Traditional money market funds seek to maintain a constant NAV (CNAV funds) ie they invest with the explicit goal of maintaining a stable NAV of $ per share. Investors like this because it avoids any market price fluctuations in their investments. A CNAV money market fund is said to “break the buck” when its NAV falls below $ per share (or the equivalent in a fund’s respective currency). This is a rare event. Prior to the crisis, it had not happened to a US money market fund since the Community Bankers US Government Fund broke the buck in 199413. The conventional perception was that the principal should be “safe”. When money funds came under pressure during the crisis, more than 60 asset managers (among others, Wachovia and Legg Mason) unilaterally made up more than $ billion of losses14. On 16 September 2008, the Prime Reserve Fund, the oldest U.S. money market fund, wrote off 3 cents of losses on Lehman Brothers. Not being able to make up the losses, the fund was left with a NAV of $ triggering a “run” in the money markets. On 19 September 2008, the U.S. Treasury announced the establishment of a temporary one-year guarantee program to protect investors in money market funds. The funds that were eligible had to pay a fee to participate in the program, and any fund that had already “broke the buck” could not participate. This example raises several interesting issues.
Why was it so hard to anticipate what would happen if there were losses on large numbers of bonds insured by monoline insurers which had relatively small amounts of capital? One reason why such risks may not be appreciated ex ante is over-reliance on local risk measures such as VaR (Value at Risk) or other historical average correlations, and not enough on severe stress tests over different horizons. For example, in the United States it was widely believed that house prices would not fall significantly nationally (it had never happened after the Great depression in the 1930s). We assert that, if one had stressed bank capital in the US with the explicit assumption that national residential real estate prices could go down 30 to 40%, and in some local markets more, most of the losses for US banks could have been correctly predicted (at least if the complexities of structured credit products were properly assessed6). The collapse of functioning inter-bank money markets and other “runon-the-bank” phenomena obviously added further costs, but the first-order effect was caused by residential house prices falling. The key, however, was to correctly predict what that kind of price drop would do to other market participants, and market structures, as well as to the individual firm. Extreme stress tests have served a crucial purpose after the crisis to re-establish confidence in banks, and might usefully play a wider role in more aspects of on-going bank oversight.