Can Mutual Funds Prevent the Next Financial Meltdown?

The federal government invested more than $245 billion in banks through the Troubled Asset Relief Program. The biggest recipients included Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , Goldman Sachs (NYSE: GS  ) , JPMorgan Chase (NYSE: JPM  ) , Morgan Stanley (NYSE: MS  ) , and Wells Fargo (NYSE: WFC  ) . The new financial reform law is aimed at heading off another crisis (and negating the need for another TARP) but Boston University economics professor Lawrence Kotlikoff doesn't think the new law will produce fundamental change. In part one of our interview, he explained why he thought the United States was bankrupt. In this second and final part of our interview, Kotlikoff explains his proposal for financial reform -- a proposal detailed in his book Jimmy Stewart is Dead: Ending the World's Ongoing Financial Plague with Limited Purpose Banking.

Mac Greer: You have said we need a financial system that does not rely on honest people, so you have proposed this concept of limited purpose banking. Can you explain what "limited purpose banking" is and how it would reform the financial system?

Lawrence Kotlikoff: Limited purpose banking forces financial intermediaries to operate as mutual fund companies. Whether they call themselves a commercial bank, an investment bank , a hedge fund, a private equities fund, an insurance company, we have to realize that all these institutions are doing essentially the same thing under different names. Fundamentally they are engaged in the same business. So they all need to be regulated the same way and they all need to operate as mutual fund companies.

If you look at what happened here, we had a financial earthquake and the mutual fund industry did not collapse. The rest of the financial sector pretty well collapsed. The administration is trying to rebuild the financial system in straw and the fabric, the material that constitutes that part of the financial sector that collapsed, as opposed to rebuilding in brick.

Now mutual fund companies market mutual funds. Mutual funds account for one-third of the financial assets in the U.S., so I am saying let's make that glass not one-third full, but three-thirds full, and teach the concept that mutual funds, and there are 8,000 of them, are like little banks taking in money on a higher percentage equity basis. So it is like banks having 100% capital requirements, not 10% capital requirements, but 100%. So people put their money in. If they want to invest in safe things, they could invest in a Treasury bond fund or a Treasury bill fund or a cash mutual fund that holds just cash where they can invest in short-term corporate bonds. They can also invest in very risky things like junk bonds or stocks of developing countries, but you see exactly what you are investing in and the mutual fund managers have to invest in the things that their mutual fund is chartered to invest in.

So I am talking about a very simple structure which entails Main Street being safe from Wall Street, Wall Street just intermediating. They would not be allowed to borrow money to invest at risk and then turn to the taxpayer and say, bail us out. We don't need to have Wall Street take us to Las Vegas. That is not their job. Their job is to connect people and to connect people that want to save and want to lend to people that want to invest and want to borrow. That is their sole job. There is no reason to have leverage within the financial intermediaries, and we have seen how dangerous letting them engage in that is, so we could never have financial collapse with limited purpose banking because mutual funds, by definition, are 100% equity financed.

They can lose all the value of what they have invested in, in the sense that the stocks they buy, the bonds they buy could all go down to zero, so your mutual fund shares could go to zero, but they can't actually formally go bankrupt. There are no liabilities to anybody outside of the mutual fund owners, and consequently, we would never, ever again have the financial collapse. The only mutual funds that would be backed to the buck would be cash mutual funds, of which there would be buck for every buck that was deposited. Those cash mutual funds already exist and they just hold cash, period. Everything else would float on the market and the prospectus for every mutual fund, except cash mutual funds, would have a single page. It would have to be signed by any investor in the mutual fund, and that page would have one sentence. It says, "This mutual fund is risky and can break the buck, and there is no guarantee of any kind as to the value of this mutual fund," and you have to sign it.

Greer: I don't know if you saw the article in Business Week where some of the economists were worried that your idea of limited purpose banking would throw out the good of banking along with the bad. They quote an Ohio State business professor, Renee Stoltz, who says, "We did not have airplane crashes when people used horses for transportation, but going back to using horses is not the solution to eliminate airplane crashes."

Kotlikoff: I think she has got the metaphor backwards. What we are seeing in the financial world, if you go from 1944, when the Investment Company Act which regulates the mutual fund industry was passed, till today, we have seen an enormous expansion in the mutual fund industry. So they [mutual funds] are the new airplanes. They are not the old horse and buggies.

We have gone from basically a non-existent mutual fund industry to it representing a third of the financial system, and for most Americans, the mutual fund industry is their banking system. Most Americans had most of their assets in mutual funds through their 401(k)'s and 403(b) plans and IRAs, and there is a reason why Congress prescribed that these retirement accounts had to be run through mutual funds. It was to cut down on the possibility of fraud. It was to cut down on the ability of a Madoff to steal the money. That is why mutual funds have third-party custody -- because Congress requires that to happen. So I think that she has got it exactly backwards in terms of the course of financial history here.

Want to hear more from Lawrence Kotlikoff? Check out Is the U.S. Bankrupt?

And read why Motley Fool Income Investor Advisor James Early thinks banks got the better of the financial reform deal.

Mac doesn't own any of the stocks discussed. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.  


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