Could a Greek default destroy American money market funds?, Megan McArdle asks:
During the wave of banking regulation that followed the Great Depression, the government slapped heavy controls on the interest rates that banks could offer. They weren’t very good, which made the banks sounder, and consumers worse off. When inflation and interest rates rose in the late sixties, this became a big problem. Then some clever chap came up with the money market fund. Legally it worked like an investment fund, not a bank account: you invested in shares, with each share priced at a dollar. The fund invested in the commercial paper market and committed to keep each share worth exactly one dollar; whatever investment return they got was paid out as interest on your shares. This gave you something that looked a lot like a bank account, without all the legal tsuris.
In 2008, it turns out that these money market accounts were–as was always pretty obvious–a lot more like bank accounts than mutual fund shares. The Reserve Primary fund held a lot of Lehmann Brothers commercial paper, which plunged close to zero, meaning that there were no longer enough assets in the fund to make all the shares worth at least a dollar. This is known as “breaking the buck”, and it was not the first time it had happened. But it was the first time in more than a decade that it had happened at a fund which didn’t have enough money to top up the assets in the fund to bring them back to a value of $1. Bigger investment houses had been quietly topping up their money market funds for month, but Reserve Primary was a smaller firm, and they didn’t have the spare cash handy.
This triggered a run on the money markets, which the government really only stopped by a) passing TARP and b) guaranteeing money market funds.
Wait, what does it mean to make a run on a mutual fund that holds short-term paper?
As I’ve said before, with no notion of first-come, first-served, a fund’s in no danger of a run; its shares simply drop in value when its assets drop in value. It’s comparatively stable, since no one has an incentive to make matters worse for other investors in order to save their own skin.
Sort of. Even with short term paper (as seen in the last crash), there can be liquidity problems.
Specifically, enough redemptions can force sufficient sales of the underlying (already troubled) assets to saturate the market over the short term — causing the price of those assets to drop and triggering even more redemptions.
Certainly the realization that everyone’s short-term paper is worth much less than they all thought is going to lead to liquidity problems, and, as you point out, this can snowball, but it’s fundamentally different from a run on a fractional-reserve bank, where the slightest drop in the bank’s portfolio’s value — the equivalent of it “breaking the buck” — should mean that a few quick customers lead the run and get 100 percent of their money out, while the rest come away with nothing.
I believe the requirement for money market funds to redeem shares at their net asset value contributes to the problem you describe, by the way. If they were legally more like closed-end funds, ETFs, or ordinary corporations, then shares would trade on an exchange, and the funds would not need to unwind their own positions.