Even with the stock market reaching all-time highs and many Americans smiling at the look of their 401(k) valuations, storm clouds are gathering in Washington and abroad that may mean higher costs for investors, lower returns in the long run, and less freedom to cash out when that rainy day comes. If you are trying to save for retirement, college tuition, or a down payment, it is worth paying close attention to this unfolding debate on whether central planners in Washington should impose a virtual tax on mutual fund investors and interfere with their investments.
Mutual funds have become the preferred investment vehicle of a vast majority of Americans. Investors pool their hard-earned money into funds and the funds, in turn, hire professional money managers to buy securities with the investors’ money. These investments, by both investors in the first place and then by their funds, are almost entirely for cash – there is virtually no borrowing involved (by law with respect to mutual funds). Thus, the funds and their investors bear the losses, but also reap the rewards. Investors know this, and that is why they trust their money to a professional manager and why they like the ability to move their money around to different kinds of funds with different investment strategies.
Banks are different altogether. Savers are creditors (not owners) of a bank and have a government guarantee on their deposits, on which they earn a very small rate of interest. Banks, in turn, borrow large amounts based on their savers’ deposits and their shareholders’ capital. Unlike mutual funds, they “leverage” this money by borrowing. Banks are a welter of assets and liabilities, complex products and maturity mixes, all deeply and fully woven into our financial system. A bank’s failure could send shocks – small ones, usually – through part of our financial system.
The attempt to decrease leverage
In 2010, Congress enacted the 2,300-page Dodd-Frank Act, which was sold as a just-add-water solution to the 2008-09 financial crisis and as a safeguard against future meltdowns. One goal was to decrease leverage and systemic risk in the financial system, because Congress believed that leverage was a major cause of the crisis. The statute demands that regulators take severe steps against banks to lessen systemic risk, mainly by requiring banks to raise more capital and lower their leverage.
To oversee this process, Dodd-Frank created the Financial Stability Oversight Council (FSOC), which is made up of the heads of the financial services regulators. The FSOC claims very broad power to designate certain activities (like asset management) or companies and products (including mutual funds) as systemically important and subject them to Federal Reserve bank-style regulation, including leverage and capital requirements. The FSOC is doing just that – first with banks, then insurance companies, and now potentially mutual funds. In fact, President Barack Obama’s insurance expert on the FSOC issued a blistering dissent when FSOC designated Prudential as subject to this sort of regulation. It was, he asserted, unwise, unneeded, and would be harmful to insurance companies and their policyholders.
No threat to the financial system
Indeed, mutual funds – already heavily regulated – have shown that they are no threat to the financial system, even during the last financial crisis. While hundreds of banks failed, sending reverberations throughout the financial system, mutual funds go out of business all the time with no systemic noise because they do not “fail” – investors hold their equity stake and simply ride their investment up or down.
What should investors fear from this designation process? The Federal Reserve might impose capital requirements on your fund, meaning that 8 to 12 percent of your investment would not be put to work and would earn a rate similar to a bank account. Further, investors might not be able to sell when and how they want.
They might be asked to “take one for the team” in turbulent financial times since the Fed could restrict sales of certain securities. The Fed could also decide to create disincentives to selling fund investments by imposing fees for doing so – in effect, saddling you with a loss if you did precisely what any prudent investor or fund manager would do.
Even worse …
Even worse, mutual fund shareholders might have to pay into a bail-out fund in case a too-big-to-fail bank collapsed. Dodd-Frank authorizes the taxing of FSOC-designated companies to pay into a TARP-style fund.
Capital markets are risk markets, and investors’ risks are not the same as banking risks, much less threats to the “financial stability of the United States.” We should not subject our capital markets to central planning by the Fed. Invested capital has long fueled the extraordinary growth of U.S. entrepreneurial ventures and corporations. It is that record of vibrancy and resiliency that policy makers in Washington should seek above all to preserve.
Paul S. Atkins is chief executive officer of Patomak Global Partners, a financial services regulatory consultancy with offices in Washington and New York. He is in the Twin Cities this week for talks and meetings about the mutual-fund proposals in Washington. Previously, Atkins served as a commissioner of the Securities and Exchange Commission (2002-08) and later as a member of the Congressional Oversight Panel for TARP (2009-10).
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