Exchange Stabilization Fund: Understanding its Role During a Financial Crisis

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Exchange Stabilization Fund: Understanding its Role During a Financial Crisis

Sam Bourgi

|

Investment protection concept
Established in 1934 under the Gold Reserve Act, the Exchange Stabilization Fund (ESF) is an emergency reserve account that allows the U.S. Treasury to mitigate instability in the financial sector.

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.

Learn more about mutual funds here.

The 2008-09 Financial Crisis

The ESF was used in the fallout of the 2008 financial crisis when the Federal Reserve began accepting a broader range of assets as collateral for loans. This was a way for the Central Bank to encourage financial institutions to continue lending to businesses and consumers during the economic downturn.

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.

Check our Money Market Funds center to keep up to date with happenings in the money market world.

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.

Use the Mutual Funds Screener to find the funds that meet your investment criteria.

Fed Reopens ESF Programs

The coronavirus pandemic compelled the Federal Reserve to implement a new easing campaign designed to boost lending and economic growth. On March 25, the Senate passed a multi-trillion-dollar stimulus package that included a $500 billion ESF appropriation from the Senate. The legislation permitted the temporary use of the ESF to guarantee money markets. As such, the Central Bank began accepting as collateral money market funds, corporate bonds, municipal bonds, and securities backed by consumer and small business loans.

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.

Don’t forget to click here to see the 2016 reforms that drastically changed how money market funds operate.

The Bottom Line

The coronavirus pandemic is expected to ripple through the economy and financial system for quite some time. In this environment, investors can expect more unconventional policies from the Federal Reserve as the threat of a recession looms large.

Be sure to check our News section to keep track of the latest updates from the mutual fund industry.


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Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

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Find out why $30 trillon is invested in mutual funds.


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Investment protection concept

Exchange Stabilization Fund: Understanding its Role During a Financial Crisis

Sam Bourgi

|

Established in 1934 under the Gold Reserve Act, the Exchange Stabilization Fund (ESF) is an emergency reserve account that allows the U.S. Treasury to mitigate instability in the financial sector.

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.

Learn more about mutual funds here.

The 2008-09 Financial Crisis

The ESF was used in the fallout of the 2008 financial crisis when the Federal Reserve began accepting a broader range of assets as collateral for loans. This was a way for the Central Bank to encourage financial institutions to continue lending to businesses and consumers during the economic downturn.

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.

Check our Money Market Funds center to keep up to date with happenings in the money market world.

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.

Use the Mutual Funds Screener to find the funds that meet your investment criteria.

Fed Reopens ESF Programs

The coronavirus pandemic compelled the Federal Reserve to implement a new easing campaign designed to boost lending and economic growth. On March 25, the Senate passed a multi-trillion-dollar stimulus package that included a $500 billion ESF appropriation from the Senate. The legislation permitted the temporary use of the ESF to guarantee money markets. As such, the Central Bank began accepting as collateral money market funds, corporate bonds, municipal bonds, and securities backed by consumer and small business loans.

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.

Don’t forget to click here to see the 2016 reforms that drastically changed how money market funds operate.

The Bottom Line

The coronavirus pandemic is expected to ripple through the economy and financial system for quite some time. In this environment, investors can expect more unconventional policies from the Federal Reserve as the threat of a recession looms large.

Be sure to check our News section to keep track of the latest updates from the mutual fund industry.


Sign up for Advisor Access

Receive email updates about best performers, news, CE accredited webcasts and more.

Popular Articles

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.

Why 30 trillion is invested in mutual funds book

Download our free report

Find out why $30 trillon is invested in mutual funds.


Read Next

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