Money Markets

Abstract

For businesses seeking to find asset security in between their investments, there are two general choices. The first is a long-term capital investment strategy, such as the acquisition of bonds. The second is more short-term investment strategy, one that provides shorter-term financial return with more liquid assets available. It is on the latter of these concepts, money markets, which this paper focuses, with the aim of defining an important part of any strong economy.

Overview

Calvin Coolidge once said that the "chief business of the American people is business," adding that Americans are "profoundly concerned with producing, buying, selling, investing and prospering in the world." Indeed, the backbone of a strong capitalist economy like that of the United States is an extensive marketplace that offers its patrons the opportunity to maximize profits and minimize losses.

At the core of any business or commercial enterprise is financial solvency. A business relies on an ability to protect its assets by placing them in savings, hoping to see growth and expecting to avoid losses. This simple concept is in fact an extremely complex one; dependent on the preferences and decisions of the individual business owner. Some experience modest gains upon their savings but benefit from the protection by conservative investment strategies. Others seek a higher yield, while accepting the potential for sudden loss. Depending upon the specific case, long-term or short-term growth can be a focal point for a business and its funds.

For businesses seeking to find asset security in between their investments, there are two general choices. The first is a long-term investment strategy, such as the acquisition of bonds. The second is a more short-term investment strategy, one that provides shorter term financial return with an availability of more liquid assets. It is to the latter of these concepts, money markets, that this paper focuses with the aim of defining an important part of any strong economy.

Money Markets: An Introduction. A marketplace is an entity wherein items are bought or sold. In the stock market, for example, individuals invest in interests in publicly traded companies, seeking to profit from their positive performance and to avoid losses when the stocks they hold wane in value. Money markets are similar to the stock market concept, except for the fact that in a money market (as its name suggests), it is money that is traded rather than stocks.

The basic premise of a money market is that individuals invest monies into money market funds (which, like mutual funds, spread investment monies around to various market members in order to foster stability and maximum opportunity). The funds return, usually on a monthly basis, a portion of the earnings on the investor's money in the form of dividends. The targets of investment, known as "instruments," are typically government sponsored (Treasury issues, known as "T-Bills") accounts, bank-sponsored accounts (so-called "CDs, or Certificates of Deposit) or short-term corporate paper (Pritchard, 2009).

Money markets are constructed for the purpose of strengthening investments on short-term borrowing and lending relationships. A corporation, for example, might sell paper (unsecured obligation such as accounts receivable or inventory ("Commercial paper," 2009)) on the market to meet its financial needs. On the other hand, an investor who profited from another investment might deposit some of those funds into a CD as a safe way to earn more money on interest and dividends ("The money market," 2009).

Money market funds were first introduced to Wall Street in 1971, when investment entrepreneur Bruce R. Bent created the Reserve Fund. Bent's idea was not the first money market fund in history, however. Several years earlier, in 1968, John Oswin Schroy introduced the Conta Garantia to the Brazilian marketplace. 31 years after Conta Garantia was floated to investors in Rio de Janeiro and 28 years after Bruce Bent took the money market fund to a much grander scale, there are approximately 2,000 money market funds in operation worth $2.3 trillion in assets.

Types of Money Market Funds. There are two basic types of money market funds in operation. The first of these money market funds are "retail" accounts. These funds are typically offered to high-net worth investors who tend to use the accounts in between investment actions. In other words, an investor may sell a given share or asset on the stock market, and take his or her liquid earnings from the sale and "park the cash" into a retail account, where it can further generate modest interest while the investor looks for another intermediate- or long-term investment opportunity. Such funds comprise about 40 percent of all money market assets, and are offered primarily by brokerage houses. Retail accounts also prove useful for people who are simply seeking a safe, risk-free investment for their liquid assets. The largest of the retail accounts is the Fidelity Cash Reserve, which boasts about $120 billion in assets and a seven-day yield rate of 3.4 percent (Kosnett, 2008).

The second form of money market fund is the "institutional" fund. This type of money market fund is offered to large corporations, government agencies and other sizable organizations. These entities collect free-floating cash within their programs and deposit them, in many instances on an automatic, nightly basis, into the institutional fund. Like retail accounts, they are offered largely by brokerage houses and are useful for the purposes of putting a good use to idle funds ("Money market funds," 2009).

