Money Market Funds – A Bad Deal is About to Get WorseFebruary 8th, 2012 by The Financial Lexicon
New SEC Proposals and the Impact on Money Market Funds
By: The Financial Lexicon
When I recently read news of the Securities and Exchange Commission’s (SEC) two proposals concerning money market funds, my first thought was, “Why do people still park money in those things?” After the Reserve Fund broke the buck (net asset value dropped below $1) in 2008 and money market mutual fund yields eventually plunged to near zero, I stopped using the funds as a place to park my cash and instead moved my money into an FDIC insured account with a bank.
In years past, I found it acceptable to trade the FDIC insurance of a checking or savings account for the higher yields of a money market. After all, the idea of a stable net asset value for money market funds was sacrosanct. Therefore, I and other investors alike would collect higher yields than we could from an FDIC insured account and at the same time be able to confidently park our cash in brokerage money market sweep accounts. The events of 2008 changed this. And, given the new proposals from the SEC, which are in direct response to the events of 2008, how investors view money markets might never go back to the way it used to be.
Here is the current situation regarding money market mutual funds (not to be confused with money market deposit accounts at banks) without any new proposals from the SEC:
- Lower yields than many checking and savings accounts.
- No FDIC insurance
- As of January 27, 2010, the SEC adopted new rules for money markets, one of which permitted the board of directors of a money market fund to suspend redemptions if the fund is about to break the buck and will be liquidating.
In review, here is where we stand today:
Investors can park cash in a money market mutual fund and receive lower rates of return than they could in a checking or savings account (depending on deposit levels and varying by bank). Furthermore, the money market mutual fund will not be FDIC insured, as the checking or savings account would be. On top of this, in the event of a run on the money market system, similar to what occurred in 2008, redemptions can now be suspended with the blessing of the board of directors (rather than the pre-2010 way of having to request an order from the SEC allowing suspensions).
With all that said, there are still at least two reasons investors might use money market funds over FDIC insured bank accounts.
First, when investors have brokerage accounts, money market funds are used as sweep accounts, sweeping money back and forth after transactions (such as buying or selling stocks). However, FDIC insured sweep accounts at some brokerages are now available. Only time will tell how popular they become. Second, investors with large amounts of cash often find it preferable to park that money in money market funds due to their perceived liquidity. For investors with smaller amounts of money, an electronic funds transfer between a bank account and a brokerage account (or vice versa) could satisfy any liquidity concerns (such as needing funds quickly to purchase stocks or bonds).
Regardless of whether you think the ability of the board of directors to approve redemption suspensions is a big deal, based on the lower yields and lack of FDIC insurance alone, money market funds’ appeal was already becoming questionable. Now let’s throw in the two new proposals. One of the two proposals would allow for money markets to hold back 3% of investor funds for 30 days after a redemption request. In other words, if you want your money, they’ll give you 97% of it now and the other 3% in 30 days. There goes the liquidity benefit of money markets.
The second proposal calls for floating net asset values. In other words, it allows for the net asset value of a money market mutual fund to fluctuate from $1. During the 2008 financial crisis, several firms managing money markets had to pump money into the funds to avoid breaking the buck. The $1 “stable” net asset value proved to be unstable during the severe financial stresses of 2008, requiring bailouts from the firms that manage the funds. However, most investors probably never knew this ever happened. If the SEC’s new floating net asset value proposal goes into effect, how many investors do you think will stick around to find out whether the $1 value of these funds survives the next financial crisis (whenever that might be)?
With money market fund assets already down by nearly a third over the past three years, how much lower will they go if either of the SEC’s new proposals comes to fruition? Will investors decide to park their money in money market mutual funds during the next equity bear market as they have in the past, or will other alternatives become the preferred choice? There are times when investors want a return of their money rather than a return on their money, such as during a recession, a bear market, or a financial crisis. A financial instrument that withholds part of your money after a redemption request or a financial instrument that fluctuates in value without the ability to mature at par (unlike individual bonds, which do mature at par) doesn’t seem like the type of financial instrument I would choose to park cash in when markets are under stress. If enough investors feel the same way, I’d hate to be a company relying on short-term loans from money market funds the next time the world economy falters and financial markets take a dive.
Editor’s Note: The Largest Money Market Funds are Fidelity Cash Reserves (FDRXX) and Vanguard Prime Money Market Fund (VMMXX)
More from The Financial Lexicon