There’s a growing risk that credit woes spark bank-like runs on bond mutual funds. That’s the message from the latest in a series of studies from the Federal Reserve Bank of New York on how market liquidity has changed since the crisis. In two investigations published on Friday, the regional central bank’s wonks lay out a scenario that shows how fire sales caused by problems at some funds could lead to broader losses than a decade ago.
Some will blame new regulations that have curtailed the ability of investment banks to act as middlemen. It’s a weak argument, though, and one that the New York Fed tackled in a separate study last October.
Instead, according to the authors of the new research, entitled “Are asset managers vulnerable to a fire sale?” the problem has three causes. First, funds are larger. Second, they hold a bigger concentration of illiquid assets. Third, investors are acting in a more skittish manner, selling earlier and in greater amounts than in the past.
That all makes sense, but also misses a broader point. Mutual funds and their managers have not evolved with the times. The more assets they hold – especially in a low-rate environment where they snap up riskier, harder-to-sell securities in a hunt for returns – the more important it is to ensure they have ample liquidity to cope with a problem.
The first line of defense is cash. Most tend to hold up to 7 percent of assets, more than enough to cover the 5 percent redemptions over three months in the 1994 market rout. In 2008, however, some funds lost up to 20 percent. And jumpy bondholders are likely to run through the rainy-day stash pretty quickly.
Another option is to prevent investors from taking money out at will. That practice compounds the problem, especially the more illiquid holdings – like real estate – in a fund. Money managers could even start hawking products that remove investor-driven runs, like closed-end funds.
Such measures would neither eliminate all risk nor prevent all losses. It would, however, reduce the pain for the funds and financial system alike.