Recent Surges in Money Market Use. In both of these cases, money markets typically represent safe havens for liquid assets during particularly unsteady economic times. By 2008, money market mutual fund assets reached an all-time high, having increased by more than $19 billion to a total of $3.43 trillion, according to one watchdog group. In 2008 alone, the increase in money market assets was staggering—a 43 percent jump worth $1.1 trillion. The causes for this surge in money market participation were two-fold. First, signs of a deteriorating economic landscape led a much larger percentage of the population to install their liquid assets in less volatile markets. Second, the Federal Reserve was wary at the time to cut interest rates, which meant that entities paying back on loans within the money market did so at higher interest rates, thereby ensuring a stronger return for market investors ("Money fund asset gains," 2008).

In 2008, the money market again came to a critical use when Wall Street giant American International Group (AIG) was close to complete closure. The federal government, deciding that AIG's influence was too important to allow the company to collapse, lent nearly $85 billion to AIG through US Treasury securities, effectively giving the federal government almost 80 percent of equity holdings. A British bank, Libor, bolstered the loan (Karnitschnig, et al, 2008).

Money markets are considered relatively safe and secure institutions for investors. At a typical $1 per share, money market funds are short-term in nature (the maturity of such investments are between one day and one year), which helps prevent severe impacts should the companies involved encounter rough waters. Additionally, money market funds are liquid-based, which means an investor's money is easily accessed like that of a checking account. During times of stock market volatility, investors often pour their money into money accounts to help weather the storm.

In 2008, for example, two of The Vanguard Group's money market funds, the Vanguard Admiral Treasury Money Market Fund and the Vanguard Treasury Money Market, saw enormous surges in money market investment activity. While the stock markets saw increased unpredictability and assets began suffering as a result, these two money market funds saw extremely large growth over a one-year period—the former saw an increase of $5.4 billion and the latter saw $1.7 billion more—as investors poured their money into the typically safe, conservative funds (Sullivan, 2009).

Despite this relative safety; however, it is important to remember that with any investment, there are both benefits and risks to the investor. This paper next turns to an overview of the positive and negative aspects of money markets.

The Benefits of a Money Market. Money markets exist for the purposes of borrowing and lending. In light of this fact, any investment into a money market must be expected to provide conservative returns.

In an average or bull market (a period in which investment prices rise faster than their historical average), such a conservative return provides the investor with another avenue to experience a consistent return on profits already generated from other investments.

Under United States Securities and Exchange Commission rules, most money market funds must invest at least 95 percent of their assets in so-called "first-tier securities" (such as the aforementioned Treasury certificates and private bank notes). Such securities must have an exceptional credit rating (T. Rowe Price, 2009). This practice, coupled with the short-term nature of investments, money markets represent to the investor a relatively safe account.

Types of Money Market Investments. There are two types of money market investments—money market funds and money market deposit accounts. The latter of these, deposit accounts, have been federally insured, as they are bank accounts, since their introduction. However, the US Department of the Treasury announced in September of 2008 that it would establish a temporary guarantee program for money market funds as well (US Securities & Exchange Commission, 2009). During an increasingly unstable market period, then-President George W. Bush included a $50 billion earmark for the protection of the money market industry.

The Treasury Department's implementation of this one-year program underscores its position that money markets are invaluable components of the US economy. According to a statement issued after the program's introduction, "Maintaining confidence in the money market fund industry is critical to protecting the integrity and stability of the global financial system" (US Department of the Treasury, 2008).

Growing Attractiveness of Money Markets. Since the introduction of money market funds in 1972, interest in such accounts has grown exponentially. This trend is due in no small part to inflation. In the 1970s, inflation created considerable widespread concern among leaders and consumers alike. However, inflation during and after the 1980s sent interest rates skyward, particularly as expectations for the impact of inflation drove investment practices. Such increases led to significant returns on money market investments, particularly in T-bills. While interest rates have stabilized with industrialized economies gaining a better hold on inflation, the potential returns on money markets (especially in a down market) remains strong in the twenty-first century.

