Throughout the financial crisis nearly five years ago, everyone finally realized that major financial institutions have an immense impact on the markets, and when those institutions go awry, markets are in danger. Solving the financial crisis involved protecting those institutions long enough for them to survive, and then seeking to reform them to avoid similar problems in the future.
That lesson was hard-learned, but regulators seem to have forgotten it in their fight to protect money market mutual funds from creating systemic risk that could lead to a new financial crisis. Fortunately, though, the companies that run money market funds have come up with a novel solution that could protect the funds from the threat of collapse by pinning the cost squarely on the big institutional investors that create it. You'll learn more about that solution later in this article, but first, let's take a step back and look at the issues facing money market funds as well as some of the regulatory proposals presented to solve those issues.
Why money market funds are risky
For decades, investors have looked at money market funds as substitutes for bank accounts. Usually, they pay higher rates than bank checking accounts, yet they allow daily access to your money on demand. Most money market fund managers even allow their shareholders to write checks against their accounts, offering the same convenience of bank accounts.
Yet beneath the surface, money market funds are very different from bank accounts. Money-market funds typically invest in Treasury bills, commercial paper, or other fixed-income investments with very short maturities. By owning only short-term investments, money market funds can handle outflows without having to sell securities at a substantial gain or loss, helping them preserve their fixed $1 per share price. But for those funds that own commercial paper, issuer default risk creates at least the potential for a catastrophic meltdown of the fund, as happened in 2008 to the Reserve Primary Fund when Lehman Brothers went bankrupt and couldn't repay its obligations.
Solving the problem
Initial regulatory solutions involved elaborate schemes that would have been unwieldy at best and impractical at worst. One suggestion involved allowing money market fund prices to float up or down from their $1 target, which would have evenly distributed risk across all shareholders. But the solution also would have made money market funds essentially useless, as every purchase and sale would potentially be a taxable event requiring separate documentation.
A somewhat less problematic solution would have required funds to maintain capital reserves. Yet with funds already earning very little interest, forcing them to sit on cash earning absolutely nothing would only have forced them to eat more losses.
The best fix?
But earlier this week, money-fund giant Fidelity suggested imposing a 1% redemption fee under certain circumstances on the large financial institutions that invest in their institutional money market funds. The fee would take effect only during stressful financial periods during which liquidity was scarce, as happened with the Reserve Primary Fund during the financial crisis.
The smart thing about the Fidelity proposal is that it pins the blame squarely on the big institutions that can actually cause problems. It avoids leaving individual investors holding the bag for those institutions, which is the fairer result given that individuals don't have large enough holdings to have a true influence on overall fund liquidity.
Of course, that fact may itself draw controversy. For JPMorgan Chase (NYSE:JPM), Goldman Sachs (NYSE:GS), and other money-fund companies with a focus on institutional clients, imposing a redemption fee voluntarily could dissuade their customers from using them as managers, pushing them to other providers. But for more retail-oriented fund managers, the benefits of essentially leaving their customers alone are indisputably favorable.
The right answer for you
For now, investors shouldn't really care about money market funds, because they shouldn't be investing in them. Major banks Bank of America (NYSE:BAC) and Wells Fargo (NYSE:WFC) have profited in part during the recovery from the financial crisis by paying insignificant rates to depositors on their savings accounts, but the fact that those accounts are FDIC-insured gives them a level of protection beyond what money market mutual funds offer. Some institutions, including General Electric's (NYSE:GE) banking unit, pay somewhat higher rates that leave money market funds in the dust.
With systemic risk and near-zero interest, money market funds aren't worth investing in right now. As such, let institutional investors desperate to preserve capital in any way they can find figure out how to keep them alive during the next crisis.
Fool contributor Dan Caplinger owns warrants on Bank of America and JPMorgan Chase. You can follow him on Twitter @DanCaplinger. The Motley Fool recommends Goldman Sachs and Wells Fargo. The Motley Fool owns shares of Bank of America, General Electric, JPMorgan Chase, and Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.