Case Study: Money Market Funds and the Commercial Paper Market

- by Ben Bernanke in George Washington University 

Money market funds (MMMFs) are investment companies that sell shares and invest the proceeds in short-term assets. MMMFs historically has almost always maintained stable 1 dollar share prices, so they act very much like a bank. They are usually used by institutions like a pension fund. These institutions do not invest their money in banks because such large sums are not insured by the banks or Fed, instead, MMMFs, despite not being insured as well, invest in short term safe liquid assets. They are used by investors like checking accounts (redeem shares on demand for dollar 1) and they also earn interest. MMMFs invest heavily in commercial paper (CP) and other short term assets.

Commercial paper is a short term (typically 90 days or less) debt instrument issued by corporations. CP is used by non-financial corporations to pay immediate expenses such as payroll or inventories. Financial corporations may also issue CP to raise funds that they then use to lend to businesses and households.

During the crisis, this arrangement crashed. Lehman Brothers was a global financial services firm. It was not a bank but an investment company and so was not overseen by the Fed. Because it was not a bank, so it relied on financing from sources other than deposits. Like other securities firm, Lehman relied heavily on short-term borrowing (for example, CP) to fund their investments. During the 2000s, Lehman invested extensively in mortgage-related securities and commercial real estate (CRE). As house prices fell and delinquencies and foreclosures increased, the value of Lehman's mortgage-related assets fell. Lehman's CRE holdings also were showing large losses. So, as confidence depleted amongst creditors, they withdrew funding (for example ceased to buy Lehman's CP) and curtailed business with Lehman. With increasing losses and without any buyer, it went bankrupt.

After the collapse of Lehman Brothers, one MMMF that held CP issued by Lehman failed to maintain a $1 share price (breaking the buck). This led to a rapid loss of confidence by investors in other MMMFs and a sudden flood of redemptions. In response, the Treasury provided a temporary guarantee of the value of MMMF shares. Acting as lender of last resort, the Fed created a program to provide backstop liquidity. Under this program, the Fed lent to banks who in turn provided cash to MMMFs by purchasing some of their assets.

MMMFs had responded to the run by curtailing their purchases of short term assets, including CP. Consequently, the demand for newly issued CP dried up and interest rates on CP soared. Thus, Lehman led to run on MMMFs which shocked the CP market as well. Strains in the CP market contributed to an overall contraction in credit available to financial institutions and to non-financial businesses. The federal reserve established special programs to repair functioning in the CP market and restart the flow of credit.