Mutual Funds Vulnerable to Runs – -Even Fed Staff Agrees

Mutual funds are vulnerable to runs that can spill over and cause problems in the broader financial system, according to a blog post published today on Liberty Street Economics by staffers at the Federal Reserve Bank of New York.
The authors, Nicola Cetorelli, Fernando Duarte and Thomas Eisenbach, argue that a run can occur when heavy withdrawals from a mutual fund cause the fund company to sell illiquid assets at fire sale prices. In that situation, the post said, investors will have an incentive to get their money out early, triggering a race for the door that can have a ripple effect beyond the original fund.
‘Redemption runs at the fund level trigger fire sales that depress market prices and spread losses to the broader financial system,’ the authors wrote.
The post does not mention Third Avenue Management, which in December shuttered its $788.5 million Focused Credit Fund after losses and withdrawals left it unable to meet redemptions without selling assets at depressed prices. Third Avenue’s move led to a selloff in high-yield bonds.
Sean Collins, a senior director at the Investment Company Institute, a trade group for the mutual fund industry, said the blog post was a theoretical exercise.
‘We had a real world test of what they are talking about in May and June of 2013 and none of their assumed effects occurred,’ he said in a telephone interview Thursday.

This post was published at David Stockmans Contra Corner on February 22, 2016.