we didn't fully anticipate; but, of course, in the end it did bring the commercial paper market and the money market mutual funds under pressure. So there was never any doubt in our minds that it would be a calamity, catastrophe, and that, you know, we should do everything we could to save it."

To say that MMFs were brought "under pressure" is a masterpiece of understatement.  According to the FCIC, when Lehman failed, "among the first to be directly affected were the money market funds and other institutions that held Lehman's $4 billion in unsecured commercial paper and made loans to the company through the tri-party repo market." In short, it should have been readily apparent that a Lehman failure could cause significant losses to any MMF that held an appreciable amount of Lehman paper, and that such losses could cause a breaking of the buck, with a consequent wave of redemptions from any such fund, and perhaps others as well.