MONEY- MARKET MAYHEM / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( A MUST READ )

REVIEW & OUTLOOK

JUNE 27, 2011.

Money-Market Mayhem

Once again, regulators miss the systemic risk right in front of them.Amid the Greek mini-panic this month, did you notice the really shocking news? To wit, U.S. regulators are worried about the "systemic risk" posed by the exposure of American money-market funds to European bank debt.


That's right, nearly three years after the panic of 2008, our all-seeing regulators have somehow not fixed what was arguably the single biggest justification for government intervention at the time. In 2008, the feds felt obliged to guarantee all money-fund assets after they let the Reserve Primary fund pile into bad Lehman Brothers paper, Reserve broke the $1 net-asset value, and in the following days some $400 billion fled prime money funds. We'd have thought our regulatory wise men would have fixed this systemic risk before all others.


Yet now we learn that since 2008 U.S. money funds have been allowed to pile into European bank debt even as everyone knew those banks had stocked up on bad European sovereign paper. The Treasury is even saying privately that the U.S. needs to support the European bailout of Greece lest European banks fail, U.S. funds take big losses, and we get another flight from money funds.


Can this possibly be happening?


Yes, and this time it's an entire industry as opposed to a particular fund. Half the assets in U.S. prime money market funds were invested in European banks as of the end of May, according to Fitch Ratings. Apparently, our regulators were too busy writing 2,300 pages of Dodd-Frank law and thousands of new rules to notice the systemic risk that is right before their eyes.


The flight from money funds in 2008, and potentially now, highlights a key vulnerability of the financial system: Money funds are perceived as akin to bank savings accounts because they seem to be all but guaranteed against loss, even though they aren't. Even worse, they employ a creative accounting technique that rewards the first customers to head for the exits.


This investor conditioning is courtesy of a 1983 Securities and Exchange Commission rule that allows money funds to report a stable net-asset value of $1 per share, even if that's not precisely true based on changes in the fund's underlying assets. The result is that investors have come to expect that money funds never "break the buck," never decline in value. It also means that if big institutions notice that a fund's underlying assets start to decline, they have a strong incentive to get out quickly while their 99-cent investment is still officially valued at $1.


When the Reserve fund barely broke the buck in September 2008, that was enough for Washington regulators to slap a guarantee against losses on the whole industry, though money funds had never paid for deposit insurance the way that banks do. Treasury did collect more than $1 billion in premium payments from funds before letting the program expire in the fall of 2009, but being able to buy flood insurance while the waters are cresting is not an option for most industries, or most Americans.


The Beltway crowd is now trying to cover its failure to enact money-fund reform by trotting out the old canard that nontransparent derivatives are also the cause of this crisis. Nice try, but thanks to the transparency provided by the Trade Information Warehouse we know that sellers of credit-default swaps worldwide have net exposure to Greek government debt of about $5 billion. And even a default wouldn't mean the bonds were worthless so the total hit among all the world's financial houses involved in this business might be significantly less.


The real systemic risk is a U.S. government that has regulated and redistributed everything under the financial sun while choosing not to enact the reform that everyone knew had to get done. Stocks and bonds rise and fall without government having to guarantee against losses, and if investors understood that money funds could decline like the securities that they are, investors would be more likely to accept a modest decline in stride.


U.S. regulators certainly realize the problem. In 2010 the SEC issued a rule requiring that funds publish the actual market value of their assets, but only on a 60-day delay. Last year, Treasury issued an admirable study laying out the risks and policy choices, but again it did nothing. Instead, Secretary Tim Geithner and the White House assured us that if only Congress passed Dodd-Frank, the days of crisis and bailout were over.


As for the mutual fund industry, so long as funds can enjoy an implicit taxpayer guarantee while hunting for higher yields in Europe or elsewhere, don't expect them to willingly accept reform. The industry has been working to come up with a self-regulatory safety net that would stop a run against all funds if one or more failed, but its fail safe includes access to the Federal Reserve's discount window. In short, a government lifeline. Congress isn't helping, as a House Financial Services hearing on Friday that mostly took the industry line showed.


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We've criticized Dodd-Frank for assuming omniscience among regulators. But equally as flawed is the assumption that the regulators will do something about the systemic risks they see right before them. If the political opposition is too high—e.g., Fannie Mae and Freddie Mac, the housing lobby, sovereign debt accumulation, and the structure of the money fund industry—regulators will explain the threat away, or look the other way until it's too late. Meanwhile, taxpayers will be on the hook one more time.


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