Definitions

buyers' strike

Money fund

Money funds (or money market funds, money market mutual funds) are mutual funds that invest in short-term debt instruments.

Explanation

Money market funds, also known as principal stability funds, seek to limit exposure to losses due to credit, market, and liquidity risks. Money market funds in the United States are regulated by the Securities and Exchange Commission's (SEC) Investment Company Act of 1940. Rule 2a-7 of the act restricts investments in money market funds by quality, maturity and diversity. Under this act, a money fund mainly buys the highest rated debt which matures in under 13 months. The portfolio must maintain a Weighted Average Maturity (WAM) of 90 days or less and not invest more than 5% in any one issuer, except for government and repurchase agreement securities.

Eligible money market securities include commercial paper, repurchase agreements, short-term bonds or other money funds. Money market securities must be highly liquid, and have a stable value.

Breaking the buck

Money market funds seek a stable $1.00 net asset value (NAV): they aim never to lose money. If a fund's NAV drops below $1.00, one says that the fund "broke the buck".

This has rarely happened: as of September 16, 2008, two money funds have broken the buck (in the 37 year history of money funds), and from 1971 to September 15, 2008, there was only one failure.

The Community Bankers US Government Fund broke the buck in 1994, paying investors 96 cents per share. This was the first failure in the then 23 year history of money funds, and there were no further failures for 14 years. The fund had invested a large percentage of its assets into adjustable rate securities. As interest rates increased, these floating rate securities lost value. This fund was an institutional money fund, not a retail money fund, thus individuals were not directly affected.

No further failures occurred until September 2008, a month that saw tumultuous events for money funds.

September 2008

The week of September 15, 2008 to September 19, 2008 was very turbulent for money funds, and a key part of financial markets seizing up.

Events

On Monday, September 15, Lehman Brothers Holdings Inc. filed for bankruptcy.

On Tuesday, September 16, Reserve Primary Fund, the oldest money fund, broke the buck when its share fell to 97 cents after writing off debt issued by Lehman Brothers.

On the same day, BNY Institutional Cash Reserves, which was not a money fund, but a securities lending fund run by BNY Mellon, also broke the buck – its NAV fell to 99.1.cents – also due to Lehman holdings.

The resulting investor anxiety almost caused a run on the bank for money funds, as investors redeemed their holdings and funds were forced to liquidate assets or impose limits on redemptions: through Wednesday, institutional funds saw net outflows of $173 billion, to $2.17 trillion, a withdrawal of over 7%. Retail funds saw net inflows of $4 billion, for a net outflow from all funds of $169 billion, to $3.4 trillion (5%). The lack of retail outflows is attributed to the lag required for individuals to open a new account to transfer their funds out, and retail funds expected significant withdrawals the following week.

On Thursday, September 18, Putnam InvestmentsPutnam Prime Money Market Fund, a $12.3 institutional fund, announced that it was liquidating, due to redemptions.

In response, on Friday, September 19, the United States Treasury announced an optional program to "insure the holdings of any publicly offered eligible money market mutual fund — both retail and institutional — that pays a fee to participate in the program." The insurance will guarantee that if a covered fund breaks the buck, it will be restored to $1 NAV. This program is similar to the FDIC, in that it insures deposit-like holdings, and seeks to prevent runs on the bank. The guarantee is backed by assets of the Treasury Department's Exchange Stabilization Fund up to a maximum of $50 billion.

The program immediately stabilized the system and stanched the outflows, and drew criticism from banking organizations, including the Independent Community Bankers of America and American Bankers Association, who expected funds to drain out of bank deposits and into newly insured money funds, as these latter would combine higher yields with insurance.

Analysis

The crisis almost developed into a run on the shadow banking system: the redemptions caused a drop in demand for commercial paper, preventing companies from rolling over their short-term debt, potentially causing an acute liquidity crisis: if companies cannot issue new debt to repay maturing debt, and do not have cash on hand to pay it back, they will default on their obligations, and may have to file for bankruptcy. Thus there was concern that the run could cause extensive bankruptcies, a debt deflation spiral, and serious damage to the real economy, as in the Great Depression.

The drop in demand resulted in a "buyers strike", as money funds could not (because of redemptions) or would not (because of fear of redemptions) buy commercial paper, driving yields up dramatically: from around 2% the previous week to 8%, and funds put their money in Treasuries, driving their yields close to 0%.

