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Monday, June 11, 2007

The Important of Money Market Funds

Money market funds first became important in 1974 when short-term interest rate rose to record levels, and has an explosive growth in 1979-1982 when rates again rose sharply. The funds, organized by brokerage firms and firms managing mutual funds for stocks and bonds, invest in treasury bills, commercial paper, and bank CDs (Certificates of Deposit). They arrange with banks to honor checks drawn by fund shareholders on the funds account. When the bank presents the check the fund liquidates assets and, of course, reduces the number of shares credited to the person drawing the check.

Money market funds is far easier to acquire than large denomination banks CDs, commercial paper or even treasury bills, they provided an easy way for households to take advantage of high market rates. Thus they intensified the effect of variations in short-term market interest rates. When interest rate rose in 1978-1979 the public responded with enthusiasm, placing about US$ 30 billion per year in money market funds in 1979 and 1980. By 1981 the word of high yield safe liquid assets that were available had spread to relatively unsophisticated investors who placed over US$ 100 million in money market funds in 1981. They absorbed one-third of the total increase in liquid assets; deposits at thrift institutions actually fell.

The shift of funds had a severe impact on home construction and was a major factor in the recession. It also left a permanent mark on the financial markets. The growth of the money market funds hastened the trend toward payment of market interest rates on all kinds of deposits.

Money Market Certificates (MMC). In 1978 banks and thrift institutions were authorized to offer money market certificates (MMCs). The six month certificates carry interest rates linked to the Treasury bill rate. In one way they were remarkably successful. They attracted a huge volume of funds, for about US$ 200 billion by the end of 1982. Most of those funds were shifted from existing deposits but the offer of money market certificates may have reduced the loss of funds to thrift institutions. In 1982 banks and thrift institutions were authorized to offer a three month certificate at a rate linked to the bill rate.

While the MMCs may have helped to limit the outflow of funds from thrift institutions, they proved to be very costly. Most of the funds attracted to MMCs were switched from other accounts at lower interest rates. Thus the offer of MMCs led to a sharp rise in interest expense for the thrifts. The overall rise in interest costs led to operating losses (expenses in excess of current revenues). A number of institutions were forced to merge with stronger ones as operating losses depleted their capital.

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1 comment:

Lesley said...

High risk, high gain. It is true that MMC can offer better yield than any bank CDs!

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