April 12, 2011 / 5:41 PM / 8 years ago

Money funds face multipronged threat to existence

NEW YORK (Reuters) - Life is only going to get harder, analysts say, for money market funds, which are already imperiled by an environment in which ultra-low short-term interest rates make good returns scarce.

A trader counts his money on the floor of the New York Stock Exchange October 7, 2008.REUTERS/Brendan McDermid

Three new regulatory changes, all originating from the Dodd-Frank financial reform legislation, are set to take a toll on the funds’ ability to earn returns and hold on to clients.

One has already been implemented: a new method for assessing bank deposit insurance fees by the Federal Deposit Insurance Corp has made it harder for money funds to engage in repo agreements with U.S. banks, which no longer see an advantage in borrowing cash in overnight loans and using surplus securities as collateral.

Rates money funds can earn lending cash in the repo market now are down into the single digits, and likely to stay low, even as the market itself stabilizes.

“Overnight markets were hit harder by the transition to the new FDIC deposit assessment base than we expected,” a note from Wrightson ICAP said on April 3. “The pullback from overnight borrowing by domestic banks in both the funds and repo markets had a greater impact than anticipated.”

Repo rates could stay low until the Federal Reserve makes its first monetary tightening move, either by raising interest rates or trying to drain cash from the financial system.

If the April 1 implementation date of the new FDIC assessment added pressure to money funds, the July 21 start of two other changes to the short-term rates environment threatens them even more.

Banks will get two years of unlimited insurance on nondemand deposit transactions, while also gaining new power to pay interest on demand deposits, such as checking accounts.

The combination of those two changes will make it more desirable for some money fund customers to simply put their cash into interest-paying bank accounts, while others will seek the unlimited insurance on nondemand bank account transactions, safer than money fund accounts which lack an explicit government guarantee.

“The change could draw assets from both retail and institutional funds,” wrote Alex Roever, head of short-term fixed income strategy at JPMorgan, in a note to clients on Monday in which he discussed the banks’ new interest-paying powers.

“We suspect retail funds will ultimately be more impacted,” he added, estimating the potential outflows from retail funds at between $80 billion and $100 billion.

In the meantime, there is little love for money funds, which have been criticized as underregulated by government officials and investors alike.

A year ago, Paul McCulley, then portfolio manager at Pimco, told an audience at the Levy Economics Institute’s Hyman P. Minsky conference money funds contributed to the instability of the financial system. He said he regarded them as banks with no capital.

Last October, the President’s Working Group on Financial Markets sent a report to the Securities and Exchange Commision suggesting ways to better regulate money funds, but the SEC has not yet acted on the report.

While regulators are loath to admit it, the problem of how best to restructure money market funds to make them safer may solve itself, as the low short-term rates and expanding cash-management alternatives for investors and companies push the funds themselves toward the maw of history.

Editing by James Dalgleish

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