Markets: News  

Chuck Jaffe

Money fund reform won't work

7/15/12 9:01 AM ET (MarketWatch)Print

BOSTON (MarketWatch) -- The money in your piggy bank is not earning any interest. You could lose some or all of it to theft or deception, and the cash inside is not keeping pace with inflation.

In other words, it's pretty much like a money-market fund account. Except no one thinks your piggy bank is broken.

The Securities and Exchange Commission is currently working to overhaul the money-market business and should have some sort of proposal in the next few weeks, even if it mostly comes forward with an idea and requests more public input.

While regulators and the fund industry are at loggerheads over the "right" solution, involved politicians are desperately trying to fix issues that led to the last crisis without acknowledging that it most likely won't stop the next one.

The problem, according to at least one expert, is "unsolvable."

The only good news here is that average investors don't much care because, like a piggy bank, most money funds currently earn virtually nothing. They're a place to park money, and probably won't be more than that for years to come.

Truth and consequences

Still, the issues here have big implications, and investors should be worried about how the solution might impact the economy and the market; with more than $2.5 trillion in money funds -- down from more than $4 trillion due to the rate reductions -- any rules changes will have a big impact.

Money-market funds are supposed to be safe, boring, pain-free investments. Shares are priced at $1, and should stay that way; interest earn that might raise the price gets shaved off and reinvested.

In 2008, the nation's oldest and largest money fund, Reserve Primary, "broke the buck" in the wake of the Lehman Brothers' bankruptcy. The $64 billion fund was stuck holding $785 million in Lehman paper; when the fund broke the buck, it started a run of investors fleeing money funds, a dangerously destabilizing event for the entire economy.

Thus, in 2010, the SEC adopted rules requiring greater transparency, while forcing money funds to invest in more liquid assets with higher credit ratings and shorter maturities.

The fund industry supported that move, but the regulators wanted to go further, in an effort to prevent any future runs before they start.

The problem is that regulators are expecting the "next run" to look like the last one; their proposals to stop it may be ineffective overkill.

Mostly, regulators are considering a) pricing funds by their net asset value rather than the constant $1 per share and b) forcing funds to have a capital buffer that can offset a small loss. The former idea means that, mid-run, investors get back the actual net asset value. Eliminating the incentive to move at the first sign of a loss -- whereas Reserve shareholders tried to get out to lock in the $1 share price, even though most suffered a small loss -- while the latter would create a form of self-insurance against loss, but would be another blow to returns that already are practically non-existent

SEC chairwoman Mary Schapiro testified before the Senate recently that her agency had found more than 300 cases where mutual fund advisers had to step in and buy problem paper to keep their money funds from breaking the buck. That said, with the exception of Reserve -- where the failure was too severe -- the fund firm's always did step in; no investment business can survive the bad press that comes with letting your safest funds rot and erode share prices.

Ultimately, investors want a guarantee, or at least some assurance that the Federal Reserve or the Treasury will step in; that's what will calm the markets better than any legislation, and chances are that any next run will still require that kind of action.

The politicians and regulators won't make that promise, which means investors will stay nervous.

"Everything that is being discussed is a half measure, so you either have to do nothing and let investors live with the losses and hope to condition them to eventually not stampede and blow up the world economy, or you have to talk to access to the Fed or insurance or something," said Peter Crane of Crane Data, which tracks money-fund activity. "As things exist right now, the problem is unsolvable; you can't radically change the industry, you can't leave it alone and there aren't any clear good short-term solutions."

Whatever regulators come up with -- my bet is that any proposal will include some sort of restriction on withdrawals during any crisis time -- will be designed to placate investors, but don't expect it to be effective.

Investors want to believe the idea that a money-fund is "risk-free," just as kids want to feel that their piggy bank is always safe.

It's true, but only to a point. Whatever "solution" gets offered up next will be ignored by investors now -- at a time when rates are unattractive -- and will fail the next time rates have risen enough to spark investor interest and cause the next crisis.

Even in investments with a return of zero, it's a buyer-beware world.