The ESF allows the Treasury to convert special drawing rights funds (SDRs) into dollars by exchanging them with the Federal Reserve. An SDR is an international reserve asset established by the International Monetary Fund. The ESF is used as a backstop to cover any losses the Fed might incur through its new lending programs that target the securities, credit, and foreign exchange markets.
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The 2008-09 Financial Crisis
On October 21, 2008, the Fed announced the Money Market Investor Funding Facility (MMIFF) and pledged to lend up to $540 billion. The MMIFF was established about a month after a money market fund called the Reserve Fund ‘broke the buck,’ meaning that the value of its shares had plunged below par value of $1. The Reserve Fund broke the buck after Lehman Brothers filed for bankruptcy on September 15, 2008, exposing investors to crippling losses.
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In response, the Treasury announced it would finance any losses using the ESF mechanism. The ESF guaranteed deposits and protected the value of the dollar.
Looking back, one can argue that the Fed’s post-crisis programs were successful because they brought in more money than was paid out by the government. Most of the Treasury and Federal Reserve programs have zero principal outstanding. That means net income exceeded the amount doled out by the government.
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Fed Reopens ESF Programs
Although these measures were considered necessary to stabilize the financial system in the wake of the COVID-19 crisis, they carry significant risks. For starters, money market funds own about $325 billion of the $1 trillion commercial paper market, which has been under considerable stress as companies continue to rely on their revolving credit lines to shore up cash flow.
For many investors, this conjures up images of another ‘break the buck’ scenario as Lehman Brothers in 2008. Although post-crisis legislation prevents this, money market funds exposed to commercial paper are still vulnerable to a run on assets. As a result, there has been significant outflow from prime funds as investors continue to be cognizant of the risk.
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The Bottom Line
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