Cash Money Net Worth Utility

Kennon-Green & Co. Fiduciary Financial Advisor, Wealth Management, Global Value Investing

On an earlier post about the new Disney MyMagic+ program, which discussed capital budgeting from the investor’s perspective, there was a question left in the comments by Donald Pato about money market funds and money market accounts.  I couldn’t fit my response in the comments box, so I am writing it as a stand-alone post as I think some of the rest of you might at least find it interesting.  Keep in mind, this is not advice, just my personal perspective on the matter.  Take it for what you will and, as always, seek qualified counsel for your own, specific situation, such as a good tax attorney or registered investment advisor.

The question Donald asked was:

Joshua, I read the link to your “Capital Preservation” article, is there a reason that you did not address money market funds? Aren’t many money market funds just managed portfolios, which combine the instruments you suggest? I recently peppered my Vanguard representative with questions about their money market sweep account (VMMXX) and about the risk of “breaking the buck” in a severe liquidity crisis, he of course tried his best to assuage any concern. Would you please weigh in on this?

First, we need to talk about the difference between money market deposit accounts and money market mutual funds.  They are not the same, though too many people seem to think they are, using the phrase, “money market funds” interchangeably for both investments (it’s so common, I actually decided to use that term on the blog hierarchy when assigning this post to a category because that is what people search for when they are researching the topic!).  Here is a short breakdown of each.

Money Market Deposit Accounts

These are FDIC insured (currently up to $250,000) deposit accounts held at FDIC member banks in the United States.  The purpose of a money market deposit account is to help banks attract higher net worth customers and compete with money market funds (see below) offered by brokerage firms, mutual fund management companies, and other financial institutions tied to Wall Street.  As a result, a money market deposit account often requires a higher minimum and maintenance balance, limits the withdrawals you can make in a given period (e.g., up to 6 free withdrawals in a 6 month period), and, in exchange, pays a much higher rate of interest than is available on checking and savings accounts.  From a government regulation standpoint, these money market accounts are considered a type of savings account.  

Money Market Mutual Funds

These are are a special type of plain-vanilla mutual fund that focus on buying highly liquid, high grade sovereign debt and other paper of short-term duration.  The very first money market mutual fund was created in 1971 and was called The Reserve Fund.  It was designed to get around something known as Regulation Q, which at the time, prohibited banks from paying interest on demand deposit accounts (checking, savings; anything where you can go in and liquidate your cash with no prior notice, or “on demand”).  These new securities quickly became a huge business for Wall Street.  Brokerage firms, mutual fund advisors, and other financial institutions began setting up their own money market funds so they could charge a small administration fee on the underlying holdings, grabbing market share from banks.

These funds are not FDIC insured.  Though they are regular mutual funds, they are managed with a mandate to keep the share price at exactly $1.00 at all times so investors think of them like deposit accounts (which, of course, they aren’t).

[mainbodyad]When this objective fails, it is a fairly catastrophic event known as “breaking the buck”.  Up until the Great Recession a few years ago, there had only been a single consumer money market fund that had ever broken the buck, many decades ago.  There was a small institutional failure in the 1990’s that shaved a few pennies off principal, leaving institutional investors with only 96% of their expected net asset value.  Then, in 2008, several money market funds began to break the buck or were expected to break the buck.  

Few, if any, investors lost money from their money market funds because the parent companies of the funds in trouble decided to cash out investors at $1.00 per share to maintain their reputation, and the United States Government decided to step in and establish a temporary program to make sure investors received full value for those funds that didn’t as an attempt to stabilize the market during the collapse and avoid a run on money market shares, which would have exasperated the problem.  In any event, many money market funds have a provision buried in the prospectus that allow them to distribute securities and assets “in kind”.  That means if a run on the fund ever did happen and cause the quoted market value to fall far below the actual underlying assets of the fund itself in some sort of 600-year event, the managers could distribute the underlying property pro-rata; you’d get your share of the Treasury bills, cash balances, commercial paper, or whatever else your particular money market fund happened to own.  It’s a sort of nuclear switch provision that, to my knowledge, has rarely been used and most people don’t even notice when reading the disclosures (it’s buried in almost all mutual fund prospectuses, though some funds don’t have the right as, in 1971, the SEC adopted Rule 18f-1, which allows an investment company to waive their ability to make in-kind distributions to satisfy redemption requests).

Comparing Money Market Deposit Accounts and Money Market Mutual Funds

Based upon historical performance, both money market deposit accounts and money market mutual funds have been very safe.  If the former fails, the FDIC steps in and makes you whole up to the insurance limits.  If the latter fails, a rare event that can be counted on one hand in the past half century, investors have almost always been made whole, even though they don’t have a right to expect such treatment.  A historical example: In the 2008-2009 crash the United States Treasury announced the Treasury Guarantee Program that covered money market fund shareholders for up to $250,000 held in participating taxable and tax-exempt money market mutual funds as of the close of the business day on September 19th, 2008.  The original program was going to expire on December 18th, 2008, but as the panic continued, the Treasury extended the deadline to April 30, 2009.

To quote one of the world’s greatest financial minds, I never want my family to have to depend on the kindness of strangers for our checks to clear.  That is not a position I would consider acceptable nor enviable.  The idea of clutching the daily paper, hoping that the Treasury is going to cover my assets … nope.  Not a game I want to play.

