Risk of Money Market Mutual Funds Research Paper - 8250 Words

Risk of Money Market Mutual Funds (Research Paper Sample) Content: Risk of Money Market Mutual FundsProfessors NameName of StudentDate [Abstract]Presented is an analysis of the money market fund risks with respect to the recent 2007/2010 financial crisis. One of the most stable investment options to date, the turmoil within the MMF was a surprise to majority of investors, bringing to question the safety of the fund. Reviewing background research and a comprehensive literature review, the paper utilizes a qualitative research to analyze six key parameters: Sponsors business concerns, the role of financial strength, flow performance relationship, the role played by retail money market funds, business concerns and risk taking. Primary results indicate that, following the 2008 financial meltdown, the treasury, for the first time in history, had trusted a single product and a single industry. Using a qualitative methodology, the paper validates the six parameters with the role played by sponsors, expansion of risk taking opportunities and individual MMFs financial strength being key to eventual successes. 1.0 Introduction Across decades, the safety of the Money Market Mutual funds, also known as the Money Market Fund (MMF), has been unquestioned due to its tradition of investing in multiple safe, higher yielding financial options. As a result, they have enjoyed a significant market success owing to their safety, conservative nature and stable interest rates (RBC 2). The 2008 financial crisis, however, subjected the fund to a major test eliciting controversial debates about its safety. The failure of the Lehman Brothers, a major broker and dealer on September 15th 2008 created panic resulting in a massive flight by institutional investors who were out to cut their losses. For the very first time, the future of the fund was at stake and the federal government, to save the fund, put forth a number of measures. Years after the crisis, options are still under consideration: whether to continue regulating the mutual fun ds under federal legislation while tightening the standard; to subject all money market mutual funds to regulation similar to banks or to allow mutual funds have fluctuating net asset values depending on the directions of the market. Money market mutual funds have relatively lower risks comparative to other mutual funds or most of other investments. They have proved to be valuable cash management instruments for both individual and group investors. Legally, mutual funds can only invest in specific short-term, high quality investments issued by U.S corporations, U. S federal government or the state and local governments. In essence, money market funds often try to maintain their Net Asset Value (NAV), the value representative of one share in the fund, at a generally stable price of $1 per share. A fall in the NAV value to less than $1 is indicative of the funds poor performance. It is noteworthy to state that, until now, with the exception of certain isolated cases investment losses have been rare. 1.1 Call for Concern The United States has the largest Mutual Fund and by extension, the largest money market mutual fund in the world (See Appendix 1). The tumult within the money market fund was a surprise to majority of investors and other money market participants. Prior to the period, investors agreed that MMFs had very low potential risk investment and were almost as secure as cash deposits. In the entire history of the money market funds, nearly all investments had been on very safe assets that generated consistent returns similar to the securities issued by the US treasury. The sudden increase in money market funds returns in the early periods of the financial crisis brought to question the safety of the fund. This is because; money market funds are large financial intermediaries that play a critical role in the financial stability in the US. They are, at present, the largest short-term financers of the U.S. economy, the largest provider of liquidity to Amer ican corporation and their size is equivalent to equity mutual funds. MMFs often rely on runs in order to mitigate any threats, with the sponsors being large financial institutions that have the responsibility of managing funds on behalf of investors (See Appendix 3). Investors tend to feel secure since it is their expectation that the sponsors will financially support the fund in case of a failure even though there is no contractual agreement between the sponsors and the funds. The agreement are therefore, only reputational in nature without which the sponsor could lose a lot of business in its investment banking, commercial banking or insurance operations. 