By Kevin G. Hall, McClatchy Newspapers –
WASHINGTON — Plain-vanilla money-market funds, part of the skeletal structure of American finance, may be a $2.7 trillion disaster hiding in plain sight.
When Congress in 2010 passed the most sweeping changes in financial regulation since the Great Depression, it tried to address most of the problems that led to or were exposed by the near-collapse of the financial system. Money-market funds slipped through the cracks.
Money-market funds, a $2.7 trillion industry, remain largely unregulated. They remain vulnerable to runs from investors, who retain the false perception that there’s no risk in them. The funds have been pitched as “can’t fail” investments, yet as recently as last summer the largest money-market funds had 45 percent of their assets tied up in European bank debt.
“Nothing in financial services is as dangerous as a guarantee without capital backing it,” Sallie Krawcheck, the former president of wealth management for Bank of America, warned in a recent op-ed article in The Wall Street Journal.
In an interview with McClatchy, Krawcheck said the Securities and Exchange Commission is right to be concerned and seek ways to bolster this crucial segment of the financial sector. Although these funds offer many pages of disclosures, she said, many investors still wrongly assume that the funds guarantee at least a break-even return. They’re unaware that many fund managers aren’t even banks with capital reserves, but rather simply asset managers.
“Individuals are very happy to spend quite a bit of time on risky investments, but for cash, individuals look for much more straightforward investments. Do you want to research websites on what the underlying investments (in money-market funds) are?” Krawcheck said.
The reason ordinary investors like money-market funds is they are similar to checking accounts, where cash earns a small amount of interest but the money is not locked in and is accessible. Money-market funds matter in the broader sense because they invest heavily in commercial paper, short-term debt issued by corporations to manage their cash-flow needs. These markets are lifeblood for corporate finance.
An October 2010 report by the Presidential Working Group on Financial Markets warned that a run on money markets could cause shocks throughout the U.S. financial system.
Big Wall Street players such as J.P. Morgan Chase say that enough has been done to bolster these funds and that additional fixes being considered might reduce returns to investors and thus kill the industry, or least put it at a disadvantage. And money-market fund managers are upfront now about risks.
“An investment in a money-market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund,” investment giant Fidelity warns on its website.
That doesn’t calm SEC Chairman Mary Schapiro. Asked during a recent breakfast with reporters what keeps her up at night, she put money-market funds atop her list.
“I do feel a sense of urgency about the structural weaknesses that do exist in money-market funds,” Schapiro said. “There is a structural weakness that makes them prone to runs, and I think we need further debate and discussion about some concrete ideas there.”
Schapiro declined to discuss specifics, but SEC spokesman John Nester confirmed that rule changes are being prepared.
“At the chairman’s direction, the staff is currently drafting proposals to address the susceptibility of money-market funds to runs,” he said in a written statement.
In 2008, after the giant Wall Street bank Lehman Brothers failed, money markets fell into panic. The oldest money-market fund, Reserve Primary Fund, had to write off its investment in commercial paper issued by Lehman, and could not guarantee its investors 100 cents on the dollar. It was a phenomenon called breaking the buck, and had happened only twice before as isolated events.
The third time, however, skittish investors worried what other failures lurked, and in the financial market equivalent of a bank run, began tried to cash out en masse. Within a single week, $310 billion was withdrawn from money markets. Only when the Treasury Department stepped in to temporarily insure money-market funds did panic ease.
Fast forward to today.
Money-market funds in 2010 were forced to have more access to capital on short notice, and the credit quality of what they can invest in was tightened. The funds are no longer government insured and the revamp of financial regulation, called the Dodd-Frank Act, prohibited government from future market intervention like that which saved the system in 2008. Instead the new law provided a path to shut down failing financial institutions formerly regarded as “too big to fail.”
However, money-market funds are just as vulnerable to runs as they were then, but this time they’ll be on their own. Few analysts see this as probable, but it remains possible.