Chapter 4. Money Markets Supplant Banks
“We are pleased to report that you, and the markets in general, have embraced the very concept and foundation on which The Reserve was founded, an unwavering discipline focused on protecting your principal, providing daily liquidity and transparency, and all the while boring you into a sound sleep.”
Bruce Bent, chairman of the Reserve Fund in July 2008, weeks before his fund took a loss on bonds issued by Lehman Brothers1
Capital markets took over the core functions of banks, with money market funds even offering checkbooks. This left decisions about lending to the market, with its big swings of sentiment, rather than to banks’ lending officers, and forced banks to find new lines of business. This stoked speculation as banks poured money into areas that were new to them.
Banking underwent the same change as investment, as the market split the principals from their agents. In 1975, Merrill Lynch launched its Ready Assets money market fund, one of the most boring financial instruments ever invented. A money market fund is like any other mutual fund: it invests solely in the money markets—certificates of deposit, bank deposits, or very short-term bonds. These instruments carry negligible risk, but their high minimum investments put them beyond the reach of most investors. Funds got around this by holding a big portfolio of such deposits, and then offering shares, with a much smaller minimum investment, to small investors. Even after the fees the fund charged, small investors could earn a higher interest rate.
The first such fund, The Reserve Fund, was launched in 1969. Merrill Lynch now added a crucial marketing twist: a checkbook. Henceforward, its clients could treat money market funds exactly like bank accounts, pulling out money instantly. It was a stunning success. In its first year, savers poured in as interest rates rose, taking Merrill’s fund from 1.6 million to 8.1 million shares, or from $8 billion to $40 billion in assets.2 By 1982, as inflation and interest rates finally came under control, the burgeoning money market fund industry controlled $207 billion in deposits.
Without a branch network to keep up, without the regulated interest rates imposed on banks, and with no premiums to pay for deposit insurance, money market funds had drastically lower costs than banks. To maintain the sense among clients that this was really a bank account by another name, they maintained a constant share price of $1.00, with all gains accruing as interest.
But despite appearances, they were not bank accounts. Instead, they removed power from banks and gave it to markets. By not having to pay for deposit insurance, one of their critical advantages, money market funds were an end run around one of the critical Depression-era reforms to rebuild confidence in the banks. Without insurance, there was a (very small) danger that the investments they held might default or fall in value to bring the fund’s share price below $1.00. “Breaking the buck” would show the funds to be riskier than bank accounts.
Paul Volcker, legendary head of the Federal Reserve, the U.S. central bank, was a cynic. In 2009, he made clear that he thought they should be subject to the same restrictions as banks: “They didn’t exist before, and they exist as a pure regulatory arbitrage. They promise to return at par. You can write checks against it. That’s what demand deposits in banks do, and money market funds can do it without the inconvenience of reserve requirements and all the other regulatory requirements.”3
Regulators did codify some new requirements. In 1983, the Securities and Exchange Commission set rules on the credit quality of the bonds the funds could hold, along with their maturity and their diversification, and ensured that the funds had to be able to sell their investments quickly if necessary. Provided the funds kept to these guidelines, they could keep the value of each share pegged at $1.00. In other words, they could realistically aim never to lose money. Even though they were not insured, the rules bolstered the impression that they were, leading to a further explosion in the uses to which the funds were put. Money markets funds became a parking area for the global investment community.
Money moved in and out of them at staggering speed. In the 25 years after the SEC adopted its rule, the period that saw the growth of the super-bubble, $325 trillion flowed in and out of money market funds.4 (The gross domestic product of the entire planet in 2009 was about $70 trillion.) Meanwhile, the assets held in the funds rose almost without interruption and grew far faster than the economy. By 1997, they topped $1 trillion for the first time. By 2008, they held $3.8 trillion. During this time, banks themselves developed arcane structures using the same principles as money market funds—borrowing in the short-term and putting the proceeds into longer-term bonds—until they had created what has come to be known as the “shadow banking system,” accessible only to the world’s biggest bankers.
These new financial beasts needed to be fed. States and cities could now borrow money much more easily, by issuing bonds and selling them to money market funds. The funds were also buyers of commercial paper: very short-term loans to big companies, which would previously have been made by banks. Generally the terms of these loans were so short that default was not an issue—a big company may default in the next 20 years, but almost certainly not in the next month. Because the funds had much lower overheads than banks, they would let the companies borrow at a lower interest rate.
