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Yellen addresses mutual fund failure, but fire-sale issues remain

After the Federal Reserve announced it would raise interest rates today, Federal Reserve Chairwoman Janet Yellen addressed concerns that more mutual funds might fail.

Last week, Third Avenue Focused Credit Fund announced it would suspend investor redemptions for a year after it suffered nearly a 50% loss in value since June 2014. Yellen said the assets of Third Avenue were heavily invested in companies with high credit risk. Yahoo Finance recently revealed that $27 billion invested over 29 mutual funds may also be at risk, with two of them suffering larger losses than Third Avenue.

Yellen said that the Securities and Exchange Commission is in the process of implementing measures to address liquidity and maturity mismatch. This concerns a longstanding problem in the mutual fund industry whereby investors in the funds can withdraw their money with a day's notice (daily liquidity), yet the investments of the mutual funds themselves are oftentimes illiquid and not immediately available for sale. Various U.S. regulators have implemented rules since the passage of Dodd-Frank to address this issue, including the requirement that funds keep a shorter maturity and higher liquidity profile of their investments.

Credit markets have been under pressure recently for a variety of reasons, but principally because of problems in emerging markets and the decline in the price of crude oil. The marginal producers of crude, especially shale oil companies, are capital-intensive enterprises that issue high-yield debt to finance their operations. If yields, or the cost of debt, get too high, these companies may decide to issue more stock to raise money. However, this dilutes the company's share price and makes it more unattractive as an investment.

Another problem that exacerbates the process of returning investor money is fire-sales of fund assets. When risk markets are roiled and funds need to raise cash, the markets for their worst investments become extremely illiquid. Funds are then forced to sell better quality assets, which in turn causes those markets to become illiquid. During the financial crisis of 2008, both gold and U.S. Treasurys, seen as safe havens, experienced precipitous drops as investors scrambled to sell the assets to raise cash.

Fire-sales have been an ongoing concern of the Federal Reserve since 2013, as several officials have spoken on the issue, including New York Fed President William Dudley. In particular, the Fed has been concerned that the shadow banking market, which is largely funded by money market mutual funds, may exacerbate market pressures in a downturn, with the potential of precipitating another financial crisis.

On Wednesday, the risk markets were rallying after the Fed's announcement and Yellen's press conference. However, the price of crude oil was down 5.5% intraday, indicating that credit problems for mutual funds that invest in high yield debt are not going away any time soon.