Seeking True Value in Money Market Funds
We should stop pretending that a dollar invested in a money market fund will always be worth a dollar. Let prices float as they do with other mutual funds.
The mutual fund industry shouldn't be able to assure savers that a buck is a buck and then ignore its pledge in times of panic. If federal regulators get their way, that kind of behavior by sponsors of money market mutual funds will be a thing of the past.
On August 29, the Securities and Exchange Commission is expected to vote on a new regulatory regime for money market funds. The most important of the proposals orchestrated by SEC chairman Mary Schapiro would do away with money funds' fixed $1 share price and instead require sponsors to report the actual value of a fund's holdings, which could well be something less than $1 per share. In such situations, money fund investors seeking to redeem their shares would know in advance that they might not get the full $1-per-share price.
Schapiro has been pushing for changes to prevent a repeat of the near-catastrophe that occurred during the 2008 financial crisis, when Reserve Primary Fund "broke the buck," the euphemism for the value of a money market fund's holdings falling below $0.995 per share. (The stable $1.00 share price holds as long as the value of a money fund's underlying assets doesn't deviate by more than 0.5 cent per share.) The incident prompted a run on the fund by its shareholders and precipitated a government-engineered rescue, not just for Reserve but for the entire money fund industry. Schapiro has the backing of other regulators, including Federal Reserve Board governor Daniel Tarullo and Federal Reserve Bank of Boston president Eric Rosengren. The mutual fund industry is fiercely opposed, however, and several SEC commissioners aren't convinced, either. The outcome is uncertain.
Too bad. Taxpayers may be called on to bail out the money fund industry during the next global capital market implosion. No one knows when catastrophe will strike, but regulators and finance executives haven't inoculated us from the risk of another financial collapse. (If you doubt that judgment, read the chilling tale This Time Is Different: Eight Centuries of Financial Folly, by economists Carmen Reinhart and Kenneth Rogoff.)
The key reform proposed by Schapiro is to have the net asset value of money market mutual funds fluctuate with the market, rather than pretending that a dollar invested in a money market fund will always be worth a dollar. The change would provide a more accurate gauge of what's happening with the underlying securities. Net asset value fluctuates with all other mutual funds.
The move would sever the false sense of security that comes with a stable $1 value. Other proposed ideas include requiring money funds to hold a larger capital buffer against turmoil and for them to keep 3% to 5% of an investor's assets for 30 days before an investor could withdraw all of his money from the fund.
The modern money market mutual fund business for individual investors dates back to the 1970s and early '80s. Baby-boomers can still remember how these funds were a stellar innovation during an era of hyperinflation and double-digit interest rates
At the time, a government limit on interest rates, Regulation Q, prevented banks from offering savers anything more than 5.25%. Yet with inflation running at double-digit levels, the yield on short-term, fixed-income securities soared far above that rate. For example, the yield on three-month U.S. Treasury bills climbed to a monthly average peak of 16.3% in May 1981. Who wants to get 5.25% in a 16.3% world?
The limit on interest-rate savings was phased out in the '80s. But money market funds were still seen as "turbocharged savings accounts," says business journalist Joseph Nocera in his book A Piece of the Action: How the Middle Class Joined the Money Class. "By then, the question was no longer whether you dared risk your savings in a money market fund. The question had become: How could you not risk your money in such a fund."
Even as inflation subsided and interest rates retreated, money market funds retained their appeal. You earned a market rate of interest on your money, minus a small fee. You could write several checks a month on the account. Most important, the industry pledged that a dollar invested in a money fund would be worth a dollar no matter what. Marshall Loeb, the personal finance pioneer and founding editor of Money Magazine, reviewed the main options for safe savings in his 2001 book 52 Weeks to Financial Fitness: a bank savings account, bank money market account and a money market mutual fund. "Keep your emergency cache in a money market mutual fund," he concluded.
The money-fund world changed seven years later, however, on September 16, 2008. That's when Reserve Primary Fund, a $62 billion money market fund, broke below a buck. Primary Fund also indefinitely suspended redemptions of its shares for cash.
The reason: It had invested in the short-term debts of Lehman Brothers, and the investment bank had declared bankruptcy on September 15th. "Our clients assumed their money market fund investments [Primary Reserve Fund] could be converted into cash by the next day," recalls John Taft, chief executive of RBC Wealth Management, in Stewardship: Lessons Learned from the Lost Culture of Wall Street. "This meant, in many cases, that they had no way to settle pending securities purchases and therefore no way to trade their portfolios at a time of historic market volatility. No way to make minimum required distributions from retirement plans. No way to pay property taxes. No way to pay college tuition."
Worse yet, other funds were at risk of breaking the buck as investors started cashing in their shares. More than 100 funds were bailed out by their parent companies during September 2008. The fund flight gathered momentum until the U.S. Treasury temporarily guaranteed the $1.00 share price of money market fund shares on September 29. The Federal Reserve actively supported the short-term markets, too.
The lesson in all this: You can't trust the industry's "we won't break a buck" pledge anymore. Even more haunting, will a nation soured on finance bailouts shore up the industry during the next bust?
To be sure, calls for more regulation should always be treated warily because they often turn out to be an overreaction to a particular trauma. Yet when it comes to emergency savings -- the $1 that needs to be worth $1 -- nothing beats the explicit backing of the U.S. government. The buck-is-a-buck guarantee applies to U.S. Treasury bills and bank accounts backed by the FDIC and its credit union equivalent. It doesn't apply to money market funds. The clearer that is, the better investors will sleep at night.
Contributing Columnist Chris Farrell is economics editor for American Public Media's weekly "Marketplace Money" show and author of "The New Frugality."
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