This month, as previously announced, Fidelity will close their Prime money market fund after the fund suffered during the illiquidity of the Corona virus-inspired volatility experienced in March of this year. We speculated that the decision was a business one made out of the preponderance of risk to reputation had the company been forced to support the fund. However, we viewed the action as a one-off decision, and not one that would impact the entire industry. It turns out that the risk posed by Prime money market funds has been on the radar of the Federal Reserve for some time. The Fed is concerned that the Prime mutual fund structure represents a shadow bank. The term shadow bank refers to an unregulated structure that has similarities to a bank. The Federal Reserve tightly regulates the banking system and if they deem the money markets as a shadow bank, they are de facto indicating that they can’t control it.
Before digging too far into the implications, it may be useful to understand the evolution of Prime money market funds since the 2008 financial panic. During the crisis there were numerous instances in which money market funds came under valuation stress as panicky investors pulled their investments and went to cash. In the most extreme instance the largest Prime money fund, The Reserve Fund, was forced to suspend liquidations until they were able to determine which investors were owed what amount. An obvious failure of what was considered a low risk sector of the fixed income market. The then SEC chair, Mary Jo White, implemented a new framework in which an event like that which befell The Reserve Fund would not happen again. In doing so, they implemented a series of rules that would allow Prime money market funds to suspend redemptions under certain circumstances, for a specified period of time and under extreme circumstances impose an exit fee on existing investors.
When put in place we were immediately skeptical of the plan and believed that if investors were threatened with a suspended fund or forced to pay an exit fee they would have an even greater reason to panic under times of market stress. It turns out we were right as witnessed in March.
What’s confounding is the Federal Reserve’s policy of ultra-low interest rates is directly responsible for the proliferation of investments in Prime funds. In pushing interest rates to nearly zero, banks responded by paying little or no interest on bank deposits. Historically, investors depended on a nominal rate of interest to grow their savings and deemed bank deposits as a safe way of doing that. To be clear, when we refer to savers, we’re not just speaking of “Mom and Pop” growing their nest egg. Savers include multi-billion dollar corporations growing their accumulated earnings. If the bank is not going to reward savers with any interest, it’s only sensible that the savers will look to an alternative, and prime money market funds represented an attractive alternative. The funds have varying degrees of risk based on their stated mandate, but in the simplest form the investment manager buys short maturity fixed income instruments and collects the interest. As money flows into the funds, the manager buys securities and as investors redeem the manager sells those securities back to one of the brokers from whom they originally bought them. The Fed has no control over the management of those portfolios, and in March when investors redeemed, fund managers such as Fidelity struggled to raise the needed cash to meet those redemptions.
That begs the question, is the Fed correct in their assumption that money market funds are actually shadow banks and they should be regulated? The answer is not so simple. We’d argue that the flaw in Prime money market funds is that so many of the funds are poorly managed. In an attempt to generate top performance in their category the fund managers are motivated to invest in the highest yielding notes they can buy. Since the financial panic of 2008, the highest yielding investment grade paper has been issued by European and Asian banks. The credit risk for those entities is arguably greater than U.S. banks. During times of heightened volatility, the demand to buy that bank paper falls as does the price a counterparty is willing to pay to assume the risk. Exacerbating the problem was the fact that the Prime funds held large undiversified holdings of the European bank paper.
One cannot be faulted for agreeing with the Fed that some control or elimination of the prime market is the obvious solution, but we disagree with that conclusion. The Reserve Cash Management (RCM) strategy that we manage is a direct competitor with Prime money funds. The big difference is that we build the portfolios to be broadly diversified and with high quality credits and view short term performance as a secondary mandate. We’ve been through several panics and in each case the RCM has performed quite well because of that management style.
Finally, the Fed’s wish that Prime money market funds would go away isn’t entirely motivated by a need to reduce risk. Especially considering that the ever growing, deficit-induced government bond market needs to be financed. The more than $1 trillion invested in prime money market funds assets would go a long way to financing that amount.
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