Money market funds and liquidity risk of GSE assets

The liquidity crisis will mark its first anniversary in a few weeks. Brief account of the last year pain includes XABCP extensions, SIVs, monolines, the auction rate market, broker/dealers, and GSEs.

Last week ended on a highly worrisome note of reduced liquidity of the short-term GSE's papers. It would be an extreme to alarm the world of the United States going under BUT in our "used to be quiet" corner of cash management liquidity does equal credit. Accordingly, our view of the world has to be, as contingent on occupation, more intense.

Here is a few flashbacks: (1) when XABCP extended, there was no default; only investors took it as such. In fact, the structures performed "as expected". While still being "money good", other programs with similar features became a source of headline risk and an illiquid part of cash portfolios.
(2) when first SIV-lites went into enforcement, other CP/MTNs issued by SIVs became a source of headline risk and an illiquid part of cash portfolios.

Over the last year I've participated in a few "deja vu" conversations:
Cash manager's wishful thinking: the asset is "money good" at the end and there is plenty of liquidity in the portfolio.
Careful investor: what if you need to sell it?
Cash manager: I want to believe I can, but I don't want to find out.
The outcome of these talks is well know: 17 money market complexes had to buy assets from their money market portfolio. The assets are probably money good "at the end"; the advisor will likely to receive 100% recovery. The only worry is that a money fund investor is not to wait through "the end". If a buck is not in your MMF today, the buck is broken.

The last of my "deja vus" came on Friday: "I do see some cash going from our Government fund to Treasury", a Government fund's PM was saying, "I still want to believe I will be able to sell, if I have too, but I don't want to find out".

Now my "worst case" scenario. The size of the money market industry is about $3.5 trillion, close to 1/3 of it are Government money market funds. Size of these funds roughly tripled over the last your as a result of "a flight to quality". My estimate is about 1/3 of assets are from foreign investors for which Fannie/Freddie creditworthiness might be a tougher sell. So far money funds were only gaining cash, but at this point we may see the waive reversed.

Well known fact: if a money fund experiences 20%-30% outflow at 60-day WAM with spread widening of 300 bps it breaks the buck on marked-to-market. On average, funds are currently between 40 and 50 days and 300 bps in this environment is not unthinkable. The size of govvy funds is indigestible for most of investment advisor to support.

I'm not a GSE analyst to ponder on their insolvency; the black magic of the short-term market is in the instant transfer of any type of risk of the underlying assets into the credit risk of a money fund portfolio as a whole. Ironically, the only money fund that "broke the buck" was a Government fund.