Why You Should Kiss Your $1-Per-Share Money Market Fund Goodbye
If you overlooked the details of the Federal Reserve's data dump on Wednesday, consider this fact: Of the ten largest money market fund managers in 2008, nine of them (Vanguard was the exception) participated in the Fed's AMLF program -- in which the Fed lent $150 billion to purchase commercial paper owned by the firms' money market funds. What does that mean? Essentially, without the Fed's extraordinary measures, money market funds run by the managers of two-thirds of all money market assets were in danger of "breaking the buck."
I don't know if we'll ever get an accurate picture of just how close we were to financial armageddon in late-2008, but that news paints a pretty stark picture. And the fallout could -- and, indeed, should -- result in some significant reforms in the money market industry.
For years, money markets occupied a staid corner of mutual fund industry -- a place where you stashed the money needed to cover next month's rent check in return for a few pennies on the dollar. But while most investors might view money markets as a rather hum-drum investment option, the truth is that they've come to occupy a place of enormous importance in the financial world.
As the largest buyers of the short-term debt that corporate America issues, money market funds are a large component of the so-called "shadow banking system" upon which our financial system has become so reliant. How large? According to a recent report issued by BlackRock, "money market funds hold almost half of the commercial paper that businesses issue to finance payrolls and inventories."
There's no greater testament to the importance of money market funds to the daily functioning of our economy than the speed with which the Fed stepped in to keep a contagion from spreading two years ago.
To briefly recap what happened, the nation's oldest money market fund, Reserve Primary, broke the buck on September 16, 2008. The fund, which owned a large amount of Lehman Brothers debt, couldn't maintain a $1 per share price when Lehman defaulted on its debt.
That, in turn, caused a massive run on all money market funds, as investors rushed to redeem their shares in anticipation of the trouble spilling over to other money market funds. As a result, the market for commercial paper essentially froze -- few money market funds were interested in purchasing new paper, and many were trying to sell what they did own to meet redemption requests. Three days later, on September 19, the Fed initiated their AMLF program.
Those events highlight an inherent problem in money market funds, as identified by a recent Wall Street Journal article: "it is essentially impossible to maintain the $1-a-share price benchmark while guaranteeing immediate liquidity."
Thus, to guard against the government needing to serve as a backstop in future crises, one of the money market reforms under consideration is doing away with the fixed share price of $1, and letting money market funds' net asset value fluctuate from day to day. Indeed, just last month the President's Working Group on Financial Markets released their report on money market reform. Among the eight reforms the group proposed, three involved floating share prices to one extent or another.
The mutual fund industry is fighting such an outcome tooth-and-nail. They fear that investors accustomed to stable share prices will flee money market funds if their share prices are required to fluctuate. An unspoken by primary motivation for their opposition is that if investors leave money market funds in favor of bank savings accounts, fund managers' revenues will take a hit.
But if you're concerned less with the profitability of our nation's fund managers and more with mitigating the damage of the next financial crisis (as, I hope, our politicians and regulators are), there seems to be little doubt that moving away from the fixed share price is the best way to do so.
The logic behind such a change is simple. The primary differentiator between money market funds is their yield, and there are only two ways for a fund manager to increase their fund's: 1) lower the fund's expense ratio; or 2) lower the quality of the debt that it owns. I'll give you three guesses as to which method most fund managers choose, and the first two don't count. Regardless of how many strictures the SEC places on the sort of debt that these funds can own, fund managers will always find a way around them in an effort to boost their funds' yields, which, in turn, increases assets and revenues.
Of course, this isn't a new problem. When poor investment choices put the fund's share price at risk, the manager almost always contributes the capital needed to make the fund whole. But as 2008 showed, there can be instances in which the losses outstrip the manager's ability to solve them, which can pose a threat to the economy as a whole.
Why is the $1 share price a problem? Because it encourages a "run on the bank" mentality, similar to what we saw in the banking industry in the 1930s, before the advent of deposit insurance. No one wants to be the last investor standing when there's a widespread belief that the fund's assets won't be able to meet its liabilities. As a result, there's a great deal of motivation to get your money out as quickly as possible.
Floating share prices, on the other hand, mitigate this behavior. When interest rates rise, for instance, you have no motivation to quickly cash out your short-term bond fund, because you know that change will be reflected in the price you sell your fund's shares at. You have the option to sell now at a loss, or wait and hope share prices rise in the future.
This reform does not need to be as disruptive as the ICI and their member firms would have us believe. For instance, we could, as the President's Working Group proposes, develop a two-tier system of money market funds. The first tier, with a stable share price, would pay lower yields, face higher regulatory requirements, and be forced to pay into a privately run "bailout pool." The second tier would pay slightly higher yields, with share prices that fluctuate to reflect the slight day-to-day change in value of the securities they own.
Further, the creation of such a second tier would also offer firms another way to differentiate themselves in the marketplace. Investors who value stability above all would migrate toward those firms whose "second tier" funds have demonstrated such stability in the past. Those who are motivated to earn a few extra basis points of yield could choose to invest with those firms who offer it, with the understanding the the fund's share price may end up reflecting the higher risk they're assuming in exchange for that higher yield.
The list of reforms needed in our financial system is depressingly long, with entrenched interests willing to fight common sense every step of the way. The money market crisis of 2008 wasn't the cause of our current plight, but it did pose a grave threat to our nation. Fortunately, a few relatively simple reforms could go a long way toward minimizing the threat they would pose during our next crisis. Let's hope that our political, regulatory, and industry leaders are able to take the steps necessary to do so.
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