By: Frank Armstrong
The recently floated proposal by the U.S. Securities and Exchange Commission to allow money market funds to “break the buck” and restrict liquidity under certain circumstances would be a disaster.
Money market funds are one of the most important innovations in finance of the last 40 years. Once Merrill Lynch introduced their Cash Management Accounts (CMAs) in 1977 there was no going back.
Over time, banks responded with NOW accounts and finally money market funds emerged. Today they hold approximately $2.6 trillion, accounting for about 9% of all mutual fund assets, clearly demonstrating both market need and acceptance.
Because instruments with a duration of less than 180 days can be held at face value, money market funds can maintain a constant net asset value (NAV), even though the underlying assets vary slightly as they march toward maturity and endure interest rate fluctuations.
As long as funds maintain their shadow (the actual) NAV in a range of $0.9950 to 1.0050, money market funds are allowed by SEC regulation to round the effective NAV to $1.00, allowing for transactions at $1.00. This allows money market funds to report a stable NAV, despite the small variations in the shadow NAV (which reflects market values).
If a money market fund’s shadow NAV moves outside the allowable range of $0.9950 to $1.0050, the fund must take immediate corrective actions to bring the shadow NAV back inside the range, or discontinue using amortized cost accounting.
Investors have come to rely on a constant dollar value with almost instant liquidity as a “safe” place to keep their cash. They are such a key part of our financial system that it’s hard to remember a time without money market funds or a world without them.
Since inception the funds have been a giant cash cow for their distributors. Especially during times of higher interest rates investors happily traded off fat fund fees for the perceived safety and convenience of the funds. Fees for “sweep” accounts at brokerage firms like Charles Schwab, Fidelity, Merrill Lynch and Citibank were especially rapacious and contributed mightily to the brokerage houses’ bottom lines.
Most customers never noticed, but the savviest of them quickly learned to keep anything above their trivial cash needs in institutional money market funds which offered lower operating expenses and higher yields. However, in today’s near zero rate environment fees are being squeezed.
If investors respond to anything, it’s yield. So, even tiny differentials will result in a torrent of new assets for the funds. Enter moral hazard. Investors clearly don’t want to do their homework on the risk of the underlying assets. The fund with the highest yield wins regardless of the quality of the underlying investments. So the incentives to stretch for yield are enormous.
While there are quality constraints on the funds, money market fund managers began to juice their yields by including higher risk assets such as commercial paper, repurchase agreements and short term bonds. So, while money market funds may look the same to the great unwashed investor, under the hood they are not.
All this worked quite nicely until September 2008 when the Reserve Primary Fund in New York said it cut its share price to 97 cents after marking down the value of $785 million in Lehman Bros. debt securities, following the brokerage’s filing for bankruptcy court protection on Monday, September 15, 2008. The resulting run on the bank caused the U.S. government to institute a temporary insurance program on September 16, 2008. That program ended a year later, and the government is understandably in no hurry to reenter the business.
Investors of all sizes need an absolutely safe, fully guaranteed place to keep their liquid assets. I don’t care if you are saving up $300,000 for a new sailboat, or just sold your company for $300 million, you want to be able to draw on it on an instant’s notice without worrying about market fluctuations, potential loss, or liquidity constraints. Unless I’m ready to establish my own account with the U.S. Treasury to buy T-Bills, my options for this important need are fairly limited.
At best, current alternatives are inconvenient. For instance, I’m on the board of a local yacht club that must maintain cash reserves against potential hurricane damage. The manager of the club wastes valuable time and energy maintaining a portfolio of CD’s fully covered by FDIC.
The SEC proposal converts money market funds into short term bond funds. They are far from a perfect substitute. If that’s what I wanted, I could find plenty of them.
In lieu of the SEC proposal I believe that if necessary until interest rates return to a “normal range,” a large number of investors would accept a zero yield and even pay reasonable account fees if necessary in order to maintain the safety, convenience, and liquidity of the traditional money market fund. Such funds could be restricted to invest in only U.S. government guaranteed issues and may even have to post reserves, eliminating the need for government insurance and preserving a necessary fixture of the financial system.