Money market funds aren’t cash!

August 26, 2009

Paul Volcker wants to kill money market funds. He says that investors don’t understand them and that the funds could crash the financial system. He’s right.

The root of the problem is that money market funds are sold as “cash equivalents,” when really they’re anything but.

Investors allocating a percentage of their assets to “cash” are typically looking for a “riskless” place to park money. They want their principal protected, but they would  also like a few extra points of interest thank you very much. Free checks ? Even better.

Money market funds can offer all of the above, so naturally investors gravitate to them.

What they don’t realize is that their principal is at risk. The $1 net asset value that money funds market is just an accounting gimmick, a milder version of the same gimmick banks use to avoid writing down bad loans.

Because money market funds hold their assets to maturity, they’re allowed to use so-called “amortized cost” accounting instead of mark-to-market. If the value of securities in the portfolio rises or falls, investors don’t see that because it isn’t reflected in the fund’s share price. So they sleep soundly thinking their principal is perfectly protected.

To be fair, their principal is pretty safe. Most money market funds invest only in high quality ultra-short term paper. If the NAV did reflect the fluctuating value of holdings, it would still be very stable, probably never moving more than a penny or two.

And that’s what Volcker wants to do. He wants to force money funds to abandon accounting gimmickry that essentially permits them to market short-term fixed income funds as a “cash equivalents.”

Last fall, when an investment in Lehman Brothers paper forced the Reserve Primary Fund to break the buck, the veil was suddenly lifted and cash was pulled from money funds everywhere. Agile investors knew the money wasn’t perfectly safe, so they pulled out – redeeming at the promised $1 per share – leaving all the losses to be absorbed by slower shareholders.

That’s how that $785 million investment in Lehman paper turned into a systemic rout that threatened to drain a $3.5 trillion pool of capital from the market over a period of days. To stop the run, Treasury Secretary Hank Paulson offered a blanket guarantee for all money market fund assets, a guarantee that was extended earlier this year.

Volcker doesn’t want investors blindsided again. He wants money funds to stop marketing unbreakable $1 NAVs.

Money fund managers are fighting back because they know this would kill their business. If they can’t market $1 NAVs, their place in the asset allocation pie would be the “fixed income” slice not the “cash equivalent” slice. Investors would dump the funds in favor of bank accounts and CDs.

This would put significant pressure on the banking system. With hundreds of billions of deposits suddenly flowing in, banks would have to raise a lot of capital to protect their balance sheets.

If money funds want to keep operating like banks, fine. But in that case they should raise capital and subject themselves to bank regulation. Money funds aren’t keen on this idea either, it presents a number of problems that would also kill their business.

Perhaps it should be killed. It’s built on the fiction that investors can make riskless profits investing in short-term paper.

But when fiction meets reality, people panic. The only way to avoid that is to tell investors the truth. For money market funds, that means advertising them as what they are – fixed-income funds, not cash equivalents.


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I don’t see that this would really kill money market funds (which are NOT the savings account like money market funds you get a bank, if anyone is wondering).

Thing is you’re right about the underlying assets: 30-90 day paper, rated A1-P1 for the most part with some A2-P2 mixed in doesn’t have a long enough maturity horizon to really leave much room for price fluxuations due to credit changes, interest rate changes, or time value of money. Think about it: money market funds earn low single digit returns over the course of a year. Moving a penny or two in a day would be the money market equivalent of a three toed sloth outpacing Usain Bolt (how’s my hyperbole today?).

And those are the assets that aren’t US Gov’t issued.

So what would this accomplish? It’d make money funds go through the excercise of marking the assets every day, which would be an expense that would reduce the return to the consumer. Funds would probably continue to market the invincibility of the $1 level, even if they may start pricing the NAV at $1.01 or $1.02. Consumer would become confused and would CONTINUE to ignore the risk profile literature that is offered with the investment. And they’d also never notice the fraction of a fraction of a cent change in the NAV that occured every day.

