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Effects of interest rates on money market mutual funds

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The prolonged low interest rate environment has pressured returns on money market mutual funds (MMMFs), and MMMF portfolios are earning the lowest returns on investments since the funds were established more than 30 years ago (see chart below).

In this environment, there has been some concern about MMMFs "breaking the buck," a situation in which the net asset value (NAV) of a MMMF falls below $1 per share. Breaking the buck can occur if some of the fund's investments experienced significant losses, or if the fund's investment income declined below operating expenses. A byproduct of the prolonged low rate environment could be increased risk taking by MMMF managers searching for higher yields. Higher risk investments tend to be more volatile and would decline in value more quickly in a scenario of sharp interest rate increases. Indeed, a scenario of rapidly increasing interest rates may be the more problematic scenario for MMMFs. There has only been one instance of a MMMF breaking the buck and liquidating; this was due to losses associated with high-risk structured note investments that were incurred when rates spiked up sharply in 1994. While this is the only MMMF that failed, there are several examples where sponsoring companies have sustained faltering MMMFs, primarily by buying or otherwise supporting troubled fund assets, sometimes expending hundreds of millions of dollars to do so. These companies viewed the perception of safety as an overarching factor as to why investors have placed, in aggregate, some $2 trillion in MMMFs. Therefore for them, the reputation risk of allowing a fund in their family to fail far outweighed the cost of support. Currently, banks and bank affiliates sponsor approximately 33 percent of all MMMF assets. Like other firms, banks and bank affiliates that sponsor MMMFs are experiencing low asset returns, diminished income from the need to reduce fees, and are subject to the general risks associated with operating a MMMF. Although banking organizations are not statutorily required to provide financial support to the funds they sponsor, they may decide to do so to minimize reputation risk that would arise in the event of liquidation or to limit liability. To alert banking organizations to potential risks and the legal framework for providing support to bank-advised funds, the FDIC and the other federal banking agencies released the "Interagency Policy on Banks/Thrifts Providing Financial Support to Funds Advised by the Banking Organization or its Affiliates" on Jan. 6. This policy statement indicates that bank management should consult with the appropriate federal agency before or immediately after (in the event of an emergency) providing support to funds; should have proper controls over such transactions; and should adopt policies governing support transactions. These policies should ensure that the bank will not:

? Inappropriately place its resources and reputation at risk for the benefit of the fund's investors and creditors. ? Violate the limits and requirements contained in Sections 23A and 23B of the Federal Reserve Act and Regulation W, other applicable legal requirements or any special supervisory condition imposed by the agencies. ? Create an expectation that the bank will prop up the advised funds.

In addition to sponsoring MMMFs, some banking organizations hold MMMFs as an investment, traditionally as a way to earn a better return on funds invested for the short term. Like other MMMF investors, banking organizations that hold these investments are experiencing diminished returns on them. Credit risk can also become a factor for banking organizations should they hold MMMFs as an investment. In fact, the only MMMF that broke the buck, the U.S. Government Money Market Fund, was marketed to community banks, which lost $2.5 million in the aggregate, before recovering some of the losses in a legal suit. This example indicates that while it is extremely rare, investors can lose money with MMMFs, and if banks choose to invest in MMMFs, management should perform proper due diligence and monitor the funds' performance on an ongoing basis.

Related Link: For the full FYI report: www.fdic.gov/bank/analytical/fyi/2004/051904fyi.html

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