Throughout the financial crisis nearly five years ago, everyone finally realized that major financial institutions have an immense impact on the markets, and when those institutions go awry, markets are in danger. Solving the financial crisis involved protecting those institutions long enough for them to survive, and then seeking to reform them to avoid similar problems in the future.
That lesson was hard-learned, but regulators seem to have forgotten it in their fight to protect money market mutual funds from creating systemic risk that could lead to a new financial crisis. Fortunately, though, the companies that run money market funds have come up with a novel solution that could protect the funds from the threat of collapse by pinning the cost squarely on the big institutional investors that create it. You’ll learn more about that solution later in this article, but first, let’s take a step back and look at the issues facing money market funds as well as some of the regulatory proposals presented to solve those issues.
Why money market funds are risky
For decades, investors have looked at money market funds as substitutes for bank accounts. Usually, they pay higher rates than bank checking accounts, yet they allow daily access to your money on demand. Most money market fund managers even allow their shareholders to write checks against their accounts, offering the same convenience of bank accounts.
Yet beneath the surface, money market funds are very different from bank accounts. Money-market funds typically invest in Treasury bills, commercial paper, or other fixed-income investments with very short maturities. By owning only short-term investments, money market funds can handle outflows without having to sell securities at a substantial gain or loss, helping them preserve their fixed $1 per share price. But for those funds that own commercial paper, issuer default risk creates at least the potential for a catastrophic meltdown of the fund, as happened in 2008 to the Reserve Primary Fund when Lehman Brothers went bankrupt and couldn’t repay its obligations.
Solving the problem
Initial regulatory solutions involved elaborate schemes that would have been unwieldy at best and impractical at worst. One suggestion involved allowing money market fund prices to float up or down from their $1 target, which would have evenly distributed risk across all shareholders. But the solution also would have made money market funds essentially useless, as every purchase and sale would potentially be a taxable event requiring separate documentation.
A somewhat less problematic solution would have required funds to maintain capital reserves. Yet with funds already earning very little interest, forcing them to sit on cash earning absolutely nothing would only have forced them to eat more losses.