Unlike many, I have long felt that money market funds possess credit risk. Does that mean that I don’t own money market funds? I have a lot of money in money market funds, but I review the holdings of my funds to make sure that there are no “yield hogs” in the funds that might imply unreasonable risk. I don’t go for the treasury only funds — I am willing to take ordinary high quality risk, so long as the managers aren’t doing anything to weird with structured products, ABCP, etc.
Money market funds break the buck when the market value of the instruments drops below 99.5% of par. That rarely happens, though in this environment it is a risk, if a fund hasn’t availed itself of the cheap insurance offered by the US Treasury.
The real risk comes when a fund “breaks the buck” and allows withdrawals at par for a time, leading to a “run on the fund.” My proposal says this: When a fund “breaks the buck,” it announces a credit event. It tells shareholders that they have lost money, and to protect the interests of all shareholders, all shareholders will suffer a small capital loss.
Whatever the fairly calculated NAV is when a capital loss is announced, the new NAV would be 100.25, and the number of shares reduced to the level that supports that NAV. If the value of the assets has been accurately calculated, and there are withdrawals, the premium to NAV should rise, not fall, for the remaining shareholders.
No one will like the concept of a credit event in money market funds. That said, the idea would have many salutary effects on money market funds:
- It would eliminate runs on the funds.
- It would get people used to the idea that there is some risk in money market funds, though limited.
- It would eliminate the need for the government to intervene and insure money market funds.
- It would allow some money market funds to take more risk, and offer more return.
- The cost would be minimal, most of the time losses would be 1-2%, which would be paid for through interest in less than a year.
Now, my main application was money market funds, but there are two other areas to consider. Area one: short-term income funds. Here is my poster child. Under my proposal, instead of freezing redemptions, units are eliminated for the capital losses to the degree that it is not in the interests of anyone to liquidate assets. A run on the fund would increase the NAV relative to the price.
Here’s area two: stable value funds. I’ve written about this before, but stable value funds possess more levers to continue operating, even when the NAV drops below 99.5% of par. Stable Value funds don’t typically reveal the NAV, and when the NAV is lower than the price, they lower the credited rate relative to the earnings rate in order to bring the two back into balance.
But what if a Stable Value fund is in a deep hole? What if the credited rate is nearing zero, and investors are fleeing, worsening the problem? My view is that at some threshold for NAVs the Stable Value funds have to announce a credit event and reduce units. That value might be 96-97% of par, with a revaluation of units around 101-102% of par. Even if there is no fleeing, the excess would be amortized into the credited rate over time.
On the negative side, this could lead money market funds, short-term income funds, and stable value funds to be more aggressive. That said, it would encourage invest to analyze these funds that are not riskless, because they could undergo devaluations.
For those who hold pseudo-cash through money market funds, short-term income funds, or stable value funds, you need to be aware that they are not riskless, and that in their present form they may deliver capital losses, and more so if withdrawals are not limited. My proposal provides an orderly way for recognizing and dealing with those losses in a way that does not require the government to step in with guarantees.