It’s midnight. Do you know where your money market mutual fund is? Just as with a teenager, your money may well be out somewhere you don’t like and doing something that would horrify you. Many people, especially in the upper half of the income distribution, have savings in money market funds either directly owned or via 401(k) accounts. But many really don’t understand what such funds are or the risks that can go with them.
Why should anyone be concerned? Go back to mid-September 2008, as Lehman Brothers went under and panic pervaded world financial markets. The Reserve Primary Fund, the oldest and one of the best regarded funds, announced it was suspending payment because it no longer had enough good assets to cover its liabilities. In other words, it didn’t have enough money to repay everyone if they chose to withdraw their money. It was like the classic movie examples of a bank run when worries about the safety of a bank become a self-fulfilling prophecy.
Minneapolis-based Ameriprise Financial, which had $3.2 billion of its clients’ money invested in the fund, didn’t get word of the shortfall until it was too late. Ameriprise sued Reserve, accusing the fund of tipping off big institutional investors first, enabling them to get out in time.
Could this happen again? Yes, it certainly could, although the issue largely blew over after the Reserve fund incident, when the Treasury stepped in to extend FDIC-like guarantees to all money market funds. However, those who had already suffered losses received little help.
Unfortunately, averting that crisis diverted public attention from potential problems, lulling many investors into a sense of security that may prove false in a future crisis. The SEC proposes new regulations that the industry is resisting. Many people have a lot at stake, but because these funds and the markets they operate in are poorly understood, few among the general public are paying much attention. This is a mistake.
So start with understanding what “money markets” are. The term refers to financial markets in money loaned for a period of less than a year. This is in contrast with “capital markets,” that trade financial securities with a term of one year or more, such as corporate stocks and bonds, municipal and treasury bonds, securitized mortgages and other “collateralized debt obligations.”
Money markets go back centuries and often comprised credit between merchants and investors that bypassed the formal banking system. They have burgeoned in recent decades, however. Prior to 1970, virtually all market participants were businesses or large institutions. Now millions of households participate, though indirectly through a mutual fund.
On one side are savers who want to earn some return on money but don’t want to tie it up for long periods. These might include a large corporation that has enjoyed good sales and accumulated cash, but knows it will have to meet other expenses in a few months. It might include a private college that gets several million dollars in tuition payments at the beginning of each semester, but must pay salaries and utilities over a 12-month period. It might even include a city or county that gets real estate tax payments in May and October but must make outlays over an entire year.
In each case, the entity has excess cash and would benefit from earning some return on it, but should not buy a long-term bond. For such investors, protection of principal is important. Nothing prevents them from buying longer-term securities like stocks and bonds. These can be resold at any time. But their prices fluctuate and short-term investors don’t want to be caught having to sell in a market dip. So they prefer relatively safe investments in which it is nearly certain that they won’t lose any principal. Money markets historically offer this.
Such investors also value liquidity, the ability to quickly convert an asset to cash. This is another feature of money markets.
Borrowers in money markets might include retailers that have to buy seasonal merchandise months before they will sell it or a manufacturer that might need to purchase raw materials to produce products for which they will receive payments months into the future.
Increasingly, borrowers also might include an investment bank or a hedge fund that thinks it can take advantage of lower short-term interest rates to fund longer-term investments in something else.
Prior to the 1970s, all of this was irrelevant technical detail for most people. Money markets helped the economy operate, but households did not participate. That changed in 1971 when the first money market mutual fund was established – the very same Primary Reserve Fund mentioned earlier. This allowed small investors to access the benefits of liquidity and security of principal that larger investors enjoyed.
Savings accounts in banks, long the primary way for families to save, had become less attractive as inflation rose. The Federal Reserve still had Regulation Q that limited ordinary banks to paying no more that 5.25 percent on savings accounts and savings-and-loans to 5.5 percent. When inflation was around 2 percent, this allowed a real return of 3 percent. But as inflation moved to 3 and 4 percent, the real return became less and less, eventually becoming negative as bad Fed policies caused the great inflation of the 1970s.
People with at least several thousand dollars in savings perceived money market funds as having nearly all the advantages of a savings account, but without a cap on interest. Money market interest rates rose with inflation, and investors were able to get positive real returns that were impossible in traditional bank accounts.
Billions poured out of banks and into these funds. It seemed to many like a wonderful new era for borrowers and savers, with both benefitting from more efficient use of capital.
There were dangers, however, that would become evident only over time and that became particularly acute after 2000. But that is the subject for another column.