Unfinished Business From the Financial Crisis

Phillip Swagel is a professor at the School of Public Policy at the University of Maryland and was assistant secretary for economic policy at the Treasury Department from 2006 to 2009.

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 â€" by itself a major jolt â€" 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 trn 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 â€" 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 â€" 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.

Four days after the Lehman collapse, the Treasury Department announced an insurance program to guarantee money market funds to end the panicked withdrawals, while the Federal Reserve announced a new lending facility so that the funds did not need to undertake fire sales of their holdings to generate the cash to pay off any investors who were still running for the door. The Fed eventually provided credit to issuers of commercial paper to ensure that corporations had access to this financing mechanism. A revealing detail is that even money market mutual funds that invested only in government securities like Treasury bonds till paid for the government insurance, even though if the bonds were no good it would indicate that the United States government did not have the financial capacity to make good on its guarantee. Such was the degree of uncertainty that funds evidently decided that they needed the government insurance as a seal of safety, even if it was purely symbolic.

These government programs together stabilized short-term credit markets â€" and neither the Treasury nor the Federal Reserve lost money on these interventions (both actually had positive returns from premiums and interest paid by users of the programs) â€" but the problems arising from money market mutual funds are widely viewed as a crucial channel through which the financial crisis spread from Wall Street to Main Street.

The House Financial Services Committee on Wednesday morning is holding a hearing to examine reforms to prevent another meltdown in the money market fund industry. As explained in a wonderfully clear background memo by the staff of the committee chairman, Representative Jeb Hensarling, Republican of Texas, the S.E.C. started in 2010 to require the funds to hold either more cash or more assets like Treasury bonds that could readily be turned into cash, and it is considering further measures.

Among the options are requiring money market funds to provide more precise information on the value of their holdings so that investors can see more clearly that these vehicles involve risk and are not guaranteed like bank deposits, or having the money market funds impose a penalty on investors seeking to withdraw cash when the funds’ assets are illiquid, like in times of market stress. These proposals would apply only to funds that serve large investors and not the broad public, and would likewise not apply to money market funds that invest only in United States government obligations (which are assumed to be liquid even in a crisis, as was the case five years ago). The S.E.C. had previously considered but did not approve broader regulations on money market mutual funds put forward in 2012 by Mary L. Schapiro, then the ageny’s chief.

As I wrote last week in discussing the Lehman bankruptcy, the problems at the money markets were not anticipated â€" indeed, these funds were widely seen as safe by investors and policy makers alike. This probably made the impact of problems in the industry that much more profound a blow to already-fragile market confidence. If the Reserve Primary Fund was not safe, the thinking went, then perhaps nothing could be trusted.

Some $2.5 trillion was held in money market mutual funds as of the end of March 2013, according to the Federal Reserve’s flow of funds statistics, with about $1.1 trillion of this belonging to households. These funds remain a crucial component of short-term credit markets, relied on by both businesses and families. Future problems in the industry would doubtless warrant another intervention that puts taxpayers and the broader economy at risk - and the fact that taxpayers made money on the interventions five years ago does not change the reality that the problems in money market mutual funds greatly compounded an already difficult situation in financial markets following the Lehman bankruptcy.

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.