Analysis: Regulators weigh Greek risk to money funds

WASHINGTON/NEW YORK Thu Jun 30, 2011 12:17pm EDT

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WASHINGTON/NEW YORK (Reuters) - Regulators are looking at contingency plans in case Europe's debt crisis triggers another run on the $2.7 trillion money fund industry, though crafting an effective response this time may be tougher than in 2008.

Officials at the Federal Reserve and other agencies are watching and weighing their options over the impact a Greek default could have on the European banking system.

U.S. prime money market funds have a heavy exposure to Europe, and managers probably breathed a sigh of relief on Thursday when the Greek government's austerity push passed a second test in parliament.

"We've been taking a good, long, hard look at this," the Fed's director of supervision and regulation, Pat Parkinson, said this week.

On Wednesday the Fed announced a step that could reassure money funds by extending U.S. dollar swap lines, in effect a backstop to ensure European banks can continue to access dollar funding.

"The swap option is a backdoor way of reassuring the money market funds," said Dino Kos, managing director of Hamiltonian Associates in New York and former head of the New York Fed's markets group.

"Ultimately, though, it is the clients such as treasurers of corporations who need to be reassured."

If those clients quickly withdraw cash, the options that supported the money fund industry at the height of the 2007-2009 financial crisis may no longer exist or work so well in today's legal, economic and political environment.

Money market mutual funds seek to offer investors the convenience of a savings account but with a higher yield. To compete with bank accounts, they seek to prevent the price of their shares falling below $1.

The collapse of Lehman Brothers in 2008 caused a flood of redemptions, pushing the price of shares in the Primary Reserve Fund to 97 cents, "breaking the buck."

Worried about a possible domino effect, the Fed used its emergency powers to create two special facilities to ensure funds could raise money to pay shareholders. Both facilities have since been closed.

The Fed could still invoke its emergency powers but the Treasury Secretary would have to sign off on any such move under a new law.

The Fed may also be wary about invoking powers that exposed it to widespread criticism from lawmakers who protested angrily last time that it was overstepping its mandate and tried to trim the central bank's powers and independence.

Currently rock-bottom interest rates may be another impediment to a re-run of the Fed's emergency moves.

Under one of the facilities used in 2008, the Fed offered loans to banks so they would buy commercial paper from the funds. Its success depended on banks being able to earn a spread between their borrowing costs from the Fed and the rate they earned on the assets they were buying.

With benchmark interest rates and yields on assets held at money funds so low, those spreads may be minimal now, making it questionable whether banks would have an incentive to buy assets from the funds.

The Treasury Department, for its part, put in place guarantees of up to $50 billion to protect money market fund shareholders from losses. While the amount was a fraction of the size of the industry's assets, the move was viewed as a strong signal to nervous investors.

However in approving the $700 billion bank bailout fund in 2008, Congress expressly prohibited the Treasury from tapping the Exchange Stabilization Fund to backstop money market funds in the future.

Reforms of the money fund industry were under discussion even before the Greek crisis flared up again in recent weeks.

A leading proposal would create an industry-funded emergency liquidity facility but is unlikely to be immediately available.

The Investment Company Institute, representing the fund industry, says the fund would be chartered as a bank in order to access to the Fed's emergency loan window and would have an estimated capacity of $7 billion at its start. That would be a small amount but potentially enough to send a signal of support.

Securities and Exchange Commission rules adopted early last year aimed to make money market funds more resilient, including limits on lower quality securities they can hold and requiring a minimum percentage of assets to be in cash or very liquid securities.

While money market funds can still "break the buck", regulators believe this is now much less likely than during the height of the financial crisis.

"Money market funds are in a better position now than in 2008 to withstand liquidity runs," said Michael Gapen, director of U.S. economic research at Barclays and a Fed staffer during the financial crisis.

"If there was a run on money markets, then they would be most likely to reopen previous facilities. They are most likely to go with what they know and what they have used."

(Reporting by Mark Felsenthal and Kristina Cooke; Editing by Tim Dobbyn)

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