Money market funds are one of the greatest U.S. financial innovations of the 20th century. Originally developed to help retail depositors circumvent archaic regulatory caps on bank deposit rates for retail clients, the money market funds now serve a different role: they help depositors who don’t want to get paid “retail” or small depositor rates. By pooling the funds of small depositors, both individual and business, the funds help depositors earn a rate that (after management fees) is much closer to wholesale money market rates. For legal and marketing reasons, it has been enormously helpful to fund management that the funds have more than 25 years of history of maintaining a stable net asset value of $1.00 per “share,” so that one dollar deposited is almost a certainty to be withdrawn at the same price per share, unlike other mutual funds.
During the week of September 15, 2008, in the wake of the Lehman Brothers bankruptcy, almost $300 billion was withdrawn from money market funds and the Reserve Primary Fund “broke the buck” and fell below the historical $1.00 net asset value. The SEC proposals of June 24, 2009 are designed to prevent a recurrence of these events by requiring that certain percentages of fund assets be of very short maturities and that the average maturity of fund holdings be shortened from 90 days to 60 days. For details on the proposals, see www.sec.gov and “SEC Proposes Rule Amendments to Strengthen Regulatory Framework for Money Market Funds” (Morrison & Foerster, news bulletin, June 25, 2009). Instead of proposing any changes in the net asset value calculation, the SEC pronouncements seek public comment on whether changes in the NAV reporting for money funds should take place.
News reports argue that the industry can’t survive in its current form unless the NAV convention of $1.00 is maintained, both because of legal requirements faced by many investors to invest in securities with stable values and because of consumer perceptions of money market funds as a safe, stable investment. This is the heart of the problem, because it was in fact the NAV convention that was the root cause of the runs last September. The SEC proposals treat the symptom of the problem, not the root cause.
Consider the ABC Money Market Fund that collects $100 million from retail investors by the sale of 100 million “shares” at $1.00 per share. The fund invests the $100 million in the certificates of deposit of 50 banks at $2 million per bank. Immediately after the investment, the market value of the investments is still $100 million, and the net asset value is still $1.00 net asset value per share. Then a traumatic event happens---it could be any of these events:
- A sharp rise in interest rates, decreasing the net present value of even these short term investments
- A default of Lehman Brothers, causing investors to increase the spreads they require to invest in any financial institution. This again decreases NPV.
- A default of one of the 50 banks whose CD is held by the fund. If there is a 75% recovery upon default, this results in a $500,000 loss in value for the fund.
Assume one of these three events affects $50 million face value of the fund’s investment, so that they trade at 99% of face value, or $49.5 in market value. We assume the other $50 million are unaffected and still have a true market value of $50 million. What happens to investors? If NAV is rounded to two decimal places, a naïve investor would ignore the fact that the net asset value of the fund is now only 99.5% of face value, because rounded to two decimal places the NAV is $1.00 instead of 0.995.
What would a sophisticated investor do? They have the option to withdraw funds at 1.00 per share that are actually only worth 0.995 per share. They’d be crazy or lazy not to make the withdrawal. Let’s assume that $50 million is withdrawn immediately. The fund is left with $50 million in assets from a book value point of view and $49.5 million from a market value point of view. The fact is now inescapable. The NAV is 0.99 and the number is there for all the world to see. The sophisticated investors, instead of a pro rata share of the $500,000 loss of the fund’s assets, caused the investors who did not withdraw to bear the full loss. It’s the classic game of musical chairs where the last one to sit down gets the floor, not the chair.
What would have happened if the net asset value had been calculated to four decimal places, not two, as is normal in the bond market? Industry observers would argue that the funds would not have been deposited in the first place and they may well be right. If the funds were deposited, however, the advantage of being “first out” would go away because the loss of fund value would have been instantly calculated as 0.9950 asset value. There would be no loss avoidance from early withdrawal. Therefore there’s no reason for early withdrawal from an arbitrage point of view. The loss has already been incurred.
This simple example shows that “the buck” itself is the cause of money market fund runs. The SEC’s liquidity proposals, with no change to the granularity of the NAV calculation, simply make it easier for investors who withdraw early to arbitrage those who don’t. That’s not investor protection in my book.
Are investors really so sophisticated that they can “see through” a portfolio and understand such losses before they’re formally reported? Well, certainly $300 billion of investors did so during the week of September 15, 2008. One year earlier than that, the Bank of England was forced to support Northern Rock plc whose retail investors caused a classic bank run even though the bank had never published a loss in its financial statements (that came with the December 31, 2007 financial reports).
Any SEC changes requiring greater “liquidity” are dealing with the symptoms of the problem, not its root cause. Shortening the effective maturity of money funds just causes the financial institutions who sell CDs to money market funds to take a more dangerous “short funded” financial position as well. This increases systemic risk, which is hardly what bank regulators are trying to do in their proposed regulatory changes.
Comments welcome at firstname.lastname@example.org.
Donald R. van Deventer
Honolulu, June 29, 2009