Question

How did the money market funds drive the Savings and Loan banks into bankruptcy and liquidation?

Answer 1

Money Market Fund is a type of mutual fund that invests in short-term maturity debt securities. US Treasury bills and Commercial papers are examples of such instruments. They offer a higher liquidity and have high credit ratings. They are regulated in the United States by Securities and Exchange Commission (SEC) under the Investment Company Act 1940.

Money Market Funds aims to maintain a stable value of NAV (Net Asset Value) per share (which is $1 per share in US). The $1 NAV is maintained by distributing the excess earnings to investors in the form of dividend payments. For maintaining this the fund manager makes regular payments to the investors, at an amount equal to fund's net income.

If the fund's NAV drops below $1 it is said to be in a condition known as breaking the buck. This situation occurs when the investment income of a money market fund fails to exceeds its operating expenses or investment losses. This happens when the fund uses its excess leverage that leads to capital risk, or when overall interest rates drop to very low levels nearing to zero. Under such circumstances when the money market fund breaks the buck, the Regulator jumps in and forces its liquidation.

For SEC registered money funds, to maintain the $1 NAV is accomplished under a provision under Rule 2a-7 of the Investment Company Act 1940 that allows a fund to value its investments at amortised cost rather than market value, provided that certain conditions are maintained. The fund's published, amortised value may not exceed this market value by more than 1/2 cent per share, a comparison that is generally made on weekly basis. If the variance exceeds $0.005 per share, the fund could be considered to breaking the buck, and regulators may force it into liquidation.

The 2008 financial crisis that led to the bankruptcy of Lehman Brothers, the Reserve Fund broke the buck when its NAV fell to 97 cents per share.