On October 14, 2016, the form and function of what most investors believe to be the safest investment they have will change. On that date, new rules governing money market funds go into effect. We'll get to that at the end. After all, this is about history. So, like all good stories, this one will start at the beginning.
Bank Deposits and The Great Depression
Before the Great Depression, banks would compete for consumer deposits by paying interest on checking accounts (demand deposits). This competition led banks to ratchet up the rate of return they offered their customers in an effort to attract more and more deposits.
Sadly, in the early 1930s, many banks (and subsequently, the economy) collapsed. Between the stock market crash on October 29, 1929 and the end of 1933, more than 9,000 US banks failed. This prompted Congress to enact what has affectionately become known as the Glass-Steagall Act.
Glass-Steagall (formally the Banking Act of 1933) was amended several times before its ultimate repeal in 1999. And in 1935, it was amended to strengthen the Federal Deposit Insurance Corporation (FDIC) and to prohibit the payment of interest on demand deposits.
In his 1978 thesis, Interest-Bearing Checking Accounts and Macro Policy, Douglas W. Mitchell postulated that the motivation for the prohibition was a belief among lawmakers that paying depositors interest on their checking accounts led the banks to take undue investment risks as the margin between what they got paid for lending and what they paid on deposits shrank to unprofitable levels.
By straying from their primary mission of borrowing from savers and lending to debtors, the banks were motivated to make more and more speculative investments (gee, doesn't that sound familiar), which led to their collapse when the stock market crashed. So, regulators wanted to put policies in place that would prevent this from happening again.
Whatever the case, the reality was that if you had money in the bank, you had just two options; either you got paid nothing on your checking account, or you had to tie up your money in a savings account to get any interest. What's more, gaining access to the money in your savings account subjected you to early withdrawal penalties (we'll come back to this later). The reason for this was that regulators imposed different reserve requirements on checking and savings accounts.
Reserve requirements are imposed so that banks hold onto a portion of deposits rather than lend them out, just in case folks come looking for their money, the way they did in 1930. And, as you may have guessed, the higher the reserves that need to be held, the lower the bank's profitability on its deposits.
Interest Rates and Inflation
The Banking Act of 1935 did something else. It put a cap on the rate of interest that a bank could pay depositors on their savings accounts. This didn't present much of an issue to savers until the 1950s, when interest rates started to rise.
(Source: Federal Reserve Economic Data)
The trend became more problematic for savers as inflation reared its ugly head in the mid-1960s, and just kept rising. By 1974, the annual rate of inflation was 12.34%.
(Source: Federal Reserve Economic Data)
Advent of The Money Market Fund
Thank goodness Bruce Bent and Henry Brown met each other in the 1960s and in 1969 started exploring the idea of creating a mutual fund that would allow consumers to take advantage of higher yielding investment instruments that were previously only available to large institutions. After reviewing banking laws in all 50 states, Brent and Brown launched the Prime Reserve Fund in 1971. It was the first money market fund in the world (Source: The New York Times, Henry B. R. Brown Obituary).
Money market funds came to be considered by investors, in fact by the entire investment community (regulators, banks, brokers, money managers, financial planners, etc.), as being nearly as safe as cash in the bank (even though they are not insured the way bank deposits are). The fact that they pay higher rates than banks pay makes them wildly popular. And, the fact that they are completely liquid helped them grow from virtually zero in 1970 to more than $2.6 trillion (yes, with a "T") in assets right now.
(Source: Investment Company Institute)
Money market funds are mutual funds regulated under the Investment Company Act of 1940 that invest in very short-term interest-bearing securities. These can include US Treasury bills, federal agency notes, Eurodollar deposits, repurchase agreements, certificates of deposit, and corporate commercial paper.
Because of the very short-term maturities of these types of investments, money market funds are virtually devoid of volatility. For this reason, they have traditionally traded at Net Asset Values (NAVs) of $1.00. And, for more than four decades, investors have come to rely on an environment where a dollar into a fund would be priced at that same one dollar on their monthly statement, and would be redeemed at that same one buck the day they went to sell it. That is, until the day Lehman Brothers failed.
Back to the Future
Nobody boasts at cocktail parties about how brilliant they are because of the money market fund they "discovered." For all their popularity, and for all the advantages that money market funds offer to investors, they have been a completely boring, sleepy investment vehicle. That all changed on September 16, 2008.
On that day, the aftermath of the collapse of the investment banking firm Lehman Brothers took its toll on the storied Prime Reserve Fund started by Bruce Bent and Henry Brown. The fund had a $785 million exposure to Lehman debt, approximately 1.2% of the fund's total assets. Lehman's failure forced the Prime Reserve Fund to lower its NAV to under $1.00.
That sent shockwaves through the financial system as investors made a 1930s-type run from money market funds in general, exacerbating the growing financial crisis and forcing many fund managers to support their funds to prevent them from likewise "breaking the buck." The Prime Reserve Fund dissolved within two years.
Money Market Reform After the Financial Crisis
After the collapse of the Prime Reserve Fund, regulators became determined to find ways to avoid a similar circumstance in the event of severe market disruption. In other words, they wanted to come up with ways to prevent investor runs from money market funds if another financial crisis happened.
In 2010, the Securities and Exchange Commission adopted a number of reforms to do this. And, here's where we get to the part about October 14th, the date that a number of new rules go into effect. Here's a summary of those rules, courtesy of the Securities and Exchange Commission.
Beginning October 14th, institutional money market funds will be required to let their NAV fluctuate (except for "Government Funds," which must maintain a stable $1.00 NAV). All other institutional money market funds may actually break the buck, or rise above it. As such, there will also be new rules allowing investors in these funds to use a simplified tax accounting method to track gains and losses.
These funds will have to report their NAVs based on the actual value of the securities held in their portfolios to the closest 10,000th of a dollar (the 4th decimal place: $1.0000).
Institutional money market funds are defined as those that you (a natural person) can't buy. They can be owned by an institution, an endowment, a business or a defined benefit plan.
For all money market funds, the Securities and Exchange Commission will also impose greater reporting requirements, will require more diversification and will require funds to perform and disclose portfolio stress testing.
Fees & Gates
For retail money market funds (the kind that you can own in your own name, your IRA, your kid's 529 plan, your HSA, etc.) there will be two new simple measures to deter runs.
The first is that a fund will be able to charge you a redemption fee when you sell (sort of an early withdrawal penalty, right?). The second is that they may impose a waiting period before you actually receive your money.
So, What's The Bottom Line?
For both retail and institutional investors in money market funds, the choices boil down to sticking with the fund you have, or going out and looking for more yield. Ultra-short-term and short-term bond funds may offer more yield than an institutional money market fund, but they come with risks.
Funds with longer average maturities come with more interest rate risk. Those that include mortgage-backed securities also include convexity risk (the risk that early payoffs may change the average duration of the portfolio). And switching between funds exposes the investor to manager risk (the risk of relative underperformance).
In our opinion, investments in money market funds are (for all intents and purposes) investments in cash. And, we view cash investments as a portfolio diversification and risk mitigation tool, not a performance enhancer. So, we would caution investors against stretching for yield in an asset class that we use to keep our clients out of harm's way.
The October 14, 2016 changes are intended to make structural and operational reforms to address the risk of investor runs in money market funds, while preserving their benefits. We don't think they should be viewed as a catalyst for making unnecessary portfolio changes.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.