Will Greece Spur Money Market Reforms?

Last Updated Jun 26, 2011 4:01 PM EDT

Ten or 15 years ago, an American investor watching something like the drama currently unfolding in Greece might be correct in assuming that such events had little impact on his portfolio. Investors today have no such luxury.

Most obvious is the impact that the Greek debt crisis has had on the stock market, which on many days over the past few months has gained or shed hundreds of points in reaction to the twists and turns the crisis has taken.

But the impact doesn't stop there, for in recent weeks investors have learned that the Greek debt crisis could have important implications for their money market investments.

A report published by Fitch Ratings last week said that the ten largest prime money market funds -- which account for 45 percent of all prime money market assets -- have roughly 50 percent of their total assets in debt issued by European banks.
Why is that worrisome? Because those banks hold billions of dollars worth of debt issued by Greece, Portugal, Spain, and the like, leaving the banks exposed to severe losses if the Euro crisis takes a turn for the worse. Those losses, in turn, could cause the value of that bank-issued debt to plummet, which would have dire consequences for the money market funds which own it.

This crisis follows on the heels of the Lehman Brothers bankruptcy in 2008, which brought the money market industry as close to collapse as it had ever been. Lehman's failure caused the industry's original money market fund to "break the buck"; it became one of the few money market funds to ever see its share price fall below $1. Further, an unknown number of funds would have suffered a similar fate if not for the unprecedented efforts of the federal government, which insured money market investments and arranged to take more than $100 billion worth of troubled debt off fund managers' books.

That experience has prompted a furious and ongoing debate between industry experts, regulators, and participants. Most experts and regulators believe that the events in 2008 prove that money market funds have to adopt a floating share price. The funds' traditional fixed price of $1 per share, they believe, is unsustainable in times of crisis, and encourages investors to adopt a "run on the bank" mentality, in which they try to pull their money out as quickly as possible at the first sign of trouble, when liquidity is often at a premium.

Industry insiders have fought furiously against such a change, fearing that floating share prices would prompt investors to eschew heretofore stable money market funds in favor of bank savings accounts and certificates of deposit. Such a development, of course, would deprive those managers of billions of dollars worth of management fees.

In making their case, these managers have, in part, argued that the events of 2008 were of a once-in-a-generation variety, and that it would be foolhardy to overreact to them while ignoring the decades of stability that have for the most part characterized the industry.

While that is undoubtedly true, the current European debt crisis underscores the fact that the financial markets today are worlds away from earlier eras, and are interconnected in a way that was unimaginable when the money market industry was in its infancy. In the 1970s and 1980s it likely would have been impossible to believe that a crisis in a country with a GDP that is roughly equivalent to that of the state of Washington could have ripple effects that an investor in Nebraska would fear. And in the coming years that interconnectedness is only going to increase.

Recognition of that fact, and of the need for the share prices of money market funds to reflect the risk inherent in these oft-occurring crises, is what has prompted the likes of the President's Working Group on Financial Markets and the Wall Street Journal's editorial board to call for letting the share prices of money market funds float.

The industry can try, as they have, to construct a backtested alternative plan that would have held up under previous market crises, but the problem is that history has demonstrated time and again both that tomorrow's crisis has little in common with yesterday's, and that in the financial markets, one-hundred year floods occur with surprising regularity.

The question is whether during the next crisis we will again rely on an implicit federal government guarantee to save the money market industry, or whether regulators will force the funds to adopt a pricing model that reflects the risks inherent in our interconnected financial markets.

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  • Nathan Hale

    View all articles by Nathan Hale on CBS MoneyWatch »
    Nathan Hale has spent decades working in the financial services industry, during which he has researched and written extensively about personal investing, the mutual fund industry, and financial services. In this role, he uses a nom de plume because many of his opinions about the mutual fund industry and its practices would not endear him to its participants.