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In a space once dominated by low-interest savings accounts, money market mutual funds turned the financial world upside-down. Yet in another example of the long cycles that financial markets often follow, it looks increasingly likely that money market funds are an endangered species, and the alternative that may profit the most from their demise is none other than the good old-fashioned savings account.
Money market funds under attack
The source of the latest challenge that money market funds face comes from financial regulators, who are concerned about the possible systemic threat they see from the funds. During the financial crisis in the immediate aftermath of the failure of Lehman Brothers, the notorious Reserve Fund fell below its $1 net asset value, causing losses for some investors. The fund's "breaking the buck" threw cold water in the faces of investors who had previously perceived money market funds as being perfectly safe and secure and led to the government providing temporary FDIC-like protection for the investors.
Now, regulators are trying to address the possibility that such an episode might happen again. Among the solutions they're trying to press forward are forcing funds to keep capital reserves to protect against sudden mass withdrawals, or even allowing the sacrosanct $1 per share standard to give way to a floating net asset value that would leave investors exposed to the swings in the money markets, giving investors potential profits or losses from the funds. Yet industry players have pointed out that letting fund share prices float would take away a key element of what makes money market funds attractive to investors: protection from loss of principal.
The bigger threat
As much as the industry is focusing on regulators, the real problem that money market mutual funds have to deal with comes from the Federal Reserve. Ultra-low interest rates have made it impossible for many funds to earn enough interest to pay their once-lofty expenses, and rather than facing the mass exodus that would result if they passed on those net losses to their fund customers, the companies that manage those funds have eaten the losses. That's taken a big bite out of profits at Schwab (NYSE: SCHW ) and other major money fund managers, enough to show up as material hits to overall net income in quarterly results.
In order to deal with the situation, many brokers have turned away from money market funds entirely, in favor of a more traditional solution. Both E*TRADE Financial (Nasdaq: ETFC ) and TD Ameritrade (Nasdaq: AMTD ) , for instance, have used relationships with affiliated banks to offer FDIC-insured accounts as sweep vehicles for brokerage accounts. These accounts don't offer substantial interest rates either, but the protection that federal insurance provides gives customers more assurances than they get from money market funds.
Banks are back!
For money that isn't locked up in brokerage accounts, savers have even more options. High-yield savings accounts offering rates exceeding 1% have popped up in a few corners, and even though 1% may not seem like anything to write home about, it's a lot better than anything you'll see from a money market fund or even some of the riskier short-term bond funds that fund companies have tried to portray as viable alternatives. Even big money-center banks Citigroup (NYSE: C ) and Bank of America (NYSE: BAC ) , which have rarely been particularly competitive on the interest rates they offer, now look better than money market funds because of their FDIC insurance.
Whether banks will make money on these deposits in the long run, however, remains to be seen. Banks themselves are struggling to find lucrative ways to invest capital, so the true test of their success will rely on how well they hang onto savings-account balances even after rates start to rise.
With the Fed's interest rate policies pointing to several years of low interest rates ahead, money market funds will continue to face attacks on multiple fronts. Even if regulators don't end up killing the fund industry with huge changes, it's still worth the effort for you to take advantage of higher-paying alternatives that are also safer places to keep your hard-earned money.
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