On March 18, 2020, the Board of Governors of the Federal Reserve System (“Federal Reserve”) established a facility that will provide liquidity to certain types of money market mutual funds (“MMFs”) by making secured loans to financial institutions that purchase certain assets from MMFs (the Money Market Mutual Fund Liquidity Facility, or “MMLF”).[1] The MMLF is intended to support prime, state and municipal MMFs that experience significant stress in the coming days in the event that investors seek to liquidate MMF shares into cash. This facility is similar to one operated by the Federal Reserve during the 2008 financial crisis but will be available for a wider range of assets. It also builds on efforts taken last week through the launch of the Commercial Paper Funding Facility to purchase unsecured and asset-backed commercial paper rated A1/P1 directly from eligible companies and the Primary Dealer Credit Facility to offer overnight and term-secured funding to primary dealers.[2]

We recommend that financial institutions review the procedures used in connection with the 2008 facility and that MMFs begin discussions with financial institutions regarding liquidity support through the MMLF.

Historical Perspective

In 2008, in response to the financial crisis that began in 2007 (and a particular money market fund having “broken the buck”), the Federal Reserve established the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (“AMLF”) to provide funding to US depository institutions and bank holding companies to finance certain purchases of high-quality asset-backed commercial paper (“ABCP”) from MMFs.[3] In other words, this facility gave MMFs an avenue to sell their ABCP. The Federal Reserve intended for the AMLF to assist MMFs that held qualifying ABCP in meeting demands for redemptions by investors and to foster liquidity in the ABCP market and help stabilize the money markets more generally.

The AMLF was operated by the Federal Reserve Bank of Boston. That facility began operations on September 22, 2008, and was closed on February 1, 2010. All loans made under the facility were repaid in full, with interest.

The AMLF was one of six facilities that the Federal Reserve launched in response to the 2008 financial crisis. The others included the Term Securities Lending Facility, Primary Dealer Credit Facility, Commercial Paper Funding Facility, Money Market Investor Funding Facility (never used), and Term Asset-Backed Securities Loan Facility. In addition, in 2008, the US Treasury Department instituted a guarantee program for money market funds. The temporary guarantee program provided coverage to fund shareholders for amounts that they held in participating money market funds if the fund’s net asset value were to fall below $0.995 (i.e., if the fund “broke the buck”).

2020 Facility

As has been widely reported, as a result of the ongoing COVID-19 pandemic, investor demands for cash have been increasing.[4] As investors seek cash, there is a concern developing in the markets that MMFs will come under liquidity pressure in the coming days and weeks if investors seek to liquidate MMF shares to fund their cash requirements.[5] As demonstrated in 2008, this liquidity pressure has the potential to exacerbate the liquidity crunch as MMFs may be forced to sell assets into a declining market. The Federal Reserve is now establishing the MMLF to provide liquidity support to MMFs that are designated as “prime”, “single-state”, or “other tax exempt” funds in their reports to the US Securities and Exchange Commission on Form N-MFP.[6] As with the AMLF, the MMLF will be operated by the Federal Reserve Bank of Boston.

The MMLF will make secured loans to “eligible borrowers” to finance the acquisition of “eligible assets” from prime MMFs. Eligible borrowers are US depository institutions, US bank holding companies (including US broker-dealer subsidiaries), and US branches and agencies of non-US banks. Eligible assets are:

  1. US Treasury securities and fully guaranteed agency securities;
  2. Securities issued by US government-sponsored entities (“GSEs”);
  3. ABCP that is issued by a US issuer, is rated at the time purchased from the MMF or pledged to the Reserve Bank not lower than A1, F1, or P1 by at least two major rating agencies or, if rated by only one major rating agency, is rated within the top rating category by that agency;
  4. Unsecured commercial paper that is issued by a US issuer, is rated at the time purchased from the MMF or pledged to the Reserve Bank not lower than A1, F1, or P1 by at least two major rating agencies or, if rated by only one major rating agency, is rated within the top rating category by that agency; or
  5. US municipal short-term debt that has a maturity that does not exceed 12 months and, at the time purchased from the MMF or pledged to the Reserve Bank:
    1. If rated in the short-term rating category, is rated in the top short-term rating category (e.g., rated SP1, MIG1, or F1, as applicable) by at least two major rating agencies or if rated by only one major rating agency, is rated within the top rating category by that agency; or
    2. If not rated in the short-term rating category, is rated in the top long-term rating category (e.g., AA or above) by at least two major rating agencies or if rated by only one major rating agency, is rated within the top rating category by that agency.[7]

