Should money funds be allowed to continue to price their shares by “buck” accounting, whereby the price of each share is fixed at one dollar? Or should they be compelled to price them by “mark-to-market” accounting, common to all other mutual funds, whereby changes in the market value of shares move their prices higher or lower than a dollar?
Today’s money fund agenda centers on mitigating systemic risks associated with money funds. These risks compelled the U.S. Treasury to offer a taxpayer guarantee on all money funds in September 2008, when the Reserve Primary money fund was forced to “break the buck,” setting the price of shares below a dollar.
A proposal to price money fund shares by mark-to-market accounting has been met with fierce opposition. Paul Schott Stevens of the Investment Company Institute wrote that “investors prize the stability, simplicity, and convenience” of money funds. David Hirschmann of the U.S. Chamber of Commerce wrote that investors would flee from money funds burdened by “the complexity and cost of accounting” of mark-to-market funds. And Kenneth White, a Chicago investor, threatened to liquidate his money funds if their prices were set by mark-to-market accounting.
We cannot understand the passions underlying the money fund debate unless we understand the psychology that underlies the attraction of buck accounting. That psychology centers on our cognitive errors of mental accounting and hindsight, and our emotions of regret and pride. An understanding of the attraction of buck accounting would help us overcome it.
Money funds were introduced in the early 1970s to circumvent regulations that limited the rate of interest banks could pay. They soon turned into substitutes for bank checking accounts. Money fund investors received checkbooks similar to bank checkbooks and could write checks for use everywhere. But money funds were not a close enough substitute for checking accounts because they lacked the “no-loss” psychological benefit.
Investors who deposited a dollar in a checking account were assured that they would be able to withdraw a dollar the following day, week, or year. But money fund investors had no such assurance. A dollar invested in a money fund one day might be worth 98 cents the following day. Investors who contemplated buying a television set for $500 would have had to withdraw 510 shares of the money fund if its share price declined from $1 on the day of the purchase to 98 cents when their check was cashed. The extra ten shares registered as a loss in the minds of money fund investors.
Investing, whether in a stock or a money fund, marks a hopeful beginning. We place a stock into a mental account, record its $100 purchase price and hope to close the account at a gain, perhaps selling the stock at $150. As stock fate has it, the stock’s price plummets to $40 during the following month rather than increase to $150.
Losses make us feel stupid. Hindsight error misleads us into thinking that what is clear in hindsight was equally clear in foresight. We bought the stock at $100 because, in foresight, it seemed destined to go to $150. But now, in hindsight, we remember all the warning signs displayed in plain sight on the day we bought our stock. Interest rates were about to increase. The CEO was about to resign. A competitor was ready to introduce a better product.
The cognitive error of hindsight is accompanied by the emotion of regret. We kick ourselves for being so stupid and contemplate how much happier we would have been if only we had kept our $100 in our savings account or invested it in another stock that zoomed as our stock plummeted. Pride is at the opposite end of the emotional spectrum from regret. Pride accompanies gains. We congratulate ourselves and feel proud for seeing in foresight that our $100 stock would soon zoom to $150. Mark-to-market accounting of money funds opens the door to both regret and pride every time we write a check, but regret is more painful than pride is pleasurable. It is no wonder that money fund investors prefer buck accounting over mark-to-market accounting, and money fund executives hear their voices.
In 1977, following much lobbying by mutual fund companies, the SEC approved the use of buck accounting such that the price of their shares remains at $1 even when the market value of the shares deviates from it. Managers of money funds promised not to “break the buck” and, at last, money funds seemed to have acquired the no-loss benefits of checking accounts.
The promise of managers of money funds not to break the buck was sincere but not guaranteed. The small print always said that the buck might be broken. Still, managers of money funds kept their promise for many years, on occasion paying from their own pockets so as not to break the buck. But when the financial crisis arrived in 2008 the managers of the Reserve fund announced that their fund contained securities of bankrupt Lehman Brothers and they must break the buck and set its shares to 97 cents. The development “is really, really bad,” said Don Phillips of Morningstar. “You talk about Lehman and Merrill having been stellar institutions, but breaking the buck is sacred territory.” This breaking of the buck was prominent among the events that led Henry Paulson and Ben Bernanke to recommend drastic measures, including government insurance of money funds, fearing the panic that would ensue if money fund investors raced to withdraw their money.
The demise of Reserve fund is ironic because Bruce Bent, one of its founders, opposed buck accounting when it was considered in the 1970s. Bent feared that buck accounting would compel money fund managers to buy risky securities in attempts to provide higher returns than their competitors. In a 1978 letter to the SEC Bent wrote that buck accounting “presents the illusion of higher returns in times of declining interest rates” and makes money funds “appear to have overcome the risk” of fluctuating interest rates. Bent noted further that buck accounting would encourage money funds to buy risky securities that “pay higher interest rates than those which must achieve stability by exercising judgment…” Bent vowed not to buy such risky securities, but he broke his vow under the pressure of competition. This is why the Reserve fund held Lehman securities when Lehman went bankrupt. What started as an attempt to turn money funds into no-loss investments ended with very real losses.
Jeffrey Lacker, President of the Federal Reserve Bank of Richmond, advocated mark-to-market accounting for money funds, noting that buck accounting promotes runs on money funds. I agree. Regret over losses is likely to seize money fund investors from time to time, but such regret is a small price to pay for a central block of a stable financial system.