Americans' hopes and dreams have always been based on the premise that by saving their money carefully they could fulfill their financial goals. Conventional wisdom said to place your money in the bank and it would grow. Your savings would be safe—the Federal Deposit Insurance Corporation (FDIC) guaranteed it. For more ambitious savers, government and Triple-A corporate bonds provided an alternative investment. Saving was all so easy and pat. But then something went wrong.
After the early-warning signs of a 9 percent peak in the prime rate in 1970 and a 12 percent peak in 1974, we were lulled into the comfortable doldrums of the 5-6 percent rates of 1975 and 1976. Then the "interest rate roller coaster" started to climb, and the conventional wisdom no longer held true. But bank savings accounts still paid 5 percent. Bond values began to erode. And the average person on the street had no idea where to look for the high interest rates he had heard about. As concerned savers began to see the effect of escalating inflation, demands for a higher rate on savings accounts poured into the Federal Reserve. The passbook savings account rate was increased to 5¼ percent.
SAVERS' LIBERATION DAY On June 1, 1978, money market certificates were authorized. Now, the public could obtain a relatively free-market rate of return on their savings—provided they had $10,000 or more to work with and were willing to tie up that money for six months. It was a start.
The banks and the Fed agreed that the name "money market certificate" was a good name for a certificate whose rate was tied to the six-month Treasury bill rate. They forgot, however, that the money market was and had been a well- kept secret. Now the secret was out.
Up until then, the money market had been the private preserve of the affluent institutional investor with $100,000 or $1 million. In this situation, the banks had a substantial advantage—they took in small savers' money by the billions, paid only 5¼ percent and reinvested in the money market at substantially higher rates with little or no risk. This amounted to a dramatic and unwarranted subsidy of the banking industry, worth billions in profits at the expense of ordinary savers. Banks were able to call 5¼ percent "the highest rate permitted by law" at a time when free-market rates would ride as high as 20 percent plus.
Once the cat was out of the bag and news of the money market spread, new investment instruments developed. Recognizing a way of fighting the inflation ravaging their savings, individual savers and investors moved over $600 billion of savings monies from traditional savings accounts into "the new money market" between June 7, 1978, and April 1, 1981.
The new money market includes several types of investments:
• Money market certificates. The $10,000-minimum, 6-month savings certificates offered by the banks and thrifts. MMC rates are tied to T-bill discount rates. There is a three-month interest penalty for early withdrawal.
• Small saver certificates. The no-legal-minimum, 30-month savings certificates offered by banks and thrifts. SSC rates are tied to 2½-year Treasury notes, and there is a six-month interest penalty for early withdrawal.
• Money market mutual funds. The usually $1,000 minimum investment, daily dividend-bearing mutual funds. Money funds offer convenient check and telephone redemption features and have no penalties for early withdrawal. These are normally offered through the mail.
• Treasury bills. These are, in effect, short-term loans to the US Treasury and are backed by "the full faith and credit of the US government." T-bills are offered in $10,000 minimums (and $5,000 increments over that) and in maturities of 3, 6, and 12 months.
• Unit investment trusts. A generic title for several types of trusts. "The Corporate Income Fund," offered by Merrill Lynch and a few other brokers, is the only currently offered example of this vehicle. These come in $1,000 units and are excellent investments in a falling interest rate environment.
• Savings bonds. The traditional patriotic, low-minimum, highly safe savings vehicle. Savings bonds' yields are not competitive, but they still attract a portion of savings money.
Note: Not included in "the new money market" are old-style savings certificates and passbook savings accounts.
PANIC IN THE BANK RANKS The banking community has by its very nature and by regulation insulated itself from competition until recent years, when challenged by two significant new developments—commercial paper and money market mutual funds.
Commercial paper—or, as the banks love to call it, "corporate IOUs"—has emerged as a very effective way to remove the middle man—the banker—from corporate lending. Very simply, corporations and investors lend to each other at lower rates than the banks can offer. The bankers, of course, do provide the corporations with the lines of credit necessary to back this paper. This is a fine example of how the financial markets are adapting to changes and developing more efficient markets.
The emergence of money market mutual funds is perhaps the biggest threat, as the bankers see it, to banking. From assets of $3.3 billion in September 1977, the money market funds have grown to over $100 billion. There are now 148 banks and 70 savings and loan associations with over $1 billion in deposits. There are 25 money funds that can claim over $1 billion in assets.
The convenience and safety of the money funds has attracted money from several sources: bank trust departments, institutional investors, corporations, pension plans, brokerage accounts, and, of course, individual savers. The high yields offered by the funds are derived from their highly safe money market investments, including commercial paper.
For their part, bankers are concerned about the money funds taking money from those juicy (for the bank) 514 percent savings accounts and lending it to corporations (and back to the banks) at money market rates. In an attempt to protect their "savers' subsidy," the banks have attacked the money funds.
