Money Markets Pose Systemic Risk

Today, James Staley, head of JPMorgan Chase & Co.’s investment unit, said at a lunch discussion hosted today by Credit Suisse Group AG in Davos, Switzerland that the $4 trillion money-market fund industry is the “greatest systemic risk” to the financial system that hasn’t been adequately addressed.

His point actually emphasized the nature of money market fund, that is the funds aren’t allowed to set aside capital to protect for investment losses, leaving no “margin for error” against a potential collapse.

If you’re running a money-fund and all of a sudden you think there may be a slight run or a problem in the credit markets you have to liquefy your portfolio as fast as you possibly can because your margin of error is zero because there’s no shock absorber or capital insurance protecting that.

It partly explained why Lehman could collapse so quickly. Money market funds, which typically hold highly rated, short-term debt instruments, were forced to pull their money from the firms when they saw any signs of trouble.

Against the nature of no insurance behind money market funds, Fed and other policy makers may need pay some attention to back this industry to stabilize the financial market.

Commercial paper market recovered

Sales of longer-term commercial paper soared 10-fold, a sign that the Fed's efforts toward unlocking the market may be working.

The Fed’s move as I wrote in my blog several days ago is helping to free up money for investors to place in other assets and it is also reducing the corporate sector's dependency upon bank credit, freeing up money for the inter-bank market.
The commercial paper market shrunk by $366 billion, or one- fifth, to a three-year low of $1.45 trillion from Sept. 11 to Oct. 22, its worst slump on record. During the last recession seven years ago, the commercial paper market declined 17 percent from its then peak in December 2000 to September 2001.

The surge in borrowing longer-term means more issuers, especially financial companies, will have fewer funding concerns through the end of the year. In money market, LIBOR rate fell another 5 bps today, its 13rd straight decline. This rate has dropped 140 bps since Oct. 10, when it rose to a record high 4.82 percent. Ted spread remains 192 bps, up from 80 bps three months ago.

Sentiment has improved given easing in commercial paper market, money market and measures taken by the central banks. But rates are still not back to normal levels as there's still concern that people would rather keep cash for themselves than blow their balance sheets again as year-end approaches.

Close eyes on money market funds

The Federal Reserve announced yesterday would provide up to $540 billion in loans to help relieve pressure on money-market mutual funds beset by redemptions.

The initiative is the third government effort to aid the funds, which usually provide a key source of short-term financing for banks and companies. Last month, the Fed agreed to give loans to banks so they can buy back asset-backed commercial paper from money funds. There was $122.8 billion of such loans outstanding as of Oct. 15. The Treasury separately used a $50 billion emergency pool as well.

How important is the money market funds for U.S. credit market? U.S. money-market funds held more than 63 percent of outstanding unsecured commercial paper and 39 percent of asset- backed commercial paper at the beginning of September. If this source dries up, U.S. banks and companies have to shut down in a considerable number.

What the Fed and the Treasury did is to give a liquidity buffer to credit market, and ultimately avoid the “Great Depression II”. But it will take a lot of pressure off the Fed and the Treasury. Once their balance sheets keep deteriorating, the next shoe to drop is Treasury bills! United States of America will go bankruptcy!

TIPS broken

TIPS fell 7.85 percent since June as investors shunned all but the most easily traded debt amid the seizure in credit markets. TIPS were the only part of the U.S. government bond market to lose money in that time as Treasuries of all maturities gained 2.11 percent. TIPS make up about $520 billion of the $4.8 trillion in U.S. marketable debt outstanding.

Fed officials watch the TIPS market for signs of inflation expectations. The slump of TIPS reflects the dire economy. The inflation rate will fall below 1 percent by the second half of next year as the economy lapses into a recession.

But some institutions including BlackRock Inc., Brown Brothers Harriman & Co., DWS Investment GmbH and New Century Advisors are buying the securities because they bet that inflation will likely increase at a faster pace over the next decade than the 1 percent annual rate TIPS yields suggest. According to the median estimate of 69 forecasters surveyed by Bloomberg, consumer prices, unchanged in September, may increase 4.5 percent this year and 2.65 percent in 2009.

Maybe it’s not a good time to bottom fishing the U.S. equity but a good time to bottom fishing TIPS?

Interest on Reserve, new route for Fed?

Today Fed announced another $630 billion injection to market. The Fed's expansion of liquidity, the biggest since credit markets seized up last year will settle the funding markets down, and allow trust to slowly be restored between borrowers and lenders. On the other hand, the Fed's balance sheet is about to explode.

Under current procedures, any time the Fed has provided market liquidity by injecting reserves into the banking system, the increase in reserves has had to be ’sterilized’ by selling Treasuries, or conducting reverse repos. However, those means of sterilization threatened to run up against certain balance sheet constraints: The Fed now has less than $250 billion of Treasuries that it hasn’t lent out, and the Treasury’s overfunding could eventually bump up against the debt ceiling.

With interest on reserves, the Fed would not have to sterilize injections of reserves into the banking system. Normally, reserve injections need to be sterilized to prevent the fed funds rate from undershooting the FOMC’s funds rate target. With interest on reserves, wherever the Fed sets the rate on its deposit facility would effectively set a floor under the funds rate: anytime the effective funds rate would be below the deposit rate, banks would have an incentive to deposit excess reserves with the Fed. Excess reserves would be ’sterilized’ by banks depositing them with the Fed.

One proposed method would be like this: Fed set the deposit rate at the FOMC funds target rate and then inject massive amounts of reserves into the banking system — possibly by increasing TAF or similar facilities — and allowing the excess reserves to be deposited with the Fed at the target rate. Following such an operation, the Fed’s balance sheet would contain more risky assets and — on the liability side — more deposits and the monetary base would be roughly unchanged; the private sector’s balance sheet would contain less risky assets and more safe assets in the form of deposits with the Fed. The effect on the private sector balance sheet from the TARP is similar, though in that plan Treasury debt takes the place of Fed deposits.

This is regarded as an alternative route for Fed compared to direct bailout. Instead of buying bad assets in one step, Fed leaves himself a backdoor and increases its ability to expand its existing size of liquidity facility. But the key problem left here is how to determine the floor rate and how about the willingness of banks to deposit the money in Fed other than pursue other higher profitable investments?

Hedge fund retreated to money market fund

Hedge funds charge hefty fees for sophisticated trading strategies aimed at outperforming the wider market, but according to a report from Citigroup, hedge funds are estimated to have now placed $600bn in cash, and that $100bn of this is held in simple money market funds typically used by investors seeking safe rather than spectacular returns.

Analysts say the extent of hedge fund investment in money market funds shows how scarce attractive investment opportunities and safe havens have become.

US mutual fund managers are also holding near to record levels of cash. The average actively managed stock fund has 5.4 per cent of its portfolio in cash, according to Morningstar.

However, those money funds became embroiled in the wider financial crisis to the point that the US Treasury was forced to offer a blanket guarantee on them as part of its attempts to prevent the spillover of the financial crisis into the $3,400bn sector.The extreme measures taken by the Treasury followed mounting fears that retail investors in the sector could be starting to panic and might withdraw funds on a large scale.