Bruce Bent and the Money Market Mutual Fund
Panic of 2008
Bruce Bent, one of the originators of money market
mutual funds, almost brought down the industry dur-
ing the financial crisis in the fall of 2008. Mr. Bent
told his shareholders in a letter written in July 2008
that the fund was managed on a basis of “unwaver-
ing discipline focused on protecting your principal.”
He also wrote the Securities and Exchange
Commission in September 2007, “When I first cre-
ated the money market fund back in 1970, it was
designed with the tenets of safety and liquidity.” He
added that these principles had “fallen by the way-
side as portfolio managers chased the highest yield
and compromised the integrity of the money fund.”
Alas, Bent did not follow his own advice, and his
fund, the Reserve Primary Fund, bought risky assets so
that its yield was higher than the industry average.
When Lehman Brothers went into bankruptcy on
September 15, 2008, the Reserve Primary Fund, with
assets over $60 billion, was caught holding the bag
on $785 million of Lehman’s debt, which then had to
be marked down to zero. The resulting losses meant
that on September 16, Bent’s fund could no longer
afford to redeem its shares at the par value of $1, a
situation known as “breaking the buck.” Bent’s share-
holders began to pull their money out of the fund,
causing it to lose 90% of its assets.
The fear that this could happen to other money
market mutual funds led to a classic panic in which
shareholders began to withdraw their funds at an
alarming rate. The whole money market mutual fund
industry looked like it could come crashing down. To
prevent this, the Federal Reserve and the U.S.
Treasury rode to the rescue on September 19. The
Fed set up a facility, discussed in Chapter 8, to make
loans to purchase commercial paper from money
market mutual funds so they could meet the demands
for redemptions from their investors. The Treasury
then put in a temporary guarantee for all money mar-
ket mutual fund redemptions and the panic subsided.
Not surprisingly, given the extension of a govern-
ment safety net to the money market mutual fund
industry, there are calls to regulate this industry more
heavily. The money market mutual fund industry will
never be the same.
468
Part 6 The Financial Institutions Industry
One problem for investors in long-term coupon bonds, even when investors have
a long holding period, is that there is some uncertainty in their returns arising from
what is called reinvestment risk. Even if an investor holding a long-term coupon
bond has a holding period of 10 years, the return on the bond is not certain. The prob-
lem is that coupon payments are made before the bond matures in 10 years, and these
coupon payments must be reinvested. Because the interest rates at which the coupon
payments will be reinvested fluctuate, the eventual return on the bond fluctuates
as well. In contrast, long-term zero-coupon bonds have no reinvestment risk because
they make no cash payments before the bond matures. The return on a zero-coupon
bond if it is held to maturity is known at the time of purchase. The absence of rein-
vestment risk is an attractive feature of zero-coupon bonds, and as a result, investors
are willing to accept a slightly lower interest rate on them than on coupon bonds,
which do bear some reinvestment risk.
The fact that zero-coupon bonds have lower interest rates, along with the abil-
ity to use computers to create so-called hybrid securities, which are securities derived
from other underlying securities, gave employees of Salomon Brothers and Merrill
Lynch a brilliant idea for making profits. They could use computers to separate
(“strip”) a long-term Treasury coupon bond into a set of zero-coupon bonds. For
example, a $1 million 10-year Treasury bond might be stripped into ten $100,000
zero-coupon bonds, which, naturally enough, are called Treasury strips. The lower
interest rates on the more desirable Treasury strip zero-coupon bonds would mean
that the value of these bonds would exceed the price of the underlying long-term
Treasury bond, allowing Salomon Brothers and Merrill Lynch to make a profit by pur-
chasing the long-term Treasury bond, separating it into Treasury strips, and selling
them off as zero-coupon bonds.
To see in more detail how their thinking worked, let’s look more closely at a
$1 million 10-year Treasury bond with a coupon rate of 10% whose yield to maturity
is also 10%, so it is selling at par. The cash payments for this bond are listed in the
second column of Table 19.1. To make things simple, let’s assume that the yield curve
is absolutely flat so that the interest rate used to discount all the future cash pay-
ments is the same. Because zero-coupon bonds, which have no reinvestment risk,
are more desirable than the 10-year Treasury coupon bond, the interest rate on
the zero-coupon bonds is 9.75%, a little lower than the 10% interest rate on the
coupon bond.
How would Fran, a smart and sophisticated financial institution manager, fig-
ure out if she could make a profit from creating and selling the Treasury strips? Her
first step is to figure out what the zero-coupon Treasury strips would sell for. She
would find this easy to do if she had read Chapter 3 of this book: Using Equation 1
in that chapter, she would figure out that each of the Treasury strip zero-coupon
bonds would sell for its present discounted value:
The results of this calculation for each year are listed in column (4) of Table 19.1.
When Fran adds up the values of the collection of the Treasury strip zero-coupon
bonds, she gets a figure of $1,015,528, which is greater than the $1 million purchase
price of the Treasury bond. As long as it costs less than $15,528 to collect the pay-
ments from the Treasury and then pass them through to the owners of the zero-
coupon strips, which is likely to be the case since computer technology makes the
Cash payment in year n
11 ⫹ 0.097522
n
Chapter 19 Banking Industry: Structure and Competition
469
TA B L E 1 9 . 1
Market Value of Treasury Strip Zero-Coupon Bonds Derived from a
$1 Million 10-Year Treasury Bond with a 10% Coupon Rate and Selling at Par
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