he next financial crisis in America probably will involve a large run on our money market funds, which now hold $2.6 trillion in assets. Regulators are well aware of the potential problem, but little has been done about it.
Runs have occurred before. Shareholders ran from the $62 billon Reserve Primary Fund when Lehman Brothers went into Chapter 11 bankruptcy protection in September 2008. Investors withdrew their money when they realized that the fund's net asset value would drop below $1. The run occurred because the first investors out expected to receive more for their shares than later investors would receive.
To stop the run — and the potential for runs on other money market funds — the Department of the Treasury used the Exchange Stabilization Fund to temporarily guarantee the $1 share price for more than the then-$3 trillion in money market shares. The federal government indicated that it would never do this again, and in October 2008, Congress prohibited the use of this fund for this purpose.
Such assurances are not credible given the size and importance of money market funds in our economy. In the midst of a crisis that seriously threatens financial stability, the Treasury, Federal Reserve, or even Congress might find other ways to intervene.
The next run may occur when one or more banks fall if the European credit crisis escalates, as many observers believe likely. As of the end of August, 26.2% of assets of the top 10 U.S. prime money market funds were invested in debt issued by European banks.
In 2010, the Securities and Exchange Commission required that the average maturity of money market fund investments be reduced and that the fraction of the portfolio invested in liquid assets be increased. These changes hardly address the problem: securities issued by failing firms drop in value regardless of how soon they mature.
Someone must lose when securities held by money market funds depreciate. Any solution to the run problem must explicitly identify who will bear this risk.
Money market fund investors now bear it. If the net asset value of a fund's portfolio drops below 99.5 cents per share, current regulations require that the fund must price redemptions at the actual NAV, and not at the normal $1 stable value. Expectations of these losses cause runs.
Faced with investment losses, some investment managers that sponsor money market mutual funds have made payments to their funds to avoid “breaking the buck.” These payments prevented runs, but future payments are not guaranteed. Indeed, managers are least likely to make these payments when they are most needed.
Two potential solutions to the run problem would require that managers guarantee the performance of their money market funds, or that the funds purchase third-party insurance to provide these guarantees. Both solutions remove the investment underperformance risk from shareholders and place it on other entities. Both would be costly to shareholders.
Another solution would be to reorganize the funds so that they have two classes of shareholders. Most investors would obtain a guaranteed investment that performs exactly as money market mutual funds are expected to perform. The “equity” investors would bear all the risk of loss should the value of the fund investments drop during extraordinary times. For bearing this risk, they would receive a slightly higher rate of return during normal times, which would be funded by lower returns paid to the other investors. The equity investors thus would insure the other investors. Money market funds also could only invest in Treasury securities or federally insured securities. This restriction also would decrease fund returns.
Lowering risk without lowering returns is impossible unless the government guarantees performance, which is unacceptable.
Another solution would have money market fund investors explicitly bear the risk of underperformance by pricing deposits and redemptions at actual NAV every day. This floating NAV solution would allow the fund investors to bear more risk and thus obtain higher returns.
Finally, money market funds could prevent their investors from redeeming all their shares during a crisis. The money held back would be used to ensure that every investor shares equally in any liquidation of fund assets, which would significantly limit runs.
The SEC is exploring various combinations of the above solutions. The mutual fund industry believes that many of these changes would alienate investors. Much of its concern has focused on floating NAV and on holdbacks.
Floating NAV is unattractive to investors because it changes the character of the funds. Instead of being stable value funds that operate like bank deposit accounts, the funds would be similar to equity mutual funds with NAVs that vary over time. Varying NAVs would make cash management confusing and would significantly complicate tax accounting for investors, outside of 401(k) plans and other tax-sheltered investment vehicles.
Holdbacks are unattractive because nobody wants access to their funds to be restricted. However, some kind of holdback feature is necessary to prevent runs if shareholders are to bear the underperformance risk, and if the funds are to be stable priced at $1.
Fortunately, a better solution exists. SEC regulations presently permit two types of mutual funds: Most equity and bond funds price deposits and redemptions daily at NAVs that reflect their current portfolio values. These funds also pay annual or quarterly dividends to shareholders of record as of a particular date, regardless of how long they have held their shares. In contrast, money market funds price deposits and redemptions at a stable $1 (if the NAV is within 0.5% of $1), and they pay dividends monthly based on the average assets in each account during the month.
Between these two structures lies another one: Require money market funds to price deposits and redemptions internally at actual NAV, but allow them to report these transactions externally (and for tax purposes) at a stable $1 per share, and reconcile any differences when the fund pays dividends at the end of the month. For example, if a redemption occurred when NAV was less than $1, the transaction would be reported at $1 and the difference would be subtracted from the dividends paid to the investor at the end of the month, and if necessary, in future months, too. Finally, if a shareholder requested full account liquidation, the liquidation — which in a crisis might be delayed a few days — would include an adjustment to reflect the actual account value.
During normal times, the external stable value accounting would make these accounts look exactly like deposit accounts. During extraordinary times, the internal NAV accounting would substantially reduce the incentives to run on the fund. With this proposal, everyone gets what they want.
Any of these solutions could effectively solve the run problem. The SEC would be wise to allow funds to choose, and fully disclose, any alternative. Investors then could choose the fund structure that most appeals to them. The unacceptable alternative is the status quo: The Federal Reserve — and indirectly American taxpayers — should not bear the risk of money market fund investment failures.
Larry Harris holds the Fred V. Keenan Chair in Finance at the USC Marshall School of Business. He served as chief economist of the SEC from 2002 to 2004.