Wednesday, September 5, 2012

Are Money Market Funds Toast?

Yesterday I posted a short note discussing the possibility that interest rates in this country might go negative. 

While I still think this is unlikely - the practical implications of paying a fee to simply park your money in a savings account seems too unwieldy - negative interest rates are already a reality in several European countries.

Short term government rates in Germany, France and Denmark are all negative at the present time.  The level of anxiety and fear over the fate of the euro, and the shaky status of the banking system, have lead a large group of investors to prefer to pay for the safety of northern European government paper.

However, this is creating a real problem for money market funds, as the Financial Times wrote this morning.

Money market funds have been subsidized by their sponsors since 2009, but this subsidy has taken the form of waiving management fees, not paying out actual cash.

However, if the funds are not able to earn a positive return, they face the choice of either shutting their money market fund down (which Bank of America has already done in Europe) or "break the buck" on the net asset value of their fund.

The latter means that for the first time in most investors' history, they would lose money by investing in a money market fund:

Here's what the FT wrote:

The €1.1tn money markets funds industry invests in “ultra-safe” short-term debt and puts money on deposit at banks on behalf of corporations and other investors looking for a safe harbour, rather than strong returns, for their excess cash. 

But with interest rates on German and French short-term government paper now negative, the funds are already struggling to provide any returns at all. 

According to Crane Data, which tracks the industry, the average European money market fund now yields zero, and fund managers have cut fees sharply in the past year to prevent yields turning negative. 

Were the ECB deposit rate to turn negative and be backed by other controls to ensure that banks could not sidestep the penalty rate, the knock-on effect on short-term government paper and bank deposit rates might force funds to give up the fight. “Negative rates on high quality cash will just destroy the money market industry,” says Andrew Bosomworth, head of portfolio management in Germany for the bond investor Pimco.

Money market funds are a relatively recent innovation.  In this country, money funds started in the mid-1970's when federal regulations prevented banks from paying depositors more than 5 1/4%.  However, this regulation - Regulation Q - did not apply to large depositors, who could earn prevailing market rates which were much higher than 5 1/4% at the time.

Thus the mutual fund industry came up with the brilliant idea to pool the funds of smaller investors, and allow them to earn the same money market returns as their wealthier cousins.

SEC regulations were enacted to allow the industry to create the accounting fiction that the value of the shares of in a money market were unchanged (even though the market reality was different) so that investors could enjoy a bank-like stability and earn good returns.

When short term interest rates soared in the 1980-81 period in the wake of the Fed's effort to wring inflation out of the system, money market funds boomed, and the banking system never the same since.

Until now.

I'm not sure that most central bankers would be all that sorry to see money market funds disappear.  In the credit crisis of 2008 the Fed had to ride to the rescue to save the money market fund industry even though they did not fall under any sort of central bank regulation.

And recent efforts to try to force some sort of regulatory oversight on the money fund industry was beaten away by industry lobbyists just two weeks ago.  SEC Chairman Mary Schapiro had planned on enacting new rules on money market funds that would take effect on August 29, but industry insiders have recently forced her to reconsider.

If the trillions of dollars now parked in money funds flow back into the banking system it could be a serious blow to the entire mutual fund industry.  At the same time, it would be a huge earnings impediment on the banking industry, which already has more capital than lending opportunities.