Question

“After Lehman Brothers’ bankruptcy, money market funds had a flight-to- quality.” Explain this quote.

Answer 1

THIS QUOTE MEANS THAT AFTER THE LEHMAN BROTHERS BANKRUPTCY MONEY MARKETS FUND WERE EXPREINCING INCREASED REGULATION SO THAT MONEY MARKET COULD BE BOUGHT BACK ON TRACK.

Anatomy of a Meltdown

The Reserve, a New York-based fund manager specializing in money markets, held $64.8 billion in assets in the Reserve Primary Fund. The fund had a $785 million allocation to short-term loans issued by Lehman Brothers. These loans, known as commercial paper, became worthless when Lehman filed for bankruptcy, causing the NAV of the Reserve Fund to fall below $1.

Although the Lehman paper represented only a small portion of the Reserve Fund's assets (less than 1.5%), investors were concerned about the value of the fund's other holdings. Fearing for the value of their investments, worried investors pulled their money out of the fund, which saw its asset decline by nearly two-thirds in about 24 hours. Unable to meet redemption requests, the Reserve Fund froze redemptions for up to seven days. When even that wasn't enough, the fund was forced to suspend operations and commence liquidation.

Aftermath

The Reserve Fund's collapse was bad news for money market fund providers on a variety of fronts. First and foremost was the danger of collapse, as the Reserve Fund wasn't the only money market fund holding commercial paper. More than a dozen fund companies were forced to step in to provide financial support to their money market funds to avoid breaking the buck.

Even funds that were unaffected by bad commercial paper (remember, Lehman and AIG were the tip of the iceberg) faced the possibility of mass redemption requests from investors who didn't have a thorough enough understanding of their portfolios.

Fearing just such a run on money market funds, the federal government stepped in, issuing what amounted to taxpayer-funded insurance. Under the Temporary Guarantee Program for money market funds, the U.S. Treasury guaranteed investors that the value of each money market fund share held as of the close of business on Sept. 19, 2008, would remain at $1 per share.

Investors in the Reserve Fund were ineligible for the government-sponsored program. The Fund began liquidation with a series of payments, but a year later many shareholders were still waiting for a portion of their remaining assets to be returned. Those assets were further reduced in value when the fund's management team invoked a clause that enabled them to hold assets in order to pay expected legal and accounting fees related to claims resulting from the meltdown.

Why It Mattered?

The Reserve Fund had a storied history, having been developed by Bruce Bent, a man often referred to as the "father of the money-fund industry." The failure of this fund was a major blow to the financial services industry and a huge shock to investors.

For three decades, money market funds had been sold to the public under the premise that they were safe, liquid places to park money. Nearly every 401(k) plan in the nation sells money market funds to investors under the premise that they are categorized as cash.

In the wake of the Reserve Fund's calamity, investors began to doubt the safety of money market funds. If "cash" is no longer safe, the question becomes: "where can investors put their money?" With the stock and bond markets both in decline and money market funds failing to hold their value, stuffing money into a mattress suddenly became an attractive and relevant choice for conservative investors.

The government bailout, while necessary to maintain faith in the financial system, opened up another set of questions about the appropriateness of government support. It also encouraged lawmakers to raise the question of financial regulation and oversight and revisit the rules surrounding money market funds and the investments they hold. The link between greed and capitalism was also put in the spotlight, as the vision of Wall Street being supported by Main Street in yet another failed investment scheme painted a less-than-pleasant picture.

CONCLUSION

The Reserve Fund debacle serves as a stark reminder to investors about the value of understanding the investments in your portfolio. It also highlights the importance of considering both the pros and cons of potential investments.