After 40 mostly unexciting years, the Securities and Exchange Commission (SEC) has recently taken steps to tighten oversight of the $2.6 trillion dollar business of money market funds. This move comes after several regulatory shortfalls became apparent following the collapse of Lehman Brothers in 2008 and had consumer groups calling for change.
For this installment of Investing 101, we take a closer look at the size and scope of money market funds, their history, and what lies ahead if the new rules are adopted.
1) What is a money market fund?
"They were developed in the 1970s to help investors get a better return than they could get on bank deposits," says Phil DeMuth, managing director at Conservative Wealth Management. "It's the life blood of the economy. It is where big and small investors keep their cash."
In fact, according to the Investment Company Institute (ICI), there are currently more than 7,600 money market funds in operation, which account for about 22% of all mutual fund assets. By design, they invest in very short-term debt securities with the aim of delivering a slightly higher return than could be earned in a regular savings account — without taking on much risk or foregoing the ability to withdraw your money whenever you want.
But as DeMuth says, "Ultimately they involve putting together two things that don't go together very well." He goes on to explain that "a fixed $1 net asset value [the price each share is worth] that never varies, on the one hand, is tied to an ultra-short-term bond fund that does vary, on the other."
In normal times, DeMuth points out, the dual workings of these funds "got along okay," but during rare times of extreme crisis, like 2008, "the whole thing can blow up."
Which is exactly why the industry and its regulators have been negotiating ways to fix it for the past four years.
2) What is the SEC proposing to change regarding money markets?
Whether you're a billionaire or newlyweds just starting to save, when you put cash into a money market there is an assumption that for every dollar you put in you'll get one dollar out, as well as some nominal interest along the way.
But as DeMuth says, "That ain't necessarily so." He suggests the SEC has put forth two key changes: one for the big guys and one for regular Joes.
"For the big institutions, they're going to give up the fixed $1 value, but if you want to pull your money out in a crisis, you might not get $1 out, you might have to settle for 99 cents, 98 cents, 97 cents. Whatever the market will bear at that time."
As for the ordinary retail investor, DeMuth says, "They're proposing that during times of crisis [investors] get to keep the fixed $1 NAV, but they might put up a gate. So if there's panic in the streets, they might say you can only take out $100,000 today," or else face penalties if you want to withdraw more.
We've seen cases where we have ''broken the buck,'' and that gets investors extremely concerned, because this is what is thought of as our safe money. So all of sudden you have a bank run which, in an interdependent world, affects everybody else, so you can have a huge problem like we had in 2008.
3) How would the changes impact investors?
It is hard to say what the unintended consequences of the rule changes will be, but since proposing the changes in early June, the SEC is currently in a 90-day public comment period to allow different parties to weigh in with their thoughts and concerns. “Our goal is to implement effective reform that decreases the susceptibility of money market funds to runs [mass, panic-fueled withdrawals] and prevents events like what occurred in 2008 from repeating themselves,” said Mary Jo White, chair of the SEC in a statement.
4) What should investors consider when choosing a money market?
There's certainly no shortage of choice out there, but as far as DeMuth is concerned, investors should seek out "a large, well-known institution with a national presence." His thinking is that if a small institution hits hard times, the burden will fall to the investor, while the failure of a mega-bank would be Congress's problem. For most people, a quick check of local rates (on a website such as Bankrate.com) is considered a good place to start. You can at least see how your own local lender stacks up to the competition.