1.2 Money Market Fund: Overview Money Market mutual funds emerged in the 1970s as viable alternatives to the more understood bank deposits. During the period, bank deposits paid very low interest rate compared to other money market instruments. This made the funds very attractive to investors who received relatively higher inte rest while taking only comparable risk. Even with the eventual abolition of regulations, which characterized bank deposits, the money market fund continued to grow exponentially reaching a whopping $2.4 trillion by the year 2007. Compared to the bank deposits, money market funds are uninsured by the government. This implies that even though the funds tend to preserve their asset values, investors might still have losses. In order to limit risks within the money market mutual fund, all holdings are regulated under Rule 2a (7) of the 1940 Investment Company Act (RBC 12).The regulation offer restrictions to all funds holding short-term assets preventing them from purchasing long-term assets such as corporate bonds, equity or mortgage-backed securities. It further requires all short term debt to have high levels of credit quality. The regulation further requires portfolio diversification hence money market funds are expected not to have more than 5% of their assets invested in securitie s of one issuer having the highest rating (RBC 12). They must also not hold more than 1% of their assets with any other individual issuer. Prime money market fund are known to invest in a variety of high quality money market instruments such as corporate debt obligations, bank securities, taxable municipal obligations, U.S government securities, repurchase agreements and certificates of deposits. The eligible securities in which the fund invests must have received at least of the two highest ratings from two recognized statistical rating organization such as Fitch Ratings Ltd., Financial Services LLC (SP) or Moodys Investors Service Inc.2.0. Literature Review 2.1 MMF Prior to the financial Crisis Data provided by iMoneyNet serves to illustrate the different market instruments held by money market mutual funds. Focusing on the taxable funds which account for 84.5% of the funds mutual funds, it is evident that as of January 2006, there existed 485 taxable money market funds and 148 sp onsoring companies with a total asset value of 1.67 trillion (iMoneyNet 1). 23.8% of this (estimated at $396 billion) were held by Treasury funds, which specifically hold government backed agency debt, repurchase agreements and government debt. The remaining 76.2% of the total assets valued at $1.26 trillion were invested in prime funds some of which invest in non-government assets. Of the prime funds, 43% were retail funds while the remaining 57%, prime funds. During the period, the largest asset class was the commercial paper, which accounted for 25.6% of the total assets valued at $325.3 billion (iMoneyNet 1). Other asset classes included floating-rate notes valued at $265.9 billion, asset backed commercial paper at $186.3 billion, bank obligations at $235.3 billion, repurchase agreements at $151.1 billion, and government backed agency debt and government debt at $62.5 billion and bank deposits valued at $39.4 billion (iMoneyNet 1). Prior to the financial crisis, the 20 largest financial institutions, which managed mutual funds, accounted for $429 billion worth of assets. The largest fund was under JPMorgan Prime money, which managed $68.1 billion while the second and the third largest were Columbia Cash Reserves and BlackRock Liquidity funds respectively (iMoneyNet 1). Even the lowest managing fund within the top 20 list still managed a sizable $12.6 billion worth of asset. It is noteworthy to state that on average, the funds were well diversified with assets in virtually all sectors of the industry. A combination of bank obligations, financial commercial paper, repurchase agreements and structured securities totalled to 91% of the total money market funds.
Source: The graph shows the turbulent period, a sudden drop from $3.92 to $3.27 Trillion in February 2008 resulting from massive losses in the prevailing risk taking opportunities. Depicting the total net assets with respect to the number of money market funds, it is evident that there was a steep ri se in the total net assets between the first of February 2008 and the first of February 2009 from $3.15 Trillion to $3.925 Trillion. This was followed by a massive drop in the total net assets held by the funds from 3.925 trillion to 3.27 Trillion between February 1st and December 2nd 2009. The number of Money Market Mutual Funds was relatively stable before the financial crisis, peaking at 2, 078 as at 10th, February 2008. This however declined to 1828 as at December 2, 2009, representative of 12% of the total number of funds in February 2008. The graph indicates that after September 2008, Money market mutual funds experienced considerable decline in both their sheer numbers and the total net assets they held. This was as a result of the significant withdrawals of funds by investors following the AIG bailout and the Lehman Brothers bankruptcy. As represented by the massive decline in the fund...