Money Market Melt Down; Lessons for Fund Directors - March 2009 Print E-mail
Written by By Anthony Aveni, CFA, President Capital Metrics LLC and Meyrick Payne, Partner, MPI   

In September 2008 two well-known and respected money market mutual funds (MMF) imploded.  In the case of the first, The Reserve Primary Fund, the problem was due to credit quality issues, stemming from its ownership of Lehman Brothers commercial paper. In the case of the second, Putnam Prime Money Market Fund, credit quality seemed to play no role. The Putnam Fund held no AIG, Washington Mutual or Lehman paper. Putnam’s predicament was due to the fear of a credit quality problem that precipitated a run on the fund. Keep in mind that both funds operated entirely within the confines of the existing regulations for money market funds, principally Rule 2a-7.

In response to these events, the US Treasury announced an optional plan to insure the value of MMFs at $1.00 for a fee. We are not offering an assessment of the Treasury’s proposal, but rather an ex-post review of the problem, and an ex-ante plan for fund directors to consider. The Treasury’s plan does nothing to change the need for director due diligence going forward.

At its very core, the essence of the problem mutual fund directors confront is the result of a mispricing of risk. This statement is so simple that it’s easily misinterpreted as an “incisive grasp of the obvious.” Mispricing of risk is perhaps the single most dangerous judgment that a fund director can make when it comes to valuing the investments in a fund’s portfolio. Concentrating on minutia—the daisy chain of events that led up to the money market crisis—or pointing fingers at guilty parties is less than productive.   This bulletin is focused on recognizing the heart of the problem, namely inadequate risk premiums which from time to time become embedded throughout the capital markets.

Recognition of the problem is the first step. The second step is to understand that MMFs and the macro financial system are connected at the hip; that is to say hard wired. The direct connection is seemingly obvious, but often overlooked because macro financial problems are very rarely transmitted to MMFs in an overt and recognizable way.  Money market funds very rarely “break a buck.” When they do, the transmission is long and circuitous due to well conceived regulation. Small pulses of macro “current” are diffused and manageable.  Inevitably the pulse of the economy, if strong enough, transmits the tension in the capital markets through to the fund and the canary in the coal mine succumbs. That’s what happened in mid-September 2008.

Strong pulses of macro “current” are an anomaly. In the history of MMFs we have witnessed three failures. Should fund directors focus on a four standard deviation event?  Our response is that the probability may be small, but its consequences are potentially fatal. Russian roulette comes to mind. Myopia, defined as focusing on tiny details, creates the illusion of security.  In its most basic construct, money market regulations, particularly Regulation 2a-7, govern maturity, diversification, and credit quality issues of the money market portfolio. 

In actual fact, in the real investment world the complexity of Regulation 2a-7 is difficult for fund directors to fully appreciate.   This regulation focuses on procedures and protocol to address virtually every conceivable specific risk that an MMF may encounter. Regulation 2a-7 must, of course, be followed. Unfortunately, adhering to specific rules can blind the fund director to the all-important macroeconomic drivers.

Here are some steps from a former CIO for MMF directors to consider when valuing the investments included in a money market fund:

1)  Avoid the regulation-driven tendency to focus exclusively on specific risk. Every performance review should include a comprehensive assessment of risk at the macroeconomic level. Understand that a refined calibration of risk promotes the illusion of security.

2)  Recognize the direct connection between MMFs and the macro environment. Hard wire the culture of fund management to ensure this understanding. As macro risk rises, management’s primary assessment should be on the impact to the product that is most vulnerable: money market funds.

3)  MMF profitability may be overstated. Economy of scale is an economic axiom in the management of money, especially MMFs. This promotes treating the product as a cash cow and under-accruing expenses. Remember that banks charge to provide standby liquidity because there is real cost to standing ready to redeem the entire fund with a minimum of notice.

4)  The paper in MMFs requires sophisticated credit analysis, and credit analysis at the management company may well be underappreciated and possibly deficient. Relying solely on an external rating agency is not good practice. High caliber credit analysts are expensive, and their value is seldom recognized.

5)  Having a contingency plan in place that affords a quick response and treats all shareholders equitably before a crisis develops is always preferable to writing one during the heat of massive redemptions.

6)  Understand the anatomy of your shareholder base. Metrics should be developed to assess the probability of “hot money” exiting and its impact on the well-being of the overall shareholder base. Institutional investors may bring large quantities of assets, but they can evaporate on a whim.

7)  Consider the capital adequacy of the management company. The implicit obligation to make good should a money market fund “break a buck” places a real capital reserve requirement on an adviser, especially if large sums of institutional money are involved.

 
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