Truly mutual Money Market Funds, that do mark their shares to NAV, solve the age-old liquidity problem of banking: Borrowers want loans with positive maturity and therefore variable present value, yet banks traditionally try to fund these loans with deposits that have a fixed present value. If depositors ask for their money all at once, the banks may be forced to sell assets at a discount, perhaps leaving the last depositors to withdraw with little or nothing—therefore giving all depositors an incentive to be the first in line to withdraw.
Mutual MMFs invest in short-term money market instruments that do have some present value risk.[2] But instead of concentrating this risk on the last depositors in line the way traditional banks do, mutual MMFs efficiently spread this risk over their shareholders so that each is bearing a negligible risk. If a sudden rise in interest rates, or even a spontaneous withdrawal of funds, causes share values to fall relative to the promised future payments of the assets, the return to putting money back in will simply rise. In other words, the longer the line at the front door to take money out, the longer the line will be at the back door to make new investments. Mutual MMFs are therefore run-proof, without any need for government deposit insurance.[3]
However, if MMFs instead “penny-round,” they are asking for trouble because shrewd investors will withdraw their money whenever their NAV falls below $1.00 — and move it to other funds with full or surplus NAV. This will inequitably dilute the position of investors who leave their money in. The prospect of an abrupt fall in share value from $1.00 to $0.99 when true NAV “breaks the buck” by falling from $0.9951 to $0.9949 provides an even greater incentive to run against the fund.
From some time after their inception in 1971 until 2014, most Money Market Funds have in fact penny-rounded. This occasionally caused funds to come near to “breaking the buck” over the years. In most cases, the fund sponsors simply swallowed part of their management fee (typically 1/2% per year) in order to save face. But two funds actually broke the buck in 1978 and 1994.[4] During the 2008 financial crisis Reserve Primary Fund also broke the buck, as a result of a bad bet on Lehman Brothers that would have sent its NAV to 97 cents on the dollar. Rather than simply allowing these investors to take the 3% loss that they were entitled to, the Treasury and Fed flew into a regulatory panic and instead protected investors in Reserve Primary and other penny-rounding funds from negative returns.[5]
In response to the 2008 crisis and bailout, the SEC promulgated rules in 2014 requiring institutional prime and municipal MMFs to mark shares to NAV.[6] Institutional funds are those that are not designed to be held by natural persons and which therefore tend to have the largest investors. Prime funds specialize in highly rated private commercial paper, while municipal funds primarily hold tax-exempt municipal issues. Unfortunately, the new rule did not apply to retail prime and municipal funds, nor to governmental funds that primarily hold US Treasury securities. The SEC should not have exempted such retail funds since individuals should be treated as fairly as institutions, and since even default-free Treasury bills are subject to present value fluctuations. However, it was a big move in the right direction.
Another shortcoming of the 2014 regulations is that they allowed NAV funds to impose redemption fees and limits or “gates” on redemptions that are entirely unnecessary when funds mark to NAV. Redemption fees are essentially a back-end load that negates the fundamental no-load property of a mutual fund, while the possibility of “gates” that temporarily block redemptions altogether destroy the liquidity that MMF investors are after. Fortunately funds have the option of not imposing either these fees or “gates,” but the SEC was wrong to even permit funds to impose them. I concur fully with the Wall Street Journal’s editorial position on this matter.[7]
Naturally, however, investors like to have their cake in the form of high upside returns without ever having to eat occasional negative returns, and therefore have lobbied Congress to reverse the 2014 SEC rules.
Municipal officials in particular have complained, since their states typically require them to park funds in accounts that can never fall in value. Yet one beneficial provision of the 2010 Dodd-Frank Act was to roll back the New Deal’s 1933 anti-competitive, anti-consumer ban on interest on bank demand deposits, so that municipalities are now free to earn interest on bank accounts—with no present value risk short of bank failure. If state laws don’t allow cities to earn higher interest with perhaps even greater safety from mutual Money Market Funds, municipalities should take that up with their state legislators, and not with Congress.
On January 18, lobbying congress seemed a success when the House Financial Services Committee passed H.R.2319, a bill sponsored by Rep. Keith Rothfus (R‑PA) that would pare back the new SEC rules — particularly for funds that purchase municipal bonds. Fortunately, the Committee appears to be reconsidering. Just last week it was reported that the legislation will likely undergo adjustments before it advances to the full House.[8]
Rather than abolishing NAV accounting, the House should encourage it to be applied, not only to institutional Money Market Funds, but to retail and government funds as well. Although government-only MMFs are immune from default risk, they are still exposed to some degree of interest-rate risk, and so should be marking to NAV just the same as prime funds that invest in prime commercial paper. Congress should grill SEC officials as to why the new rules didn’t apply to these funds in the first place and take steps to prohibit any future bailouts of risky penny-rounding funds.
If consenting adults want to “invest” their savings in Powerball tickets, Bitcoins, poker hands, or penny-rounding Money Market Funds, they should be allowed to do so. But the taxpayers should not be expected to bail them out in the event these gambles do not pay off. Furthermore, if a Money Market Fund claims to be a mutual fund and not a game of bluff, the SEC should require it to act as a mutual fund.
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[1] Andrew Ackerman, “Bringing Back the Money-Fund Fight,” Wall Street Journal, Dec. 15, 2017; Robert Schmidt, “House Panel Backs Bill to Scrap Floating Prices for Money Funds,” Bloomberg Markets, Jan. 18, 2018.
[2] The Macaulay duration of a short-term financial instrument with no coupons is equal to its maturity. A sudden rise in yields therefore causes such assets to fall in value by approximately the change in yields times their maturity. MMF portfolios have an average maturity of no more than 60 days, or approximately 1/6 year. A sudden increase in yields from say 3% to 4% will therefore cause their prices to fall by at most 1/6%, i.e. to about 99.83 cents on the dollar. However, investors who leave their money in may then expect to make 4% to the 60-day maturity.
[3] See also Larry White, “Money-Market Mutual Funds: Restrictions, Run-Proofing, and Regulatory Pretense,” Alt‑M, March 1, 2016.
[4] First Multifund for Daily Income dropped to 94 cents per share in 1978 after investing in a portfolio with an average maturity in excess of 2 years. Community Bankers US Government Fund paid 96 cents per share in 1994. In 1980, Salomon Brothers and First National Bank of Chicago restored their Institutional Liquid Assets fund to full NAV after it nearly dropped to 99.46 cents per share.
[5] For this purpose, the Treasury used the Exchange Stabilization Fund, a slush fund that originated in 1934 with the profits that the US Government made by confiscating the public’s gold holdings. The Fed simultaneously supported the market for risky money market instruments with a $120B Commercial Paper Funding Facility, a $15B Money Market Mutual Fund Funding Facility, and a $25B Term Asset-Backed Securities Lending Facility. (Figures as of July 2, 2009). The Treasury itself closed its program on 9/18/09 with a profit of $1.2 billion from fees collected, but it is hard to disentangle this from the value of the Fed’s programs or from the value of the implicit put options granted by such programs.
[6] SEC, “SEC Adopts Money Market Fund reform Rule,” July 23, 2014; and 2014 changes to Rule 2a‑7 of the Investment Company Act of 1940.
[7] Wall Street Journal, “The Money Fund Mistake,” Editorial, Aug. 16, 2016.
[8] Andrew Ackerman, “House Money-Fund Bill Hits a Snag,” Wall Street Journal, Jan. 30, 2018.
