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Caveat investor! Now they want a bite of your mutual fund

We should not subject our capital markets to central planning by the Fed.

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.

Paul S. Atkins

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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Comments (6)

  1. Submitted by Greg Kapphahn on 10/03/2014 - 07:38 am.

    So Now that the Government Doesn’t Have Political Cover

    To “bail out” the too-big-to-fail banks using taxpayer money pulled from the US general fund,…

    because average citizens would likely pick up their pitchforks and torches and attack Wall Street and/or Washington DC,…

    these new regulations are seeking to quietly and invisibly do the SAME thing by swiping, in advance, money out of the proceeds of those SAME average citizen’s pension funds,…

    (money which Wall Street would probably find a way to put themselves in the position to “manage,” further enriching the Wall Street tycoons right up until they lost it in the next Wall Street-create crash, anyway)?

    AVERAGE CITIZENS are NOT the ones responsible for the extreme greed-induced stubborn stupidity of the leaders of those too-big-to-fail banks,…

    who, even now, are once again seeking to make massive profits by steadfastly avoiding investing in any actual research and development or innovative, job-creating manufacturing concerns,…

    but rather, are lying to each other about the quality of the bundled financial products they’re trading back and forth,…

    while the insurance schemes they’re buying into to insulate themselves from, and thereby, pretend that the risks they’re taking do not even exist,…

    are as worthless were the “credit default swaps” they had all purchased by 2008,…

    all of which will blow up like a wet, sloppy, bubble from too many pieces of artificially-sweetened bubble gum chewed together,…

    as soon as each of them figure out that he’s not the ONLY one lying through his teeth about the worthless products he’s selling, but everyone ELSE is lying to him just as much,…

    and he can’t trust anyone he’s been trading billions of dollars worth of worthless crap with to tell him the truth, either.

    Why can’t/won’t/don’t we set up these systems so that, when the inevitable crash which results from all this larceny and dishonesty happens, the FIRST thing we do is zero out all the financial accounts,…

    (wherever in the world they exist),…

    of all the principles of these too-big-to-fail banks?

    After all, if “corporations are people,” then the same thing that would happen to each and every one of us average Americans if we set up an “investment” firm, then lied to and defrauded, took unreasonable risks with, and pocketed for our own personal use the funds of our friends and neighbors,…

    funds which we had a fiduciary responsibility to protect and preserve,…

    should happen to every CEO, management underling, and board member of any too-big-to-fail bank that is doing or has done the same thing.

    As long as we continue a system whose rules allow those at the top to profit from massive dishonesty and placing predictably unwise bets with other people’s money,…

    then, when it all blows up, those same people at the top get to keep the dishonest gains they’ve arranged for themselves while other people who are not, in any way, responsible for those losses, are forced to make up the difference,…

    our American Investment System will serve no other purpose but to allow the richest of the rich to steal money from those less fortunate,…

    whom they have arranged to have no other choice but to invest that money with their investment companies,…

    then keep that stolen money when the system crashes,…

    while the crash allows them to steal EVEN MORE from those who are less fortunate than themselves.

    The entire American Investment System is nothing more nor less that a Casino Gambling Enterprise where, whether the gamblers win or lose,…

    the HOUSE always wins.

    This needs to be changed so that the first to lose are those running the system and making, or requiring others to make the bad bets that have crashed the system, in the first place, while the investors are protected from the losses those at the top have incurred.

  2. Submitted by Jon Kingstad on 10/03/2014 - 09:23 am.

    Central planning

    I’m not quite sure what to make of this article. The Federal Reserve’s (read Alan Greenspan’s) complete bungling of its regulatory role after that repeal bears a huge responsibility for the bubble that burst in 2008 and the financial calamity that resulted. But the SEC was also a cop on the beat. The author was a member of the 5 member SEC from 2002-2008. With blameworthy targets like the too big to fail banks and Alan Greenspan, the SEC managed to escape much public criticism over its role in allowing the bubble to happen. Nevertheless, it wasn’t any help. So I’m a bit skeptical of listening to anyone who was a member of that agency during that period. As far as I’m concerned, they’re not in any position to offer any more useful advice about reform than than Alan Greenspan is.

    The Dodd-Frank Act has come in for its share of criticism, probably a lot of it deserved. The most I hear about it is that it did nothing to address the systemic causes of the bubble and the ensuing crisis. These are besides leaving the “too big to fail banks” in place or not reinstating the Glass-Steagall Act (which required a compete separation of banking from investment banking and insurance). Since the repeal of the Glass-Steagall Act, the differences between banks, insurance companies, mutual funds and other financial service entities has blurred almost to the point of disappearing. What the author seems to be deploring is a requirement that such (formerly) nonbank type entities be treated like banks in maintaining a certain (cash) reserve. Requiring a prudent cash reserve doesn’t strike me as particularly radical idea nor does it sound like “central planning” (which through Goldman-Sachs and its ilk we get except it’s not regulated). It seems more like a sound investor and public protection against the speculative, reckless practices that caused the bubble and the crash and which still predominate on Wall Street.

    I completely disagree with the author that “banks are completely different” from mutual funds and these other nonbank entities. The author uses the concept of “leverage” in two different ways: one to describe the bank’s use of depositors’ accounts for other financial activities; the other describing (I think because he doesn’t say) the use of borrowed funds to make essentially speculative investments. His point is a bit misleading. The fact that depositors’ accounts are insured is completely irrelevant to the point. If a mutual fund or any financial entity uses “leverage” i.e. borrows money using their fiduciaries’ investments as collateral to make riskier investments, that needs to be regulated. There’s a risk when any financial entity borrows to invest. It’s not a bad idea to limit the degree to which a fund’s assets are “leveraged” by making them hold a cash reserve.

    As a mutual fund holder myself, I have no problem having my funds paying their fair share of a “bail out tax” if that strengthens the system. Before doing that though, I would hope Congress would consider the financial transaction tax that would tax, ever so minutely, the every financial transaction. That would also help dampen the excessive speculative trading. I would also hope Congress would repeal the “carried interest” loophole that enables hedge fund managers to escape income taxes.

  3. Submitted by jason myron on 10/03/2014 - 03:44 pm.

    I completely agree, Jon

    but unfortunately, I think you’re putting too much hope into a congress that has shown absolutely no desire to do the right thing, especially when it comes to any type of financial reform

  4. Submitted by E Gamauf on 10/04/2014 - 07:04 am.

    Responsible Managers

    This is hard to sort out for people that are not economists.
    Do congressmen know any better, or do they take lobbyists’ word?

    Whenever things get tight in one area – the financial market stakes out new territory.

    The trick is that the managers get to cash out anytime & live like kings. Wall Street walked after the mess we had – and if anyone saw it coming, it was the “investment professionals.”

    They don’t bear any personal burdens, that I can see – other than losing their reputations.

    Its not money – its just gambling?

  5. Submitted by E Gamauf on 10/04/2014 - 07:24 am.


    “…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.”

    Please explain how that should make anyone happy.

  6. Submitted by Gerald Abrahamson on 10/06/2014 - 11:27 am.

    Where is “pay for performance”?

    We never see programs that pay investment managers based on performance. That tells the public what they need to know.

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