The loans from the MMF will be for a term of no more than 12 months, and loans will be originated only through September 30, 2020. There will be no fees for using the facility.

Secured loans made under the MMF that are secured by US Treasury securities, fully guaranteed agency securities, or securities issued by US GSEs will be made at a rate equal to the primary credit rate in effect at the Reserve Bank that is offered to depository institutions at the time the loan is made. Secured loans made under the MMF that are secured by US municipal short-term debt will be made at a rate equal to the primary credit rate in effect at the Reserve Bank that is offered to depository institutions at the time the loan is made plus 25 basis points. All other loans will be made at a rate equal to the primary credit rate in effect at the Reserve Bank that is offered to depository institutions at the time the loan is made plus 100 basis points.

Related Regulatory Capital Relief

Because of the non-recourse nature of the secured loans under the MMLF, the borrower is not exposed to credit or market risk from the assets it purchases and pledges as collateral. However, under the US regulatory capital rules, the assets purchased from the MMFs and the secured loans through the MMLF could increase a borrower’s regulatory capital requirements.

To recognize the risk-free nature of the secured lending (from the borrower’s perspective) and encourage financial institutions to participate, the Federal Reserve and other federal banking regulators amended the regulatory capital rules to “fully neutralize” the impact of the MMLF on regulatory capital ratios.[8] The amended rules will fully exempt from risk-based capital and leverage requirements (i) any asset pledged to the MMLF and (ii) any asset purchased from a MMF on or after March 18, 2020, that the financial institution intends to pledge to the MMLF upon opening of the facility. The amended rules are effective immediately.

SEC Rules Related to Affiliated MMF Asset Purchases Remain in Place

All purchases of assets from MMFs by affiliated persons, promoters and principal underwriters, and their affiliated persons, whether or not for purposes of the MMLF, are subject to restrictions on affiliated transactions under the Investment Company Act of 1940 (“1940 Act”). These purchases should comply with the requirements of Rule 17a-9 under the 1940 Act, which generally requires that: (i) the purchase price be paid in cash, (ii) the purchase price must be equal to the greater of the amortized cost of the security or its market price (in each case, including accrued interest), and (iii) if the asset remains an “eligible security” under 1940 Act Rule 2a-7 and is not in default, if the purchaser later sells the asset for a higher price than the purchase price paid to the MMF, the purchaser must promptly pay to the fund the amount by which the subsequent sale price exceeds the purchase price paid to the fund.[9]

Money Fund Liquidity Fees and Redemption Gates

Rule 2a-7 under the 1940 Act, which governs the operations of MMFs, permits any type of MMF to impose a liquidity fee of up to two percent and/or temporarily suspend redemptions (i.e., impose a “redemption gate”), if the fund’s weekly liquid assets drop below 30 percent of total assets.[10] Under the rule, a non-government MMF (such as a prime fund) is generally required to charge a one percent liquidity fee if weekly liquid assets drop below 10 percent of total assets. Redemption gates are intended to curtail a “run on the fund” by hitting the pause button on redemptions so that fund managers can assess the fund’s condition and ability to meet redemptions; liquidity/cash buffers can increase as portfolio investments mature; and market volatility can subside. Similarly, a liquidity fee is designed to discourage but still permit redemptions. Given the impact on shareholders, MMFs generally view liquidity fees and redemption gates as options of “last resort.” Accordingly, other liquidity options for MMFs, such as those that were established in 2008 and those that are being established now, are likely to be welcomed by market participants.

