Thursday, April 19, 2012

Money Market Runs

A good oped in Bloomberg's "Business Class" series tackles money market funds. (I signed it along with the rest of the Squam Lake group, but I can't take credit for much of the writing.)

There was a run in money market funds. We have to do something about this.

Money market funds are a bank. Their liabilities are fixed value, first-come first-serve, just like deposits. Their assets are longer term, and less liquid. This fact puts them at risk for a run. The essence of stopping future financial crises is stopping runs.

One way to stop a run is for the government guarantee all the liabilities. That stops the run, but gives horrible incentives to the fund managers, so now you need regulation.  This is what we did with banks and what the industry seems to want for money market funds. Watch for what you ask for, you just might get it.

The Squam Lake group, and others thinking about these issues, note two other eminently sensible possibilities.

First, money market funds can trade at net asset value, just like equity mutual funds or exchange traded funds. (The small difference between those doesn't matter here.) Now there is much less incentive to run. The situation that happened with the Reserve Fund in the financial crisis, that everyone sees net asset value less than a dollar per share and knows it's time to run, cannot happen.

This seems like the simplest fix. In the modern world, liquidity need not mean fixed value.

Alas, as the more knowledgeable Squam members informed me, this conceptually simple resolution to the problem causes accounting and tax problems. Money funds are used as money. If I have to pay you $1,000, it's easy to say "sell 1,000 shares and send the proceeds." It's much harder, technically, to say "sell $1,000 worth of shares and send the proceeds."

The tax issue is that if every transaction takes place at a different market value, then you have to track capital gains and losses on a huge number of transactions.

Say I, well, for a few hundred billion dollars we can surely fix these accounting and tax law problems (like get rid of capital gains tax!). Why accept that one bad regulation must beget another? But critics are right that this does spread the difficulty of making a change.

Second, money market funds can include capital just as banks do. If there is an equity tranche holding even a few percent of value, then money funds can promise $1 per share and always have net asset value above that. Banks have equity tranches. So can money funds. If we're going to maintain $1 per share, this seems like a no brainer, and basically what the Oped calls for.  The objections, like most objections to higher capital for banks,  basically don't understand the Modigliani Miller theorem.

That said, money market funds are a lot simpler than banks, and fixing the regulatory system is a bit less crucial in my view.

The chance of a systemic run is lower for money market funds. The danger in a systemic run is that bank A is found to be insolvent; people don't know what bank B's assets are, so they run just to be sure. That's not what happened at the Reserve Fund: People knew it held a lot of Lehman paper, and knew it was insolvent. People can see what assets the other money market funds had, and quickly verify if the did or did not hold Lehman paper.

The transparency of money market funds -- the fact that we know the net asset values  pretty well and the composition of assets -- makes the chances of a "multiple equilibrium" run or a "systemic" run a lot less than that of banks. 

Still, there is no reason to put up with runs at all, or to provide a blanket government guarantee, when fairly simple changes to the contracts can fix the problems.

Facilitating NAV trading or an equity buffer is important for another reason -- to expand money market funds and let them take on more risk.

The SEC has already started the "regulate" part of the traditional model by forcing money market funds to shorten the maturity of their assets. Great, but as forcing institutions to buy "AAA" debt subsidized the artificial creation of "AAA" assets, forcing funds to hold "short term" debt subsidizes creation of short-term liabilities. And short term debt anywhere is the poison in the well that causes crises. It encourages banks and other issuers to finance themselves with a lot of short-term debt, exactly the opposite of what we want.

You can move risk around, you can't eliminate it. Keeping the risk in the fairly transparent money market funds with a solid equity tranche rather than in the bowels of horribly complex too big to fail banks seems like a good idea.


  1. There was a run - that was obvious years ago.

    The real run however was in the commercial paper markets which dried up.

    Money market funds are an administrative convenience that facilitates liquidity. A bit of regulation and a bit of capital are not going to save the market if suddenly investors decide that they do not want to hold GE or Cat or John Deere paper either directly or indirectly.

    Go back and look at what GE really had to pay Buffett for what was in effect a few billion in three year subordinated debt. By my calculation it was about 20% per year.

    The solution for the money market is for the Fed to stand ready to buy commercial paper of reasonable quality at a yield, say, 2% higher than treasuries.

  2. On reflection, there is an irony here. You generally sound like a doctrinaire libertarian who believes unfettered markets will spontaneously generate optimal solutions and who mocks anyone who disagrees.

    Yet here you are advocating some form of intervention into a market where large sums of money are involved and all of the participants are sophisticated. If the commercial paper and money market fund industries cannot spontaneously create an optimal solution then a large part of your world view goes out the window.

  3. If the gov't would stop inflation (by implementing M. Friedman's suggestion) we wouldn't need to take on risk to preserve capital.

    In other words, risk-free banks should just be vaults with cash that stays un-investd. If you want a return, you take on risk. It's just that simple.

  4. Well of course MMFs should be capitalized like banks. Their existence depended upon the financial peculiarities of the 1970s through 90s, including laws that forbade banks from paying interest on transaction deposits, the lack of nationwide branch banking, high short term rates, and a stable high growth environment.

    Ironically, with the market rates where they are, MMFs are dying on the vine. But, if they want to continue to exist, and if they want to continue to provide banking services, they should be capitalized and regulated as banks.

  5. On the tax complications of varying value, you could adopt the uk taxation system for mutual funds - the fund/investor has no liability or reliefs on assets sold by the fund at a gain or loss. Her capital gains tax liability only occurs when she sells her share in the fund.

  6. This was quite an interesting analysis, and I think there's an agreement that systemic firms do create a substantial amount of moral hazard, as the government is unlikely to commit to letting an entire industry fall apart with the rest of the economy that supports it. And I also find myself agreeing that it's the assets, not the firms, that are so dangerous, as you described in your earlier post on the failure of Dodd Frank.

    To me, it seems like the issue is a lack of financial diversity, rather than these concerns about specific equity tranches or the lack of government guarantees. If all the financial firms weren't all fed on the same crop of investments, it seems unlikely that any kind of large systemic crisis could make them eventually all insolvent. For a more in-depth explanation, I wrote about these issues yesterday on my personal blog at

    Yichuan Wang


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