Mutual vs. Penny-Rounding Money Market Funds

NAV, money market mutual funds, SEC regulation, penny rounding, Dodd-Frank Act
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NAV, money market mutual funds, SEC regulation, penny rounding, Dodd-Frank ActLast month, the House Financial Services Committee voted to overturn 2014 SEC regulations requiring larger Money Market Funds to mark their shares to Net Asset Value (NAV) on a daily basis, rather than “penny rounding,” i.e. rounding their share values to the nearest cent on the dollar.[1]

Truly mutual Money Market Funds, that do mark their shares to NAV, solve the age-old liquidity problem of banking: Borrowers want loans with positive maturity and therefore variable present value, yet banks traditionally try to fund these loans with deposits that have a fixed present value. If depositors ask for their money all at once, the banks may be forced to sell assets at a discount, perhaps leaving the last depositors to withdraw with little or nothing—therefore giving all depositors an incentive to be the first in line to withdraw.

Mutual MMFs invest in short-term money market instruments that do have some present value risk.[2] But instead of concentrating this risk on the last depositors in line the way traditional banks do, mutual MMFs efficiently spread this risk over their shareholders so that each is bearing a negligible risk. If a sudden rise in interest rates, or even a spontaneous withdrawal of funds, causes share values to fall relative to the promised future payments of the assets, the return to putting money back in will simply rise. In other words, the longer the line at the front door to take money out, the longer the line will be at the back door to make new investments. Mutual MMFs are therefore run-proof, without any need for government deposit insurance.[3]

However, if MMFs instead “penny-round,” they are asking for trouble because shrewd investors will withdraw their money whenever their NAV falls below $1.00 — and move it to other funds with full or surplus NAV. This will inequitably dilute the position of investors who leave their money in. The prospect of an abrupt fall in share value from $1.00 to $0.99 when true NAV “breaks the buck” by falling from $0.9951 to $0.9949 provides an even greater incentive to run against the fund.

From some time after their inception in 1971 until 2014, most Money Market Funds have in fact penny-rounded. This occasionally caused funds to come near to “breaking the buck” over the years. In most cases, the fund sponsors simply swallowed part of their management fee (typically 1/2% per year) in order to save face. But two funds actually broke the buck in 1978 and 1994.[4] During the 2008 financial crisis Reserve Primary Fund also broke the buck, as a result of a bad bet on Lehman Brothers that would have sent its NAV to 97 cents on the dollar. Rather than simply allowing these investors to take the 3% loss that they were entitled to, the Treasury and Fed flew into a regulatory panic and instead protected investors in Reserve Primary and other penny-rounding funds from negative returns.[5]

In response to the 2008 crisis and bailout, the SEC promulgated rules in 2014 requiring institutional prime and municipal MMFs to mark shares to NAV.[6] Institutional funds are those that are not designed to be held by natural persons and which therefore tend to have the largest investors. Prime funds specialize in highly rated private commercial paper, while municipal funds primarily hold tax-exempt municipal issues. Unfortunately, the new rule did not apply to retail prime and municipal funds, nor to governmental funds that primarily hold US Treasury securities. The SEC should not have exempted such retail funds since individuals should be treated as fairly as institutions, and since even default-free Treasury bills are subject to present value fluctuations. However, it was a big move in the right direction.

Another shortcoming of the 2014 regulations is that they allowed NAV funds to impose redemption fees and limits or “gates” on redemptions that are entirely unnecessary when funds mark to NAV. Redemption fees are essentially a back-end load that negates the fundamental no-load property of a mutual fund, while the possibility of “gates” that temporarily block redemptions altogether destroy the liquidity that MMF investors are after. Fortunately funds have the option of not imposing either these fees or “gates,” but the SEC was wrong to even permit funds to impose them. I concur fully with the Wall Street Journal’s editorial position on this matter.[7]

Naturally, however, investors like to have their cake in the form of high upside returns without ever having to eat occasional negative returns, and therefore have lobbied Congress to reverse the 2014 SEC rules.

