Fed starts financing money market funds

The US Federal Reserve has established a new facility to lend indirectly to money market mutual funds, triggering US Congress to suspend a clause of the Dodd-Frank Act designed to protect taxpayers.

Through the facility, the Money Market Mutual Fund Liquidity Facility (MMLF), the Federal Reserve Bank of Boston will provide loans to banks that are secured by certain assets that the banks have purchased from money market funds.

The Fed’s aim is to assist money market funds in meeting demands for redemption by household and other investors. The facility should stop any possible spike in redemptions causing a potential run on the funds’ assets, thereby limiting the chance of initiating a negative feedback loop.

The facility is similar to the crisis-era Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF). The 2008 facility was created following fire sales of money fund assets following the collapse of merchant bank Lehman Brothers.

The MMLF was established under Section 13 (3) of the Federal Reserve Act, as were the other two crisis-era facilities announced this week, the Commercial Paper Funding Facility (CPFF) and the Primary Dealer Credit Facility. The provisions of the act mean that the facility had to be approved by US Treasury secretary Steven Mnuchin.

While the loans are funded by the Fed, the Treasury has provided a subordinate loan of $10 billion from the US Treasury’s Exchange Stabilization Fund (ESF). The Treasury’s loan ensures that if the facility takes any losses, the Treasury will take first loss, a funding arrangement comparable to that of the CPFF.

Despite the ESF’s broad remit, using the fund for any means other than stabilising the US dollar requires approval from the US president. Furthermore, following the enactment of the Dodd-Frank Act, the Treasury has been prohibited from using the fund for any “any future guaranty programs” for the money market mutual fund industry. The Treasury was forced to ask Congress to suspend the Dodd-Frank restrictions, according to a memo seen by the Wall Street Journal.

Insulated credit risk

In contrast to the 2008 AMLF, the Fed has designed the new facility so that banks can be insulated from any credit risk associated with the transaction. The loans from the facility will be “non-recourse”, which is a secured debt, but one for which the borrower is not liable.

“The ‘non-recourse’ provision means that in the still unlikely event that there are defaults on high-quality commercial paper, the Fed will absorb those losses,” Peter Ireland, former Fed economist, tells Central Banking.

In co-ordination with its counterpart US regulators, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, the Fed says it will also not penalise any firm that uses the facility.

The Fed says it will “fully neutralize the impact” of participating in the facility. Furthermore, any assets that are either pledged to the MMLF or intended to be pledged will both be “fully exempt” from risk-based capital and leverage requirements, it says.

The MMLF also allows a broader set of collateral than its 2008 precursor. The AMLF’s scope was limited to high-quality asset-backed commercial paper. But the MMLF also includes high-quality unsecured commercial paper, Treasury securities and securities issued by a US government-sponsored entity.

Ireland believes that, in the short-term, the facility “will surely help” calm market volatility. But in the longer term, he argues, it shows that there is “still a problem” in allowing non-insured money market funds to operate alongside insured banks.

“Once we get through the crisis that confronts us now, we’re likely to see a second round of regulatory reform, building on post-2008 efforts,” he says.