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The writer is a former investment banker and author of ‘Power Failure: The Rise and Fall of an American Icon’
In the last 10 years, both retail and institutional investors have swarmed into US money-market mutual funds, supposedly a safe place to park money in the short term while figuring out what else to do with it. At the moment, some $5.6tn of cash sits in these funds, according to the Investment Company Institute, up from $2.6tn a decade ago.
Is this something to worry about, or just a reflection of the human instinct to creep up the risk scale in exchange for a higher yield? According to Crane Data, the top-yielding money-market funds are these days offering investors an annual return of around 5 per cent.
Investors have noticed. According to The Kobeissi Letter, since the Federal Reserve started raising interest rates in March 2022, some $862bn in bank deposits has been withdrawn and invested elsewhere, including in money-market funds, some 12 times more than was withdrawn from big banks in the aftermath of the 2008 financial crisis. Considering that JPMorgan Chase, the biggest US bank, pays depositors on their checking accounts 0.01 percentage points of interest annually, the collective decision appear to make sense.
But are money market funds as safe as many people think? The industry has been made safer since the financial crisis with a series of reforms. That has spurred a big shift by investors. Sector funds largely come in two main flavours. Government funds invest solely in government debt while prime funds, popular before the financial crisis, can invest a wider range of assets. Of the $5.6tn in money markets funds, some $4.6tn is in the safer government funds.
But, as we saw in the collapse of Silicon Valley Bank this year, there are still risks in investing in government securities in a rising interest-rate environment if money heads out of the door quickly and managers are forced to sell assets, crystallising losses.
The flood of cash into money market funds is worrying several people I speak to regularly on Wall Street. “No one is willing to say the truth,” one longtime finance veteran told me by email. “There is too much money parked in these funds and there really are no safety nets. People have run in a panic from banks into higher yielding instruments without understanding them.”
And in the midst of the SVB meltdown, Treasury secretary Janet Yellen said: “If there is any place where the vulnerabilities of the system to runs and fire sales have been clear-cut, 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 uninsured. With government money markets funds, the risk of losing money is very low. With prime funds though, there is more risk in return for the higher returns offered.
For instance, the Dreyfus Money Market Fund, which is part of Bank of New York Mellon, has some $2.4bn in assets under management. It’s been around for 41 years. It’s now offering investors a 5 per cent annual yield. As you would expect, Dreyfus is not hiding 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 boilerplate disclosure and one with a clear warning. Still, investors have flocked to it and many other similar funds, to try to capture higher yield.
But, as many readers will no doubt recall, back in September 2008, the Reserve Primary Fund, one of the oldest and best-known money-market funds, “broke the buck” in the midst of the financial crisis. The value of what looked like safe investments — such as those in the bonds of Lehman Brothers — lost value precipitously after the collapse of the bank, causing the fund to trade as low as 97 cents on the dollar. It was one of the few times a money-market fund had dipped below par value and further spooked an already jittery financial system.
Obviously, the same thing could happen again if a tremor comes along in the financial markets and panic ensues. Investors may try to flee their money-market funds to return to FDIC-guaranteed deposits. The stampede out will force the funds to sell assets, probably causing them to lose value and exacerbating the downward spiral.
That’s the thing about financial crises. We know they occur with some regularity and that in retrospect it’s easy to see the warning signs. Money market funds have been made safer, yes, but there are still risks that need careful watching.
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