THE BLOG
09/28/2012 08:57 am ET | Updated Nov 28, 2012

The Ethical Investor : Wall Street Ripoff #5 - Convincing You That Money Markets Are the Same As Cash

I tell my investment advisory clients that quite possibly the worst advice that Wall Street brokers are giving their clients today has to do with asset allocation. Clients aren't stupid. They come to their broker worried about the global economy and understand that inflation poses a very big risk to the future. The funny thing about inflation is the worse the economy gets, the more likely inflation is to reignite because the government will have trouble collecting sufficient tax revenue in the future to cover its bills. They will be more likely to print new currency to pay their bills, thus causing increased inflation. You don't need a booming economy for prices to increase, just a Fed that prints lots of money as more money chasing the same amount of goods will cause inflation. Think the Weimar Republic in Germany or the recent experience in Zimbabwe where they ended up printing single bills worth $100 trillion Zimbabwe dollars each.

So, investors get nervous and tell their broker they want to reduce the risk of their portfolio. The first mistake the broker makes is he recommends that they hold more bonds instead of stocks thinking that bonds are higher up in the capital structure of a company and so should be less risky. But, no asset does worse than bonds when inflation hits. More on this next week.

So, then the investor says he wants to get out of everything and take a break and just hold cash. What does the broker do? He makes his second mistake. Very often he puts the client into a money market fund and tells the client it is the same as cash.

Money market funds used to be fairly safe because they lent money to big corporations on a very short term basis through the commercial paper market. But now, US corporations are sitting on over $2 trillion of cash so they aren't borrowing. Who is borrowing nightly from these money market funds? Domestic and European banks, exactly the people we wanted to keep our money away from. It is still the case, even after five years of a global recession, that the biggest banks in the world would all be insolvent tomorrow if they had to mark all their bad loans to market. They still have bad mortgage loans and mortgage derivatives on their books, they have poorly performing loans to troubled countries on their books and they have loans to other banks on their books which may be in the worst shape of all.

While money market funds are supposed to be restricted in the type of securities they hold, you need to get ahold of the prospectus for the fund you are in to see exactly what type securities they can indeed purchase. Surprisingly, many can hold longer term debt of corporations and banks, shares in public companies, sovereign credits from countries around the world in addition to traditional commercial paper.

The risk of course is if the assets they hold get in trouble, one or more money market funds could break the buck, that is trade at $99 instead of par or $100. If this happens, it could cause a run on these funds as they do not have FDIC insurance like bank CD.

This is not a hypothetical discussion. This is exactly what happened in the crisis in 2008. One large money market fund announced they had broken the buck and didn't have sufficient collateral to make everyone whole. The government immediately came in and guaranteed all money market funds. Next time, we may not be so lucky. As a matter of fact, language in the Emergency Stabilization Act of 2008 and in the Dodd-Frank Act prevents Congress, the Treasury or, even the Fed to a great degree, from using any of their programs for future guarantees of the money market fund industry.

And the damage was not limited to one firm. E-trade, the discount broker, was found to be lending out its customers' securities at night and taking the proceeds and investing it in mortgage backed securities, among other things. They almost completely collapsed as a result.

As the Huffington Post reported this week, the money market fund industry is still fighting new regulations from the SEC that would force it to hold cash buffers to give it some protection during crises. Even Tim Geithner who never met a banker he didn't like is pressuring the SEC to act so you know it must be serious.

If you want to hold cash, make sure it is held as cash in either currency or a very liquid guaranteed instrument like an FDIC guaranteed bank CD. And don't hold more than $250,000 in any one bank's CD products. And get a hold of the money market prospectus that you currently invest in and just see what kinds of things they can do with your money including overnight lending of your securities. Don't take your broker's word for it, make him show you the documents. If things go sour, he will be in on his yacht in the Cayman Islands and his secretary will tell you he is unreachable for the duration of his hiatus and your crisis.

20 Ways Wall Street is Ripping Off Small Investors

  1. Providing nominal returns, not real returns.
  2. Encouraging too much diversification, if that's possible.
  3. Hiding fees and expenses.
  4. Turning you into a passive investor.
  5. Convincing you that money markets are the same as cash.
  6. Telling you that bonds are safer than equities.
  7. Explaining that in the long run equities outperform bonds.
  8. Simply by lying about their products.
  9. Convincing you that their bank is a large, stable, safe operation to deal with.
  10. Recommending products that have enormous sales commissions attached to them.
  11. Cheating you on bid/ask spreads.
  12. Selling you what they don't want.
  13. Measuring your success in dollars.
  14. Lending your securities to others.
  15. Ripping your eyes out if you ever try to close your account.
  16. Grabbing any slight positive real return for themselves.
  17. Sticking toxic waste to small investors.
  18. Pretending they can pick stocks.
  19. Acting like they are your best friend and they have your best interests at heart.
  20. Knowing next to nothing about the value of holding real assets like gold and real estate

John R. Talbott is a bestselling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com

Content concerning financial matters, trading or investments is for informational purposes only and should not be relied upon in making financial, trading or investment decisions.