Striking a balance on money market funds

Since the financial crisis of 2008, money market funds have been the subject of fierce debate. Regulators say money market funds need to be fundamentally transformed to prevent them from creating too much systemic risk. The fund industry has pushed back, trying to preserve the utility of money market funds for millions of investors. Fortunately, a smart compromise exists that would reform the riskiest money market funds while protecting retail investors.

Money market funds may seem an unlikely object of controversy because they take such a conservative investment approach. They must invest at least 97 percent of their assets in securities with the top credit rating and these securities must have an average maturity of 60 days or less.

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Because money-market funds are usually very safe, they are allowed to calculate their share price in a special way. Stock and bond mutual funds calculate their share price — known as the “net asset value,” or NAV — based on the market prices of their investments at the end of the day. By contrast, money-market funds may maintain a fixed NAV at $1 per share, subject to the strict conditions mentioned above. In exchange for these conditions, investors can almost always buy and sell shares in money-market funds for $1 each, which is very convenient.

But this apparent stability can mask some volatility. For this reason, money-market funds must also calculate privately an actual market price for their shares on a regular basis, which reflects market prices. If this market price drops below $0.995 per share, the fund might be forced to “break the buck” — that is, reduce its reported NAV below $1.

That’s exactly what happened to one money-market fund during the financial crisis. In September 2008, the Reserve Primary Fund — a $60 billion money-market fund owned solely by large institutions — incurred losses on debt issued by Lehman Brothers. The fund was forced to reduce its NAV from $1 to 97 cents a share.

After the Reserve Primary Fund broke the buck, large investors became skittish about their holdings in other money-market funds and began withdrawing their money. Just as a bank run can destroy a bank that might have otherwise survived, this wave of redemptions forced another fund manager to close one of its money-market funds, even though that other fund didn’t own any toxic Lehman assets.

Regulators maintain that a fixed NAV makes money-market funds more vulnerable to runs like these. If investors perceive that a money-market fund’s investments have slightly decreased in value, the fixed NAV allows them to withdraw their investment with no losses — so long as they do so quickly, before the fund breaks the buck.

As a simple example, consider the Reserve Primary Fund’s large institutional investors in the days before Lehman Brothers failed. Because these large investors closely follow their investments, they knew that the fund had a position in debt issued by Lehman. As they saw Lehman coming closer to collapse (which caused the market price of its debt to decline), these investors suspected that the market value of the Reserve Primary Fund’s investments had decreased.

Yet, these investors could still redeem their shares for $1 each — effectively, for more than they were worth. In the case of the Reserve Primary Fund, this dynamic led to a wave of redemptions by large shareholders, putting that fund in further jeopardy.

Regulators have proposed reforming this system by requiring money-market funds to recalculate their NAV daily based on the most recent market prices, as is required of stock and bond mutual funds. In practice, this would mean that a money-market fund’s NAV could fluctuate day to day.

A fluctuating NAV would reduce the incentive for large institutional investors to sell their shares at the first sign of trouble. As always, if investors worry the value of their shares might decrease more, they might still choose to sell. However, these investors would no longer be able to take advantage of the spread between $1 and the market value of the fund’s investments.

The fund industry has vigorously resisted this proposal. It has argued that retail investors strongly prefer the convenience and stability of a fixed dollar account; thus, a fluctuating NAV might lead millions of retail investors to abandon money-market funds. If that were to occur, those investors would lose the benefits of money-market funds: a relatively safe, higher-yielding alternative to bank deposits. Such withdrawals would also make it more difficult for high-quality corporate and government issuers to obtain short-term financing.

Moreover, the industry argues that a fluctuating NAV would impose high costs that are not commensurate to the problem: Only two money-market funds (both institutional funds) have ever broken the buck. And actual losses realized by investors were ultimately minimal — roughly 1 cent on the dollar, in the case of the Reserve Primary Fund.

A compromise that protects the financial system while continuing to provide investors with an important alternative would be ideal. This proposal was first floated by Walt Bettinger, the president and chief executive of investment services firm Charles Schwab. This proposal would require the most systemically risky money-market funds to adopt a fluctuating NAV while allowing safer funds to continue using a stable $1 NAV.

Here’s how it would work:

Roughly speaking, the universe of money-market funds is divided along two dimensions: assets and investors. First, different types of funds invest in different types of assets. “Nonprime” money-market funds invest solely in securities issued or guaranteed by the federal government. Although “prime” money-market funds may also invest in federally backed securities, they may invest largely in commercial paper issued by corporations, CDs issued by banks, and similar types of securities.

Second, different types of money-market funds are owned by different types of investors. Retail funds are owned by small investors who typically use money-market funds as an alternative to bank deposits. Institutional money-market funds are owned by large investors such as banks, corporate treasuries and pension funds.

This compromise proposal would require a fluctuating NAV solely for prime institutional funds: funds which are both owned by large investors and that invest in securities not backed by the federal government. Although a fluctuating NAV presents complicated accounting and tax considerations, these issues could be addressed by the SEC and the IRS.

Nonprime (government) money-market funds would be exempt from the fluctuating-NAV requirement because the assets underlying these funds are viewed as highly safe. During the financial crisis, investors of all types poured into nonprime funds, which were a haven from the volatility elsewhere in the market.

All retail funds (prime and government) would also be exempt because they are far less vulnerable to runs than institutional funds are. On Sept. 17, 2008, two days after Lehman Brothers failed, prime institutional funds had withdrawals of about $130 billion — more than 10 percent of their total assets. By contrast, no more than $10 billion (about 2 percent of total assets) was withdrawn from prime retail funds on any day during the crisis.

Institutional money-market funds are more susceptible to runs because of the nature of their shareholder base. A small number of large shareholders are more likely to redeem shares all at once than a large number of small shareholders would. Such mass redemptions can force the fund to incur losses by selling assets quickly in a thin market.

Furthermore, institutional investors are much more likely to actively monitor their holdings for the smallest changes in interest rates or credit risk. As a result, if a money-market fund’s investments decrease in value, say to $0.997 per share, institutional investors might immediately sell their shares for $1 each. Retail investors, by contrast, are unlikely to monitor their investments with this level of detail; therefore, retail money-market funds are unlikely to face a mass redemption of shares.

Of course, policymakers will need to establish a definition for an “institutional” money-market fund. We propose a test based on a maximum account size, such as $1 million or $2 million. This test would ensure that small businesses, as well as individuals, would continue to be able to store cash in money-market funds with a stable NAV. Regulators could impose additional tests based on the degree of concentration in ownership.

In summary, regulators are grappling with competing concerns. On the one hand, certain money-market funds could be a source of systemic risk in the next financial crisis. On the other hand, millions of retail investors value the convenience of money-market funds as an alternative to banks, as thousands of businesses and local governments rely heavily on money-market funds for short-term financing.

Regulators should balance these competing concerns by requiring a fluctuating NAV for institutional funds that invest in commercial paper and bank CDs. This compromise would reduce systemic risk while preserving the money-market fund for millions of retail investors.

Pozen (@Pozen) is a senior lecturer at Harvard Business School and a senior fellow at the Brookings Institution. Hamacher (@NICSAPres) is president of Nicsa. Together they are co-authors of “The Fund Industry: How Your Money Is Managed” (Wiley, 2011).

Assets of money market funds, by type, in billions of dollars

$200.15 billion
Retail, nonprime

$539.12 billion

Retail, prime

$727.06 billion

Institutional, nonprime

$947.21 billion

Institutional, prime

Source: Investment Company Institute as of Jan. 3. Retail and institutional funds are categorized based on how they are defined by their management companies. Our compromise proposal might classify certain funds differently.

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