The U.S. Securities and Exchange Commission is supposed to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” It is odd, then, that the regulatory body decided last week to preserve one of the most egregious loopholes in the entire financial system. Money market mutual funds were effectively declared “Too Big to Fail” by the authorities in 2008 yet remain wholly unregulated. They are the rotten core of the shadow banking system—providing ridiculously cheap leverage to speculators courtesy of the American taxpayer.

Money market funds were created to get around bad regulations. Until the 1980s, banks were limited by law on how much interest they could pay to depositors. The thinking was that the financial system would be safer if banks did not have to do anything risky or competitive to earn a profit. Thus the government suppressed funding costs and bankers got to live the 3-6-3 lifestyle: pay 3% on deposits, earn 6% on loans, and leave the office in time to tee off at 3 in the afternoon. It is not a surprise that bankers accepted relatively strict supervision and international capital controls under these circumstances.

This arrangement broke down when inflation accelerated in the late 1960s. Faced with negative real interest rates on their deposits, savers pulled their money out of the banking system and put it to work in the short-term debt markets, which offered better returns.[*] Money market mutual funds were the vehicles of this “disintermediation.” These unregulated instruments pretend to offer the same features as regulated checking accounts (stable value and access to the payments system) while paying higher interest rates. In reality, they issue shares to investors and use the funds to purchase commercial paper and t-bills. Sometimes they lend out their securities in the repo markets. Unlike banks, money funds do not shield savers from losses with an equity cushion, much less a government-backed insurance program like the FDIC. Money funds also have no formal relationship with the lender of last resort in case “depositors” ever try to redeem their shares in large numbers.

The funny thing about the multi-trillion dollar money fund industry is that most of its business involves lending to the big banks, including investment banks and foreign banks: about three-quarters of the U.S. commercial paper market funds financial firms rather than the real sector. The perceived safety of money market accounts allows speculators to fund their positions cheaply. When the bankers’ bets go right, nobody notices that the system “rests on quicksand,” as the FT’s John Gapper artfully put it. The truth only becomes apparent when things start to go south.

In 2008, the Reserve Primary Fund, the oldest of the American money funds, was stuck with losses on its $785 million portfolio of Lehman Brothers debt. Unable to maintain the charade that its shares would always be worth $1, investors fled and the Reserve Primary Fund was forced to dissolve. This untimely demise created a panic. According to the Investment Company Institute, a trade body, more than $134 billion left money funds in less than two weeks. Only the unprecedented extension of the Treasury’s safety net—a full guarantee of all the savings held in money funds—stopped the bleeding:

Ironically, the low short-term interest rates established by the major developed world central banks since 2009 have caused nearly $1.5 trillion to bleed out of money funds—far more than left during the panic:

After the crisis was over, the money markets were an area that seemed worthy of further scrutiny. Like asset-backed securities before them, they had appeared boring and safe when they were actually a large source of hidden risk. The industry, however, put up an unprecedented lobbying campaign against the SEC. As a result, it was able to avoid any changes the existing rules, even though they had proven so hopelessly inadequate prior to the crisis. How could this have happened? An excellent and detailed investigative report by Bloomberg provides an answer: the SEC is a captured organization whose employees regularly alternate between government and lobbying on behalf of the firms the SEC is meant to keep in line. It is not right to call this a “revolving door,” since that implies some kind pause while going from one side to the other. Let’s be clear. If the events described in the Bloomberg article happened in China, everyone would immediately (and rightly) decry cronyism and corruption. Why not do the same here?



[*] Gradually, the rules on deposit rates (Regulation Q) were relaxed so that banks could pay fair prices for short-term funds. Unfortunately, these prices were higher than the interest rates on their old long-dated assets because of inflation. Despite many law changes and acts of “regulatory forbearance,” this process ended up destroying the thrift industry.