Municipal officials in particular have complained, since their states typically require them to park funds in accounts that can never fall in value. Yet one beneficial provision of the 2010 Dodd-Frank Act was to roll back the New Deal’s 1933 anti-competitive, anti-consumer ban on interest on bank demand deposits, so that municipalities are now free to earn interest on bank accounts—with no present value risk short of bank failure. If state laws don’t allow cities to earn higher interest with perhaps even greater safety from mutual Money Market Funds, municipalities should take that up with their state legislators, and not with Congress.

On January 18, lobbying congress seemed a success when the House Financial Services Committee passed H.R.2319,  a bill sponsored by Rep. Keith Rothfus (R-PA) that would pare back the new SEC rules — particularly for funds that purchase municipal bonds. Fortunately, the Committee appears to be reconsidering. Just last week it was reported that the legislation will likely undergo adjustments before it advances to the full House.[8]

Rather than abolishing NAV accounting, the House should encourage it to be applied, not only to institutional Money Market Funds, but to retail and government funds as well. Although government-only MMFs are immune from default risk, they are still exposed to some degree of interest-rate risk, and so should be marking to NAV just the same as prime funds that invest in prime commercial paper. Congress should grill SEC officials as to why the new rules didn’t apply to these funds in the first place and take steps to prohibit any future bailouts of risky penny-rounding funds.

If consenting adults want to “invest” their savings in Powerball tickets, Bitcoins, poker hands, or penny-rounding Money Market Funds, they should be allowed to do so. But the taxpayers should not be expected to bail them out in the event these gambles do not pay off. Furthermore, if a Money Market Fund claims to be a mutual fund and not a game of bluff, the SEC should require it to act as a mutual fund.

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[1] Andrew Ackerman, “Bringing Back the Money-Fund Fight,” Wall Street Journal, Dec. 15, 2017;  Robert Schmidt, “House Panel Backs Bill to Scrap Floating Prices for Money Funds,” Bloomberg Markets, Jan. 18, 2018.

[2] The Macaulay duration of a short-term financial instrument with no coupons is equal to its maturity. A sudden rise in yields therefore causes such assets to fall in value by approximately the change in yields times their maturity. MMF portfolios have an average maturity of no more than 60 days, or approximately 1/6 year. A sudden increase in yields from say 3% to 4% will therefore cause their prices to fall by at most 1/6%, i.e. to about 99.83 cents on the dollar. However, investors who leave their money in may then expect to make 4% to the 60-day maturity.

[3] See also Larry White, “Money-Market Mutual Funds: Restrictions, Run-Proofing, and Regulatory Pretense,” Alt-M, March 1, 2016.

[4] First Multifund for Daily Income dropped to 94 cents per share in 1978 after investing in a portfolio with an average maturity in excess of 2 years. Community Bankers US Government Fund paid 96 cents per share in 1994. In 1980, Salomon Brothers and First National Bank of Chicago restored their Institutional Liquid Assets fund to full NAV after it nearly dropped to 99.46 cents per share.

[5] For this purpose, the Treasury used the Exchange Stabilization Fund, a slush fund that originated in 1934 with the profits that the US Government made by confiscating the public’s gold holdings. The Fed simultaneously supported the market for risky money market instruments with a $120B Commercial Paper Funding Facility, a $15B Money Market Mutual Fund Funding Facility, and a $25B Term Asset-Backed Securities Lending Facility. (Figures as of July 2, 2009). The Treasury itself closed its program on 9/18/09 with a profit of $1.2 billion from fees collected, but it is hard to disentangle this from the value of the Fed’s programs or from the value of the implicit put options granted by such programs.

[6] SEC, “SEC Adopts Money Market Fund reform Rule,” July 23, 2014; and 2014 changes to Rule 2a-7 of the Investment Company Act of 1940.

[7] Wall Street Journal, “The Money Fund Mistake,” Editorial, Aug. 16, 2016.

[8] Andrew Ackerman, "House Money-Fund Bill Hits a Snag," Wall Street Journal, Jan. 30, 2018.

  • Bill Bergman

    Three cheers! Now, consider large, uninsured bank deposits in the same light. How should large, uninsured bank deposits be valued? At 'par?'

