Paul Volcker wants to kill money market funds. He says that investors don’t understand them and that the funds could crash the financial system. He’s right.
The root of the problem is that money market funds are sold as “cash equivalents,” when really they’re anything but.
Investors allocating a percentage of their assets to “cash” are typically looking for a “riskless” place to park money. They want their principal protected, but they would also like a few extra points of interest thank you very much. Free checks ? Even better.
Money market funds can offer all of the above, so naturally investors gravitate to them.
What they don’t realize is that their principal is at risk. The $1 net asset value that money funds market is just an accounting gimmick, a milder version of the same gimmick banks use to avoid writing down bad loans.
Because money market funds hold their assets to maturity, they’re allowed to use so-called “amortized cost” accounting instead of mark-to-market. If the value of securities in the portfolio rises or falls, investors don’t see that because it isn’t reflected in the fund’s share price. So they sleep soundly thinking their principal is perfectly protected.
To be fair, their principal is pretty safe. Most money market funds invest only in high quality ultra-short term paper. If the NAV did reflect the fluctuating value of holdings, it would still be very stable, probably never moving more than a penny or two.
And that’s what Volcker wants to do. He wants to force money funds to abandon accounting gimmickry that essentially permits them to market short-term fixed income funds as a “cash equivalents.”
Last fall, when an investment in Lehman Brothers paper forced the Reserve Primary Fund to break the buck, the veil was suddenly lifted and cash was pulled from money funds everywhere. Agile investors knew the money wasn’t perfectly safe, so they pulled out – redeeming at the promised $1 per share – leaving all the losses to be absorbed by slower shareholders.
That’s how that $785 million investment in Lehman paper turned into a systemic rout that threatened to drain a $3.5 trillion pool of capital from the market over a period of days. To stop the run, Treasury Secretary Hank Paulson offered a blanket guarantee for all money market fund assets, a guarantee that was extended earlier this year.
Volcker doesn’t want investors blindsided again. He wants money funds to stop marketing unbreakable $1 NAVs.
Money fund managers are fighting back because they know this would kill their business. If they can’t market $1 NAVs, their place in the asset allocation pie would be the “fixed income” slice not the “cash equivalent” slice. Investors would dump the funds in favor of bank accounts and CDs.
This would put significant pressure on the banking system. With hundreds of billions of deposits suddenly flowing in, banks would have to raise a lot of capital to protect their balance sheets.
If money funds want to keep operating like banks, fine. But in that case they should raise capital and subject themselves to bank regulation. Money funds aren’t keen on this idea either, it presents a number of problems that would also kill their business.
Perhaps it should be killed. It’s built on the fiction that investors can make riskless profits investing in short-term paper.
But when fiction meets reality, people panic. The only way to avoid that is to tell investors the truth. For money market funds, that means advertising them as what they are – fixed-income funds, not cash equivalents.