Money Market Funds and U.S. Downgrade - 4 Reasons Not To Worry

This article was updated on August 1, 2011.

I initially wrote on the issue of money market funds and a government default the other day, but that's moot now, I hope. Still many of the same considerations would apply to a downgrade of the U.S. from its lofty AAA credit rating.

Money market funds own large amounts of U.S. government debt, something like $338 billion worth -- in the aggregate, it's the largest holding. When, as and if there is a downgrade of the federal government's creditworthiness, what happens to all those Treasury bills, and could there be a ding to the $1 share price fund managers promise?

No one can say for sure, because such an event has never occurred. But there are a number of safeguards in place that should prevent runs on money market funds, and enable managers to keep share prices intact. (Recently the Treasury's Financial Stability Oversight Council issued its first annual report, and on page 50 addressed the risks of money market funds.)

Unfortunately the government has not been helpful on contingency planning, and created something of an information vacuum. This is in contrast to the time of a threatened government shutdown a while back, when the Treasury and Fed provided the banks with a roadmap. No contingency planning this time, however, probably because they don't want to acknowledge in any way that there might be a default, even one of short duration, so as not to spook the cattle.

What might happen to hurt money market funds? The main concern seems to be a "run," where some money fund shareholders would cash out their shares in anticipation of a downgrade (fearing that the Treasury securities funds own would lose value). If money funds ran out of cash on hand and had to sell securities, it could depress the price of the other holdings in their portfolios.

To prepare for large liquidations, money fund managers have been selling securities to raise cash for redemptions, says the Financial Times:

Government-only money market funds have boosted the amount of cash available to meet redemptions within one week to 68 per cent of assets, from 48 per cent at the end of March, according to Barclays Capital. "We've built up liquidity with a rather meaningful amount of maturities prior to the debt ceiling," said Robert Brown, head of Fidelity's money market business.

...

Money market funds are avoiding the one-month Treasury notes which mature on August 4 and August 11. "Those are the securities most vulnerable to some sort of change," said Joseph Abate, strategist at Barclays Capital.

Second, if there is a downgrade, which is looking more and more likely, the funds might not be forced to sell their government securities. In the worst case, they could let their government securities mature, collect the full proceeds, and just not reinvest during the turbulence -- put it in bank accounts, perhaps.

Third, when money market funds have gotten in trouble in the past, in some cases the fund management companies have stepped in and bought impaired securities from the funds. (They are not obligated to do so, however.)

Last, the Securities and Exchange Commission revamped the regulations on money market funds in 2010, implementing lessons learned in the financial crisis. Funds are required to invest in higher quality assets with shorter maturities. The new rules also allow managers to suspend redemptions, so that a rush of early cashing out will not leave the remaining shareholders at a disadvantage.