What Really Happens when a Fund Breaks the Buck?

Institutional Money Market Funds Association

Money market funds have received significant press attention in recent months. This is primarily the result of a single incident in September 2008, but one which happens so infrequently that it sent reverberations throughout the financial sector globally. That incident was when a money market fund managed by The Reserve Management Corporation “broke the buck”.

It is important here to quantify exactly what happens when a fund breaks the buck.

A money market fund is designed to provide security of capital and liquidity. The fund seeks to maintain a constant net asset value (i.e. $1, €1 or £1), allowing the investor to have instant access to the investment and with no loss of capital. The funds achieve this by using amortised cost accounting, which permits a straight-line extrapolation of the asset price from its purchase to its maturity. Regular comparison of the amortised cost with the mark-to-market cost of the assets and the portfolio is conducted to determine whether there is any discrepancy between those two values, and to take action if any material discrepancy arises.

Whilst maintaining a constant value, the funds are permitted to have a variance of plus or minus 50 basis points from the par value, i.e. the value of an individual share can move within the range 0.9950 to 1.0050. Should any situation arise in which the value of a share moves outside this range, the fund is said to have broken the buck and the constant net asset value is lost. This can therefore be considered as the point at which the share price, calculated to two decimal places, varies from the par value.

So what exactly happened to money market funds in September 2008?

The issue largely centres around one fund – the Primary Fund managed by The Reserve Management Corporation. This fund, a US based money market fund with a mixed base of retail and institutional investors, had grown significantly in the year prior to September 2008. This was a result of a notable increase in the yield payable by the fund when compared against its peer group, which corresponded with an increase in the amount of commercial paper held by the fund. Just before the Lehman Brothers announcement, the fund had approximately USD 62bn invested.

The increased amount of commercial paper held by the fund included some paper issued by Lehman Brothers. The total exposure of the fund to Lehman Brothers amounted to USD 785m, or 1.2% of the fund’s net assets.

On September 14, Lehman Brothers declared bankruptcy. The Reserve did not write down the value of its Lehman exposure immediately. Consequently, with investors seeking to distance themselves from any Lehman exposure, whether direct or indirect, the Primary Fund received redemption requests of USD 25bn on 15 September.

A money market fund is designed to provide security of capital and liquidity.

On 16 September, The Reserve valued the Lehman exposure at zero, resulting in a reduction in the net asset value of a share to USD 0.97. The fund had broken the buck. In a statement, The Reserve confirmed that the proceeds of redemptions would not be transmitted for a period of up to seven calendar days. However, on 19 September, The Reserve stated that it had filed with the SEC an application for an Order to suspend all rights of redemption from the fund and to postpone the date of payment of redemption proceeds for a period longer than seven days after the tender of shares for redemption. Not only had investors lost money, but they could no longer have access to their cash.

This announcement of the postponement of the payment of redemptions requests by The Reserve followed shortly after Putnam Investments announced that it was closing one of its money market funds due to significant redemption pressures. The action of Putnam was taken not as a result of any credit impaired assets within the portfolio, but due to a concentrated investor base and an illiquid market, creating difficulties for Putnam to sell assets to process redemption requests. To ensure there was no loss of principal, Putnam decided to close the fund and enact an orderly wind-down. (The fund was subsequently purchased by Federated Investors Inc.) [[[PAGE]]]

When The Reserve announced that the Primary Fund had broken the buck, it was only the second such announcement by the money market fund industry since it began in the 1970s. The only other occurrence was in 1994 when the Community Bankers US Government Money Market Fund, a small institutional fund of approximately USD 80m, returned USD 0.96 per share. This occurrence was a result of significant derivative exposure within the portfolio.

Not only, therefore, is it extremely rare for a money market fund to break the buck, but this coincided with a suspension of redemption activity, and at a time when financial markets were witnessing unprecedented levels of uncertainty and volatility. By this point in mid-September, Lehman Brothers had declared bankruptcy, Merrill Lynch had agreed to be purchased by Bank of America, the Federal Reserve had agreed to lend AIG up to USD 85bn, HBOS was in talks with LloydsTSB, Washington Mutual was up for sale, and the European Central Bank and Federal Reserve had pumped billions into financial markets in attempts to ease liquidity strains.

