Money-market funds (MMFs) are meant to be super-safe, super-liquid vehicles for short-term assets in which investors can park their cash and still earn a competitive rate of return.
Yet in September 2008, the surprise default of Lehman Brothers so roiled the markets that Reserve Fund Management's $62 billion prime money-market fund broke the buck.
This in turn was so unprecedented that it gummed up repurchase and securities-lending markets; it was the mechanism that created a credit crunch.
If the United States defaults next week, is there a chance of a repeat in the $2.7 trillion US money-market funds industry?
Not really, say liquidity managers at US fund houses. But the uncertainty of the US's ability to raise its debt ceiling, and the increasing likelihood of it suffering a credit downgrade by the 'big three' rating agencies, poses risks for MMFs.
Yesterday, Moody's Investors Service rang the alarm, noting that these uncertainties create both direct and indirect risks.
Direct risks include the possibility of a missed payment of principal or interest, and a weakening of overall credit quality of MMF portfolios that have US government exposure.
Indirect risks - and the more likely ones - include the prospect that greater volatility affects investor behaviour, leading to more redemptions, which in turn creates liquidity pressures, which then leads to more redemptions.
"This could be a self-fulfilling prophecy," notes one bond house executive. "This could cause investors to run for the exits, creating a liquidity issue, which might by itself cause a downgrade even if the sovereign does not [formally] get downgraded."
So far, however, the markets are not showing signs of undue alarm. Overall MMF levels haven't changed. There has been movement out of prime funds (ie MMFs that include credit, and which constitute around 60% of the US market) into government-only MMFs. That has taken place over the past few weeks due to jitters about the eurozone.
But net flows are positive, with only a very small number of investors deciding to exit MMFs into cash.
Prime fund yields have edged up, to perhaps 5 basis points from 2bp a few weeks ago, but managers don't see this as a sign that the markets are repricing prime exposures. The added return is far too minor compared with the damage that would ensue were a fund to break the buck.
Another explanation is that the US Treasury will rush to issue lots of debt once the debt ceiling is raised, and the current premium on prime funds reflects expectations of an incoming wave of supply of government paper.
Moreover, even if there is a systemic impact on global financial markets should the US default, where do investors go? US Treasuries are likely to be still considered a safe haven. Funds can be placed with banks, but are banks safer than the US government? Or funds can go to spread products, or emerging-market debt, or high yield. In the event of volatile markets, are these safer than US government instruments?
(Well, maybe Asian local-currency debt is safer, but it's not sufficiently liquid or accessible to foreigners.)
Also, the US government responded to the Reserve Fund Management debacle by imposing new requirements for prime funds, which were implemented late last year. These stipulate that prime funds must have at least 30% of their assets in a 'liquidity bucket' of US Treasuries or securities maturing within seven days.
Worries about Europe have already prompted many MMF managers to reduce risk, and the average prime fund has 35-40% allocated to the liquidity bucket, according to a major MMF manager in the US.
One question is whether US Treasuries in these liquidity buckets still 'count' if the US defaults or is downgraded. This could lead to some changes in yields - the truth is, no one is fully confident in making predictions - but MMFs are far better equipped to handle redemptions. No one sees another example of breaking the buck.
While the safety of MMFs is therefore not in question, there do remain concerns about liquidity, particularly if many investors do need to redeem because of either fear or because their internal guidelines limit them to triple-A-rated sovereign paper. There is a slim chance that herd mentality and volatility could prove mutually reinforcing to the extent that it affects pricing.
The other area of concern is the repo market... about which, more tomorrow.