In a world of risk, there has always been one safe place for assets: money market funds. With no promise of a capital gain, nevertheless they pay interest. It’s not immediately evident because the net asset value, in Canada, is a permanent $10 a share. In the U.S., it’s $1. The interest is paid in the form of additional units or shares.
The idea is to protect against interest rate risk, credit risk and liquidity risk. For that reason, money market funds have been convenient parking places for retail and institutional investors, and corporate treasurers, seeking a way station until they figured out how to deploy their assets.
In the lead-up to the financial crisis, more than a few investors sought this timeout. As the U.S. Investment Company Institute reports, “from the end of July 2007 through August 2008, money market funds absorbed almost $900 billion in new cash, boosting the size of the money market fund industry by more than one-third. Eighty percent of this vast inflow (more than $700 billion) was directed to institutional share classes, as institutional investors, such as corporate cash managers and state and local governments, sought a safer haven for their cash balances.”
But September 2008 changed all that. The pioneer in money-market funds, the Reserve Primary Fund, “broke the buck.” Net asset value fell below $1, thanks to Lehman commercial paper that had become worthless. The result: a run on money market funds. Evidently, 100 funds were bailed out by their sponsors in September 2008, according to the U.S. Securities and Exchange Commission. And the Treasury Department temporarily guaranteed the $1.00 share price of more than $3 trillion in money market fund shares.
A one-time event? It turns out, however, that U.S. money-market funds have “broken the buck” many times. As SEC Chairman Mary Schapiro told the U.S. Senate Banking, Housing and Urban Affairs Committee in June:
“sponsors have voluntarily provided support to money market funds on more than 300 occasions since they were first offered in the 1970s. Some of the credit events that led to the need for sponsor support include the default of Integrated Resources commercial paper in 1989, the default of Mortgage & Realty Trust and MNC Financial Corp commercial paper in 1990; the seizure by state insurance regulators of Mutual Benefit Life Insurance (a put provider for some money market fund instruments); the bankruptcy of Orange County in 1994; the downgrade and eventual administrative supervision by state insurance regulators of American General Life Insurance Co in 1999; the default of Pacific Gas & Electric and Southern California Edison Co. commercial paper in 2001; and investments in SIVs, Lehman Brothers, AIG and other financial sector debt securities in 2007-2008. In part because of voluntary sponsor support, until 2008, only one small money market fund ever broke the buck, and in that case only a small number of institutional investors were affected.”
So even though money market funds focus on the least risky part of of the investment universe (apart from money under the mattress of course), there’s a lot more risk than money-market sponsors have hitherto chosen to reveal. More than that, Schapiro argues, they can pose a systemic risk: “By 2008, more than two-thirds of money market fund assets came from institutional investors, which could wire large amounts of money in and out of their funds on a moment’s notice. Some of these institutional assets were what are known in the business as ‘hot money’—assets that would be quickly redeemed if a problem arose, or even if a competing fund had higher yields.”
Which is problematic, Schapiro argues, “Money market funds are vulnerable to runs because shareholders have an incentive to redeem their shares before others do when there is a perception that the fund might suffer a loss. … The stable $1.00 share price has fostered an expectation of safety, although money market funds are subject to credit, interest-rate and liquidity risk. Recurrent sponsor support has taught investors to look beyond disclosures that these investments are not guaranteed and can lose value. As a result, when a fund breaks a dollar, investors lose confidence and rush to redeem.”
The buck doesn’t stop, here, there or anywhere. Investors flee, first movers (usually institutional investors), cash out at net asset value, funds faced with redemptions have to liquidate securities on the open market, net asset values plunge. Without government protection, you’re on your own.
Far-fetched? As Schapiro notes, money-market funds “continue, for example, to have considerable exposure to European banks, with, as of May 31, 2012, approximately 30% of prime fund assets invested in debt issued by banks based in Europe generally and approximately 14% of prime fund assets invested in debt issued by banks located in the Eurozone.”
So she proposes floating NAVs for money-market funds, just like for regular mutual funds. That way, fund holders could anticipate what may come. Failing that, there should be a capital buffer to maintain the NAV. It’s been there implicitly. Schapiro wants to make it transparent: “many money market funds effectively already rely on capital to maintain their stable values: hundreds of funds have required sponsor bailouts over the years to maintain their stable values. Requiring funds to maintain a buffer simply would make explicit the minimum amount of capital available to a fund.”
Of course, the money market industry would rather not have the public know how sausages are made. Says Paul Schott Stevens, president of the Investment Companies Institute, the main lobby group for mutual funds, “Regulators reportedly are pursuing flawed proposals that will harm investors, damage financing for businesses and state and local governments, and jeopardize a still fragile economic recovery. Indeed, the ideas under consideration will drive funds out of business, reducing competition and choice, and alter the fundamental characteristics of money market funds—such as a stable NAV and ready liquidity—thereby destroying their value to investors and the economy. Rather than making our economy and financial system stronger, such reforms have the potential to increase systemic risk by driving investors into less-regulated, less-transparent products.
Wasn’t it investments in “less regulated, less-transparent products” such as asset-backed commercial paper and structured investment vehicles that started the run on money market funds in the first place?