First they tried to win federal restrictions on competition, but in January 1980 the banking regulators, the Securities and Exchange Commission (the money funds' regulators), and the Senate Banking Committee agreed that the best thing to do was not to regulate money funds further but to deregulate banks. Shortly afterward, Congress passed the Monetary Control Act of 1980, providing the legal authority to phase out the law (Regulation Q) that sets the "highest rates allowed by law." The catch was that this phase-out process would take six years. And in fact the Depository Institutions Deregulation Committee, created to oversee the deregulation, has shown a reluctance to free up the banking industry and has even added regulations.
After failing at the federal level, the banks have taken their battle to the states, appealing to legislators to protect local interests by passing laws to regulate "unregulated and uninsured" money funds. The first major attack took place in Utah, and it backfired on the banks. Of the 20,000 Utahans who owned shares of money market mutual funds, 7,000 contacted their state legislators—99 out of 100 protesting money fund restrictions—and the bill was defeated. It was close, though, demonstrating the power of the banking lobby.
The lobby's strategy is this: they know that money funds are forbidden by law to discriminate against any class of investor (even at the request of state legislators). If state legislators were to require that reserves be kept for money fund shares owned by their citizens, that their citizens be restricted from using the funds' convenient check-writing services, or that any other special discriminatory treatment of their citizens' investments be observed, the SEC would not allow the money fund to do business in that state. Money funds are an excellent example of financial democracy, since they are not allowed to treat any investor—no matter how large or small—differently from another. What the banks are asking state legislators to do is require money funds to provide the investors in their state with inferior services—all to protect the banks' right to provide what are clearly inferior services.
It will not work. The Utah experience shows that people will fight for their right to a free-market rate of return. The "Savers' Liberation Movement" will only expand, and savers will demand more and better financial services.
BANKING ON COMPETITION There's no denying that bankers face a challenging future. Deregulation of the industry is proceeding slowly and cautiously, while the free market passes them by. Interest rates are becoming more and more volatile and unpredictable, and the price of wrong decisions is becoming more and more costly.
In this kind of economic environment, the public's confidence in the banking system is essential. It can do the banks no good to set themselves up in the public eye as the "bad guy" by attempting to strangle and strong-arm their competitors nor to spend their time fighting for outdated and obsolete goals such as the banks' oft-demanded "level playing field."
Banks and money funds are not equal. They are two different and complementary institutions. The two can coexist and provide services to a wide range of customers.
It seems to me that the banks should not participate in the short-term money market deposit business. It is simply too volatile and risky a business; borrowing in the short-term market to finance long-term investments was what nearly bankrupted First Pennsylvania Bank last year. Instead, banks should be promoting the 30-month SSCs, rather than the 6-month MMCs, to get their assets and liabilities more in line. With over 25 percent of M2 (the broadly defined money supply) consisting of 6-month certificates—neither profitable nor stable bank offerings—it's time banks put a cap on how many of these certificates they'll issue.
And if the regulators were to lift the 12 percent limit on the 30-month SSC rate, banks could sell these certificates more easily. This would be a better deal both for banks (more stable and profitable deposits) and for investors (a fairer rate of return for the long-term deposit). This is what the banks should be fighting for instead of making mindless attacks on the money funds.
Besides, the facts show that money funds have put more money in banks than they have drawn away! Only about $20 billion of the money funds' assets came from savings accounts, but over $50 billion has been put into bank deposits and investments. The bankers will say, "That's true, but at a higher rate and in the larger banks only." And they're right; the former is a fact of life and the latter is being mollified by the flow of money fund investments back to some of the smaller banks through investments in small bank CDs (only up to the FDIC-insured $100,000 limit, of course, to be consistent with the money funds' safety and investment quality restrictions).
The process of adapting to the realities of the financial marketplace has been slow but sure, and if given a free market in which to operate, the progress will continue. In the meantime, you, as an investor, should write to your state and federal legislators to state your position on the banks' campaign to free themselves of Regulation Q sooner rather than later and on encouraging the free market instead of restricting money funds.
If President Reagan's budget cuts are not taken seriously and turn out to be a case of "rearranging deck chairs on the Titanic," both the banks and the money funds will need all the free rein they can have to react quickly and decisively to the changing marketplace. Savers' Liberation is your movement; support it.
William Donoghue is executive director of the Cash Management Institute and publisher of the Money Fund Report, the Cash Manager, and Donoghue's Moneyletter. His book, William E. Donoghue's Complete Money Market Guide, is now a national best seller.
THE TEN BEST DEALS IN THE MONEY MARKET Best Deal #1—Money Market Mutual Funds
Money funds offer an ideal combination of safety, liquidity, and yield. They offer convenience and attractive returns; in addition, you can get your money out easily and efficiently when you want to withdraw it.
