How Safe is Your Money Market?

Money markets have been around since 1970 when Bruce Bent created “The Reserve Fund”, as it was called, to offer investors a way to preserve cash liquidity and still earn a small return. Today 18% of all mutual fund assets are invested in nearly 900 money market funds.

Money market funds are a type of mutual fund that seek to keep their share price at exactly $1.00. Consumers gain interest earnings plus the stability of getting their principal back. Unlike other mutual funds, money market funds are restricted to investing only in the highest quality debt with average maturities less than 90 days.

Money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Instead they are governed by several rules that restrict their investment choices.

  • They must invest at least 95% of their assets in securities that get the highest credit rating.
  • Money market funds cannot have more than 5% of the portfolio invested in debt from the same issuer, except for the federal government debt.
  • They can invest in Asset Backed Commercial Paper (ABCP) which is backed by a pool of assets that can include credit card debt, car loans, regular mortgages and subprime mortgages.
  • Money market funds can invest up to 5% of their assets in securities with the second highest rating, but cannot put more than 1% with any one issuer. When an issuer’s credit rating drops from the best credit rating to the second best credit rating, a money market fund will be on alert to sell the position quickly in order to satisfy SEC rules.

Typically money market funds are very stable, but it is possible to lose money by investing in these funds.

A good money market fund manager should be diversified enough to weather the inevitable market storms without showing losses in the money market. But sometimes they “break the buck,” meaning the price of the money market drops below $1.00. If a money market has broken the buck, when you withdraw your money, they return less than you put in. This breaking the buck only happened a few times. It happened with one fund in 1994 and three funds in 2008. Depending on your definitions of “mutual fund” and “break the buck” there may be a few more instances. Some funds, for example, have been saved from breaking the buck by their parent companies pumping cash into them.

Any brokerage firm that showed a loss on a money market fund would ruin their reputation and their future business. Brokers would rather spend a fraction of their marketing budget supplementing their returns than face the public relations nightmare of their money market losing money. This is why several parent companies rescued their money market funds in 2008 keeping them from breaking the buck.

Historically, some money market funds lent money to what are called structured investment vehicles (SIV) which promise to pay the money back within a short period of time. The SIVs repay their debt by bundling and selling this high-yield, risky subprime mortgage debt. They make money by collecting much more in interest and the sale of the loans than the cost of borrowing the money. But when it became much more difficult for SIVs to sell their subprime mortgages these funds had trouble. Whenever the number of foreclosures and defaults increases, companies devalue the bundle of mortgages, increasing the likelihood of SIVs defaulting on their loans from the money market funds. The ratings on this type of commercial paper dropped with the increasing defaults on subprime mortgages.

Wrikipedia records the following instances of mutual funds which broke the buck:

The first money market mutual fund to break the buck was First Multifund for Daily Income (FMDI) in 1978, liquidating and restating NAV at 94 cents per share. An argument has been made that FMDI was not technically a money market fund as at the time of liquidation the average maturity of securities in its portfolio exceeded two years. …

The Community Bankers US Government Fund broke the buck in 1994, paying investors 96 cents per share. …

On Monday, September 15, 2008, Lehman Brothers Holdings Inc. filed for bankruptcy. On Tuesday, September 16, 2008, Reserve Primary Fund, the oldest and one of the world’s largest money funds, broke the buck when its shares fell to 97 cents after writing off debt issued by Lehman Brothers.

As you can see, in each case the loss due to breaking the buck was relatively small.

Historically money markets offered a relatively low-risk, investment. Money market funds served several purposes in an investment portfolio.

  • They provided a liquid stable place to park free cash.
  • They provided a place to keep money for rebalancing your portfolio in case of a market run up or a market correction.
  • They provided a place to collect interest and dividend payments.
  • They served as their own investment category. In 1970′s with its rampant inflation, money market was the investment category with the highest returns at the end of the decade.

But recently the rules of money market funds have changed.

The Securities and Exchange Commission (SEC) changed the rules and required all financial institutions to move pricing their money market from a stable $1.00 price per shares to a floating net asset value. They allow provisions for money market funds sold to individual investors to appear to maintain the fixed $1.00 share price. But they also allow the fund, during times of extreme volatility, to prevent investors from making withdrawals and to impose fees on investors who make withdrawals. All financial institutions were required to comply with these elements by October 14, 2016.

Here is how Schwab defined the liquidity fees and redemption gates now allowed in times of market stress:

Liquidity fees:

  • An optional fee of up to 2% if fund’s weekly liquid assets fall below 30% (if the fund’s board determines the fee is in the best interests of the fund), and
  • A required fee of 1% if it falls below 10% (unless the board finds that the fee is not in the best interests of the fund or that imposing a lower or higher fee would be appropriate).
  • The fee would be lifted when weekly liquid assets return to 30%, or when the fund’s board determines that a liquidity fee is no longer in the best interest of the fund.

Redemption gates:

  • Redemption gates are also subject to fund board determination of the fund’s best interests.
  • Suspension of all fund redemptions (and purchases) for up to 10 business days in any 90-day period may be imposed if the fund’s weekly liquid asset fall below 30%.
  • The gate would be lifted when weekly liquid assets return to 30% or when the fund’s board determines that a redemption gate in no longer in the best interests of the fund.

Schwab implemented these rules for clients of registered investment advisors by switching the cash sweep feature for most accounts to a bank product with FDIC insurance. Currently at Schwab if you want to invest in a money market subject to the ability to potentially break the buck you must submit a trade and purchase shares. Money market is no longer set as the default investment of any cash in the account.

This change at Schwab was not without controversy.

On the one hand, it is nice that the cash in Schwab accounts is now covered by FDIC insurance. On the other hand, the bank product pays a lower interest rate and makes more money for Schwab. Estimates are that the bank product earns a profit of about 160 basis points or 1.60% for Schwab.

Schwab uses the profit on cash to ensure that their robo investing service produces a minimum amount of profit. They require a minimum 6% allocation to cash in their Schwab Intelligent Portfolio service. While they earn a portion of the expense ratio on many of the funds, a minimum 6% allocation to cash which earns them 160 basis points produces a minimum 9.6 basis point profit on all such accounts.

Not having these rules produced, on average, a much better return for consumers despite the fact that a few funds have historically “broke the buck.” And in some regards Schwab is simply saying that they are going to leave the decision of where to invest to registered investment advisors. Advisors should recommend keeping cash to a minimum and investment to a maximum. There is no required minimum cash allocation for clients of a registered investment advisor. And there is now no worry about cash at Schwab not being FDIC insured.

The original version of this article was published January 7, 2008. Photo by Gary Bendig on Unsplash.

About the author

David John Marotta, CFP®, AIF®

David John Marotta, CFP®, AIF®, is President of Marotta Wealth Management, Inc. of Charlottesville providing fee-only financial planning and wealth management at www.emarotta.com and blogging at www.marottaonmoney.com.

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