This is a bank run in the sense that there is a mismatch in maturities, and thus a money fund is a "virtual bank": the assets of money funds, while short term, nonetheless typically have maturities of several months, while investors can request redemption at any time, without waiting for obligations to come due. Thus if there is a sudden demand for redemptions, the assets may be liquidated in a fire sale, depressing their sale price.

An earlier crisis occurred in 2007–2008, where the demand for Asset Backed Commercial Paper dropped, causing the collapse of some Structured Investment Vehicles.

Similar investments

Money market accounts

Banks in the United States offer savings and money market deposit accounts, but these shouldn't be confused with money market mutual funds. These bank accounts offer higher yields than traditional passbook savings accounts, but often with higher minimum balance requirements and limited transactions. A money market account may refer to a money market mutual fund, a bank money market deposit account (MMDA) or a brokerage sweep free credit balance.

Enhanced cash funds

Enhanced cash funds are bond funds similar to money market funds, in that they aim to provide liquidity and principal preservation, but which:

  • invest in a wider variety of assets, and do not meet the restrictions of SEC Rule 2a-7;
  • aim for higher returns;
  • have less liquidity;
  • do not aim as strongly for stable NAV.

Enhanced cash funds will typically invest some of their portfolio in the same assets as money market funds, but others in riskier, higher yielding, less liquid assets such as:

In general, the NAV will stay close to $1, but is expected to fluctuate above and below, and will break the buck more often. Different managers place different emphases on risk versus return in enhanced cash – some consider preservation of principal as paramount, and thus take few risks, while others see these as more bond-like, and an opportunity to increase yield without necessarily preserving principal. These are typically available only to institutional investors, not retail investors.

The purpose of enhanced cash funds is not to replace money markets, but to fit in the continuum between cash and bonds – to provide a higher yielding investment for more permanent cash. That is, within one's asset allocation, one has a continuum between cash and long-term investments:

  • cash – most liquid and least risky, but low yielding;
  • money markets / cash equivalents;
  • enhanced cash;
  • long-term bonds and other non-cash long-term investments – least liquid and most risky, but highest yielding.

Enhanced cash funds were developed due to low spreads in traditional cash equivalents.

There are also funds which are billed as "money market funds", but are not 2a-7 funds (do not meet the requirements of the rule). In addition to 2a-7 eligible securities, these funds invest in Eurodollars and repos (repurchase agreements), which are similarly liquid and stable to 2a-7 eligible securities, but are not allowed under the regulations.

History

In 1971, Bruce R. Bent established the first money market fund in the U.S. The Reserve Fund was offered to investors who were interested in preserving their cash and earning a small rate of return.

Outside of the U.S., the first money market fund was set up in 1968 and was designed for small investors. The fund was called Conta Garantia and was created by John Oswin Schroy. The fund's investments included low denominations of commercial paper.

Statistics

The Investment Company Institute reports statistics on money funds weekly as part of its Mutual Fund Statistics, as part of its industry statistics, including total assets and net flows, both for institutional and retail funds. It also provides annual reports in the ICI Fact Book

As of September 17, 2008, almost 2,000 money funds are in operation, with total assets of over US$3.4 trillion.

Types of money funds

Institutional money fund

Institutional money funds are high minimum investment, low expense share classes which are marketed to corporations, governments, or fiduciaries. They are often set up so that money is swept to them overnight from a company's main operating accounts. Large national chains often have many accounts with banks all across the country, but electronically pull a majority of funds on deposit with them to a concentrated money market fund.

The largest institutional money fund is the JPMorgan Prime Money Market Fund, with over US$100 billion in assets. Among the largest companies offering institutional money funds are BlackRock, Federated, Columbia (Bank of America), Dreyfus, AIM and Evergreen (Wachovia).

Retail money funds

Retail money funds are offered primarily to individuals with moderate-sized accounts. Their primary use is as temporary holding funds at stock brokerage firms. Retail money market funds hold roughly 40% of all money market fund assets.

Retail money funds invest in short-term debt, such as US Treasury bills and commercial paper, come in a few different breeds: government-only funds, non-government funds and tax-free funds. Yields are typically somewhat higher than in savings accounts. Investors will obtain a slightly higher yield in the non-government variety, whose principal holdings are high-quality commercial paper and other instruments. Instruments of the United States Government are usually exempt from state income taxes, and their returns are lower as a result.

The largest money market mutual fund is Fidelity Investments' Cash Reserves (Nasdaq:FDRXX), with assets exceeding US$110 billion. The largest retail money fund providers include: Fidelity, Vanguard (Nasdaq:VMMXX), and Schwab (Nasdaq:SWVXX).

See also

References

Recommended reading

External links

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