Money Market Funds: Are They Really Safe?
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Introduction
Money market funds have long been considered a safe haven for both retail and institutional investors. With the promise of stable returns and low risk, these funds have attracted billions of dollars in investments over the past decade. However, recent concerns have emerged about the safety of money market funds, raising questions about the potential risks involved and the prudence of parking large sums of money in these funds.
The Rise of Money Market Funds
Over the past 10 years, the popularity of money market funds has skyrocketed. According to the Investment Company Institute, there is currently about $5.6 trillion of liquidity sitting in these funds, up from $2.6 trillion a decade ago. This massive influx of capital can be attributed to the allure of higher returns compared to traditional bank deposits, as some money market funds offer annual returns of around 5%.
The Risk-Return Tradeoff
While the prospect of higher returns is undoubtedly attractive, it raises the question of whether the risks associated with money market funds are being adequately considered. The influx of liquidity into these funds has worried some Wall Street insiders, who fear that there might not be enough safety nets in place to protect investors in the event of a downturn.
One major concern is that money market funds are not insured like bank deposits. Unlike deposits, which are backed by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per account, money market funds carry a certain degree of risk. While government funds, which invest exclusively in government debt, are generally considered safer, prime funds that invest in a broader range of assets pose greater risks in exchange for higher returns.
Example
Take, for example, the Dreyfus Money Market Fund, which has been in existence for 41 years and currently offers investors a 5% annual return. Despite Dreyfus clearly stating that their fund is not insured by the FDIC and there is a risk of losing money, investors have flocked to this and similar funds in search of higher returns. This exemplifies the behavior of investors who are willing to scale up the risk in exchange for potentially higher rewards.
The Lessons from the Financial Crisis
The collapse of the Reserve Primary Fund in 2008 during the financial crisis serves as a stark reminder of the risks associated with money market funds. The fund “broke the dollar,” meaning that its value fell below the standard par value of $1 per share. This occurred as the value of seemingly safe investments, such as those in Lehman Brothers bonds, plummeted after the bank’s collapse. The Reserve Primary Fund traded at just 97 cents on the dollar, causing panic among investors and further destabilizing the financial system.
With this historical example in mind, it is crucial to consider the potential consequences of another financial shock. If investors rush to redeem their investments in money market funds and shift back to FDIC-backed deposits, the forced selling of assets by funds could lead to further devaluation and exacerbate a downward spiral.
Signs of Vulnerability
Treasury Secretary Janet Yellen has highlighted the vulnerabilities of money market funds to runs and sell-offs. Although reforms have been implemented since the financial crisis to enhance the safety of these funds, concerns persist among finance professionals. The sheer amount of liquidity parked in money market funds and the potential lack of safety nets continue to worry market insiders.
Unique Insights and Perspectives
While the basic risks associated with money market funds are widely known, there are unique insights and perspectives that can shed further light on the topic. Delving deeper into the subject matter offers a more comprehensive understanding of the risks involved and how investors should approach these funds.
The Human Instinct for Risk
One interesting aspect to explore is the human instinct to scale up the risk in exchange for higher returns. This behavior can be observed in the increasing popularity of money market funds as investors are attracted to the potential for greater profits. Understanding the psychological factors driving investor behavior in this context can provide valuable insights into the dynamics of the market.
Government Funds vs. Prime Funds
Distinguishing between government funds and prime funds is another crucial aspect to consider. While government funds invest exclusively in government debt, which is generally considered safer, prime funds have more flexibility to invest in a broader range of assets. Analyzing the composition of money market funds and their exposure to different types of assets can help investors assess the level of risk they are comfortable with.
Lessons from the Silicon Valley Bank Collapse
The collapse of the Silicon Valley Bank earlier this year provides a recent case study on the risks associated with investing in government bonds, even in a rising interest rate environment. The rapid outflows from the bank forced managers to sell assets, resulting in significant losses. This example highlights the importance of considering liquidity and potential selling pressures when evaluating the safety of money market funds.
