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.
Certainly it would not have been a difficult task to identify MMFs that would be impacted by a Lehman failure. During 2008 – and earlier – MMFs' public filings reported their exposure to Lehman. In April, the Reserve Primary Fund reported that more than $750 million of its $48 billion in investments – about 1.6% - was in Lehman commercial paper and notes.
In its annual report to shareholders in July 2008, Reserve reported similar Lehman holdings. It did not take higher mathematics to calculate that a write-off of that amount in the face of a Lehman failure would almost certainly have created conditions leading to a breaking of the buck. In fact, the day after Lehman declared bankruptcy on September 15, the Fund's management announced that the value of its Lehman paper, which then amounted to 1.2% of its total assets, was zero, and the Fund indeed broke the buck, with consequences that reverberated throughout markets.
Could the regulators have avoided this result? Knowing of Lehman's deteriorating condition, yet concerned for Lehman's liquidity and funding, they permitted Lehman to continue to sell commercial paper to MMFs and other institutional investors, despite a lack of disclosure to the markets on the depth of its problems.
On notice of the Lehman exposure in MMFs the regulators might have attempted to persuade fund managers to reduce that exposure, and thereby reduce the potential for systemic ramifications. But it can be assumed that the regulators were apprehensive that causing funds to dump Lehman at the very time there were concerns about Lehman's liquidity and access to funding might well have hastened its demise.
The debate whether Lehman should have been saved, as was Bear Stearns, will fill books for years, but that is not the point of these comments. The point is that a possible "run" on MMFs was entirely predictable months before the Lehman failure. Yet the current argument for new "remedies" for MMFs seems implicitly to be based both on the assumption that runs cannot be predicted and on the notion that the run that followed Reserve's action sprung unexpectedly and without warning from the Lehman filing.
Is it fair or reasonable now to use the consequences of the Lehman failure as evidence of a proclivity to runs at MMFs?
The elevated level of MMF redemptions, after Reserve broke the buck, occurred, after all, in the midst of a colossal and virtually unprecedented disaster in financial markets. Had the Reserve experience occurred in normal times, outside the context of a wave of major institution failures, and had it not been triggered by the failure of a major investment bank – a failure that regulators knew for months was likely to happen – the ramifications might have been quite different.
Indeed, with the 2010 changes to the SEC's Rule 2a-7 relating to the liquidity, maturities and asset quality of MMF portfolios, not to mention the significantly beefed up surveillance and oversight of MMFs by the SEC, one might speculate whether the Reserve experience would have occurred at all.
Most important, the prospect that a fund heavily invested in Lehman paper might break the buck if Lehman were allowed to fail was something that regulators either knew or should have known well before it occurred. An implicit choice was made, however, to avoid exacerbating the Lehman situation by refraining from causing MMFs to abandon their Lehman holdings. MMFs were thus essentially treated as part of the support for Lehman that regulators were trying to muster.
While regulators surely cannot be tagged with responsibility for the consequences of investment choices made by private entities, the retrospective opprobrium now being cast on Reserve and MMFs generally, stemming from the choices that were made by regulators in 2008, seems both distorted and overly pious.
John Hawke Jr. is a partner in Arnold & Porter LLP and a former Comptroller of the Currency. He represents Federated Investors, a sponsor of mutual funds.