Will Obama Kill Money Market Funds?

Presidential confidant and former Fed Chairman Paul Volcker sounds like the golfer who goes into the 18th hole 100 over par and asks his playing partner: Do you give up yet? In this case, the game is called Financial Failure. The score? Banks: 3,000+; Money Market Funds: 2.

What Mr. Volcker takes from this scoresheet is that money market funds (MMFs) should be shut down, not banks. Perhaps he thinks that in this game it's the highest score that wins.

The 3,000+ failures is not a misprint. Over 3,000 banks have failed just since 1980, when modern MMFs were first offered. This year, 95 banks have failed already, the most since 1992, when failures totaled 192.

Of course, that's a bit unfair to 1992. That year the Treasury and Fed did not inject hundreds of billions of dollars into the banking system. Today, massive bailouts have become de rigueur. Without the bailouts, the 2009 tally would be much higher. 2010 may be worse.

How do MMFs compare? There was one MMF failure in 2008. That's the most since 1994, when there was also . . . one failure. There have been no other failures and no government bailouts. None.

Yet Mr. Volcker's position on the relative success of banking and MMF regulation is that MMFs should be regulated more like banks. Following his view that banking regulation works, Congress has raised the bank deposit insurance limit from $100,000 to $250,000, while the Treasury's temporary insurance program for MMFs has been allowed to expire (but not before the Treasury pocketed $1.2 billion in premiums that it presumably will use to support sick banks). Ayn Rand would relish this spectacle of government bureaucrats punishing success and rewarding failure.

MMFs: Safer than Banks
The correct lesson to be learned from the past is that it is banks that should be regulated more like MMFs because--as the Financial Failures scoresheet shows--money market funds are safer than banks.

The reason for MMFs' safety advantage is their assets. Money market funds are required to invest only in short-term assets valued at the price at which they could be sold on short notice. The value of MMF assets fluctuates very little. When MMF shareholders sell shares, MMFs stand ready to meet those redemptions because their assets are likely to be saleable at their carrying value.

Of course, no large pool of assets can maintain its value under the most extreme liquidation scenarios. This is why the run on MMFs that was triggered by the failure of the Reserve Fund last September created a crisis. But an MMF's assets are still inherently more capable than a bank's assets of meeting unusual redemption demands.

In comparison, a bank is a house of cards waiting to be blown apart by the first zephyr of deposit withdrawals. Banks invest in long-term assets that cannot be sold quickly at their carrying value when depositors withdraw their money. You may recall the iconic scene in It's a Wonderful Life when George Bailey tells a lobby full of frantic depositors: "You're thinking of this place all wrong, as if I had the money back in a safe." The money wasn't in the safe, of course, and Bailey's Savings & Loan survives only by its customers' loyal (or foolish) forbearance.

Bank depositors don't behave like characters in Hollywood romances, however. It is only deposit insurance that saves the banking industry from collapsing in the first winds of a financial liquidity crisis. This is the structure into which Mr. Volcker wants $3.5 trillion transferred that is currently invested in MMFs.

Path of Least Insurance
The logical prescription for the current crisis is two-fold. First, insured banks should be regulated like MMFs. They should invest insured deposits only in short-term assets that stand a reasonable chance of satisfying a surge of depositor withdrawals. This structure, long known in the literature as a "narrow bank," would be the first step in reducing the distortions in the markets for cash management services and short-term capital that deposit insurance creates.

Second, MMFs should be insured like banks. Whether the insurance is provided through a government-sponsored entity or mandatory private insurance minimums, MMF insurance would help level the playing field with banks. Consumers would be free to choose the most efficient vehicle for their cash, rather than choosing between banks and MMFs based partly on the relative size of their government subsidies. This would lead us down what I've described in a separate article as the path of least insurance.

Money market fund insurance also would address the systemic risk that MMFs pose to our financial system. The run on MMFs that occurred last September threatened a systemic collapse in short-term capital markets and our payments system. The Treasury's MMF insurance program and other temporary government measures narrowly prevented this disaster.

Money market funds already enjoy an implied government guarantee. There is no doubt that in a crisis the Treasury will resurrect its MMF insurance program. Why not have MMF shareholders pay for it?

The SEC has issued rules that will reduce the already small risk of an MMF failure, but neither the SEC nor bank regulators have proposed any permanent solution to the systemic risk posed by an MMF failure. It is in this vacuum that Mr. Volcker's proposal to eliminate MMFs has gained political purchase.

The future of MMFs was supposed to be revealed on Sept. 15. That is the deadline that President Obama imposed for the President's Working Group (comprising the Fed, Treasury, SEC, and CFTC) to report on two options: (1) eliminating MMFs by allowing their net assets to fluctuate like other short-term bond funds (reflecting Mr. Volcker's MMF-terminating approach), or (2) "requiring MMFs to obtain access to reliable emergency liquidity facilities from private sources" (reflecting a public/private insurance approach).

The deadline has been extended until Dec. 1. We should hope that by then, when it comes to banks and MMFs, Mr. Volcker's fellow bank regulators know the score.

Mercer Bullard is president and founder of Fund Democracy, a mutual fund shareholder advocacy organization, an associate professor of law at the University of Mississippi School of Law, a senior adviser for financial planning firm Plancorp Inc., and a former assistant chief counsel at the Securities and Exchange Commission. The views expressed in this article do not necessarily reflect the views of Morningstar.com