The attractiveness of money markets for investors has long been the conservative returns they offer the investor. In a down economy, however, money markets have also proven durable and, in fact, bolstered by the troubled economy. The economic crisis that began in 2008 provides an excellent illustration of this point.

Money Markets During Economic Crisis. In December of 2008, the Federal Reserve reduced a key interest rate one percent to nearly zero in order to help stimulate some growth. Under such circumstances, one would anticipate that money markets would suffer, given the lower rates on return. However, the opposite was true—one-year CDs yielded an average of almost two percent, the same rate it showed seven months earlier. The key was the number of large-scale financial institutions, as well as an increasing number of bank holding companies, that took control of failing institutions. With commercial paper and Treasury issues dwindling, these institutions looked to deposit accounts for support, and in light of the demand, they remained willing to offer investors higher yield rates—sometimes three or even five percent (as was the case for Washington Mutual before it was seized by regulators).

Adding to the positive yield environment was the fact that smaller financial institutions are looking to compete with larger corporations. With lenders like the now defunct GMAC (which financed the now reorganized automaker General Motors) and Morgan Stanley offering three percent, smaller banks looked to offer higher returns as well in order to stay competitive (Kiviat, 2008). Put simply, as havok may be wreaked upon corporate viability, the money markets that are used to finance commercial enterprises provide ongoing viability for investors, even if the yield is conservative and the gain only of a short-term nature.

The Downside of Money Markets. Of course, the fact that money market investment entails short-term deposits with conservative gains means that the investor is losing out on potentially large gains over a long period of time. Between 1925 and 1993, for example, the average return on a money market investment like T-bills averaged less than four percent. Investment in the S&P 500 market, meanwhile, saw a return average of nearly three times that figure, at 10.7 percent (Jones, 1995).

In a strong economy, money markets appear to yield less of a return on investment. Still, money markets have demonstrated a consistency in return, particularly in downward economic times. Then again, market tumult can even impact the money markets, as the recent 2008 implosion on Wall Street demonstrated.

On September 19, 2008, investment giant Lehman Brothers closed its doors, unable to cover its securities. Worried money market investors quickly and in great volume placed redemption orders, looking to recoup their investments before they experienced losses on them. The nation's largest money market fund, the Reserve Fund (which had invested in Lehman Brothers), was unable to purchase all of Lehman's holdings. To make this buyout happen, the Reserve Fund had to lower its share price below $1, which would inevitably cause losses to money market investors. As mentioned earlier in this paper, the Treasury stepped in to guarantee investments made before September, but those who invested after that guarantee was implemented were left to experience losses (Waggoner, 2009).

The case of Lehman Brothers underscores the point that the long-standing reputation of money markets as consistent moneymakers for the investor (albeit yielding small returns) is not impervious to the elements. In fact, money markets are subject to risk, especially when the firm or firms in which money market funds invest cannot cover their debts.

When the Lehman Brothers incident occurred, the high rate of redemption orders that were placed subsequently caused the Reserve Fund to lock, freezing out investors from their money for nearly six weeks. Between 400,000 and one million people were unable to access their funds, and a class action lawsuit was filed against the Reserve Fund to recoup the frozen funds. Investors expressed dismay at the company's actions, citing what they believed to be the Reserve Fund's time-honored reputation for stability and reliability (Henriques, 2008).

Senior Investors & Money Markets. The economic crisis that began in 2008 cast a shadow of doubt on the reliability of money markets during a recession. Still, a large percentage of investors continue to place their liquid assets in money market funds despite the risks involved in times of economic tumult. Among the most stalwart of investors in this arena have been those who live on limited incomes: Seniors.

A recent study of senior money market investors shows the risks and gains involved with such investments during an unstable market. About 37 percent of American retirees kept a sizable percentage of their liquid assets in money market funds. Despite such incidents as the Lehman Brothers collapse (and the Reserve Fund's decision to break the $1 tradition to offset the collapse), retired seniors' dedication to such liquid accounts was consistent despite losses. 65 percent of those who had half or less of their liquid assets invested in the money markets reported losses because of the economic downturn. Interestingly, 49 percent of those who had invested over half of their assets in the money markets experienced such losses. Additionally, while seniors tend to leave their assets invested in one type of fund regardless of the economic recession, the second-largest percentage of retirees (17 percent) who want to move their assets from one type of investment to another do so by moving them into money markets, where the returns are not stellar but consistent ("Despite financial crisis," 2009).

