Dollar squeeze gave money funds a lesson in prudence
It started with bad decision, hot money, and interest rates that went up when they should have gone down. It caused a major bank to plug a financial hole with stacks of good green dollar bills.
In between, a lot of men in three-piece suits became very nervous over what now appears to have been an isolated crack in the generally solid wall of money market funds.
Earlier this year, Institutional Liquid Assets (ILA), a $3 billion money fund managed by First National Bank of Chicago, invested its $1 billion government securities portfolio in securities it believed to be a bargain. The fund's advisers felt interest rates were unnaturally high, and fund managers were hurrying to slap their money down before the rates fell to a more normal level.
Unfortunately, interest rates did not cooperate. They kept going up, and ILA was stuck with relatively low-return securities -- as if it had invested in steam engines and found airplanes were the coming thing.
In the uneasy world of high finance, this would not normally constitute a nail-bitting problem. But two unusual factors combined to put ILA behind a very expensive eight ball:
1. The managers had locked up their money and thrown away the key. Normally, a fund caught in ILA's situation would wait a few weeks for the government securities to mature, chalk one up to experience, and plow the cash back into better investments. But ILA had bought long by investing in securities with average maturities of 76 days, nearly twice the market average. All it could do was sit and sweat while peeling the days off the calendars.
2. The fund had very picky investors. ILA is an institutional money market fund, closed to individuals and dealing only with institutions that have large sums of money to invest. In industry parlance, institutions are "hot" money. They deal in lump sums, and if they don't like what's going on they take out their money and go somewhere else, quickly. ILA's investors didn't like what was going on, and they didn't wait around for the fund to get back on its feet. By September, average net daily withdrawals were $15.9 million.
To satisfy the claims of retreating investors, the fund found it had to sell securities at a loss, before maturity. With assets walking out the door, ILA's market value dropped below 99.5 cents for a $1 share. To prop up the share price, First National of Chicago returned $1 million in past fees, and Salomon Brothers, a Wall Street brokerage firm that administers the fund, bought up around $200 million of the fund's securities at $700,000 above market value.
"The problem's all behind us now," said Fred Kelsey, who is both vice-president of Salomon Brothers and presindet of Institu tional Liquid Assets. "We now have a high degree of liquidity."
The crack was repaired with cash. But its very appearance made the rest of the money market fund industry nervous.
"We hope it was an isolated incident," said Tom Drumm, portfolio manager at American Liquid Trust.
"It's a possibility for any of the institutional funds," said Emery Erickson, portfolio manager for IDS Cash Management Fund. "But it took two or three things to fit together. I think it was more of an isolated case."
In most money market mutual funds, individuals constitute the majority of shareholders. They are generally more patient than institutions and do not shift their money out of a fund to chase an extra 1 or 2 percent in interest that might be available briefly elsewhere.
An informal phone survey undertaken by the Securities and Exchange Commission came to the same conclusion.
William Donoghue, publisher of Money Fund Report, doesn't think the problem will recur. But he also thinks ILA should never have sold long in the first place. "[Money market managers] are paid to be prudent men, not smart ones," he says.
"There's no point in taking risks in money market funds," he added. "There are bigger games than that."
Besides the ILA financial tangle, at least one major fund has been beset by backroom problems.
Reserve Fund last winter was using the three-day Washington's Birthday weekend to fiddle with its computer's data base. Two hours from finishing the project, the computer crashed -- resulting in a day's delay in processing redemptions.
Reserve's prospectus states: "While the fund legally has 7 days to transmit payment for shares redeemed, it endeavors to transmit payment the same day. . . . This is not always possible, however, and transmission of redemption proceeds may be delayed." Reserve's management felt this was sufficient warning to investors that their cash returns might be delayed.
The Securities and Exchange Commission did not. The commission felt the foul-up was evidence of continuing clerical problems, and it censured Reserve to rebate 20 days management fees.
Most money market funds use service organizations or banks to handle their paper and computerwork.
Some of the half-dozen major funds that staff their own back rooms occasionally found it hard to track the flood of money that came their way as money markets boomed over the last year.
"A lot of people have had back-room problems," said William Donoghue. "Last fall and spring were a learning time."
With the high growth period over, most industry observers feel piles of clerical work are no longer a problem.
And they feel both ILA's liquidity crunch and Reserve's computer failure will be an educational experience for the rest of the industry.
"Any time anything happens, everybody else goes back and takes a hard look at their own operations," said Mr. Donoghue.