June 11, 2012 / 8:35 PM / 7 years ago

U.S. money funds still vulnerable-NY Fed blog

NEW YORK, June 11 (Reuters) - U.S. money market mutual funds are still vulnerable to heavy redemptions in times of financial turmoil, which could destabilize the broader banking system, Federal Reserve staff members said in blog post on Monday.

Investors have been worried that the euro zone’s debt troubles could spiral into another global crisis like the one of 2007-2009.

Back in September 2008, the $65 billion Reserve Primary Fund, one of the oldest and biggest money funds, broke the buck, or its per-share value fell below $1. That happened because of the fund’s heavy losses on debt holdings in Lehman Brothers, which had collapsed a few days earlier.

The demise of the Reserve fund is seen as a watershed moment of the global financial crisis. It caused credit markets to dry up and led the Fed and major central banks to embark on unprecedented measures to stabilize the banking system.

U.S. regulators have since enacted tighter rules to ensure another money fund will not break the buck again, but the New York Fed blog said weak spots in the structure of money funds remained, making them susceptible to runs by big institutional investors.

“These shareholders reportedly place great value on principal stability and are prone to fleeing money funds quickly at any sign of trouble,” wrote staff members of the New York Fed along with an economist with the Fed Board of Governors.

The comments appeared in an entry, “Money Market Funds and Systemic Risk,” published on the New York Fed’s online blog, “Liberty Street Economics.”

A stampede out of a money fund compounds its losses as it is forced to sell less-liquid investments to meet redemptions. Less-liquid assets might be sold at sold at steep discounts, the blog said.

“For this reason, shareholders have an incentive to run from troubled money funds as they leave behind risks and costs to be borne by those who remain invested in the fund,” the blog said.

Since January 2010, the U.S. Securities and Exchange Commission has required money funds to hold more Treasury bills and other low-risk investments and securities with short-maturities in an effort to curb the $2.6 trillion industry’s systemic risk.

Money funds are major providers of short-term credit. They own more than 40 percent of all U.S. commercial paper and roughly a third of all certificates of deposit.

Still, their lack of a capital buffer and their tools to maintain $1 share value, including rounding share value, make them vulnerable to heavy redemptions in times of crisis.

“Investors still have incentives to run at the first sign of trouble,” the four authors of the blog post said.

Marco Cipriani is a senior economist at the New York Fed’s money and payments studies group, while Antoine Martin is the function head of that group. Michael Holscher is a member of the bank’s markets group, and Patrick McCabe is a senior economist at the Fed’s Board of Governors.

They said in the blog that in a future post, they would put forth a proposal for improving the stability of money market funds by making them less vulnerable to runs.

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