LO 54.3: Describe specific liquidity challenges faced by money market mutual

LO 54.3: Describe specific liquidity challenges faced by money market mutual funds and by hedge funds, particularly in stress situations.
Systematic funding risks were apparent in many market sectors during the subprime mortgage crisis. As loans become shorter term, lenders and borrowers are exposed to greater liquidity risks. Borrowers must be able to refinance in order to repay short-term loans. The risk is systematic in that it affects borrowers and lenders at the same time.
Liquidity issues arose during the recent financial crisis for a variety of investment strategies including: Leveraged buyouts (LBOs). Leveraged loans became the dominate type of syndicated
bank loans as LBOs and private equity grew before the crisis. Leveraged loans accounted for a large part of collateralized loan obligations (CLOs) and collateralized debt obligations (CDOs), which provided funding for LBOs. During the subprime mortgage crisis, LBO deals fell apart as funding dried up. Some loans, called hung loans, had not been distributed to investors and demand dried up. Banks incurred significant losses as prices fell sharply.
Merger arbitrage hedge funds. Hedge funds engaged in merger arbitrage experienced losses in the early stages of the subprime mortgage crisis. After a merger is announced, the targets stock price typically increases and the acquirers price sometimes declines due to increased debt. The merger arbitrage strategy exploits the difference between the current and announced acquisition prices. Hedge funds experienced large losses as mergers were abandoned when financing dried up.
Convertible arbitrage hedge funds. Convertible arbitrage strategies rely on leverage to enhance returns. Credit is extended by broker-dealers. When financing becomes unavailable due to market conditions, as experienced in the 20072009 financial crisis, convertible bond values drop precipitously. The funding liquidity problem was compounded by redemptions (i.e., a market liquidity problem). Also, because there is a limited clientele investing in convertible bonds, when the clientele develops a dislike for the product due to deteriorating market conditions, it is difficult to sell the assets without large price declines. The gap between convertible bond prices and replicating portfolios widened dramatically during the financial crisis, but it still did not bring arbitrage capital into the market.
The broader point is that investment strategies, such as merger arbitrage, convertible arbitrage, and leveraged buyouts, are not only exposed to idiosyncratic risks, but also to systematic risks (i.e., systematic funding risks in this case). The risks are soft risks because they are difficult to relate to a particular series of asset returns. Instead, analysts must examine data on credit and liquidity spreads as well as quantitative and anecdotal data on the availability of credit in the market to understand the probability of a liquidity freeze.
Money market mutual fund (MMMF) investors can write checks and make electronic bank transfers. Like banks, MMMFs are obligated to repay investors/depositors on demand. In general, underlying MMMF assets are high credit quality instruments with short maturities (e.g., a few weeks to a few months). However, the values of the underlying assets in the fund, despite their relative safety, are subject to change. As such, redemptions may be limited if asset values fall. The liabilities of MMMFs are, therefore, more liquid than their investments, similar to banks.
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Topic 54 Cross Reference to GARP Assigned Reading – Malz, Chapter 12
MMMFs use a form of accounting called the amortized cost method, under the Securities and Exchange Commissions (SEC) Rule 2a 7. This means that MMMF assets do not have to be marked-to-market each day, as required for other types of mutual funds. The reason behind the difference is that extremely short-term securities are not likely to revalue based on changes in interest rates and credit spreads. MMMFs set a notional value of each share equal to $1.00. Flowever, credit write-downs cannot be disregarded and it is possible for net asset values (NAVs) to fall below $1.00. This is known as breaking the buck.
Liquidity risk can also cause NAVs to fall below $1.00. MMMFs, like depository institutions, are subject to runs. If a large proportion of investors try to redeem shares in adverse market conditions, the fund may be forced to sell money market paper at a loss. This can potentially result in write-downs and breaking the buck.
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