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Hidden risks in money market funds

By Sheyna Steiner · Bankrate.com
Friday, June 22, 2012
Posted: 10 am ET

Behind the placid promise of a stable $1 net asset value, or NAV, money market funds, funds made up of very short-term debt securities and piles of cash, are actually roiling with controversy.

On Thursday, the chairman of the Securities and Exchange Commission, or SEC, Mary Schapiro, testified before the Senate Banking Committee about the systemic risk the funds pose and the need for further regulation.

The stable $1 per-share price is what makes money market funds. They are able to use special accounting rules that let them round up the per-share price to $1. But if the value falls below $0.995, then they have broken the buck, as they say.

Bad things happen in that event, which is why parent companies often step in to prop up the fund. But they can't always, and if the money market fund cannot be rescued, that can lead to a crisis.

Not only do money markets provide a place for small and large investors to stash cash, they provide very short-term funding for big companies, institutions and other large entities by buying commercial paper.

Wait, what's commercial paper?

The website for the mutual fund trade association, Investment Company Institute, ICI.org, says this about the role money market funds play in the commercial paper market:

Commercial paper is issued by a wide variety of corporations -- such as domestic and foreign firms, banks, finance companies, and broker-dealers -- and carries repayment dates that typically range from overnight up to 270 days. Money market funds provide an important source of funding in the commercial paper market, holding 37 percent of outstanding commercial paper as of October 2010.

Back to the testimony

Here's what happened in 2008 when the Reserve Primary Fund broke the buck, as recounted in Chairman Schapiro's testimony on Thursday:

Almost immediately, the run on the Reserve Primary Fund spread, first to the Reserve’s family of money market funds, and then to other money market funds. Investors withdrew approximately $300 billion (14 percent) from prime money market funds during the week of September 15, 2008. Money market funds met those redemption demands by selling portfolio securities into markets that were already under stress, depressing the securities’ values and thus affecting the ability of funds holding the same securities to maintain a $1.00 share price even if the other funds were not experiencing heavy redemptions. Money market funds began to hoard cash in order to meet redemptions and stopped rolling over existing positions in commercial paper and other debt issued by companies, financial institutions, and some municipalities. In the final two weeks of September 2008, money market funds reduced their holdings of commercial paper by $200.3 billion, or 29 percent.

Money market funds were (and are) substantial participants in the short-term markets—in 2008 they held about 40 percent of outstanding commercial paper. The funds’ retreat from those markets caused them to freeze. During the last two weeks in September 2008, companies that issued short-term debt were largely shut out of the credit markets. Cities and municipalities that rely on short-term notes to pay for routine operations while waiting for tax revenues to be collected were forced to search for other financing. The few companies that retained access to short-term credit in the markets were forced to pay higher rates or accept extremely short-term -- sometimes overnight -- loans, or both. All of this occurred against the backdrop of a broader financial crisis, which was exacerbated by the growing credit crunch in the short-term markets.

The Treasury and the Federal Reserve were able to intervene in 2008, but they won't be able to use the same tools to right markets again, and as Schapiro pointed out in her testimony, money market fund investors are a flighty bunch. Despite the new rules put in place in 2010, money market funds are not without risk, and a big run on one fund could potentially spiral into a wide-reaching crisis.

From Schapiro's testimony:

… policymakers should recognize that the risk of a destabilizing run remains. Money market funds remain large, and continue to invest in securities subject to interest rate and credit risk. They continue, for example, to have considerable exposure to European banks, with, as of May 31, 2012, approximately 30 percent of prime fund assets invested in debt issued by banks based in Europe generally and approximately 14 percent of prime fund assets invested in debt issued by banks located in the Eurozone.

New rules being considered

A destabilizing run wouldn't only affect large investors; small investors who use money market funds to pay bills or simply hold cash could find themselves losing money and potentially having their funds locked up for a long time as the situation is worked out.

Obviously, the chances are slim that this could happen, but some of the reforms being considered could put limits on redemptions and require that funds keep a bigger store of cash on hand. Another option calls for an end to the stable NAV, switching instead to a floating share price used by all other mutual funds.

What do you think? Do money market funds need further regulation?

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