Summary
In conclusion, money market funds have experienced a surge in popularity over the past decade, attracting billions of dollars in investments. While these funds offer the potential for higher returns, it is essential to recognize the risks involved. Unlike bank deposits, money market funds are not insured, and there is always a possibility of losing money. The collapse of the Reserve Primary Fund during the financial crisis serves as a reminder of the potential pitfalls.
With reforms in place to enhance the safety of money market funds, investors should be cautious and consider their risk tolerance before investing in these funds. The behavior of the market and the potential for sudden shifts in liquidity should not be overlooked. By understanding the nuances and risks associated with money market funds, investors can make informed decisions and mitigate potential losses.
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The writer is a former investment banker and author of “Power Failure: The Rise and Fall of an American Icon”
Over the past 10 years, both retail and institutional investors have flocked to U.S. money market mutual funds, supposedly a safe place to park money short-term while trying to figure out what else to do with it. There is currently about $5.6 trillion of liquidity sitting in these funds, up from $2.6 trillion a decade ago, according to the Investment Company Institute.
Is this something to worry about or is it just a reflection of the human instinct to scale up the risk in exchange for a higher return? According to Crane Data, the highest-yielding money market funds today offer investors an annual return of about 5%.
Investors have noticed. According to The Kobeissi Letter, since the Federal Reserve began raising interest rates in March 2022, about $862 billion in bank deposits have been withdrawn and invested elsewhere, including money market funds, about 12 times more than how much was withdrawn by the big banks in the period. consequences of the 2008 financial crisis. Considering that JPMorgan Chase, the largest US bank, pays depositors in their checking accounts 0.01 percentage points in interest each year, the collective decision seems to make sense.
But are money market funds as safe as many think? The sector was made safer after the financial crisis with a series of reforms. This has spurred a big shift on the part of investors. Sector funds largely come in two main types. Government funds invest exclusively in government debt, while prime funds, popular before the financial crisis, can invest a broader range of assets. Of the $5.6 trillion in money market funds, about $4.6 trillion belongs to the safest government funds.
But, as we saw in the Silicon Valley Bank collapse this year, there are still risks to investing in government bonds in a rising interest rate environment if money flows out quickly and managers are forced to sell assets, crystallizing the losses.
The influx of liquidity into money market funds is worrying several people I speak to regularly on Wall Street. “No one is willing to tell the truth,” one longtime finance veteran told me via email. “There is too much money parked in these funds and there are really no safety nets. People have fled banks in panic into high-yield instruments without understanding them.”
And in the midst of the SVB meltdown, Treasury Secretary Janet Yellen She said: “If there is one place where system vulnerabilities to runs and sell-offs have been clearly defined, it is money market funds.”
Here’s the problem with money market funds: Unlike bank deposits, which are insured up to $250,000 per account by the Federal Deposit Insurance Corporation, money market funds are not insured. With state money market funds, the risk of losing money is very low. With prime funds, however, there is greater risk in exchange for the higher returns on offer.
For example, the Dreyfus Money Market Fund, which is part of the Bank of New York Mellon, has about $2.4 billion in assets under management. It has existed for 41 years. It now offers investors a 5% annual return. As you would expect, Dreyfus doesn’t hide the risks. “An investment in the fund is not a bank deposit,” Dreyfus says upfront. “It is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. You could lose money by investing in the fund.” Pretty standard standard disclosure and with a clear warning. However, investors have flocked to this and many other similar funds in a bid to achieve higher returns.
But, as many readers will no doubt recall, in September 2008, the Reserve Primary Fund, one of the oldest and best-known money market funds, “broke the dollar” in the midst of the financial crisis. The value of what seemed like safe investments – such as those in Lehman Brothers bonds – dropped precipitously in value after the bank’s collapse, causing the fund to trade at just 97 cents on the dollar. It was one of the few times a money market fund fell below par value and further spooked an already jittery financial system.
Of course, the same thing could happen again if there was a shock in the financial markets and panic ensued. Investors may try to exit their money market funds and return to FDIC-backed deposits. The stampede will force funds to sell assets, likely causing them to lose value and worsening the downward spiral.
This is the problem with financial crises. We know that they happen with some regularity and that in retrospect it is easy to pick up on the warning signs. Money market funds have been made safer, yes, but there are still risks that require careful surveillance.
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