So far, so good. Through alert financial engineering, the costs of borrowing for almost everyone in the economy had been reduced and savers could get a higher rate of return on money that would have otherwise been parked doing nothing. Lenders and borrowers alike could avoid paying for the big overheads incurred by heavily regulated banks.
But there were issues. The credit of an American state, or of a very large company, is very strong, but it is not quite as strong as that of the U.S. government or of a bank deposit. That is why they pay slightly higher interest. While low-risk, these funds were not riskless. That implied that every so often, a default might force a fund to take a loss and mark its share price down below $1.00. Further, the funds were competing with each other. A higher rate of return would generate more business while also increasing risk. And they had improved on the banks in large part by avoiding the regulations designed to ensure that banks did not crash. Did that mean they could tolerate “breaking the buck”?
It soon turned out that the answer was “no.” Instead of “more return for a little more risk,” their proposition was to be “more return for no more risk.” Several times during the 1990s, money market funds found themselves holding securities that fell in value, and on each occasion they were bailed out by their management companies. As money market funds tended to be controlled by large fund management companies with many other sources of revenue, and their losses tended to be very small, this could be done easily. Ultimately the owners of the management company, and not the investors in the funds, would take a small hit. With each successive incident, the impression took hold that the funds could not in any situation lose money.
One exception came in 1994, after the bankruptcy of Orange County in southern California, when The Community Bankers U.S. Government Money-Market Fund took a loss and opted to close itself down, paying shareholders 94 cents for each dollar they had put in. But this fund did not have a large management company to give it an implicit guarantee, and held only $82 million, a tiny amount for a money fund. The incident passed without seriously denting investors’ confidence.
By making money cheaper without making it seem riskier, or by fostering the impression that there would always be a bail-out if risks went wrong, these developments encouraged the funds’ managers and their investors to take greater risks—a concept known to economists as “moral hazard” that has now grown painfully familiar. These practices also boosted the supply of money available to pour into riskier assets—and thereby stoked speculation. By persuading investors to keep money that would otherwise be kept on deposit in insured vehicles, they also raised the risk of a bank run, or sudden loss of confidence in banks.
At a collective level, there was another problem. In many ways, the funds—and the many structures like them in the shadow banking system—were using the safety that comes in the short-term as a means to manage risk. Healthy companies simply do not default in a matter of days or weeks. This increased the temptation for investment banks seeking funding to borrow over very short periods. This cut the interest they paid and made it easier for the investment banks to make money; but it also meant that if the funds stopped lending to them (by refusing to buy their commercial paper), they could run out of money very quickly. This made the financial system less stable, as the world discovered when the synchronized bubble finally burst in 2007 and 2008.
Another crucial side effect of the rise of money markets was to strip banks of their main business. If banks were not the best in the business of offering checking accounts to customers at competitive interest rates, or at lending to big companies over short periods, what was their point?
These businesses had once belonged to the commercial banks. Lending officers would decide whether to make short-term loans. Now the same transaction came in the form of the company selling commercial paper to money market funds. The market set the price. With all its capacity for herding and overreaction, the market had taken over the job once done by individuals working in banks.
Bank executives could respond to money market funds either by shrinking their banks to acknowledge their newly diminished role, or by scrambling to find something else to do. Human nature dictated that few wanted to do the first. Therefore, banks scrambled to find new sources of profit, such as lending to emerging markets, real estate developers, corporate raiders, or subprime mortgage lenders—a roll call of the speculative excesses of the last 30 years. Many of these booms and busts were driven by banks looking for something new to do and finding themselves in rocky and unfamiliar terrain.
And so, just like index funds, money market funds embody a paradox. The case for individual investors to invest in them is overwhelming. Indeed, there is little reason not to; they are like bank accounts, which everyone needs, and they pay more money for barely any more risk. But collectively, they bolstered overconfidence and provided an incentive for everyone to fund themselves on a dangerously short-term basis. Their role was all the more important because the value of money is no longer linked to gold.
In Summary
• Money market funds took key business away from banks and gave it to markets. They provide cheaper financing for companies and higher rates for savers.
• But money market funds made bank runs more likely by avoiding deposit insurance and encouraging banks to rely on shorter-term financing. Management companies created moral hazard by intervening to stop them from “breaking the buck.”
• Regulating and insuring funds like banks might deal with these problems.