Do Money Market Mutual Funds Make Sense Anymore?
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Households, small businesses, and large corporations need places to park money on a short-term basis to pay future bills and meet unexpected cash needs. Ideally, these short-term cash surpluses could earn interest in the interim so as to reduce the opportunity cost of maintaining these idle cash balances. Unfortunately, there are very few financial instruments that allow conversion into cash at par (face value) under all circumstances. An investment in Treasury bonds, for example, may have no credit risk, but could still result in capital losses. For example, a $10,000 investment in a 5-year Treasury note with a 5% coupon rate priced at par would be worth only $9,573 in the event that interest rates increased by 1%. Should the holder of the security need to convert the instrument to cash to settle some debt, he or she would suffer a 5% loss. On large enough positions, even small movements in rates could lead to losses.
For this reason, households and businesses tend to rely on deposits in bank accounts to manage short-term cash reserves. Checking accounts allow full withdrawal at par on demand; savings accounts generally allow full withdrawal at par with some potential delays; and certificates of deposit (CDs) often require some nominal discount to par in the event of withdrawal before some agreed-upon maturity. While checking accounts are far and away the most liquid, they rarely pay much if any interest. Conversely, CDs provide competitive interest rates but require more thoughtful liquidity management because of their withdrawal restrictions.
The biggest problem with bank deposits is that the depositor is exposed to the failure of the bank above the Federal Deposit Insurance Corporation (FDIC) insured deposit cap. Until recently the cap was $100,000 – yet, it was raised during the crisis to its current level of $250,000. Thus any cash deposit above this amount is not guaranteed and, in theory, exposed to the risk of loss. This means that a deposit above the insured cap in a bank that borrows at 80 basis points above Treasury rates has roughly a 2% probability of suffering some loss. Given that these funds are not “investments” but rather cash equivalents, depositors seek safety, not optimal risk-adjusted returns. This makes a 1-in-50 implied loss potential too high, particularly for large corporations whose treasuries need to deposit millions of dollars on an overnight or short-term basis.
The money market mutual fund industry grew as an alternative to bank deposits. Regulated by the Securities and Exchange Commission (SEC) under Rule 2a-7 of the Investment Company Act, money market mutual funds are investment vehicles that pool funds from “depositors” to acquire short-duration instruments of the highest credit quality. Money market funds are designed to provide “depositors” with a competitive rate of interest and generally provide unlimited withdrawal rights. Rather than relying on the credit quality of the issuer, security is provided by the market value of the underlying assets. This means that unlike bank deposits, the security of the deposit does not depend on its size. Rather than assuming uncollateralized exposure to banks through uninsured deposits, corporations with deposits worth millions of dollars could invest indirectly in AAA-rated securities and A1/P1 commercial paper through money market funds. Historically, the one-year default rate for AAA assets is zero; while the five year default-rate is 0.1%. The implied riskiness of a money fund investing in these instruments is therefore 1/20th as risky as an uninsured deposit in a typical bank.
The problem is that as securitization and structured investment exploded, money market funds became the key pool of liquidity that supported the entire “shadow banking system.” Both structured investment vehicles (SIVs) and asset-backed commercial paper (ABCP) conduits financed their positions in collateralized debt obligations (CDOs) and other highly-structured products by issuing commercial paper to (or engaging in repurchase or repo transactions with) money market mutual funds.
The problem was a pyramid of bad ratings: the CDO had AAA ratings that turned out to be bad; 60% were downgraded below AAA within one year. This meant that the assets held by the SIVs and ABCPs were no longer AAA, which therefore compromised their credit ratings. Nearly 90% of SIV-lites lost their AAA rating. The money market funds could no longer invest in commercial paper issued by these structures and could only accept structured securities as collateral with much larger haircuts. This led to a liquidity crisis in August 2007, as banks were required to provide emergency liquidity lines to sponsored SIVs and ABCPs when money market mutual funds refused to fund them.
Eventually, the credit crisis rocked the money market mutual fund industry itself. In September 2008, one of the nation’s largest money market funds, the Reserve Primary Fund, could no longer meet redemptions at par – it “broke the buck” – due to losses it incurred on $800 million of Lehman Brothers’ commercial paper and floating rate notes. This prompted a mass exodus of withdrawals from money market funds that was only halted when the Treasury Department established a $50 billion money market guaranteed fund. Although the panic caused by the initial “run” was halted by the guarantee, total assets held by money market mutual funds have fallen by $1 trillion since the end of 2008. This represents more than a 25% decline from the peak holdings of $3.8 trillion.
Since the September 2008 crisis, policymakers have been trying to identify the most effective way to protect the money market business from further runs. The SEC has established new regulations to restrict these funds’ eligible holdings and to increase liquidity requirements. The President’s Working Group on Financial Markets (PWG) has also issued a study outlining a number of policy options to enhance the stability of the market by requiring additional private insurance, ending the practice of allowing for unlimited withdrawals, and allowing the value of depositors’ holdings to vary from par. Some of these proposals have been met with fierce opposition from the industry, especially those that would reduce the cash-equivalence of the asset class. A money market fund whose value differed from par would be like a bank account whose balance could fall on a given day – it’s obvious why such an arrangement would have such limited appeal.
The larger question for policymakers is not how to stabilize the money market mutual fund industry, but whether it serves any useful purpose. The large deposits diverted from banks to money funds may actually have a deleterious effect on financial intermediation. Rather than funding loans made by banks that would be held on balance sheet, these deposits were used to finance loans made by finance companies to be deposited in asset-backed securities (ABS) trusts and then resecuritized into CDOs and SIVs. Instead of relying on the judgment of bank loan officers, financial intermediation became dependent on the correlation and loss intensity estimates of credit rating agencies. Regardless of whether such a system could work in theory given all of the asymmetric information problems and misaligned incentives, it is obvious this system did not work in practice.
The fact is that the shadow banking system could have never grown without the corresponding growth in money market funds, which nearly doubled in size in the four years leading up to the crisis. Defenders of these funds are quick to point out that corporations access short-term liquidity through the issuance of commercial paper purchased by these funds, but this funding could just as easily come from revolving credit lines from banks. That the PWG recommendations would hasten the contraction of the industry is hardly a reason not to embrace them.
Christopher Papagianis is the Managing Director of e21 and was Special Assistant for Domestic Policy to President George W. Bush.