A Crisis of Confidence: Understanding Money Markets During the Financial Crisis

Question 1

Money market mutual funds are large financial institutional portfolios that hold money market securities and are comprised of short-term (less than a year) securities that represent high-quality, liquid debts and monetary instruments. The money market mutual funds offer two benefits to investors. The first one is that the MMF offers denomination intermediation. For the MMF to acquire the market securities, they allow different investors to participate in small dollar adding, and, thus, pool the funds from them. This fund is used to obtain the market securities. Another benefit offered by the MMF to investors is the provision of diversification. Diversification states that the lender (investor) does not save all his funds in one security but rather claim the entire MMF, thus, there is a reduction of risk for the investor.

Question 2

1. This is a situation where there is a loss of confidence, that is, when investors have concerns about a risk of defaulting or disturbance of the real value of the collateral that is highly rated. They opt for an investment that are of a lesser risk such as government treasury bills, which possess the ultimate quality under such conditions.
2. Before the financial crisis, T-bill auction was conducted in few days of the month. The yield produced by it was high. Again, only 4-week, 13-week, and 26-week maturity T-bills were auctioned during this time with one-cash management auction issued. After the financial crisis, the number of T-bill auction days per month increased drastically. The yield from this auction declined. Apart from the 4-week, 13-week, and 26-week T-bills, there was also a 52-week T-bill issued with nine-cash management auctions.
3. C. Before the financial crisis, investors had confidence in the other money markets and, thus, the demand for T-bills was down. With a low demand, the yield from them was high. As the financial crisis loomed, the loss of confidence in the other money markets appeared causing a flight to quality. With T-bills being the ideal on money market, all investors wanted to put money into them. A move that caused the demand of T-bills rise lead to a decrease in their yield. Investors can justify the low profit buying a form of deposit insurance from the government to ensure that their funds are available at the contracted time.

Question 3

The Asset-Based Commercial Paper (ABCP) was severely affected. During the financial crisis, most of the assets that served as collateral for securities performed poorly and as a result, investors were less adapt at buying asset-backed commercial papers. As this valuation issues rose, cash flow questions appeared in institutions that focused on rolling over their ABCP to finance investments that had a longer term.

Question 4

The Federal Reserve started operating the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity whose role was to make the banks from the MMF finance the purchase of Commercial Papers. The Federal Reserve also created the Commercial Paper Funding Facility that bought A1/P1-rated commercial papers from those who issued them at the overnight index swap. The Treasury Department announced that it would insure all the MMFs, and this stopped the rapid withdrawal from MMFs.

Question 5

The Fed made the discount window open to other financial institutions. They also widened the collateral acceptable for discount window loans. The aim was to remove the restriction that they placed by specifying the collateral for borrowings. The Federal Reserve also reduced the primary credit rates and the federal funds target. They also developed the Team Auction Facility, which gave loans to financial institutions that submitted bids giving specifics about the amount they needed and the rates they were willing to pay. These actions encouraged various financial institutions to borrow from the Fed.

Question 6

The Feds reduced the target federal fund rate, which is the rate that financial institutions pay as interest after borrowing from the Federal Reserve. The reduction of target federal fund rate encouraged financial institutions to borrow more, thus, increased the liquidity. The Feds created the Commercial Paper Funding Facility (CPFF) that provided liquidity to the institutions that issued asset-backed highly-rated unsecured 3-month Commercial Paper. This facility increased the level of liquidity hat those who had CP held.

Question 7

Money Markets play a major role in the trading of liquidity. In these markets, investors with cash surpluses temporary give loans to borrowers with a need for money. All money market economies have three characteristics in common: short-term debt contracts: these contracts have a low default risk, and a high yield regarding profit. These features have to be fully met for an investor to be confident that the borrower has the ability to pay back at the contracted time. Usually, a specific day for the payment of the debt is set since the lenders have the need for the money at that particular time.

Banks, Money Market Mutual Funds (MMF), and shadow banks play various roles in the trading of liquidity. MMFs are institutional portfolios holding money market securities. It offers different benefits to investors such as denomination intermediation and provision of diversification. Banks, on the other hand, take any amount of deposits from depositors and pool the money to provide denomination, maturity, and risk intermediation, and to fund a portfolio of loans. According to Pozsar, Adrian, Ashcraft, and Boesky (2012), shadow banks are financial institutions that offer credits, maturity, and liquidity transformation but have no access to the Central Bank’s liquidity or credit guarantees for all public sectors, for example, deposit insurance.

One can use various money market instruments in the trade for liquidity between lenders and borrowers. They include Commercial Papers (CP), Treasury bills (T-bills), repurchase agreements (repo), negotiable certificate of deposits (CD), bankers’ acceptance (BA), and federal funds. T-bills are short-term direct obligations of the federal government that offer the investor an extremely liquid investment of the highest quality (Boston Institute of Finance, 2005). When there is a crisis of confidence, investors opt to buy treasury bills in a move called a flight to quality. During the financial crisis, there was a flight to quality that caused a high demand for T-bills leading to the T-bills yields decrease. According to Dell’Ariccia and Marquez (2001), a flight to quality is a stock market phenomenon occurring after investors sell what they perceive as “high agency cost” to borrowers and purchase safer investments instead.

Commercial Papers are discount instruments that provide liquidity with maturities of between 0 to 270 days. Various categories of Commercial Papers exist including financial, non-financial, and asset-backed commercial papers (ABCP). The ABCP uses various assets as collateral to secure the loans. During the financial crisis, valuation issues arose since the assets used to back the commercial papers were performing poorly. Investors were, therefore, not willing to buy the ABCP, and institutions relying on the rolling over of their ABCP to fund their investments developed cash-flow issues.

Repurchase agreements (repos) allow borrowers to use their financial securities as collateral for loans, which have a fixed interest rate. According to Griffith, Kotomin, and Winters (2012), the borrower enters into an agreement to sell his/her securities to an investor and then buys them back at an agreed later date with a fixed interest rate. A repo is like a cash transaction between the buyer and seller where the buyer gives the seller security in exchange for the cash. After the set date expires, the borrower returns the cash and gets back his/her securities. The securities serve as collateral for the cash loan in case the borrower defaults in paying the lending. Repos, therefore, provide liquidity to borrowers for a certain period of time.

Fed Funds are a required percentage of deposits that financial institutions keep in the Federal Reserve. These funds are used for managing financial institutions’ reserve positions and for compliance purposes. They have the highest level of liquidity in the financial system and, thus, the fed fund rates are the most sensitive to shifts in the money supply. During the financial crisis, banks held reserves above the expected amount in the Federal reserve to make sure they meet the withdrawal demands of their customers.

From the article, various lessons are learned. Investors require money market instruments that can preserve their finances with no or very minimal default risk. Consequently, when concerns about their finances arise, investors rapidly withdraw their money, and this results in a financial crisis. To solve this crisis, credit enhancement that improves the value of loans is required, and this lures the investors to give out risky loans. Again, there has been an evolution in the money markets. Lenders, therefore, need to have an information about borrowers and their assets. This prevents a crisis of confidence as far as the assets used as collateral loans are concerned. Policies during the financial crisis were changed, and a move to more traditional money market securities was made. Thus, the Federal Reserve, therefore, needs to provide policies that solve problems arising during a financial crisis such as those concerning loss of confidence in various money market instruments or a lack of liquidity in the market.

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