Blogs & Comment

Bye-bye, money-market mutual funds?

Money market mutual funds remain a threat to the U.S. financial system, declared former Federal Reserve chairman Paul Volcker recently(1). To lower the risk they pose, policymakers are currently considering changes that could see the funds become less attractive vehicles for investors.
Money-market mutual funds in the U.S. have reached $3.5 trillion (U.S.) in assets. Because they arent bound by deposit insurance, loan reserves and other regulatory requirements, they have been able to win deposits away frombanks by offering higher interest rates to investors. Also, because they have lower costs, they have become a key lender to businesses through the commercial paper market.
However, operating outside the regulatory framework (without reserve requirements, etc.), they are vulnerable to a run on their asset bases. This was highlighted by the collapse of the $62.5-billion (U.S.) Reserve Primary Fund in the fall of 2008 (which froze the commercial paper market and threatened to tip thousands of businesses into bankruptcy).
On Sept. 15, the Presidents Working Group on Financial Markets is scheduled to release a report on the financial industry. Volcker is not directly involved in its preparation but is an advisor to President Obama and may have an influence on the course of action chosen.
The mutual fund companies naturally dont like the proposal to regulate them. They could lose their free rider edge over banks and their financial intermediation could shift back to the banks. They will lobby hard and may succeed in avoiding regulation, especially if they agree to concessions that will allow them to stay in business as less appealingvehicles. Of note, they may accept a curtailment of the practice of maintaining a constant net asset value (NAV) of $1.
Unlike bond funds that mark their investments to current prices, money-market funds value their investments according toyield at maturity. This allows them to maintain a constant $1 NAV (unless some of their paper defaults). This constant $1 NAV has been one of the main attractions for investors (making it a near substitute for bank accounts). However, whenever a fund runs into trouble and breaks the buck, investors flee in droves because ofa lack of deposit insurance and reserve requirements.
Footnote:1.Volcker wrestled inflation to the ground during his chairmanship at the Fed from 1979 to 1987. He also foresaw the financial crisis that commenced in 2007; as he said in a piece published April 10, 2005 in the Washington Post(under the headline An Economy On Thin Ice):
Yet, under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot I dont know whether change will come with a bang or a whimper, whether sooner or later. But as things stand, it is more likely than not that it will be financial crises rather than policy foresight that will force the change.