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The Broken Money Market Model

Can we keep Humpty Dumpty from falling apart next time, too?

There's a debate going on today about the future of money market funds. It's one that's been brewing for years, but only began boiling in the fall of 2008 when a portfolio under the Reserve Fund banner proved a lot riskier than its nurtured reputation and "broke the buck"--its net asset value fell below the requisite $1 per share.

The question now at hand is how to prevent the kind of catastrophic money market disasters that we nearly saw in 2008. As Lehman Brothers failed and liquidity dried up last fall, investors began to panic, yanking billions from money funds. If that had continued for long, the "run" would have tested even the best-run funds: Selling enough securities to raise cash and meet redemptions in that environment would have likely been impossible. Fortunately, the government stepped in and backstopped the industry with guarantees. With that harrowing experience still fresh in many minds, battles over the right way to avoid a relapse have begun.

A Tale of Two Ideas
Two key parties have chimed in. Andrew Donohue, the SEC's director of investment management, has argued (in this speech and others) that the best solution may be to abandon the money market fund's sacrosanct $1 per share design in favor of a $10 per share construct and a floating net asset value system. By contrast, a so-called Money Market Working Group under the auspices of the mutual fund industry's trade group, the Investment Company Institute, has put out a detailed but less aggressive set of recommendations. In effect, it says to tighten up the ship--but keep the ship. (Details on the ICI's recommendations are available here.)

Here's the problem. Forcing money markets to "float" their NAVs as Donohue suggests will essentially turn them into ultrashort-bond funds (though he seems to favor a switch to $10 per share whether it floats or not, which is a great idea; he provides a good explanation here). Absent the near certain stability of money markets--and wary of the risks that ultrashort funds have taken--it's fanciful to think that most investors will stick around. It's only a guess, but my bet is that 75% of money market assets would be yanked out in favor of FDIC-guaranteed accounts, and maybe more. Either way, investors would lack a bedrock investment option, and whole swaths of the U.S. economy would have to look elsewhere for the short-term funding that money markets supply.

On the other hand, the ICI's proposals are mostly sound but don't go far enough. The trade group suggests tightening up credit requirements, shortening maturity risk, and making sure that funds have plenty of liquid assets. It also argues for giving money fund boards the authority to suspend redemptions in a pinch. There's more, including provisions for better educating investors about risk, but none of it will stop the industry from sliding into deep trouble in a future crisis. As safe as funds would be under the ICI's plan, if panic resurfaces and liquidity disappears, investors are almost certain to run, and money funds will again find themselves in hot water.

Chasing the Grail
There's no perfect solution to this conundrum. As Donohue implies, the very concept of a fixed-price money market fund that doesn't respond to interest-rate or credit movements was a contrivance to begin with and is even more of an enigma in today's mark-to-market world. But it's an enigma that investors have come to trust and upon which the financial system has come to rely. The trick will be to retool it in a way that helps reassure investors without "socializing" its risks by using the government as a safety net.

There are all kinds of reasons that it's politically and economically unpalatable to continue supporting the industry with taxpayer money, but that could still be an option. A more balanced solution might be the creation of an industrywide insurance pool to provide emergency liquidity and credit-loss protection for a price borne by the funds themselves.

That's no easy sell, either. Profit margins for the most attractively priced funds are thin to begin with--and that's assuming that management doesn't have to swoop in and "save" its own struggling fund. When interest rates stay low for long stretches, those margins usually come under even more pressure, and we've already seen a handful of big firms pulling back from the business. Then there's the temptation to roll out money market "alternatives" (including ultrashort-bond funds) to keep fleeing money market assets in-house. That brand of yield-chasing helps fuel the same kind of caustic cycle that played out most recently in 2008.

Of course, there's no guarantee that industry insurance solutions would even be sufficient. As they stand right now, though, the two main proposals on the table are even more incomplete. One would likely wipe out the industry, while the other might leave it nearly as vulnerable as before. Those are both ugly options.

Mutual fund analyst Michael Herbst contributed to this article.