Best Deal #2—Merrill Lynch Corporate Income Fund, Short-term Series (CIF)
Can't Merrill Lynch come up with a better name for these unique 3- and 6-month unit investment trusts? This investment outperforms Treasury bills and money market certificates (MMCs) in a falling interest rate environment, and CIFS only cost $1,000 per unit. Although Merrill Lynch is the only firm currently creating these short-term trusts, other brokers sell the Merrill Lynch trusts.
Best Deal #3—Variable Annuities Using Money Funds
These particular annuity programs are the best way for people to defer taxes on their money fund earnings without having to set up an IRA or Keogh plan. Tax·deferring money market income is not the most exciting benefit that variable annuities offer, however. To get the most out of these annuities, you should choose one that offers an equity fund (stock fund) and a money fund. Then you need good market timing advice, so you know when is the best time to switch between the two funds. Once you know when to switch, you've got a real chance at building your retirement nest egg into an investment that can beat inflation and the IRS.
Best Deal #4—Merrlll Lynch's Cash Management Account (CMA)
Here's another Merrill Lynch product. But what can you say to an investment product that earns money market interest on every penny in your brokerage account that's not invested elsewhere, allows you to charge items and services on a special VISA card, allows you get cash advances—in minutes—from thousands of banks all over the world, and even lends you money when you overdraw your cash account? Granted, CMA is not for everyone. You need $20,000 in cash or the equivalent amount in securities to open an account.
Best Deal #5—Money Fund Checking
For a small business account or for individuals' larger personal bills, or even just to fund a checking or NOW account, there is simply no service available to consumers that allows them to earn a money market rate of return on check float. (Money funds also allow subsequent investments, unlike other money market investments.) So you can earn high yields on the money you would ordinarily keep in a checking account in order to maintain adequate funds for incoming checks. Special commendation should go to the following funds that offer $250 minimum check amounts instead of the normal $500 checking minimum: Money Market Management, NEL Cash Management Account, John Hancock Cash Management Trust, Dollar Reserves, and INA Cash Fund, Inc. All require $1,000 minimum initial investments except INA Cash Fund, Inc., which requires $2,500.
Best Deal #6—Mutual Fund Switching
One of the best deals in the money market is the ability to get out of a money fund quickly to reinvest in another type of mutual fund when it's appropriate. This makes the exchange, or "switch," privilege that many funds offer a very attractive feature. While most money funds offer telephone switching privileges, some require a mail notification. But with express mail services at your post office, switching by mail will not unduly delay your investment.
Best Deal #7—Tax-Exemption (State and Local) on T-Bill Interest
An added plus in high-tax states, such as New York and Massachusetts, is the fact that all income from T-bills is exempt from state and local taxes. This is another advantage T-bills offer that's not available with MMCs. T-bills' tax advantage can sometimes weight the scales against a unit investment trust—short-term variety (see Best Deal #2). If you are in a high tax bracket, be sure to figure out every tax break on money market investment earnings.
Best Deal #8—Tax Exclusion of the First $200-$400 of Money Fund Dividends
This year (1981 tax year) money fund dividends will qualify for the exclusion of the first $200 ($400 if married and filing jointly) of dividend and interest income. Previously, money fund dividends did not qualify for this exclusion. Here is one instance in which the small saver got a good deal in Washington, D.C.
Best Deal #9—30-Month SSCs with Loophole Loans at a "Net" 1% Interest
Did you know that banks can offer you a 12 percent checking account today? They can, but they won't—they can't afford it. However, banks will permit you to buy a small savers' certificate (SSC) at a maximum of 12 percent (12.94 percent with compounding at a thrift institution, 1/4 percent less at a bank) against which you can borrow at 1 percent over the stated rate on the SSC. We call this "interest rate insurance." Invest in an SSC at 12 percent and you'll never earn less than 12.94 percent—if rates go higher, borrow your money back, invest it elsewhere, and pay the bank a net 1 percent on the amount you borrow. Not a bad deal. But you may have to search to find a bank offering these loophole loans. With today's high interest rates, however, there's no point investing in an SSC until interest rates decline quite a bit.
Best Deal #10—0ne-Year T-Bills and Longer-Maturity Treasury Offerings
When interest rates decline, you can get T-bills with longer maturities than MMCs or unit investment trusts, which usually offer 6-month maturities. T-bills with longer maturities give you a bit more leverage to earn higher yields. However, you can accomplish much of the same effect when you invest in Capital Preservation Fund's Treasury Note Trust. When rates fall, TNT is a dynamite investment (excuse the pun).
Excerpted from Donoghue's Moneyletter. Copyright © 1981 P&S Publications, Inc.
This article originally appeared in print under the headline "The New Money Market: Savers' Liberation".