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J. Christopher Donahue

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Regulators' Criticism of Money Market Funds -- Long on Myth, Short on Facts

Posted: 05/10/2012 10:55 am

Washington regulators, from the Federal Reserve to the SEC, continue to take to the speaking circuit and the airwaves delivering myths about money market funds and citing recent history as their rationale for proposed rules that will destroy the funds' functionality, utility and effectiveness. For 50 million investors and the multitude of municipalities, corporations and other entities which depend on money market funds for efficient funding, it is crucial to set the record straight. Regulators cannot just ignore the facts or take potshots at a money market system that is vital to the American economy.

The first myth continually being heard is that money market funds were either at the center of, or significantly exacerbated the financial crisis 2008. Not true and the facts tell a different story. The meltdown occurred because of certain financial institutions placing enormous leverage bets on the sub-prime housing market, amplified in many cases by derivatives and by the Fed's easy money policy. When those bets went bad, the complex web of counterparty arrangements between different institutions threatened to cause a general collapse of the system. Importantly, only one money market fund lost its $1.00 NAV in September of 2008. And that was after an 18-month period that saw the failure of dozens of banks, mortgage lenders and other financial institutions causing the credit markets to freeze up.

This is often paired with the total falsehood that money market funds are susceptible to runs and were bailed out by taxpayers. The Reserve Fund "breaking the buck" in September of 2008 followed an unprecedented period that saw the collapse of Lehman Brothers, a number of major financial institutions on the brink, and inconsistent responses to these events by the government. As counterparty risk perception increased, institutional investors redeemed 15 percent of their prime money fund shares, followed by large inflows into money market funds backed by government debt. For every dollar that left the prime funds, $0.63 flowed into government money market funds. In fact, total assets were down by only 4 percent during the fateful week of Sept. 15.

The conclusion that should be drawn from this is that investors were not fleeing money market funds but were rather reallocating their assets to the most conservative investments in a reeling market beset by failures and near failures of many leading financial institutions, unpredictable government policies and widespread concerns about whether prime funds could continue to sell assets into the frozen commercial paper market.

The steps then taken by the Fed and Treasury were not a bailout of money funds but rather, especially in the case of the Fed actions, were necessary and proper steps to restore liquidity to the financial system as a whole. It is important to remember that when the dust settled, the Reserve Primary Fund investors lost less than a penny on the dollar and no taxpayer funds were needed. In fact, money market fund companies paid $1.2 billion to the U.S. Treasury for this insurance that was not asked for and never used. (Contrast this to the bailouts of 2,800 failed banks, which along with an additional 592 banks that required "assistance transactions", cost taxpayers $188.5 billion between 1971 and 2010.)

Another tall tale that's being bandied about concerns the perceived evils of Europe and the view that a significant source of credit risk in the money market funds over the past year has been the large exposure to global banks which happen to be headquartered in Europe. One official even suggested that money funds could somehow be a conduit for smuggling an unexpected economic problem on the continent back into the U.S.

Actually, the majority of U.S. money markets' holdings of European-based institutions are invested in securities of banks that have U.S. affiliates that serve as primary dealers. Primary dealers are financial institutions designated by the Federal Reserve Bank of New York to serve as trading counterparties in the Fed's implementation of monetary policy. These dealers are required to participate every time the U.S. Treasury auctions its securities. They are central players in the U.S. financial system. Among the instruments of these primary dealers that U.S. prime money market funds hold, half are repurchase agreements. Such repos are fully collateralized, the vast majority with U.S. Treasury and government agency securities that these institutions hold precisely because they are primary dealers. Here again, the facts debunk regulatory mythology.

One of my favorite of the fairy tales is the misplaced concern that investors believe that money market funds are guaranteed and there is confusion with banks and checking accounts. Nowhere in any money market fund prospectus or market material is there anything that would convey that the money market fund is guaranteed. In fact, the risks are clearly and repeatedly noted in bold print, not FDIC insured, may lose value, no bank guarantee.

Institutions hold more than 60 percent of the $2.6 trillion invested in money funds, and these professionals certainly know the difference between a money market fund and a bank account. Further, a recent survey by Fidelity Investments shows that the vast majority of retail investors also know that money market funds are not guaranteed.

Money market funds are working well and are well regulated, particularly in light of the 2010 rule enhancements and are now much more liquid, transparent, conservative, and better able to withstand systemic shocks than ever before. And that's the truth.