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Bates Research  |  02-19-16

The Long Tail of the Credit Crisis

In a new blog post, the Federal Reserve Bank of New York considers whether or not asset managers are vulnerable to ”run on the bank” scenarios and, more broadly, what the implications of those ”runs” might be for financial markets. The concern is that while open-end mutual funds may be holding sufficient levels of cash to meet the normal demand for daily redemptions, a sudden (or sustained) wave of redemptions may force them to liquidate holdings, perhaps at undesirable “fire sale” prices.

For investors in funds with assets that are less liquid than equities (for instance), there can be a pronounced “first-mover” advantage to redeeming before other investors. As an example, the FRBNY cites to the following study, which found that corporate bond funds (as compared to equity or Treasury bond funds) were more likely to face a sudden wave of investor redemptions after a period of underperformance, presumably because of the first-mover advantage. Investors who waited to redeem would likely be doing so after the fund had exhausted its cash reserves. When the fund is then forced to sell corporate bonds on the open market, it would have to do so at prices that would further depress the fund's NAV, leading to a vicious cycle of further redemption requests at progressively lower prices.

The Federal Reserve is interested in what impact these forced fire sales have on the market as a whole, citing this study, which found that even among more liquid equity mutual funds, the 10% of funds that account for the greatest selling pressure in a given quarter suppress the prices of the securities that they sell by an average of 15%. It certainly seems that these ”run on the fund” situations would have knock-on effects on markets as a whole.

We have already seen the impact of a mismatch between the liquidity of the assets held and the on-demand nature of redemptions play out in the market when the Third Avenue Focus Credit Fundannounced its halt in redemptions and wind-down. That kicked off a period of unease within corporate bond markets in general, particularly in the high-yield debt category.

In their annual report on financial stability, the Office of Financial Research (which was created in the aftermath of the Credit Crisis) has also singled out liquidity mismatch within funds as a potential source of broader systemic risks. Contrary to that report, the FRBNY did its own research and determined that there were two factors that were more dominant in creating ”spillover vulnerability” than the concentration of illiquid assets. One is the simple rise in assets invested in funds since 2009 (particularly in bond funds). The chart below, which first appeared in the Financial Times, shows the sheer volume of assets held within open-end mutual funds today.

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The second factor is identified by the FRBNY as ”aggregate sensitivity,” or as they describe it, "...the increase in the flow sensitivity to performance of the system has contributed as much to the increased vulnerability as the increase in aggregate assets. In other words, investors seem to have become more skittish since the crisis and are quicker to redeem shares, and in larger amounts, for a given degree of underperformance." [emphasis added]

The SEC has proposed new rules governing liquidity for mutual funds and ETFs, requiring new classifications of assets and periodic reviews of liquidity risk, among other items. Assets would be placed into six different groups, depending on the number of days in which they could be liquidated at "...a price that does not materially affect the value of that asset immediately prior to sale." Funds would also be required to regularly review their liquidity risk based on specific factors. The Investment Company Institute (for one) has come out against the SEC's proposed changes, though the industry group does acknowledge that there are "sensible things to do" in regards to liquidity management.

The absence of leverage and a floating NAV had long been thought to insulate funds from ”run on the fund” conditions (and the ripple effects those conditions cause), but the FRBNY and others have concluded that this might not be the case. Regulators, given their mandates to protect and promote system wide financial stability, will certainly be focusing their attention on this area.