Stephen Foley: Money market funds are still an accident waiting to happen

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The Independent Online

US Outlook: So farewell then Sheila Bair. America's most ferocious regulator says she will step down when her term as chairman of the Federal Deposit Insurance Corporation (FDIC) ends in July, robbing government of one of the few people who still seemed keen on radical reform of finance in the wake of the credit crisis.

As if she wanted to demonstrate why she will be so missed, Ms Bair was on typical bold form this week, attacking the powerful money market fund industry and demanding sweeping changes. The $2.7 trillion industry is based on a "myth", she said, and a dangerous myth at that.

She is right. If the banks and fund managers ranged against her succeed in killing real reform, it will be a scandal. Money market funds are hot money masquerading as safe money, and there is nothing so dangerous as something that looks safe and turns out not to be. The run on the money market funds in the days after Lehman Brothers collapsed is the most under-appreciated aspect of the 2008 crisis.

While the bailout of AIG and the slumping stock market were grabbing the headlines, the US authorities put a taxpayer guarantee behind the whole money market fund industry, standing behind what was then over $3.4 trillion in assets.

It was the biggest and most repugnant bailout. But it was essential. Without it, corporations would have been unable to pay their employees and individuals would have started to see cheques bouncing.

This was the nightmare scenario that prompted action on Capitol Hill – not any concern for the fat cats at Goldman Sachs, as the populists and revisionists would have it.

Money market funds only invest in very short-term assets – corporate debt that might get repaid in as little as a week or two – so there is supposedly little chance of losses. Fund managers work to keep their total assets stable at $1 per share. The idea that a fund might "break the buck", as the saying goes, and fall below $1, is unthinkable. Millions of Americans, and millions more around the world, therefore treat these funds as if they are risk-free higher-interest bank accounts.

Except they are not. If they were, Ms Bair's FDIC would regulate them and guarantee them. In fact, savers are relying on nothing firmer than the good investing sense of the fund's manager. And when it turned out that the pioneer of the industry, Bruce Bent's Reserve Primary Fund, broke the buck because it was holding Lehman Brothers' worthless short-term debt, confidence evaporated and investors headed for the exits.

Without meaningful reform, an industry that was an accident waiting to happen before is an accident waiting to happen again.

An end to the "myth" of the fixed $1 net asset value and a move to a floating NAV was proposed by Ms Bair this week (and supported, by the way, by the former Federal Reserve chairman Paul Volcker, another blunt speaker now outside the Obama administration).

Bank lobbyists countered that this would crater demand for the product, and in turn crater the amount of funding available to buy short-term debt from corporations. But neither are bad things. The fixed NAV is a marketing tool designed to dupe savers into thinking something is risk-free when it is not.

And corporations shouldn't be hooked on short-term borrowing that could dry up at a moment's notice. It was exactly that addiction to overnight borrowing that made investment banks such as Lehman so fragile, and it is a terribly risky model for funding the salary cheques on which we all rely.

The taxpayer guarantee has lapsed now, but only really in the legal sense. It still exists in investors' minds. And in bankers' minds, too, it turns out. They are lobbying for a Federal Reserve backstop as an alternative to the floating NAV. That would just entrench the industry as "too big to fail" and enshrine moral hazard into law.

Ms Bair's legacy at the FDIC is an expanded regulator that now has oversight powers across all systemically important financial institutions and a new role winding up future Lehmans before they get to the point of bankruptcy. But one of the biggest holes still has to be filled. Typically, Ms Bair has shown the way to fix it.

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