    • Hu McCulloch

      I have another post in mind, tentatively to be entitled "Too big to insure?" Insurance requires diversifying small risks. Some risks, like regional flooding, are too big for one firm to insure, and even several firms may not be able to share the risk fully. Medium-sized banks seem to be an insurable risk, but the mega banks (that were only encouraged by the 2008 bailouts) we see today may be actuarially uninsurable. My solution would be for the FDIC (assuming it continues to exist) only insure banks above some threshold, pro rata by their size. There would quickly be a lot more medium-sized banks if megabank deposits were only 25% federally insured!

      But MMFs, if mutual, efficiently spread the residual interest-rate risk over a broad base of investors with the resources to bear it, namely their own "depositors," so that they do not need outside insurance. The SEC seems to have done an adequate job of ensuring that registered mutual funds (unlike private investment companies like Bernie Madoff's) actually have the assets they claim to have.

      • Bill Bergman

        Bank insurance can be explicit or implicit. How do you deal with explicit limits that aren't really limits if implicit insurance (friends in high government places) exist?

        • Hu McCulloch

          Another way to greatly reduce the effect of FDIC without eliminating it altogether is to put a deductible of say 10% on deposit insurance, so that if your bank fails you immediately get 90 cents on the dollar from the FDIC, plus more later depending on how much the FDIC can recover in receivership. A few banks fail every year even in good times, so that there would immediately be test cases to demonstrate that the threat of losses was real, to keep depositors on their toes. However, bank failures rarely lose more than 10%, so that the FDIC would in fact not have much exposure.

          But again, with a truly mutual MMF, the investors self-insure the small risks involved, so that there is no need to even consider an outside insurer.

          • Bill Bergman

            I will be sharing your article with my Money & Banking class tomorrow, thx

    • Hu McCulloch

      Bill —
      I didn't really answer your question about how mutual MMFs should value large, uninsured bank CDs. In fact, a large part of the impetus for the MMF industry back in 1971 was Reg Q, which restricted the interest banks could pay on savings accounts and small CDs (under $100,000), but not on large, negotiable CDs (over $100,000). The large CDs could not be withdrawn on demand before their stated maturity even with a penalty, but they were negotiable so that they could be sold as easily (at least in principle) as corporate commercial paper or Treasury bills. MMFs could in effect sell shares in these large, unregulated CDs to small savers, thereby doing an end-run around Reg Q.

      In fact, few assets are perfectly marketable, though T bills come close. Even for equity funds, I am told that NAV is often to some extent based on the board's best judgement of a fair price for the assets at the end of the day. CP and bank negotiable CDs generally sell at a premium over T-bills, so that in most cases the board could simply look at the day's secondary T-bill rates and the secondary market for similar CP and CDs, and discount other instruments by adding on each asset's initial premium over T-bills or relative to other instruments. If a company's CP gets downgraded from P1 to P2, its premium would go up and the board would discount it more deeply, accordingly. (The SEC no longer requires funds to automatically believe the major rating agencies, but gives funds the discretion to use them if they think they are informative.)

      The same would go for bank negotiable CDs. The fund would ordinarily value them off the day's Treasury yield curve and the market for other CDs, but if adverse information came in about a specific bank, the board would be obligated to make a judgement call that treated all investors fairly. In any event, they should not just value them at par, or even just by amortizing the original discount as is customary for penny-rounding funds. Penny-rounding funds already do calculate NAV every day, but the problem is that they then don't use it to accurately value their shares.

      Because the unsecuritized customer loans that bank specialize in have no secondary market even in theory, they are not suitable for MMFs to hold. However, mutual MMFs can still be part of the process of intermediating them, by buying up the CDs of banks that do make these loans. The banks then can, if they choose, entirely avoid interest-rate and liquidity risk by matching the maturities of their loans and the CDs that finance them. At the same time, the MMF customers whose shares finance the CD holdings would have almost perfect liquidity, because of the marketability and minimal present value fluctuation of the MMF's own assets.

  • Hu McCulloch

    General information — in order to comment on Alt-M, it appears to be necessary to log into one of the options given. I don't do Facebook or Twitter or Gmail, so I log in under Disqus, which seems to exist for the sole purpose of commenting on blogs, and therefore doesn't unnecessarily entangle you. There used to be a "Sign in as Guest" button that didn't seem to work.