Investors were understandably nervous, not just about money market funds, but more so about financial services generally. Investors sought refuge in guaranteed instruments and government backed securities. Prime money market funds in the US witnessed outflows of approximately USD 300bn in the week commencing 15 September, much of which was then re-invested in treasury-only money market funds. In Europe, the population of money market funds represented by the Institutional Money Market Funds Association (IMMFA) witnessed outflows from prime money market funds of EUR 59bn (most of which was withdrawn from USD denominated funds).

The US authorities were quick to act given the size of the US industry and its systemic importance, both as buyers of money market instruments, but more importantly, as the holder of a huge volume of retail and corporate cash. On 19 September, the US Treasury announced a guarantee programme for money market funds, guaranteeing that investors (as of 19 September) in those funds that participated, would not suffer any loss. This guarantee effectively implemented an incentive for investors to remain invested, as to move cash elsewhere would lose the guarantee associated with the money market fund.

When The Reserve announced that the Primary Fund had broken the buck, it was only the second such announcement by the money market fund industry since it begun in the 1970's.

On the same day, the Federal Reserve announced an asset-backed commercial paper money market fund lending facility (AMLF). This facility would allow US banks to borrow from the Federal Reserve in order to purchase asset-backed commercial paper from US money market funds, thereby providing money market funds with a means to generate the liquidity necessary to cope with redemption requests. This would also provide much needed assistance to the US money markets by allowing money market funds to make longer duration investments safe in the knowledge that the Federal Reserve could be called upon to provide the liquidity necessary to cope with any additional increases in redemption volumes.

These actions helped to quell concern amongst US investors. By late September, money being invested in US money market funds was again greater than that being withdrawn.

In Europe, no such support was forthcoming. And whilst the German and Luxembourg governments made statements of support for domestic money market fund industries in mid-October, no mechanisms to facilitate the provision of assistance to such funds were announced. However, no European funds broke the buck, and, with one exception, all funds remained open to receive investment and process redemptions. That exception was the fund managed by Lehman Brothers, which closed due to headline risk associated with the parent entity and not any impairment of underlying assets. All investors in this fund received a return of principal without loss.

A break the buck situation is extremely rare. Despite the global turmoil which financial markets have recently experienced, only one fund broke the buck, bringing the total to only two since the industry began in the early 1970s. [[[PAGE]]]

The Reserve Primary Fund broke the buck because of a credit event with some of the underlying assets within the portfolio. This fund had achieved top decile performance for the previous 13 months; a simple understanding of the risk / reward conundrum would recognise that for this level – and consistency – of return, there must be an increase in risk in the fund. That risk became abundantly clear with the bankruptcy of Lehman Brothers.

The Reserve Primary Fund clearly highlights an inherent risk associated with a money market fund; that the investor is not guaranteed to receive a return of capital. A money market fund is an investment product where the risk within the underlying portfolio is spread across the investor base. However, one of the fundamental benefits of the product is the diversification of risk achieved by a collective investment scheme. This does not however totally mitigate all risk within the portfolio in all circumstances, and the potential still exists that the investment decisions of the manager or the general illiquidity of the market could result in a loss of capital or liquidity for the underlying investors.

A money market fund is an investment product where the risk within the underlying portfolio is spread across the investor base.

The investors in a money market fund, and those who are considering such investment, must satisfy themselves with two key aspects before making an investment: (i) that the inherent risk associated with the product is at an acceptable level; and (ii) that the quality of the fund management is adequate and the systems and controls of the manager are sufficiently robust. Investment should only be made after the investor has fully understood the nature of the product, and is satisfied that the fund management is conducted with suitable professionalism to placate any concerns over the outsourcing of short-term cash management.

Despite the risk inherent within the product, it is worth reiterating that there have only been two instances of a fund breaking the buck in the near-40 year history of the money market fund. The most recent instance was at a time of global market turmoil, and yet only one money market fund lost capital value (out of approximately 2,000 which seek to maintain a constant net asset value). Therefore, whilst investors should appreciate that this risk can and will occasionally materialise, the probability of default based upon historic data is minimal.

One money market fund is not the same as another. Whilst the funds operate within the same investment parameters, the management will determine the balance between the principal objectives of capital security and liquidity and the investors’ desire for a return. Where a fund is achieving consistently high returns, this is unlikely to be achieved without some compromises made in the ability of the fund to achieve the principal objectives. Investors must determine what they value most and identify the fund which most closely mirrors their objectives.