Tuesday, September 24, 2013

Safe Haven

I watched the movie, Safe Haven, over the weekend.  Based on the book by Nicholas Sparks, the movie stars Josh Duhamel and Julianne Hough, in a tale about a young woman with a mysterious past who starts a new life in a small coastal town in North Carolina and becomes attracted to a young widower with two small children.  He helps her confront her past and find comfort in the "safe haven" of his love and in her life in the small town.

The "safe haven" for most savers and investors over the last 30 years has been the money market fund. The money market fund is an open-ended mutual fund that invests in short-term debt securities, short-term t-bills and commercial paper.  MMF's were not designed to provide a large yield but were usually attractive compared to bank CD's and savings accounts as they provided a higher yield than a savings account and more liquidity as compared to a CD.

To provide some perspective, there is over $2.5 trillion invested today in MMF's.  This is more than the sum of checkable and demand deposits at commercial banks ($2.3 trillion per Federal Reserve).

MMF's are also designed, unlike most other financial instruments, to provide a stable value of $1 per share so that the fund owner will not worry about the loss of capital.  This feature has also made MMF's a popular capital preservation vehicle for investors.

However, unlike deposits in banks with FDIC backing, MMF's have no deposit or fund guarantee.  If the underlying investments in the mutual fund go bad, it is possible to "break the buck" meaning that you do not get the $1 back that you invested originally.  This has only happened a handful of times since the inception of MMF's but it could have been a serious problem in the financial crisis of 2008 if the U.S. Department of Treasury had not stepped in after the Lehman Brothers bankruptcy to "guarantee" the $1 net asset value in participating MMF's.

MMF's position as the "safe haven" for investors may change in the future as the SEC has proposed that institutional MMF's might need to move to a floating or variable net asset value.  This would end the traditional $1 stable NAV for these funds.  Alternatively, MMF's could continue to operate with the $1NAV but they would need to place restrictions on the fund to control for heavy redemptions and potential "runs on the fund".

These new rules would be designed to reduce the systemic risk in MMF's for investors and the financial system. You can read all about these proposals and the potential effects on 401(k) plans in this article by PIMCO.

A major point in the article is what is reflected in this chart showing nominal (actual) and real (after inflation) of MMF's since 2003.  It shows just how damaging the low interest rate environment has been to savers.  The reality is that MMF's may be perceived to be a "safe haven" but they have quietly been eroding the real wealth of savers by about 2% per year over the last decade.

Credit: Franklin Templeton 

Compare these rates to the yields on MMF's from 1992-2004 where nominal rates were more typically in the 3-6% range.

Compare the difference to the saver between a 4% yield and a 0.02% yield.  $100,000 in a money market mutual fund provides $4,000 of yearly income to the saver.  At .02%, it provides $20!  A $2,000 real return becomes a loss of $2,000 after taking account of inflation.

Based on the estimated $2.5 trillion invested in MMF's right now, the loss of interest income for savers in the aggregate amounts to around $100 billion this year alone.  If you take all of the interest income on savings-bank savings, CD's and bonds, you are talking about $400 million or more. That is a lot of money being taken out of the pockets of savers.

To put that in perspective, the FICA payroll tax holiday that was in place a year or so ago carried a cost of $120 billion per year.  That was supposedly done to put more money in people's pockets.  However, at the same time, we were taking 3 times that much from savers.  Could that be a reason the economy is stuck in neutral?

Can you imagine what the reaction would be if a $400 billion annual tax increase was proposed on savers at the beginning of this recession?  There would have been rioting in the streets.  In fact, that is what happened in Cyprus earlier this year.

However, this is exactly what has occurred in this country with nary a peep.

I wrote about the adverse effects of the Fed's policies over two years ago in "Robbing Savers To Pay Goldman, Chase and Citi et al" and nothing much has changed.  However, you can also include the federal government as another major beneficiary of the low interest rate policy.

Quite simply, we have reached the point where a return to normal interest rates would be nearly fatal to our federal budget and most of the other G-7 countries.  In fact, a 1% increase in interest rates means an additional $1.4 trillion in costs for these countries.

This is what I wrote in February, 2011.

The policymakers are so driven to prime the pump in an attempt to save Wall Street and the banks who made the bad loans and investments they have purposely forced savers to get almost nothing for their efforts.  Why?  Quite simply they want to make it so unattractive to save that these savers will finally give up and take a flyer on the stock market or buy a new house.  At a minimum, they would like them to go to the bank and pull the money out and spend it on something!  
Of course, the savers they are targeting are your grandparents or your parents or some other responsible soul who played by the rules their whole life.  They saved liked they should to build a nest egg for retirement or their child's college eduation.  
Now the Fed policymakers come along and they want to "smoke them out of the foxhole" by fixing it so they get no interest on their savings.  If they can't get them to trade their savings for stocks or some other investment they have a second approach lined up.  INFLATION!  What do people do when they see their money being eaten up by inflation?  They quickly decide they would rather spend it on something today rather than get a lot less than something tomorrow  

Beware the "safe haven" of money market funds and other low yielding investments that are resulting from the Fed's policies.

Watch Josh Duhamel and Julianne Hough instead.  $1.20 at Red Box (before tax, of course).  $6,000 in a money market for a year will pay for it.

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