Money funds (or money market funds, money market mutual funds) are mutual funds that invest in low-risk securities and thus pay low dividends that generally reflect short-term interest rates.
Explanation
Money market funds, also known as principal stability funds, seek to limit exposure to losses due to credit, market, and liquidity risks. Money market funds, in the United States, are regulated by the Securities and Exchange Commission's (SEC) Investment Company Act of 1940. Rule 2a-7 of the act restricts investments in money market funds by quality, maturity and diversity. Under this act, a money fund mainly buys the highest rated debt, which matures in under 13 months. The portfolio must maintain a Weighted Average Maturity (WAM) of 90 days or less and not invest more than 5% in any one issuer, except for government securities and repurchase agreements.
Eligible money market securities include commercial paper, repurchase agreements, short-term bonds or other money funds. Money market securities must be highly liquid and have a stable value.
Breaking the buck
Money market funds seek a stable $1.00 net asset value (NAV); they aim to never lose money. If a fund's NAV drops below $1.00, one says that the fund "broke the buck".
This has rarely happened; however, as of September 16, 2008, two money funds have broken the buck (in the 37 year history of money funds) and from 1971 to September 15, 2008, there was only one failure.
The Community Bankers US Government Fund broke the buck in 1994, paying investors 96 cents per share. This was the first failure in the then 23 year history of money funds and there were no further failures for 14 years. The fund had invested a large percentage of its assets into adjustable rate securities. As interest rates increased, these floating rate securities lost value. This fund was an institutional money fund, not a retail money fund, thus individuals were not directly affected.
No further failures occurred until September 2008, a month that saw tumultuous events for money funds.
The week of September 15, 2008 to September 19, 2008 was very turbulent for money funds and a key part of financial markets seizing up.
Events
On Monday, September 15, 2008, Lehman Brothers Holdings Inc. filed for bankruptcy. On Tuesday, September 16, 2008, Reserve Primary Fund, the oldest money fund, broke the buck when its shares fell to 97 cents, after writing off debt issued by Lehman Brothers.
The resulting investor anxiety almost caused a run on the bank for money funds, as investors redeemed their holdings and funds were forced to liquidate assets or impose limits on redemptions: through Wednesday, September 17, 2008, prime institutional funds saw substantial redemptions. Retail funds saw net inflows of $4 billion, for a net capital outflow from all funds of $169 billion to $3.4 trillion (5%).
In response, on Friday, September 19, 2008, the U.S. Department of the Treasury announced an optional program to "insure the holdings of any publicly offered eligible money market mutual fund — both retail and institutional — that pays a fee to participate in the program." The insurance will guarantee that if a covered fund breaks the buck, it will be restored to $1 NAV. This program is similar to the FDIC, in that it insures deposit-like holdings and seeks to prevent runs on the bank. The guarantee is backed by assets of the Treasury Department's Exchange Stabilization Fund, up to a maximum of $50 billion. It is very important to realize that this program only covers assets invested in funds before September 19, 2008 and those who sold equities, for example, during the recent market crash and parked their assets in money funds, are at risk. The program immediately stabilized the system and stanched the outflows, but drew criticism from banking organizations, including the Independent Community Bankers of America and American Bankers Association, who expected funds to drain out of bank deposits and into newly insured money funds, as these latter would combine higher yields with insurance.
Analysis
The crisis almost developed into a run on the shadow banking system: the redemptions caused a drop in demand for commercial paper, preventing companies from rolling over their short-term debt, potentially causing an acute liquidity crisis: if companies cannot issue new debt to repay maturing debt, and do not have cash on hand to pay it back, they will default on their obligations, and may have to file for bankruptcy. Thus there was concern that the run could cause extensive bankruptcies, a debt deflation spiral, and serious damage to the real economy, as in the Great Depression.
The drop in demand resulted in a "buyers strike", as money funds could not (because of redemptions) or would not (because of fear of redemptions) buy commercial paper, driving yields up dramatically: from around 2% the previous week to 8%, and funds put their money in Treasuries, driving their yields close to 0%.
This is a bank run in the sense that there is a mismatch in maturities, and thus a money fund is a "virtual bank": the assets of money funds, while short term, nonetheless typically have maturities of several months, while investors can request redemption at any time, without waiting for obligations to come due. Thus if there is a sudden demand for redemptions, the assets may be liquidated in a fire sale, depressing their sale price.
An earlier crisis occurred in 2007–2008, where the demand for asset-backed commercial paper dropped, causing the collapse of some structured investment vehicles.
Similar investments
Money market accounts
Banks in the United States offer savings and money market deposit accounts, but these shouldn't be confused with money mutual funds. These bank accounts offer higher yields than traditional passbook savings accounts, but often with higher minimum balance requirements and limited transactions. A money market account may refer to a money market mutual fund, a bank money market deposit account (MMDA) or a brokerage sweep free credit balance.
