Since September, the Securities and Exchange Commission (SEC) has been sitting on proposed rules for money market mutual funds that would affect 61 million individual investors, plus untold businesses, that collectively placed nearly $3 trillion in the funds for cash management. There’s a good reason for the delay. The proposals have encountered an enormous amount of flak, most of it deserved.
The SEC’s goals are laudable enough. It wants to reduce the risk of funds' vulnerability to bank-like runs in a financial meltdown like 2008's. Further, to avoid consumer confusion, the commission wants to make it clear that funds are not as secure as federally insured bank deposits by providing consistent regulation: Treat banks like banks and mutual funds like mutual funds.
But the SEC’s proposals won’t achieve those goals and may even make matters worse. The commission should bury these proposals and rely on the sensible regulations it adopted in 2010 to protect investors and reduce the systemic risk that such large pools of funds theoretically pose.
Here’s what the SEC is proposing:
1. Divide funds into individual and institutional funds, with the determining factor being the ability to withdraw more than $1 million in a day. The institutional funds would have floating net asset values (NAV) based on the value of their investments, rather than the standard, stable, $1-a-share value that has prevailed for more than four decades. Funds that invest largely in government paper would retain the $1-a-share value.
2. When withdrawals are so rapid that the remaining weekly liquid assets are less than 15% of total investments, permit funds to impose 2% fees for withdrawals and adopt “gates” to limit further withdrawals for a period.
3. A combination of the two.
The regulatory initiative stems from the fate of a single fund--Reserve Primary Fund--whose share value dropped below $1, or “broke the buck,” during the 2008 financial crisis. The day after Lehman Brothers announced its bankruptcy, The Reserve Fund, the nation’s first money market fund, announced that its Primary Fund--which held $785 million in Lehman commercial paper--would price its securities at $0.97 a share. This was the third time since The Reserve Fund’s creation in 1971 that a fund had broken the buck.
With American International Group (AIG) and its ubiquitous commercial paper also nearly failing along with other financial woes abounding, institutional investors fled money market funds, withdrawing about $300 billion in the week of September 15, 2008. Retail investors held steady, and government money market funds, a safer haven, actually grew. However, with money market managers retaining cash for withdrawals instead of investing in commercial paper, short-term corporate borrowing froze.
The episode sent shock waves through the system, which had relied on the stability of the funds’ $1-a-share value and complacently believed the funds were as safe as federally insured bank deposits. There are delicious ironies here. In one sense, the funds are safer than banks. Fund assets include cash, Treasuries and short-term paper. Those assets are far safer than bank loans to, say, dry cleaners, car buyers and corporate giants such as Enron, and they are more liquid than mortgages. On the other hand, banks do have the advantage of federal insurance for deposits should they lose their bets on risky loans.
But though the funds aren’t federally insured, guess who came to the rescue in 2008? To the consternation of banks, the Treasury Department pledged to help any fund that paid an insurance premium maintain its $1-a-share net asset value. Bankers were terrified that bank deposits would flee to higher-yielding money market funds that suddenly became insured, even if only temporarily. The program stabilized the market, ending a year later with no losses and $1.2 billion in income for the government. Fund sponsors also stepped in to prop up the $1 valuation, though the extent of the intervention is not clear.
The government understandably doesn’t want to go through another bailout and short-term borrowing freeze, which can cripple business, so it started to look for safeguards. The mutual fund industry shares those concerns and proposed new rules that took effect in 2010--no doubt hoping to forestall even more far-reaching regulations.
Among other things, the new 2010 rules required that at least 10% of assets be cash or convertible into cash in a day and 30% be similarly liquid in a week. The funds typically far exceed these benchmarks, with daily liquid assets exceeding 23% and weekly liquid assets approaching 37% in January. The liquidity would enable funds to pay off large withdrawals without disruption. In addition, the SEC reduced risk further by requiring funds to slash the weighted average maturity of assets from 90 days to 60 days. The SEC’s Office of Chief Economist ran some economic models and concluded the probability of breaking the buck declined after these 2010 reforms.
Why Further Reform?
But that didn’t stop the commission from pressing for further reform. What’s wrong with the latest round of ideas? For starters, a floating net asset value won’t deter investors from withdrawing funds. Quite the contrary. As Professor Jeffrey Gordon of Columbia Law School told the SEC, when there is a lot of trading and values fall, “today’s NAV would be higher than tomorrow’s NAV.” As a result, he added, money market fund investors “can be expected to exit en masse, not exhibiting the pattern of holding or ‘slow’ exits in other mutual funds.”
In addition, Sheila C. Bair, chair of the Systemic Risk Council and former chair of the Federal Deposit Insurance Corporation (FDIC), notes the liquidity fees and gates would exacerbate the present risk of a run by injecting a new source of uncertainty and instability--not the value of the fund but the ability to withdraw. Investors would have to monitor not only a fund’s assets but also the behavior of other investors, who might need to make a big withdrawal for business reasons and thus innocently threaten the ability of others to redeem shares. The fees and gates would provide an incentive to get out before you get whacked with fees or the door slams shut.
The final argument, one pushed by banks, is that it is unfair for the money market funds not to be treated like other mutual funds. The net asset value of other mutual funds changes daily as the market value of their investments fluctuates. Money market funds use a different approach, called the amortized cost method, based on the purchase price of investments with certain adjustments. Thus the share price doesn’t change with daily movements of a fund’s investments.
But the fact is that other mutual funds can use the amortized cost approach for securities with maturities of less than 60 days--which is what money market funds must average. The line between banks and money market funds continues to blur while, as the SEC notes, banks can act like the funds and use the amortized cost method for debt securities held to maturity. What’s more, bank regulators wisely have imposed money-market-like liquidity requirements on banks, further obscuring the regulatory line.
Much Ado About Little
In one sense, this is much ado about very little. The only way to spot change in the value of the short-term securities money market funds buy is to go to four decimal points, as the changes are typically only a few basis points. However, the SEC would still enable penny rounding even if it eliminates amortized cost. An Investment Company Institute (ICI) analysis shows how tiny the price changes are and the minimal deviations from $1. That means penny rounding almost always would produce the same results as the amortized cost method.
In another sense, however, this is a big deal. If funds had to use net asset value, the paperwork to keep track of minuscule gains and losses would be enormous. And institutions such as state and local governments, which are barred from investing in investments with fluctuating value, would have to shift billions of dollars to lower-yielding investments such as bank money flows. The rules would hurt municipal finance significantly, cities told the SEC. The bottom line: little gain and considerable pain.
To be sure, there are threats to money market funds. Anything without government insurance has risks. But the biggest risk beyond regulatory overkill is not a market risk, but a political one. If Congress defaults on the national debt, money market funds with all those investments in government paper would end up in the trash. But as Sean S. Collins, the ICI’s Senior Director of Industry and Financial Analysis, points out, if the government defaults, money market funds breaking the buck “are the least of anybody’s problems.”
More Harm Than Good
The SEC’s second round of regulation is an attempt to show Washington is anticipating and attempting to prevent a problem before it occurs. It made great strides toward that goal with the 2010 regulations. But unlike the well-reasoned 2010 initiatives, the current set of proposals may well do more harm than good.
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