A friend in the mutual fund business, whom I respect, has shared some observations about money market funds that are alarming and worthy of note.
He observes that, according to recent statistics from the Investment Company Institute, nearly 70% of all cash sitting in money funds is institutional. That's is an extremely high percentage, and even more alarming is that institutions now account for more than 80% of all the cash sitting in government money funds.
Why the worry? According to our informed observer, institutional money is notoriously “hot,” and will jump quickly into and out of investment vehicles to gain a little extra yield. In fact, many of the institutions — particularly corporations that park their cash in money funds — are under a fiduciary obligation to their shareholders to get the highest returns possible on comparable investments.
In the past, when the Federal Reserve hiked rates, these institutions would pull their money out of money funds and go into overnight repurchase agreements and short-term commercial paper. That allowed them to pick up additional yield, because those instruments would more quickly reflect the higher rates. After a few weeks, when money fund rates would rise, reflecting the new short-term instruments in the funds' portfolios, institutional money would return. The funds themselves, however, could cope with the inflows and outflows because retail investors typically stayed put. And retail investors constituted the bulk of money fund investors.
Today, the landscape is different.
For the most part, cash from retail investors in brokerage accounts is now swept into bank accounts, not money market funds. These bank accounts are FDIC-insured, which means Moms and Pops can breathe easier, should money market funds suffer another lockup. The bank accounts are also better for the brokerage firms and the banks that own them because the banks can offer lower interest rates to little guys and higher rates to bigger clients, something that can't be done in a fund where all shareholders are created equal (at least in terms of yield).
But the Moms and Pops are now gone from retail money market funds, making the institution-laden funds a ticking time bomb.
Stretching themselves out on the yield curve to offer a bit bigger return than pancake-flat Treasuries, money market funds have extended the weighted average maturity of their portfolios. One large fund, for example, recently had a WAM of 55 days. When the Fed raises rates (I say “when,” and not “if,” because rates can't stay near zero forever and there's nowhere to go but up), money will come pouring out of money market funds. And as money funds sell their holdings to redeem shares, we will see a liquidity freeze in the commercial-paper markets comparable to the Primary Reserve Fund crisis that sent shockwaves throughout the world.
How much money will come pouring out of funds? I don't know, but consider what large payroll-processing companies do with the money they handle. Typically, Company A wires the payroll for its 1,000 employees to the payroll processor, which puts that money into a money market fund, perhaps overnight or for two days, until it wires the money to employee bank accounts. In a more normal interest-rate environment, that little two-step makes a lot of money for the processor. But what happens when the payroll processor decides to drain its money fund account?
And what happens when Microsoft, which is sitting on about $30 billion in cash and short-term investments, decides it wants to move out of money market funds?
The flight from money funds won't be a case of corporate treasurers being greedy. If they are earning 5 bps on a money fund now and the Fed raises rates so that other short-term instruments are paying 25 basis points, the corporate executives would be violating their fiduciary duty not to seek five times their current return. Their duty is to their shareholders, not to the public or to the money fund's shareholders.
But what about the public, the shareholders and the country's financial system at large?
Yesterday, the Securities and Exchange Commission proposed that money funds shorten the permitted maturity of their portfolios to 60 days from 90 days. (For a money market fund to be rated triple-A, it must have a WAM of 60 days or less). Let's hope that's enough to avert a crisis.
Let's also hope that the Fed, Treasury Secretary Geithner and other regulators and officials are keeping an eye on this alarming situation.