published Wednesday, August 29th, 2012

Personal Finance: Regulators misfire on money fund reforms

Chris Hopkins

Last week, the Securities and Exchange Commission announced it was unable to settle upon new regulatory measures regarding money market mutual funds.

This is unwelcome news for taxpayers in the event of another financial crisis, as the government is virtually certain to step in with another bailout next time investors panic and run for the exits.

U.S. investors have $2.5 trillion parked in money market mutual funds, but few understand precisely how these vehicles operate.

Money market funds are simply a particular class of mutual fund that invests in short-term, liquid securities like Treasury bonds, CDs and commercial paper. They are generally viewed as higher-yielding alternatives to savings accounts as a repository of cash.

Individual investors have been conditioned to believe that these funds are riskless, despite the fine print disclosing the potential for losses. (Note that many banks offer FDIC-insured money market accounts that do not fall in the same category).

In order to convey an impression of safety, money fund firms traditionally have held the value of shares in their funds at a constant $1 per share. Assuming that the return on the securities held by the fund exceed the expenses incurred in operating the fund, this does not present a problem. Any residual returns are paid out to the investors as incremental yield on their invested cash.

However, fund companies have no legal obligation to maintain a $1 fixed share value. When a fund's investment returns fall below its expenses, maintaining this value becomes problematic.

During the financial crisis of 2008, one large (and venerable) money fund experienced significant losses on investments in Lehman Brothers bonds and decided it no longer could underwrite the fixed share value. Allowing the shares to dip below $1, referred to as "breaking the buck," triggered a run on the fund as investors summarily withdrew 15 percent of the assets and sparked a liquidity crisis.

Enter the federal goverment. Confronting the likelihood that the panic would spread to other money funds, the Federal Reserve created an emergency insurance facility to backstop money market funds facing similar threats. In the event, taxpayers ultimately reaped a small profit from the fees charged to the funds, but the outcome could easily have been much worse and likely will be next time.

Given the historically low returns on low-risk assets, money funds currently struggle to provide any positive return to investors (the average money fund yields just 0.06 percent). In fact some sponsors are compelled to subsidize their money funds at a loss in order to maintain the $1 share value. In such a low return environment, any shock to the system likely would lead to losses and eventual break the buck in many money funds.

This is why the inability of the SEC to reach an accord on regulation is relevant to taxpayers. In the next crisis, the Federal Reserve will feel similarly obligated to save investors in money funds which are not strictly guaranteed, but whose investors have not contemplated the possibility of losses. And next time, taxpayers may be on the hook.

Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Christopher A. Hopkins CFA, is a vice president at Barnett & Co. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by emailing him at dflessner@timesfreepress.com.

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