How to Make Money Market Funds Safer

The immediate aftermath of the Lehman Brothers’ declaration of bankruptcy in September of 2008, can only be described as tumultuous for people who held money market fund accounts. This relatively safe investment, in an industry of about $2.65 trillion, was suddenly not so safe and investors were making a run on funds that reminded many old-timers of the dark days of the Great Depression of the 1930’s.

This panic related to this economic meltdown stretched from Wall Street to Main Street and the regulators, the U.S. Congress and the President began performing financial CPR. Laws such as the Dodd-Frank Act were passed and new regulations from the Securities and Exchange Commission (SEC), including the formation of the Financial Stability Oversight Committee, were proposed to keep this financial chaos from happening again. However, three years later in July 2011, this situation was still unclear and many feel that money market funds may be permanently tarnished.

Money Market Accounts Versus Money Market Funds

Though they seem to be similar, money market accounts, which are typically offered by a bank or credit union, are different from money market funds which are usually available from brokerage houses. According to Wikipedia, “a money market account invests in government and corporate securities and pays the depositor interest based on current interest rates in the money markets.”

Since these money market accounts are offered by a bank or credit union, they are insured by the Federal Deposit Insurance Corporation. Money market accounts differ from certificates of deposit, also offered by banks and credit unions, in that they allow access to the funds with a limited number of checks or ATM withdrawals.

Another type of money market investment is a money market fund. The SEC’s website defines money market funds as “a type of mutual fund that is required by law to invest in low-risk securities. These funds have relatively low risks compared to other mutual funds and pay dividends that generally reflect short-term interest rates. Unlike a ‘money market deposit account’ at a bank, money market funds are not federally insured.”

The SEC notes that money market funds typically invest in government securities, certificates of deposit, commercial paper of companies, or other highly liquid and low-risk securities. “They attempt to keep their net asset value (NAV) at a constant $1.00 per share – only the yield goes up and down. But a money market’s per share NAV may fall below $1.00 if the investments perform poorly.”

The Shadow Banking System’s Role in the Big Crash

According to Bloomberg News, after the Lehman Brothers collapse, “Money market funds were among several financial intermediaries, collectively known as the shadow banking system that attracted intense government scrutiny during and after the financial crisis. The group, which included investment banks, hedge funds and insurance companies, matched lenders and borrowers outside the regulatory framework that governs traditional deposit-taking banks.” 

This bankruptcy caused the money market funds industry to take a serious credibility blow and thousands of formerly stable banks and mutual fund companies were unable to raise short-term debt in the commercial paper market. Since this ability is the foundation of the industry, this was a serious problem.

It was reported by Bloomberg news services that immediately after the bankruptcy institutional investors withdrew $230 billion from the industry over three days. This action forced money funds, which are the largest buyers of commercial paper, to stop buying and start selling. The financial bleeding was staunched by the Treasury Department’s guarantee of money market funds and the Federal Reserve’s purchase of the assets of the funds (at full value) to enable them to cover redemptions. The crisis was averted, for the short-term.

The President’s Working Group on Financial Markets

Regulators and brokerage houses are eager to prevent a repeat of the 2008 meltdown in the mutual funds industry, when the $62.5 billion Reserve Primary Fund became only the second money fund which had its net value asset drop below $1 (“break the buck”) and expose shareholders to a loss, and then close. The Wall Street Journal noted that this fund held $785 million in Lehman-issued debt that became worthless.

At the time it seemed that every regulator, legislator and financial pundit had an opinion about how to defuse this money market fund landmine, but a final decision on the remedy was still in a holding pattern as of July 2011. The latest twist comes from an advisory group to the Obama administration, the President’s Working Group on Financial Markets.

This group has proposed that the funds abandon their stable share price. Money market funds value their investments based on their expected payoff at maturity. This allows them to maintain a steady $1 share price. All returns on investment are credited to customers and distributed monthly as cash or as new shares.

The money market funds industry feels that this stable price is a critical selling proposition. Unfortunately, critics of these funds note that it also makes them more vulnerable to runs. They note that this encourages investors to flee after even small losses thereby reducing a fund’s net-asset value. One of the leading critics who has espoused this opinion is Paul Volcker, former chairman of the Federal Reserve and trusted confidant to President Obama.

Not be left out of the discussion, one of the leaders in the money market funds industry, Fidelity Investments, weighed in with a suggestion. According to Bloomberg News, the brokerage company proposed that, on a fund-by-fund basis, shareholders should finance capital buffers that would be used to absorb losses on defaulted holdings.

The final decision on these and other issues related to money market fund accounts will come from the Financial Stability and Oversight Committee (FSOC), which is chaired by Federal Reserve Chairman Ben Bernanke who is joined by prominent Obama appointees Timothy Geithner (Treasury Secretary), Mary Shapiro (SEC Chair) and others.

Will the recommendations of the Obama administration result in a money market funds’ industry that’s safer for investors? Or, will the clout of the brokerage industry result in maintaining the current (some say, risky) status?

Given the influence of the President on this FSOC committee, along with the still shell-shocked attitude of the average investor, the odds are good that there will be changes in the way money market funds are regulated. How drastic these changes are will depend on the strength of the industry’s argument for maintaining the status quo versus the still painful memories of what happened when the industry almost imploded.