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The COVID-19 Pandemic Breaks the Buck.
Due to economic crises caused by the COVID-19 pandemic, Prime Money Market Funds (“PMMFs”) have seen large outflows while Government Money Market Funds (“GMMFs”) have seen strong inflows due their underlying assets being liquid government securities.
PMMFs are heavily weighted in illiquid securities such as Commercial Paper and Certificates of Deposit. Under normal economic circumstances, PMMFs provide a slightly higher return over GMMFs, with minimal added risk, and the liquidity required by PMMFs is predictable.
Data from the US Treasury’s Office of Financial Research stated that money market fund industry has $4.76 trillion in AUM as of March 31, 2020. The PMMFs’ AUM market share dropped from 27.5% on February 29, 2020 down to 20.6% as of March 31, 2020. This recent run on PMMFs created massive liquidity issues causing them to “break the buck”.
A PMMF is considered to have broken the buck when the NAV falls below $1.00 per share. This occurs when the value of the fund’s underlying securities falls below the amount required to maintain a NAV of $1.00 per share. Due to the current economic situation, the Federal Reserve drastically lowered the Fed Funds Rate to near zero last March to support the US economy. This action crushed PMMF investment performance prompting large unexpected outflows, therefore, breaking the buck through no fault of the fund managers.
This crisis goes beyond the negative impact to investors in PMMFs. It damages corporations that rely on Commercial Paper to provide critical short-term financing. It also hurts banks and borrowers. Banks rely on issuing CDs, to raise deposits, in order to issue loans to borrowers such as institutions and individuals.
Two Companies that Propped Up their own Funds last March
Reuters reported last March that Goldman pumped over $1 billion into two of its PMMFs. They also reported that Bank of New York Mellon Corp stepped in twice this past March with a total of $2.1 billion to prop up Dreyfus Cash Management. In essence, the parent companies stepped in and bought illiquid assets, such as commercial paper and CDs, from the funds thus providing cash liquidity for investor redemptions while avoiding losses the fund would have incurred if they had to liquidate these holdings in a distressed sale of assets.
The CARES Act Responds to Breaking the Buck
The CARES Act suspends Section 131 of the Emergency Economic Stabilization Act of 2008 (“EESA”) until September 30, 2020 in order to provide support to PMMFs. The EESA was put in place in response to public outcry over the banking industry bailout during the 2008 recession. The EESA set certain limits to the government propping up PMMFs when a fund manager “breaks the buck”.
Under the CARES Act, the Federal Reserve and the Treasury can once again prop up PMMFs to provide investors a secure $1 NAV and desperately liquidity. This way parent companies no longer need to step in to buy illiquid assets of the PMMFs. This is especially critical if the fund manager is owned by a bank. Without this relief, the bank’s capital requirements would also be negatively impacted, and thus, threatening the banking industry as a whole.
Furthermore, this action under the CAREs Act provides critical protection to the Commercial Paper and CD markets. Therefore the corporations, banks and borrowers that depend on these investment instruments are also protected.
Liquidity is Crucial During an Economic Crisis via the MFLF
Stay at Home Orders have crippled the economy. During this necessary period to “flatten the curve”, liquidity is critical to keeping alive what remains of the economy as well as providing psychological assurances to investors that their money is safe. Otherwise, allowing runs on PMMFs can create further economic havoc.
The Federal Reserve injects cash into PMMFs to prevent them from breaking the buck. The primary mechanism is the Fed’s Money Market Mutual Fund Liquidity Facility (“MFLF”) which issues loans to institutions to purchase high quality illiquid assets from PMMFs. The cash received by PMMFs is used to support redemption requests and to maintain the critical NAV of $1.00 per share. This action provides both liquidity and investment principal security to shareholders in PMMFs.
Fund managers need to follow a complex set of rules to apply for these loans from the MFLF. Fund managers are required to have an account with one of the Fed’s branches, complete lengthy loan documentation via the Fed’s Discount Window and follow strict collateral management processes. Fund managers need to act quickly as redemption demands can increase as the Stay at Home Order and financial uncertainties become prolonged.
The MFLM program requires prompt and precise action. Risks to fund managers include inaccurate/inadequate application documentation, slowness at applying for the loans, and poor execution of collateral management. Any of these risks threatens the fund manager’s reputation, good standing with the regulators and relationships with counterparties.
Sia Partners is here to Help
Sia Partners’ Banking Advisory Practice is closely following the CARES ACT impact on financial institutions. We have deep Banking Product, Operations and Technology expertise. We can rapidly deploy changes to operating models across people, processes and technology. Furthermore, our deep experience with regulatory compliance can ensure controls are in place for the inevitable future audits.
For assistance, please contact our Covid-19 Crisis Response Team at US-COVID@sia-partners.com