Today, we’ll talk about OLA for MMFs. No, that isn’t a new salute from bull-fighters to a mysteriously-named audience. The acronyms deployed mean we’ll address how the new orderly liquidation authority (OLA) in Title II of the Dodd-Frank Act applies to money-market funds (MMFs). MMFs are under FSOC scrutiny as a possible source of systemic risk, but ongoing strains in the EU suggest to us that the FSOC should think fast. If we revisit the Reserve Primary Fund experience – when a small MMF broke the buck and, with it, the U.S. credit market – regulators are wholly ill-prepared. The FDIC’s OLA proposal at least lays down a marker about what it would do if a big bank blew up, but the proposed orderly-liquidation regime is completely ill-suited for non-banking financial entities like MMFs even though they – not so much big banks – are the most worrisome sources of unmitigated systemic risk.
MMFs on their own hold the non-trivial sum of $3 trillion under management. They are supposed to be low, low risk investments, which is why –oops – they hold almost all investor assets in AAA-rated obligations. Of course, that hasn’t worked out so hot due to all the downgrades of the asset-backed securities MMFs used to boost yield in the run-up to the crisis. The MMFs – or, if not they, then the SEC – might have thought better of this post-crisis. However, still yield-seeking and ratings-dependent, the MMFs have simply shifted to another investment field: sovereign and EU bank debt. Last year, 44 percent of a “typical” prime MMF was in non-U.S. obligations, principally EU sovereign and bank debt. For the biggest prime MMFs, the figure rises to an astonishing 69 percent.
Other offshore assets compound this risk. MMFs are huge holders of commercial paper, as the FRB found out when it was forced to develop giant facilities to sustain the market after Reserve Primary blew. Foreign financial issuers of commercial paper surged to 77 percent of the market last year, while foreign issuers as a group comprised 40 percent (double what it was in 2007). Thus, MMF holdings of CP are also big stakes in non-U.S. markets that are, in turn, closely correlated with the risk of the sovereign debt and non- U.S. bank paper held by the MMF. Translation: MMFs aren’t holding the U.S. government and agency securities investors expect when they use MMFs in lieu of bank deposits to park short-term funds in “risk-free” places.
So, what if the MMF’s bet in Greek debt goes bad? How to resolve a money-market fund, especially one of the biggest ones that match the largest U.S. banks in market heft? Title II is supposed to do the trick, but could it? In short, we don’t think so. In theory, the law gives the FDIC broad scope to posit resolution regimes for any systemic firm, not just a very big bank. In practice, though, the FDIC’s proposals to date are bank-centric. OLA has yet to be more than outlined, but the FDIC’s thinking to date on what it would do with and to a big systemic firm in freefall is directly analogous to what it’s done for years with little-bitty community banks. This doesn’t even work well for very big banks, and it’s simply a meaningless model for non-bank financial companies.
To be sure, the FDIC has asked for views on what to do with broker-dealers and insurance companies – non-banking institutions to some degree addressed by Congress in Title II’s OLA provisions. The thinking to date on what to do with them makes clear that the FDIC will have to make massive adjustments to the orderly-liquidation regime to reflect the complexities of these firms and the SIPC and state-guaranty resolution schemes already applicable to them. However, while thinking is at least under way on these non-banks, it’s hard to find for other systemic entities, MMFs first on our list. We know that some in the industry like it this way, because they hope it will forestall systemic designation for MMFs. We doubt this, especially after our read of the President’s Working Group report that counts the many ways MMFs pose systemic risk.But, lack of an orderly-liquidation process for MMFs makes them more, not less, systemic. We’re not at all sure Treasury and the Fed could prop up MMFs again even if they wanted to, but we know for sure that, should they have to intervene, MMFs would essentially disappear thereafter in favor of bank-regulated deposit instruments. Twicebitten, regulators will be not just MMF-shy, but outright opposed. Thus, we think it’s wise now to consider MMFs in the unflattering light in which recent yield-seeking strategies have cast on what was once a low-profile, risk-averse industry. “Break-the-glass” plans for them are urgently needed given their exposure to all the EU paper that’s only averted a bout with systemic risk because of the massive EU and IMF rescues struggling to sustain the market against growing stress. With a temporary systemic safety net in place, hard thinking about what to do with MMFs to support them and protect the rest of us is among the most urgent priorities a very busy FSOC must address.