Lehman’s also, I don’t believe, directly cause the collapse of the money market as the brief, short lived panic that the gov’t wasn’t going to bail every creditor out and the related worry of “who’s next”. If you’ll recall, Bear Stearns creditors were quite pleased that while the gov’t had punished the common investors (somewhat, although not the ultimate punishment), the integrity of the debt of Stearns was untouched. Shortly after that, the Feds watched Lehman’s plummet to the sidewalk. The panic from the seeming change in policy certainly had a much greater impact than the actual impact due to the CP. After all, assuming all the CP was at the holding company level, and a total loss, that would represent an average loss of 2 tenths on one cent.

You can count the number of money market funds that have broken $1 in the last X decades on two hands or less, probably. It’s a bold statement that I haven’t researched, so I hope its true. And the losses on those busted funds? 4 cents? 6 cents? less? There are certainly areas much for angst ridden than money market funds.

And yes, Banks don’t want money markets to go away. Aside from the fact that they wouldn’t want the 50% increase in deposits (assuming 100% conversion), the companies that use the CP markets would then be forced to go to banks for financing… probably initially by drawing CP backup lines. Banks don’t want that because they’d have to dedicate funding and capital to it and the spreads are terrible. Borrowers don’t want that because even though the spreads are terrible for the bank it’s still more expensive than what they could borrow for in the CP market. If the situation continued, it would get worse for borrowers because banks would reprice the line from the miniscule pricing of a “backup” line to the normal pricing of a revolver. Even for the most credit worthy that could make a 100 bp difference.

Also, the consumer doesn’t want this (eliminating money markets) because whatever small amount of interest they are earning at their bank would vanish as banks tried to chase away deposits. Think your fees are bad now? Wait until the banks start lining up high pressure water cannons to push depositors out the doors. Maintenance fees for “low balance” accounts (definition variable) would come back with a vengance, and cd and bank money market rates would fall very very low. It’d be like banking in the 70’s, but without the high interest rates.

In fact, you’ve noted in the past that there are those who advocate a negative interest rate to force spending. Eliminating the CP market would be the end around way of accomplishing that without officially making the rate negative.

And of course as corporate capital costs rose, businesses would probably be slower to expand and/or pass on the higher costs in their products.

I dunno… I’ll consult my Volcker shrine, but, even MORE than marking loan portfolios, I don’t see the value in this.

Posted by Andrew | Report as abusive

Apparently, I need an editor. I think all my points come across despite my uncultured writing.

Worth pointing out as a by the by: the CP market did disappear for months. Money market funds ran and cowered under their T-bill matresses. Even some A1-P1 issuers could get takers for their paper, A2-P2 borrowers were left wondering what happened, and A3-P3, well… they were locked out even before Lehman’s and I think they’re still out of luck.

And neither the banks nor the borrowers enjoyed it one bit.

Posted by Andrew | Report as abusive

Andrew….only two have broken the buck by my count. But that misses the point. It only took one to cause a systemic event last fall.

They’re almost designed to lead to bank runs since whenever a loss in value might be detected, agile investors will be the first to head for the exits. Those left behind will panic and run for the exit themselves.

No the decline in NAV isn’t that large, but investors are being sold a product the principal value of which is being guaranteed!

Money market funds wouldn’t go away. But they’d no longer be options for the cash equivalent slice of the asset allocation pie. that’s what kills their business.

Posted by Rolfe Winkler | Report as abusive

Either we’re talking about different products, or the investors who think their principle is guaranteed aren’t reading the prospectus for these funds.

Posted by Andrew | Report as abusive

I’m sorry but I don’t get the horror of a money market fund dropping 1% in value every 25 years. Better education and some rather basic regulation should be enough to sustain the industry.

Posted by Steve Roberts | Report as abusive

In todays interest rate market who would want to own money market funds anyway? High quality MM funds are paying in the neighborhood of 20 basis points. At these rates I’ve voted with my feet and moved to ladder CD’s for my cash. CD rates are not great, but when looked at in context with nonexistant inflation 2% on 1 year money isn’t so bad.

Posted by Barton Poran | Report as abusive

I think what is being looked at is putting stability into the system. Seems like everyone wants a hefty return, wants their investments to be totally liquid, and even use it as a checking account. This is a formula for disaster as any run on the fund can leave investors high and dry. As for me I want to spend my time doing something other than watching my money. I want to know that it is there when I want to use it.

Posted by f belz | Report as abusive