Takeaways

The Federal Reserve has not formally opened the MMLF or released documentation on how financial institutions may participate. However, we expect that the MMLF will largely track the earlier AMLF. Therefore, we recommend that prospective borrowers review the historical terms and conditions for that facility and that prospective MMF sellers begin discussions with financial institutions regarding liquidity support through the new facility.[11]

For MMFs, this measure and others taken by regulators to help stabilize current market conditions (which include extremely low interest rates and negative Treasury yields) hopefully will prevent history from repeating itself, particularly for government and retail MMFs, which are the funds at risk for “breaking the buck.”

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If you have any questions about the developments discussed above, or about bank regulatory responses to COVID-19 more generally, please contact Matt Bisanz, Leslie Cruz, Adam Kanter or Jeff Taft. We will continue to keep our clients updated on future significant regulatory developments related to COVID-19, including an update to this Legal Update to reflect the stand-up of the MMLF and related programs.

If you wish to receive periodic updates on this or other topics related to the pandemic, you can be added to our COVID-19 “Special Interest” mailing list by subscribing here. For any other legal questions related to this pandemic, please contact the Firm’s COVID-19 Core Response Team at FW-SIG-COVID-19-Core-Response-Team@mayerbrown.com.

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[1] Federal Reserve Board broadens program of support for the flow of credit to households and businesses by establishing a Money Market Mutual Fund Liquidity Facility (MMLF) (Mar. 18, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200318a.htm; Federal Reserve Board expands its program of support for flow of credit to the economy by taking steps to enhance liquidity and functioning of crucial state and municipal money markets (Mar. 20, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200320b.htm. ; Federal Reserve, Money Market Mutual Fund Liquidity Facility FAQs (Mar. 21, 2020), https://www.federalreserve.gov/monetarypolicy/files/mmlf-faqs.pdf.

[2] Federal Reserve Board announces establishment of a Commercial Paper Funding Facility (CPFF) to support the flow of credit to households and businesses (Mar. 17, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200317a.htm ; Federal Reserve Board announces establishment of a Primary Dealer Credit Facility (PDCF) to support the credit needs of households and businesses (Mar. 17, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200317b.htm.

[3] Federal Reserve, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (last updated Mar. 18, 2020), https://www.federalreserve.gov/monetarypolicy/abcpmmmf.htm (describing the 2008 AMLF).

[4] Howard Schneider, US Fed moves to ensure liquidity in money market mutual funds, Reuters (Mar. 18, 2020).

[5] Federal bank regulatory agencies issue interim final rule for Money Market Liquidity Facility (Mar. 19, 2020), https://www.federalreserve.gov/newsevents/pressreleases/monetary20200319a.htm

“the spread of COVID-19 has slowed economic activity in many countries, including the United States. In particular, sudden disruptions in financial markets have put increasing liquidity pressure on MMFs. Given these pressures, MMFs have been faced with redemption requests from clients with immediate cash needs. The MMFs may need to sell a significant number of assets to meet these redemption requests, which could further increase market pressures.”

[6] The US Secretary of the Treasury approved the establishment of the MMLF, as required under Section 13(3) of the Federal Reserve Act. 12 U.S.C. § 343(3)(B)(iv)

[7] In addition, the MMLF may accept receivables from certain repurchase agreements. The MMLF initially will not take variable rate demand notes or tender option bonds, but the Federal Reserve will consider the feasibility of adding these and other asset classes at a later date.

[8] Federal bank regulatory agencies issue interim final rule for Money Market Liquidity Facility (Mar. 19, 2020). The interim final rule will be subject to a 45 day comment period.

[9] 17 C.F.R. § 270.17a-9.

[10] 17 C.F.R. § 270.2a-7.

[11] See, Federal Reserve, Asset Backed Commercial Paper (ABCP) Money Market Mutual Fund (MMMF) Liquidity Facility (AMLF or “the Facility”) https://www.frbdiscountwindow.org/Archive/Asset-Backed-Commercial-Paper-ABCP-Money-Market-Mutual-Fund-MMMF-Liquidity-Facility-AMLF-or-the-Facility-.