Understanding the Ongoing Money Market Crisis

What investors’ mass exodus means for fund providers

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Turned away by dismal yields, investors are continuing their mass exodus from money market funds. And as a result of a prolonged period of outflows, the money market industry's assets have potentially dipped below $3 trillion for the first time since 2007. 

[See U.S. News's list of the Best Mutual Funds for 2010, and use our Mutual Fund Score to find the best investments for you.] 

For investors, there's nothing particularly significant about the $3 trillion mark. But for fund providers, it's a concrete reminder that their industry is in a severe slump. 

With yields hovering dangerously close to zero, fund providers have been forced to waive management fees to keep even more investors from fleeing. In 2009, for instance, upwards of 95 percent of retail money market funds set aside at least some of their fees, according to the money market research firm iMoneyNet. 

But even that hasn't been enough to slow outflows, which amounted to $74 billion in the week that ended Wednesday, according to the Investment Company Institute (ICI). According to ICI, that leaves money market funds with $3.02 trillion in assets under management as of Wednesday. IMoneyNet, meanwhile, puts their total assets at $2.99 trillion as of Tuesday. 

For fund providers, profits depend on two factors: asset levels and management fees. With both of these taking a hit, providers are slumping on all fronts. "When you get the combination of cutting your fees and having fewer assets that generate these fees, you do have a double whammy there," says Connie Bugbee, the managing editor of iMoneyNet. 

Peter Crane, the president and chief executive of the money market tracking firm Crane Data, estimates that as recently as a year ago, providers could expect their annual fees to generate $13 billion per year. In the current environment, that number is around $8 billion. Outflows, as opposed to fee waivers, account for the bulk of the reduction, according to Crane. "Fee waivers hurt, but not as badly as losing assets," he says. 

Still, there have been some indications that the situation could turn around in the coming months. For starters, yields are, at least by certain measures, ever so slightly rebounding. According to Crane, for example, the yields of the 100 largest money market funds have crept up to 0.05 percent recently. Even so, iMoneyNet puts the average taxable money market fund's yields at a dismal 0.02 percent. By comparison, six-month treasuries are yielding 0.26 percent. 

Money market yields will eventually improve, but it's unclear how much of the additional profits will make it into investors' accounts. That's because as yields increase, fund providers can unwind their fee waiver programs. For instance, Crane says that providers have been using any marginal increases in yields as an excuse to pocket much of the difference. All of this comes as the money market industry pushes back against proposals to change the way that funds display their net asset values. 

Earlier this year, the Securities and Exchange Commission mandated that each money market fund display its "shadow" net asset value, a number that Crane says is essentially a "second opinion" on the value of its underlying assets, every month. 

Money market funds' prices are pegged at $1 per share, but their actual value at any given moment may be fractionally more or less. These are the differences that the shadow NAV captures. A shadow NAV may show, for example, that a fund is actually at a few hundredths or even thousandths of a cent above or below $1 per share. 

[See For Money Market Funds, Changes Are Mostly Cosmetic.] 

But some regulators want to take it a step further by making money market funds adopt a "floating" NAV. This would require money market funds to update their share prices every day, much as all other mutual funds currently do. Like the shadow NAV, the floating NAV would alert investors to funds' minute ebbs and flows. 

ICI President Paul Stevens slammed this idea during a speech he gave earlier this week during a mutual fund conference in Phoenix. "Make no mistake: Forcing these funds to 'float' their NAV will destroy money market funds as we know them. It will penalize individual investors and exact a high price in the American economy," he said. "But it will not—repeat, not—reduce risks to the financial system. By any measure, it is a bad idea." 

The reform push that catapulted the floating NAV onto the national stage began in earnest in 2008, after the iconic Reserve Primary Fund "broke the buck," meaning that its value dipped below $1 per share. This touched off an industrywide wave of redemptions that threatened to undermine the money market business. 

In the aftermath of the Reserve Primary Fund debacle, regulators have had two main concerns. First, they've wanted to ensure that investors realize that the value of money market funds' underlying assets isn't always exactly $1 per share. And second, they've wanted to guarantee that funds have enough liquidity on hand to meet redemption requests. 

The SEC took a step toward both goals earlier this year. At the same time that it gave the nod to the shadow NAV—which accomplishes at least a portion of the first goal—it also approved a new liquidity threshold for money market funds. Under the new guidelines, the funds will be required to be able to sell at least 10 percent of their assets within one day and 30 percent within one week to meet potential redemption requests. 

The ICI has proposed that regulators could, instead of further tweaking NAV rules, focus more on liquidity. The ICI supports the liquidity minimums that the SEC recently adopted and has suggested that even more measures could be put in place to create buffers for money market funds. To that end, Stevens announced during the conference that the ICI is "moving forward rapidly to complete a blueprint" for a private liquidity facility. 

This facility would draw money from taxable money market funds that don't invest primarily in government securities. In the event of a liquidity crisis, funds could use money housed at this facility to meet redemption requests. 

Stevens also indicated that ICI is open to other reform options. "While we are committed to pursuing this liquidity facility proposal, we are not shutting the door to other ideas that would meet the goal of making money market funds even more resilient in the face of another deep and pervasive freeze in the markets," he said.