This is chapter five of the New Bermuda Investment Series. This week we discuss the evolution of money market mutual funds. Please note, this information is general in nature. It is not intended as a detailed analysis of the US sub-prime mortgage market debacle, nor, can it be relied upon as personal financial planning advice.

Nine years ago, almost to the day, the international commercial paper market froze up — an event of significant global proportions.

No one was buying.

Readers, I remember this incident as clearly as if it was yesterday and my thoughts that followed were just the foreboding feeling that this almost unheard of event was the start again of another downmarket cycle.

The news soon filtered out that subprime mortgage delinquencies were rising; financial institutions were experiencing challenges in trading commercial paper as well as money market funds holding the same due to the uncertain credit quality and liquidity of some of the underlying asset-backed securities.

Other reports signified further sub-prime concerns. Bear Stearns had a few days prior abruptly closed two very large hedge funds exposed to the sub-prime mortgage market, while BNP Paribas restricted several funds’ withdrawals by investors because they could not adequately value underlying sub-prime mortgage market instruments.

Six months later, Bear, facing bankruptcy from huge investor redemptions, agreed to be purchased by JP Morgan.

During the next year, due to uncertainty and lack of confidence, capital markets deteriorated, triggering continued volatility until the October 2008 market crash, while investors pulled billions out of various firms and investment segments.

Over the last five months of 2007 alone, redemptions out of money market funds filled the global trading spectrum, ultimately reducing the size of this $1.3 trillion market sector by more than 40 per cent. Along the way, several large money market funds “broke the buck” and collapsed under forced liquidity issues.

The US Federal Reserve finally propped up the sector by purchasing money market funds, for the first time. Regretfully, we all know the rest of the sub-prime mortgage market story. Many still feel the effects of the recession that followed. For those curious, or not too pained to remember, some excellent papers on this topic are sourced below.

What does commercial paper have to do with money market funds? What are money market funds? What does it mean to “break the buck?” Why did this happen? Where do money market funds stand today as a component of an investment portfolio. What has changed?

Money market funds are bundles of various types of very short-term debt instruments called commercial paper as well as US Treasury bills, generally issued in various term lengths from seven days to less than nine months maturity, by large corporations, commercial paper is bought and sold between them and financial institutions.

Highly liquid, very creditworthy due to the short maturities even though unsecured, money market funds holding commercial paper were considered low-risk and low return. They are used as a cash equivalent paying a rate of interest that would rise and fall with global market interest rates. Some investors will remember the days of money funds paying 7 per cent in the early 2000s. Further, the funds always maintained a stable net asset value of $1 per share — that did not fluctuate in market conditions.

Just as there are thousands of different types of equity, bond, and other mutual funds, money market funds were offered in many underlying asset allocations. The more conservative focused mainly on sovereign debt, in other words US Treasury bills, while others sought to boost their interest (some categorised them as dividend) returns by investing more aggressively in credit riskier short-term debt.

On to breaking the buck and how it happened. When investors lose confidence in any market or investment instrument security their first impulse is to sell off. As the 2008 sub-prime crisis evolved, it became increasingly concerning to investors that their money market funds could be, or were, exposed to underlying sub-prime mortgage market securities such as CDO’s (collateralised debt obligations) a not easily understood investment. Just taking a look at the math computations is enough to make your head ache severely.

Money market funds were traditionally valued at $1 per share, unequivocally, and legally. Therefore, investors fully expected to receive $1 per share back in redemptions. However, the real net-asset value of each money market share — in many money market mutual funds — was actually significantly less than $1 per share due to the loss exposure to the underlying sub-prime mortgage market investment positions.

Thus, the financial institution holding such an over-allocated sub-prime position in their money market fund stood at a loss from the beginning of the sell-off. Every single investor redemption put the fund further in red ink, such that, the financial institutions themselves were forced to use their own internal treasury funds to prop up their money market funds. It was a complete lose-lose proposition occurring on a global scale, including Bermuda. Those money market fund managers who were highly diversified emerged relatively unscathed. Others, well the rest is history.

This is what is known as “breaking the buck.” Many money market mutual funds could not hold the net asset value of each share at $1 — because the fund had lost value in some of the underlying security positions.

Money market mutual funds are still a vital component of investment portfolios. Times have changed, and so have the securities laws regulating money market funds.

Next week: Where do money market funds stand today as a component of an investment portfolio? Should you invest in them?

Readers, you are no doubt wondering why I have jumped from a beginning discussion on equities in chapter one, to chapter five about mutual funds. You will see this from time to time as we report on significant changes in how securities are developed handled, bought and sold. Stay with me. It will all be sorted by index and chapter when this segment, Bermuda Investment Primer, of the Bermuda Financial Planning Primer is finished.

Reference and links:

When Safe Proved Risky: Commercial Paper during theFinancial Crisis of 2007—2009 by Marcin Marcin Kacperczyk and Philipp Schnabl.

http://pages.stern.nyu.edu/~sternfin/mkacperc/public_html/commercial.pdf

Money Market commercial paper

http://www.investopedia.com/university/moneymarket/moneymarket4.asp

Deciphering the Liquidity and Credit Crunch 2007—2008 by Markus K. Brunnermeier. Journal of Economic Perspectives, Vol 23, No 1, Winter 2009, pages 77-100.

https://www.princeton.edu/~markus/research/papers/liquidity_credit_crunch.pdf

Global Regulatory Changes Affecting the Money Market Fund Industry by Mark Stockley, head of international cash sales, BlackRock

http://www.treasury-management.com/showarticle.php?article=1624

Martha Harris Myron CPA PFS JSM: Masters of Law — International Tax and Financial Services. Pondstraddler Life™ Financial Perspectives for Bermuda Islanders with Multinational Families and International Connections on the Great Atlantic Pond Contact: martha@pondstraddler.com