Most of us can reel off the institutions behind the financial crisis, names like Lehman Brothers, Fannie Mae and American International Group. Often missing from the roll call of ignominy is the Reserve Primary Fund, a money-market mutual fund. When it almost collapsed in the fall of 2008, the U.S. economy was pitched into a credit crunch that almost brought on the sequel to the Great Depression.
It turns out that money-market funds can detonate as easily as the nation’s biggest banks and securities firms. Unlike those too-big-to-fail institutions, money-market funds were all but ignored in last year’s Dodd-Frank Act. Regulators should address this oversight by ending the inherent flaw in such funds, which have amassed $2.7 trillion in assets and play a crucial role in the credit markets.
For almost four decades, the industry has operated under a pretense: Funds maintain an artificial price of $1 a share, promising investors a dollar in, a dollar out, plus interest, on demand. The funds tend to offer higher returns than banks because they don’t have the expense of paying for deposit insurance.
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But the Reserve Primary Fund, for only the second time in the history of money-market funds, “broke the buck” during the financial crisis. It held $785 million in commercial paper issued by Lehman Brothers Holdings Inc. When Lehman failed on Sept. 15, 2008, the fund no longer had enough assets to assure that customers could retrieve all their money.
Even though the fund estimated its post-Lehman-bust share price at 97 cents, investors raced each other to withdraw their money. The fund tried to meet redemptions by selling its investments into a panicked market. The contagion spilled over to other money-market funds. In the span of two weeks, $400 billion was pulled out of the funds, and the flow of short-term credit from the funds to companies froze. Only a promise by the Federal Reserve and the U.S. Treasury to backstop the entire industry stanched the run.
As these events show, the Securities and Exchange Commission, which regulates mutual funds, should make them less susceptible to mass withdrawals. The need for an overhaul is magnified by Europe’s debt crisis. According to Fitch Ratings, the 10 largest U.S. money-market funds have more than a third of their assets invested in European banks.
The SEC took an initial step last year by adopting several changes, some based on industry recommendations. Money-market funds now must hold at least 10 percent of their assets in cash or investments that can be swapped for cash within one day. Other changes include holding investments with shorter maturities, letting funds get their hands on cash more quickly.