Making the U.S. Dollar Safer: Return OF Your Money
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There is panic in the markets: reviving memories of the peak of the financial crisis, investors have recently appeared less concerned about the return on their money, rather focusing on the return of their money. In what is a hallmark of grave investor concern, investors are paying for the privilege of lending money to the U.S. government: the yield on one and three month Treasury bills has been flirting again with negative yields. What's the panic about? In our analysis, it's the market's urgent call to address one of the key flaws in our financial system: cost-based accounting by financial institutions, notably as it pertains to money market funds. To make the U.S. dollar safer, as an important step, the present form of money market funds must to be abolished - let us explain.
Money market funds currently hold about $2.7 trillion dollars in assets; investors deposit money in such funds to park cash and earn a return. However, whereas a bank deposit carries counterparty risk to the financial institution, money market funds are legally self-standing entities with credit risk to the underlying securities. Just like other investors, money market fund managers have been chasing yields to generate returns, or simply to cover their costs. Chasing yields is, by definition, not risk-free; yet investors in money market funds generally believe their money is safe. While many appear to take comfort in the fact that the industry may be too big to fail, investors have recently started voting with their feet, signaling that the paltry returns in money market funds are not worth the risks. Indeed, investors appear to prefer buying Treasury Bills at negative yields rather than parking their money in money market funds.
As a money market fund manager, where do you invest when only paltry, or negative yields are available? How about European banks? What? Don't U.S. money market funds only invest in U.S. dollar-denominated securities? As we pointed out in a recent analysis, many taxable non-government money market funds ($1.6trn of the total money market assets) are heavily invested in U.S. dollar denominated commercial paper issued by European banks. How does almost 5% of total assets invested in commercial paper issued by BNP Paribas, the French bank with billions in exposure to Greek government debt, sound? In fact, our analysis found that 50% of total money market fund exposure to European financial institutions appears to be common; we have seen over 70% exposure. If you believe these institutions are too big to fail, you might not need to worry; but why engage in the risk that you are wrong when the reward (yield) is so small? That's exactly the question institutional investors have been asking recently.
Money market funds try to keep a stable net asset value by employing what is called amortized cost accounting: the market value is ignored, assuming the issuer of the debt will pay in full. The justification for this practice is that money market funds invest in highly rated securities of extremely short duration. That may be correct, but in case of a systemic shock and a flight from money market funds, there is a risk that money market funds would need to liquidate holdings at a loss; additionally, an outright default cannot be ruled out in light of the Lehman Brothers experience.
On a recent trading day, when Portugal's debt was downgraded to junk status, the yield on three month U.S. Treasury Bills dipped into negative territory, as institutional investors became concerned about the contagion risks associated with European bank exposures to Portugal. On July 7th three-month Treasury yields came back into slightly positive territory after the European Central Bank (ECB) declared it would continue honoring Portuguese debt in ECB refinancing operations, mitigating the contagion risk. Indeed, "Too-Big-To-Fail" was at work once again: ECB President Trichet effectively came running to the rescue of U.S. investors' money market funds. This situation is untenable; our policy makers are drowning the industry in bureaucracy, but ignoring the obvious to make our financial system more stable: work with market forces, move to market-based accounting ... and abolish money market funds in their present form.
If money market funds were to use market based accounting, any shock could be anticipated and reflected in the market price of such funds. When a problem is discovered early, it may cause pain and losses, but wouldn't lead to a systemic meltdown. Too many still believe we can get through the financial crisis without anyone taking any losses; but make no mistake about it: errors have been made and someone must pay for it.
However, there is a major impediment to move towards market-based accounting: It would require money market funds to abolish stable net asset values; Kansas Fed President Tom Hoenig has been a leading advocate to force money market funds to do just that (see "Restructuring the Banking System to Improve Safety and Soundness"). However, that may not be possible because the underlying securities held by money market funds are not easily priced as there may not be a market for them. To understand why, note how commercial paper is created: unlike Treasury Bills that are extremely liquid, commercial paper is often not traded at all. Someone interested in buying, say, US$50 million in commercial paper from institution ABC is likely to approach a broker, who in turn will call institution ABC, negotiating terms (amount, duration, yield) that are acceptable to both lender and creditor. Such negotiation can take as little as a minute or two, with commercial paper issued the same or next day. To make it worth the effort of the parties involved, there may be a minimum order size of $10 million or often substantially higher. The yield is negotiated by lender and issuer, although typically rather obvious given market conditions in the context of the creditworthiness of the issuer. Selling commercial paper back into the market is possible, but depends on the availability of a willing buyer; generally speaking, there is not an active market, as the lender typically intends to hold the paper to maturity. As a result, while one can infer a price based on an assessment of the riskiness of the issuer and other observable market conditions, commercial paper does not lend itself well to market based valuations.