The issue surrounding those money market investors with limited incomes underscores an important point about the downside of such investment activity. In a money market, the interest rate is in general proportional to the amount of assets the investor deposits. Money markets therefore tend to give greater returns to those who can afford to invest more (Kennon, 2009). This fact is an important distinction from primary investments in CDs (although CDs are often one of the securities used in money markets), as CDs base interest on the maturity of the investment. The short-term nature of the money market investment, therefore, can bring greater returns to wealthy individuals and companies, while less affluent people and organizations see more modest returns.

In light of the positive and negative aspects of money markets and investments therein, it is a frequent question of investors to financial experts as to whether a money market fund is a wise choice. Then again, like any other market, an individual or corporate investment is a matter of preference. As shown here, money markets provide a safe investment as well as an invaluable mechanism for financial institutions and loan recipients to facilitate a stable transaction.

Conclusion

In the early twentieth century, attorney Horace Rackham was tempted to invest in the new business owned by his client, Henry Ford. The president of the Michigan Savings Bank advised him against it, suggesting that Ford's brainchild, the automobile, was a mere fad destined to disappear. Rackham ignored the advice and invested $5,000 in Ford stock. Later, he sold the stock—for $12.5 million ("Ford stock," 2009).

Investments are a matter of preference for the investor. As this paper has demonstrated, money markets represent a useful vehicle for a great many investors (as well as the companies who take part in the market to obtain loan assistance). Money markets will not provide a yield that is even close to the figure Horace Rackham saw with his mature Ford stock—the short-term nature of money market investments, coupled with a typically conservative return, prevent such potentials.

Then again, money markets have long been considered reliable and relatively stable when compared to stock markets. This fact is particularly interesting for investors during economic downturns. As this paper has shown, the recession that began in 2008 sent investors into the money markets in great numbers; seeking even a modest return, but most importantly, desiring the ability to remove their funds at the first sign of trouble.

Money markets have their benefits and risks, especially during fiscal crises. In a twenty-first century filled with a myriad of diverse international markets, money markets are likely to continue to attract investors at every income level.

Terms & Concepts

CD: Certificate of deposit—a bank-sponsored security.

First tier security: A security such as a Treasury bill or CD, which has the highest credit rating and is therefore more viable than other securities.

Institutional market fund: Money market fund that is owned by a corporation, government agency or other large organization and into which unused liquid assets are automatically deposited.

Money market fund: Akin to a mutual fund, provides investors with a broad range of securities in order to maximize returns and stability within a money market.

Retail market fund: Money market fund owned by an individual seeking to keep liquid assets secure and active in between investments.

Treasury bill: Government-sponsored security within a money market.

Yield: Periodic return on an individual investment after maturity and/or interest growth.

Bibliography

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Suggested Reading

Baldeaux, J., Ignatieva, K., & Platen, E. (2018). Detecting money market bubbles. Journal of Banking & Finance, 87, 369-379. doi:10.1016/j.jbankfin.2017.10.017. Retrieved March 18, 2018, from EBSCO online database Business Source Ultimate. http://search.ebscohost.com/login.aspx?direct=true&db=bsu&AN=127641002&site=ehost-live&scope=site

Low rates challenge money funds. (2009). Consumer Reports Money Adviser, 6, 10. Retrieved February 18, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36302945&site=ehost-live

Money-fund assets grow. (2009). Wall Street Journal—Eastern Edition, 253, C9. Retrieved February 18, 2009, from EBSCO online database Academic Search Complete. http://search.ebscohost.com/login.aspx?direct=true&db=a9h&AN=36415226&site=ehost-live

Nickerson, K. (2009, January 8). Yield work. Money Marketing, 18. Retrieved February 18, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36180652&site=ehost-live

Platt, G. (2009). Shortage of dollars supports greenback. Global Finance, 23, 57-58. Retrieved February 18, 2009, from EBSCO online database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=36406552&site=ehost-live

Waggoner, J. (2009, January 30). What's in store for money funds? USA Today, 4b.