What Really Happens when a Fund Breaks the Buck?
Institutional Money Market Funds Association
Money market funds have received significant press attention in recent months. This is primarily the result of a single incident in September 2008, but one which happens so infrequently that it sent reverberations throughout the financial sector globally. That incident was when a money market fund managed by The Reserve Management Corporation “broke the buck”.
It is important here to quantify exactly what happens when a fund breaks the buck.
A money market fund is designed to provide security of capital and liquidity. The fund seeks to maintain a constant net asset value (i.e. $1, €1 or £1), allowing the investor to have instant access to the investment and with no loss of capital. The funds achieve this by using amortised cost accounting, which permits a straight-line extrapolation of the asset price from its purchase to its maturity. Regular comparison of the amortised cost with the mark-to-market cost of the assets and the portfolio is conducted to determine whether there is any discrepancy between those two values, and to take action if any material discrepancy arises.
Whilst maintaining a constant value, the funds are permitted to have a variance of plus or minus 50 basis points from the par value, i.e. the value of an individual share can move within the range 0.9950 to 1.0050. Should any situation arise in which the value of a share moves outside this range, the fund is said to have broken the buck and the constant net asset value is lost. This can therefore be considered as the point at which the share price, calculated to two decimal places, varies from the par value.
So what exactly happened to money market funds in September 2008?
The issue largely centres around one fund – the Primary Fund managed by The Reserve Management Corporation. This fund, a US based money market fund with a mixed base of retail and institutional investors, had grown significantly in the year prior to September 2008. This was a result of a notable increase in the yield payable by the fund when compared against its peer group, which corresponded with an increase in the amount of commercial paper held by the fund. Just before the Lehman Brothers announcement, the fund had approximately USD 62bn invested.
The increased amount of commercial paper held by the fund included some paper issued by Lehman Brothers. The total exposure of the fund to Lehman Brothers amounted to USD 785m, or 1.2% of the fund’s net assets.
On September 14, Lehman Brothers declared bankruptcy. The Reserve did not write down the value of its Lehman exposure immediately. Consequently, with investors seeking to distance themselves from any Lehman exposure, whether direct or indirect, the Primary Fund received redemption requests of USD 25bn on 15 September.
A money market fund is designed to provide security of capital and liquidity.
On 16 September, The Reserve valued the Lehman exposure at zero, resulting in a reduction in the net asset value of a share to USD 0.97. The fund had broken the buck. In a statement, The Reserve confirmed that the proceeds of redemptions would not be transmitted for a period of up to seven calendar days. However, on 19 September, The Reserve stated that it had filed with the SEC an application for an Order to suspend all rights of redemption from the fund and to postpone the date of payment of redemption proceeds for a period longer than seven days after the tender of shares for redemption. Not only had investors lost money, but they could no longer have access to their cash.
This announcement of the postponement of the payment of redemptions requests by The Reserve followed shortly after Putnam Investments announced that it was closing one of its money market funds due to significant redemption pressures. The action of Putnam was taken not as a result of any credit impaired assets within the portfolio, but due to a concentrated investor base and an illiquid market, creating difficulties for Putnam to sell assets to process redemption requests. To ensure there was no loss of principal, Putnam decided to close the fund and enact an orderly wind-down. (The fund was subsequently purchased by Federated Investors Inc.)