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While tax-exempt money market funds don't carry commercial paper, some municipalities have their interest payments tied to the fate of European banks (c.f. WSJ: Euro Jitters Ricochet Across U.S.). Even without European exposure, municipalities certainly are not risk-free, either. And even Treasury Bills fluctuate in value. Money market funds that rely exclusively on the resources of its own holdings should not have a stable net asset value; the present pricing structure of money market funds is inherently flawed - in their present form, money market funds should be abolished.
What would be the alternatives? What are the implications for the markets, in the U.S. and beyond?
For investors that prefer to have counter-party exposure to the underlying securities rather than a bank where the cash is held (a very valid concern during 2008 in particular), the appropriate instrument to hold commercial paper may be an actively managed exchange traded fund (institutional investors may, of course, obtain the commercial paper directly as well). In an exchange traded fund, buyers and sellers determine the value of the underlying securities. As exchange traded funds have to report their holdings on a daily basis, a rational investor is free to decide whether to offer a premium or discount to the amortized cost accounting employed at the fund level. Such funds won't have a stable net asset value. The downside of such funds is that there is a bid/ask spread, as well as a brokerage commission due in buying and selling such funds. The cost of buying and selling such funds should be very low, and the risks associated with the underlying issuers held within a fund, along with present market conditions, would be more accurately reflected in the market-derived price of such a fund.
Another alternative is to have the industry shift towards a banking model. Interest bearing deposit accounts come in many flavors. Given the consolidation already under way in the industry, it could be possible for the few large players to move towards such a model. The most obvious would be a deposit account that has a clear mandate to invest in commercial paper and other high-quality, short-term debt securities. The key difference to money market funds would be that investors have counter-party exposure to the bank. There is no fluctuating net asset value to worry about, because any losses suffered by the investment would be covered by the resources of the bank. This model would continue to allow a thriving commercial paper market while addressing the key shortcoming of money market funds: a stable net asset value with inadequate backing in case of losses. In practice, it is assumed that the sponsor or a money market fund would step in when there are losses; but implicit guarantees are a very bad way of running a market, a business or regulatory policy. Those that don't like the thought of taking on the counter-party risk of a bank should seek out alternatives.
Federal Reserve (Fed) Chairman Bernanke has also become more vocal about the challenges of the "shadow banking system." What is needed, though, is action, not words. This multi-trillion dollar misallocation of capital causes financial instability. Current Fed policies are literally financing foreign financial institutions, not only attracting political scrutiny of Fed policy, but also distorting the funding cost of foreign institutions. We don't have any problem with U.S. investors buying U.S. dollar denominated commercial paper issued by European banks. But buyers of such paper must be risk-friendly investors.
As U.S. money market funds grow more cautious about U.S. dollar denominated commercial paper issued by European banks, we have seen headlines about increased funding cost of, for example, a leading Spanish bank. Ultimately, liquidity in intra-European markets should increase if U.S. money market funds don't act as a vacuum cleaner to suck up all liquidity. It may, though, imply a higher borrowing cost for European issuers. Important is not that the cost of funding is low, but that it is based on fair market conditions. Economist Murray Rothbard has quoted former German Reichsbank President Schacht as saying, "Don't give me a low [interest] rate. Give me a true rate. Give me a true rate, and then I shall know how to keep my house in order."
We have argued since 2006 that there may be no such thing anymore as a safe asset and investors may want to take a diversified approach to something as mundane as cash. In our work, we also include the currency risk of the U.S. dollar; in our next analysis, we shall discuss "return on your money" rather than a "return of your money", suggesting policies that would strengthen the U.S. dollar. Please join us for a Webinar on Thursday, July 21 and sign up to our newsletter to be in the loop as this discussion evolves. We manage the Merk Absolute Return Currency Fund, the Merk Asian Currency Fund, and the Merk Hard Currency Fund; transparent no-load currency mutual funds that do not typically employ leverage. To learn more about the Funds, please visit www.merkfunds.com.