Editorial: Time to fix money market risks

What does a money market fund have in common with a mattress? Both can hold your ready cash -- and neither is as safe as it looks.

Your mattress, after all, can be lost in a fire or ransacked by burglars. But when it comes to risk, your money market fund is more like a pair of stockings; one good run and it's history.

If you think that possibility is remote, you have a short memory. In the financial crisis of 2008, the nation's oldest money fund -- the Reserve Primary Fund -- couldn't uphold the $1 per share valuation investors take for granted, triggering an avalanche of redemptions. The ensuing industrywide panic was only halted when the Treasury guaranteed money fund accounts and the Federal Reserve provided loans.

Serious risks remain -- which is why the Securities and Exchange Commission is putting the finishing touches on proposals to make the funds safer. Unfortunately, much of what can be done to lower risks will cost investors money by raising expenses and shrinking returns, which are already microscopic.

It's imperative to reduce the risks anyway. With $2.7 trillion in assets, money market funds as a whole are quintessentially "too big to fail." Thus, taxpayers are likely to be on the hook if things go seriously wrong in this vast shadow banking system, which plays a big role in financing the global economy. A major money fund collapse could spark a wider crash that would jeopardize the savings of investors, cut off an important source of bank funding and torpedo the economy.

Fortunately, most money market funds are conservatively managed, investing only in highly rated short-term securities. And the industry has a strong track record of protecting your money. In 2010, the SEC imposed additional safeguards, including requirements that the funds hold more cash, limit illiquid assets and pass a periodic stress test.

But the nature of money funds poses special risks. While investors regard their money fund holdings as tantamount to cash or bank deposits, there are big differences. Money market funds have no explicit government insurance, the funds aren't required to have the kind of loss-buffer of capital that banks must maintain, and firms that run the funds aren't regulated like banks. Even a fund that invests only in Treasury securities could be forced to sell holdings at a loss due to a stampede of frightened investors. And money fund investors are easily frightened.

The Treasury and the Fed have called for additional reforms. Now the SEC is considering making the funds hold back a portion of investor withdrawals for 30 days, set aside more money as a buffer against losses, and abandon the sacred $1 valuation, so that share values fluctuate a bit, like other mutual funds. The industry, already struggling in a low-rate environment, opposes these ideas as potentially fatal to many of the 632 funds. The proposals would also probably cost investors money and convenience.

Yet it's hardly fair for money market funds and their investors to rely on an implied taxpayer guarantee without paying for it. Banks pay for the coverage provided by the Federal Deposit Insurance Corp. A similar plan for money market funds might work, but only for accounts below a certain threshold. To protect taxpayers, the funds would still need to set aside more money to cushion against losses.

Abandoning the $1 valuation would also be worthwhile, if only to upend the false sense of security investors derive from it. For similar reasons, it might be useful for Uncle Sam to openly declare that no further bailouts will be forthcoming. That would prod investors to more carefully scrutinize the assets in their money market fund, and to abandon funds that look too risky.

The world needs the cash-parking function provided by money market funds, which are also handy for financing business. But it can't live with the level of risk they pose to our economy.