Why Investors Shouldn't Worry About Money Funds—A Commentary by Jonathan R. Macey ’82
The following commentary was published in The Wall Street Journal on June 3, 2011.
Why Investors Shouldn't Worry About Money Funds
By Jonathan R. Macey ’82
People have worried about protecting their savings and cash since money was invented. Before the introduction of the money-market mutual fund in 1971, the commercial-bank deposit was considered the best way to safeguard the core cash that people need to go about their day-to-day lives.
Everyone knows that money invested in money funds generates better returns than money squirreled away in bank deposits. But just as important: Money in money funds is also very, very safe—inherently much safer than money held in bank deposits.
That's because banks are structurally unstable because the loans that they make are long-term, illiquid and opaque, while the cash deposits entrusted to banks are very short-term, highly liquid and, of course, completely transparent. We know to the penny in real time what every bank owes to its depositors. But neither regulators nor bank creditors have the vaguest idea what the value of a bank's assets might be at a particular point in time. And nobody kn
ows how much of a loss would be realized if a bank tried to sell its assets in fire-sale fashion. This structural instability explains federally sponsored deposit insurance.
Money funds may have a maturity mismatch as well, but it's nothing like the mismatch that plagues banks. These funds are highly stable because they match investors' money with short-term, high-quality, highly liquid assets. With this structure, money funds provide an attractive alternative not only for investors, but also for society as a whole, because the money in the funds does not create the same systemic risk that the money in the bank does.
Of course, like anything else, money funds work only when they are properly managed. Money funds pool investors' money and use it to buy short-term investments, like Treasury bills, certificates of deposit, and very short-term debt issued by large corporations (commercial paper). The Securities and Exchange Commission is supposed to make sure the funds' investments are well-diversified, highly liquid and limited to assets of the highest credit quality. But during the credit crisis of 2007 and 2008 it became clear that the SEC fell down on the job by letting poorly run funds try to boost their earnings by investing in highly risky commercial paper issued by Lehman Brothers Holdings Inc.
Critics of money funds see the 2008 troubles of the Reserve Primary Fund as evidence of the riskiness of the investment. I disagree: The fact that the value of the shares shrunk just three cents at its lowest, before additional recoveries in the liquidation process, to me shows how stable money funds really are. While the drop in share price may have been bigger if the government hadn't stepped in, I don't believe it would have been that much greater, given the level of actual losses. (When the Reserve fund was liquidated, the fund's shareholders ultimately recovered some 99 cents on the dollar.)
What's more, investors in larger mutual-fund families never faced even this small danger because their parent companies stepped in and bought their bad investments at a premium over market to preserve the expected $1 per share price for investors. Although there is no guarantee, there's plenty of historical precedent for investors to feel this will continue in the future.
Critics of money funds claim that such funds are part of a shadow banking system that operates with no supervision. This is hardly true. Money funds are subject to strict SEC rules, which were amended in 1991 and again in 2010 to impose even stricter rules on the liquidity, maturity length, credit quality and diversification of assets that money funds can hold.
Unlike banks, mutual funds need bailouts only very rarely. And when bailouts are required, the amount of assistance needed is tiny compared with the massive bailouts required by commercial and investment banks.
Critics also worry that money funds, by not rolling over certain short-term assets, will add to financial instability. On the contrary: The shorter maturities make funds safer because they make them more liquid. Also, if a money fund declines to roll over a short-term asset, it obviously does not take the money out and burn it. It puts the money in some other short-term assets. The alternative, continuing to buy securities until the issuer defaults, would be irresponsible.
Therefore, if U.S. money funds decide not to roll over the short-term debt obligations purchased from European banks because of these banks' exposure to sovereign debt, the money that would have gone to buy this debt simply will be used to buy other debt. This will increase, not decrease, financial stability by allocating capital to the most efficient borrowers rather than to borrowers with the best chance of scoring a government bailout.
If money funds were regulated out of existence in the wake of the modest problems experienced in 2008, it would be a small blow to investors as individuals. These investors would simply move their money back to traditional bank accounts, where they would typically have to settle for lower returns. But it would be a major blow to the overall safety and soundness of the economy if the trillions of dollars held in money funds migrated to bank deposits or offshore funds. This would shift resources from structurally sound investments in money funds to inherently unstable investments in banks.
Mutual-fund regulations already have been overhauled to deal with the issues that emerged during the crisis. In January 2010, the SEC began requiring money funds to hold a minimum of 10% of their assets in securities that can be sold for cash within a day and at least 30% of their assets in investments that can be converted into cash within a week. But the SEC is considering even more radical regulations, including changing funds' rules for setting net asset values.
Keep the Buck
The current rules enable money funds to maintain a stable $1-a-share net asset value by not requiring that prices be adjusted unless the value drops more than 0.5%. Thus, as long as a money fund maintains a value of at least $0.995, the money fund will redeem shares for $1. Getting rid of the $1 net asset value would be a step in the wrong direction because it would increase systemic risk by moving money from money funds into less stable bank accounts.
What's more, the proposal to somehow separate retail and institutional investors is, in my mind, absurd. We don't distinguish between banking retail and institutional investors for purposes of deposit insurance. And whatever merits there might be in making this distinction can be realized much more effectively and efficiently simply by putting a size limit on the amount of assets that get protected by the government ($250,000) and then structuring bailouts of both money funds and banks such that accounts above this limit receive "haircuts."
Instead, my recommendation is to extend deposit-insurance protection to money funds. In the absence of such insurance for either banks or money funds, the funds clearly are safer, more stable and less susceptible to runs. However, our current regulatory system gives banks an unfair competitive advantage over money funds and therefore creates economic distortions. A level playing field is better for everybody.
Mr. Macey is a law professor at Yale University.