That said, the only time I would be concerned about the difference would be a 600-year event (read: The Great Depression).  Yet, we don’t know when those events will happen.  There isn’t some huge warning sign beforehand, in many cases, saying, “The entire world is about to fall apart”.  There’s a bit of wisdom in the insurance industry: Nobody in downtown Oklahoma City saw anything different about April 19th, 1995 when they were getting their cup of coffee and reading the paper.  Nobody thought the stock market would be closed for an extended period of time when they went to bed on the evening of September 10th, 2001.

Money market funds weren’t around back during the last true Depression, so we don’t know how they would perform under such conditions.  We do know that bank depositors would be protected under current law.  If we are in an environment where shares of some very good companies are decimated by 50% to 95%, people are losing their homes, unemployment is at 25%, and there are bread lines, which has happened before – this is not some unthinkable scenario – a money market mutual fund would cause me to lose sleep, whereas a money market deposit account would not.  

Most people don’t care about these things.  The odds of a loss from a regular money market fund are extraordinarily low – if past experience can be trusted, it is more likely that you will die by hippo attack than lose cash to a money market fund.  Still, my personality is one that always runs simulations under stressed conditions and I, myself, want to know that come hell or highwater, I’ve maximized my potential defenses against all possible financial scenarios.  Is it paranoid?  Perhaps.  I think anyone who is a student of history and enjoys reading biographies tends to pick up a touch of caution that they otherwise wouldn’t have had.

For me and my household, given the choice on where to park a large amount of surplus cash that was intended to remain liquid for some time, I would always opt for either Treasury Direct or a money market deposit account.  I don’t like what I consider an unnecessary introduction of market risk.  I get nothing for it.  Why take it onto my estate’s books?

There Is an Opportunity Cost Consideration Under Present Market Conditions

In a normal interest rate environment, some financial institutions will offer sweep deposit account to a special type of tax-advantaged money market fund, focusing on state-specific issues.  For someone in the top tax bracket, when the taxable equivalent yield of these favored investments is much higher than regular interest yields, it can be compelling.  You often see this at the big brokerage firms or private banks – things like “New Jersey Tax-Free Money Market Fund”, which is designed so that the interest income should be taxed at 0% for residents of New Jersey.  These have all but disappeared from the marketing literature now that rates are effectively 0% but they will return someday and present a different question as you are now being compensated for taking on the market risk at a rate in excess of the probability of that risk leading to losses.

Second, there is a question of returns on money market deposit accounts versus money market mutual funds.  As of this afternoon, the money market fund you mentioned from Vanguard, the Vanguard Prime Money Market Fund [ticker VMMXX] is yielding 0.01% after expenses.  

Why would I accept that when a money market deposit account, with FDIC protection, is paying 0.90% at GE Capital Bank?  American Express Bank is paying 0.85%.  Ally Bank is paying 0.84%.  Discover Bank is paying 0.80%.  Mutual of Omaha Bank is paying 0.85%.  The Palladian Private Bank is paying 1.00%.  FNBO Direct is paying 0.85%.  There are several others offering comparable terms.  

In other words, imagine you had $100,000 in cash that you wanted to put into a money market:

  • $100,000 deposited into Vanguard Prime Money Market Fund = 0.01% interest, or $10 per year, with no FDIC insurance
  • $100,000 deposited with GE Capital Bank = 0.90% interest, or $900 per year, with FDIC insurance

The second option, at present, offers an extra $890 per year plus FDIC insurance.  That is 89 times the annual income with the explicit backing of the government.  This is not a difficult decision to me.  Even though I love Vanguard – I’m crazy about the place and it’s rock-bottom fees – this is one of those situations in which I find myself returning to Benjamin Graham’s refrain: “At what price, and on what terms?”.  The price is better at the FDIC bank.  The terms are better at the FDIC bank.  I’d go for the FDIC bank.  In fact, when given the choice at the various brokers my family members select, I almost always have them opt into the FDIC-insured bank sweep options instead of the cash money market fund.  Were we back in a 5% to 6% rate environment, this may be different.  At present, I don’t think there is any other rational way to behave.

If you were wanting to keep the funds on hand for “dry powder”, with the expectation that you could tap it any moment to buy stocks or bonds were there a collapse in market price, there would be a few options.  

First, one could reasonably opt for the money market mutual fund, accepting the seemingly minuscule risk as a cost of convenience.  This is especially appealing when talking about Vanguard, which is one of the best run, safest, most soundly capitalized financial institutions in the world.  It has no external shareholders, as it is member-owned, meaning the members’ interest is put above all else.

Second, one could instruct the broker to settle any trades against an FDIC insured money market account held at the third-party bank, getting the best of both worlds.  There shouldn’t be any fee for this, but I’d double check given that some institution seem far more fee happy than others; you buy the shares, and instead of sweeping it from a cash balance in your brokerage account, the broker electronically grabs it for settlement from the bank.  As long as you remained under whatever maximum withdrawal-per-period limit the bank had set, this would be the ideal solution.  Back during the brokerage failures of the 1970’s, this was a common tactic as you could avoid holding any cash with a broker, at all; they were just there to execute your trades.