Breaking the Money Market Buck
When the Chairman of the Federal Deposit Insurance Corporation Sheila Bair says money markets funds are “highly unstable in a crisis” it gets your attention. At the same May 5th meeting, former Fed chief Paul Volcker called for a “floating share price” for money market funds as the simplest solution. Is the longstanding one dollar per share value of money markets at risk?
It is easy to think of money market funds simply as savings account for affluent people – low risk, low return storage vehicles for cash – but there’s more to the story. Whereas banks promise to pay interest on a savings account, a money market is actually a mutual fund that holds a variety of very short-term, high quality securities, including commercial paper, government bills, and bank deposits. The price is held at one dollar per share, with returns of the fund’s holdings paid out as dividends, not interest.
In times of financial stress, when securities held in these funds may be less than fully secure, talk of “breaking the buck” arises – meaning giving shareholders who sell shares less than a dollar per share. This happened once in 1994, and almost happened on wide scale in 2008 when the US government stepped in to guarantee money market liquidity, avoiding a disastrous run on the $3.5 trillion money market industry.
Here we are again
One would think with all the intervening discussion and changes in law and regulation, that a money market panic like the one in 2008 could not possibly happen again. Yet, here we are again, with worries this time triggered by the US hitting its current $14 trillion debt ceiling.
Some predictions are dire. “A financial crisis is surely going to happen as big or bigger than the one we had in 2008 if we continue to behave the way we’re behaving,” says Stanley Druckenmiller, the legendary investor and onetime fund manager for George Soros.
But it’s not just hedge fund managers who are worried. Add to the comments of the FDIC’s Bair and Mr. Volcker these warnings:
- The Treasury Borrowing Advisory Committee: the debt ceiling limit “could trigger a run on money market funds.”
- Treasury Secretary Geithner in a letter to Congress in April: “Default would cause a financial crisis potentially more severe than the crisis from which we are only now starting to recover.”
- Fed Chairman Bernanke: “The stability of money market mutual funds — which suffered dramatic runs that worsened funding conditions at the height of the crisis — is clearly a systemic issue, not just an industry issue.”
These are not idle comments by rumor-mongerers or pundits fighting for airtime, but real concerns expressed by our most powerful financial regulators. With the US unable to raise money through short-term borrowing, a staple of money market funds, the dollar per share standard is less than certain.
It’s not clear how this story will play out, but the sacred dollar per share price may ultimately go away. That doesn’t mean everyone’s money market with go down, just that the implied guarantee is no longer there. The underlying securities behind the one dollar value can still be there. However, once the buck is broken, many investors are likely to abandon money markets, throwing short-term borrowing into real turmoil.
Cash as a declining asset
Money market funds are very widely held for their “safety,” but in truth constitute a drain on investor wealth. Even if the one dollar value is sustained, the return on most money market accounts – after inflation and taxes – is negative. Today’s inflation rate is below its long term rate between 2.5 and 3 percent, but still well above the near zero return on most money markets. Holding cash in money markets for long periods almost ensures a loss of purchasing power. As Bill Gross says about bonds, “prices don’t have to go down for you to lose money.”
However there are alternatives. At Osbon Capital, we typically take a different approach to balances not invested in stocks or bonds. “Money” is typically defined as a liquid store of value over time (though in money markets it often loses value to inflation). We define money as liquid stores of value designed to appreciate after inflation and taxes. Instead of money market funds we often use gold, yuan, the Swiss franc, and others. By no means are these investments risk-free, or even low risk. They can be volatile and there is no telling if they will be worth more in the future than you pay for them today. But we feel they deserve serious consideration not only to preserve and possibly grow value but also to add diversification.
Money market accounts are like many other investments – far more complicated than they seem on the surface.