The announcement Tuesday that the $62 billion Primary Fund "broke the buck," as its net asset value fell to 97 cents a share, is yet another bad omen for the global financial system.
The fact that this fund was sponsored by Reserve Management Corp., a New York cash management firm that prides itself on creating the first money market fund, is especially disconcerting. Though it has gone largely unnoticed, it is telling that the firm also announced there could also be a seven-day redemption delay in some cases.
Net asset values for a significant number of other money market funds have already fallen below $1 a share, but they have received financial assistance from their sponsors in response to the Lehman Brothers bankruptcy. It is clear that the values of other funds whose sponsors lack deep pockets will drop below $1 a share and be forced to delay cash redemptions.
Silent runs on money market funds by knowledgeable investors are occurring now and will likely gather momentum. It is no coincidence that on Wednesday, the day after the American International Group Inc. bailout and the Primary Fund announcement, gold surged by $70 an ounce on the New York Mercantile Exchange during the regular trading session, the largest one-day dollar increase in history, and the yield on Treasury bills turned negative for the first time since World War II.
The Primary Fund announcement shocked the financial markets and merits action by the mutual fund industry to prevent further deterioration in investor confidence.
One possible course of action would be the establishment of a private-sector insurance company to protect individual investors. This company, which could be called the Money Market Insurance Corp., could be modeled after the Federal Deposit Insurance Corp. and offer comparable coverages. Fund management companies would be assessed premiums, which they could absorb or pass on to owners of money market shares.
About $3.6 trillion is invested in money market mutual funds, of which $1.236 trillion is in retail funds and $2.346 trillion is in institutional funds. At the end of last year about 33 million people had shares in money market funds. Therefore, the average consumer had about $37,500 invested in money market fund shares. Under my proposal, only individual investors would be protected against loss in net asset value.
The average consumer does not fully understand the fundamental differences between the money they have in a money market fund and the money they have in an FDIC-insured bank's money market account. Nor do they understand that the value of money market fund shares is totally dependent on the underlying market value of the investments held by the fund. Many are not aware that their holdings in money market fund shares are not insured.
Recent television news reports have shown lines of people outside failed banks. These people said they feared losing their money, even though most of them had less than $100,000 on deposit. This demonstrates that the average consumer does not understand FDIC insurance, despite extensive educational efforts by the banking industry and regulators.
The recent problems at Bear Stearns and Lehman Brothers, which, of course, were investment banks, further confused consumers. After all, consumers understand even less about the workings of the Securities Investor Protection Corp., the FDIC's brokerage counterpart, than they do about the FDIC. Both these agencies, realizing that consumer fears need to be kept to a minimum, require their member institutions to prominently advertise their insurance coverage. The money market fund industry, however, has no such insurance organization to quell consumer concerns about the safety of their money. It is incumbent on money market fund sponsors to establish an insurance company immediately to protect individual investors.
In the absence of such a fund, runs on money market funds will become more frequent. Furthermore, such runs are likely to spill over to the banking industry, because of consumer confusion. In such an environment, the herd mentality that presaged the bank holiday imposed by President Franklin D. Roosevelt during the Great Depression cannot be ruled out.