The hidden cost of bailouts: The money market mutual funds and moral hazard

Treasury Secretary Timothy Geithner’s letter to leading financial regulators Thursday afternoon urging them to step up oversight of money-market mutual funds was, as these things always are, written in painstakingly formal language.

Allow a bit of translation. Here’s what Geithner was really saying to the SEC commissioners who have rejected proposed changes to the funds in the past, and to the mutual fund companies themselves: Nice little industry you’ve got there. It would be a shame if something nasty happened to it, like having Federal Reserve examiners running around all the time questioning everything they do. You might want to ask your friends at the major banks, like Citigroup and Bank of America, how they enjoy that.

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A bit more thuggish than what Geithner actually wrote (“the Council’s authority to designate systemically important payment, clearing, or settlement activities under Title VIII of the Dodd-Frank Act could enable the application of heightened risk-management standards on an industry-wide basis”), but more accurate.

The latest wrangling over money-market mutual funds is something bigger than the routine battle between financial regulators and the lobbyists paid to influence them. Rather, it is a vivid illustration of some of the hidden costs of bailouts — in this case, the government rescue of the $2.6 trillion money-market mutual fund industry in 2008 that was so successful it took away any sense of urgency for major reform.

When a problem comes out of nowhere, causes a financial crisis and wrecks the economy, it is deeply unfortunate. But when a problem that has been staring everyone in plain sight does the same, it’s just a tragedy.

Money-market mutual funds serve as part of the bedrock of the American financial system, serving as a way for millions of Americans to save money in a financial product that (normally) offers better returns than bank savings accounts and is (normally) very safe — and then funnels that money to companies that issue short-term debt, thus funding their operations.

How do we know that this system has flaws? Because they nearly brought down the financial system in 2008. After the Reserve Primary Fund suffered losses on its holdings of Lehman Brothers debt, it “broke the buck” — told investors that a savings vehicle they presumed was ultra-safe had actually experienced a loss. In the days that followed, investors in other funds withdrew money on a vast scale, which was a modern version of an old-fashioned bank run. As they pulled out money, the funds were forced to sell off the securities they owned, in an already panicked environment.

If it had continued unabated, millions of Americans would have lost what they viewed as the most secure portion of their savings, more global banks (which rely on that funding) would have collapsed or required bailouts and the ordinary companies that rely on money-market funds buying their short-term debt to finance their routine operations could have been out of luck.

To prevent that outcome, the government stepped in with a wave of programs from the Treasury and the Federal Reserve to backstop the industry. And the mutual fund companies themselves decided to subsidize their money-market funds; according to a study from the Boston Fed, at least 21 more funds would have broken the buck had their management companies not chosen to inject. Between government help and subsidies from the fund companies themselves, no more funds broke the buck and eventually the “shadow bank run” ended.

Fast forward four years. The panic of that fall of 2008 is starting to fade into history. The Dodd-Frank Act changed the law to make it all but impossible for the Treasury to bail out the industry the way it did then, which leaves it up to regulators and the mutual fund industry to find ways to redesign the funds so that bailouts aren’t necessary.

Last month, SEC Chair Mary Schapiro canceled plans to move forward on a reform proposal after concluding she didn’t have the votes. SEC Commissioner Luis A. Aguilar had indicated he would oppose her proposal, favoring a more overarching approach to overseeing the cash-management industry.

Geithner’s letter to the Financial Stability Oversight Council is an attempt to bring the pressure of the entire universe of financial regulators to bear on the SEC.

The FSOC, created by Dodd-Frank, includes leaders of the SEC, the Fed, the Commodity Futures Trading Commission, the Federal Deposit Insurance Corporation and other leading financial regulators. Geithner is looking for that group, in a private meeting Friday afternoon, to apply group pressure on the SEC to act on money-market mutual funds.

One of the purposes of the FSOC is to prevent any firm that might create risks to the financial system as a whole from falling between the cracks of America’s complicated regulatory system. (That, for example, is what happened with bailed-out insurer AIG). The FSOC has the power to put any such company under the regulatory thumb of the Fed.

But the fact that Geithner is having to resort to those kinds of implied threats shows the deeper problem in play. The Treasury and Fed deployed a massive bailout to keep investors in money-market mutual funds from losing their shirts. It succeeded. But the very fact of that success has meant there is little sense of urgency around changing the way the funds are regulated to try to keep them from putting the economy at risk again.

Economists call it moral hazard. Geithner was always a skeptic of arguments during the crisis that bailouts should be avoided out of these moral hazard concerns. And now he has the task of dealing with it.

 
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