The Securities and Exchange Commission is considering making significant changes to money market mutual funds because there is still a danger that these funds could be unable to meet redemptions when investors begin to step off the sidelines en masse and move back into equity markets.
At a seminar on money market funds held last week at the U.S. Chamber of Commerce and hosted by the Center for Capital Markets Competitiveness, Vanguard Chairman John Brennan admitted that money funds had a near-death experience late last year.
"What happened last September was terrible - and it should not have happened - but it triggered intense reflection and examination in our industry," Brennan said.
In order to get a better sense of how to improve the system and prevent similar problems, regulators and industry leaders have been looking at what went wrong last year.
Last September, the Reserve Primary Fund "broke the buck" by falling below its $1 net asset value after taking bad bets on commercial paper issued by Lehman Brothers. The fund was forced to freeze redemptions, which spurred a panic in other money funds and caused investors to pull $133 billion from prime money market funds in two days.
"We all got a wake-up call," said Brennan, who headed the Investment Company Institute's Money Fund Working Group. "We saw what happened when the money markets didn't work and the Federal Reserve had to step in and create vehicles to allow those money markets to continue to function. The markets rebelled a bit, but that rebellion was beaten back by the Fed and Department of the Treasury."
Money market funds are regulated under Rule 2a-7 of the Investment Company Act of 1940, which governs the length of maturity, credit quality and the diversity of debt that the funds can hold.
"When Rule 2a-7 was developed, there was an expectation for high-quality, short-term paper that would be liquid. That started to break down," said Andrew "Buddy" Donohue, director of the SEC's division of investment management. "It's hard for money markets to operate effectively if the rest of the markets are not functioning properly."
In June, the SEC will consider radical changes to Rule 2a-7, including the elimination of the stable $1 NAV, limiting a fund's size relative to its respective market, requiring minimum cash reserves such as 10% of the fund's total assets, and requiring money funds to have insurance guarantees similar to the Federal Deposit Insurance Corporation's bank guarantee.
But without a $1 NAV, industry leaders fear that trillions of dollars of assets could leave the mutual fund industry for other sectors that are perhaps less suited to handle such traffic.
Similar but unregulated investment pools and shadow banks mimic the liquidity of money funds, but are not subject to the same regulatory scrutiny or transparency requirements. While largely ignored by the press, these alternative investment vehicles also had problems last year, and money fund advocates warn that if the SEC clamps down too hard on money market mutual funds, assets will migrate to these areas.
Safety, Liquidity, Yield
The three key attributes that investors and issuers look for in money funds are safety, liquidity and yield, Brennan said, in that order. Yield is a byproduct of the first two, and is generally low when a fund is invested in safe and boring things like government bonds.
Many money funds prohibit managers from investing in anything but ultra-safe, AAA-rated securities, but that became irrelevant when ratings agencies started giving everything AAA ratings, including extremely risky subprime mortgages.
"Lax credit standards and the competitive frenzy to grow fund assets among major fund families may have directly contributed to riskier securities in money fund portfolios," said Lance Pan, director of investment research at Capital Advisors Group, in a recent white paper. "Motivated by yield, some portfolio managers even invested in questionable securities that circumvented the SEC's ratings-driven, formulaic 2a-7 rules.
Pan added: "The crisis last fall brought the issue back to the forefront, especially after audit committees of corporate investors were surprised by the incompatibility of the money fund assets with their own investment policies."
Barry Barbash, a former director of the SEC's division of investment management and now a partner at the law firm Willkie Farr & Gallagher LLP, said that from day one, the stable NAV was an integral part of money market funds.
"Rule 2a-7 is essentially an exemptive rule," he said. "It gives money funds an exemption from the pricing rules of mutual funds."
Barbash said Rule 2a-7 was originally created for retail investors, but money funds turned out to be such a good product that institutions began investing in them as well. While it can be difficult to distinguish between retail and institutional investors, the ICI estimates that institutions now comprise two thirds of the nearly $4 trillion in money market funds.
Money funds have become increasingly popular in the past year due to their ability to maintain a stable value as every other asset category fell approximately 38%.
"During that week in September, return on capital was not as important as return of capital," said Tate Reeves, Mississippi state treasurer. "Markets don't like confusion. [When the Reserve Fund failed,] there was so much risk in other parts of their portfolios that many investors could not deal with risk in money market funds."
So much was broken and markets were so severely disrupted, nobody seemed to know the value of anything, said Kenneth Froot, professor of business administration at the Harvard Graduate School of Business.
As market volatility rose, guarantees started to look very good, and investors began to herd into money market funds, causing them to mushroom in size, Froot said.
"We should be careful not to make these markets too attractive. Otherwise, we'll get stampedes," Froot said. "As these funds build up large volumes, they face bigger and bigger rollover risks."
Some experts fear that when investors regain their confidence in equity markets, people will start taking their money off the sidelines and putting it to work. But can money market funds handle the massive rollovers that will inevitably come?
First Ones Out
Donohue said money funds' stable $1 NAV structure is vulnerable to breaking the buck because large, sophisticated investors will watch to see if a fund starts to slip and quickly redeem their shares in the fund, leaving the loss for the remaining shareholders.
After a fund surrenders all its liquidity to these large investors, it has little choice but to freeze redemptions for everyone else, he said. In a sense, large, institutional investors are encouraged and even expected by their shareholders to cause a fund to break a buck before some other large investor does.
"We've built a system that benefits the first move, the one who gets out of a fund before it gets bad," he said. "Is there something we can do that lessens the ability to arbitrage against a fund?"
Donohue has suggested separating retail and institutional investors, as well as eliminating the stable $1 NAV and turning it into either a floating-rate NAV or a $10 NAV.
The Money Fund Working Group's report, released in March, made many recommendations but did not suggest eliminating the stable $1 NAV. Among the recommendations, the group called for increased quality standards, shorter maturity, improved disclosure, mandatory liquidity, more clarity of the business model and client type and enhanced regulatory oversight.
The working group also proposes letting funds have the authority to halt redemptions without SEC permission.
"Once a fund halts redemptions, it is difficult to reopen the fund without also causing another run," said Capital Advisor's white paper. "Despite its remote probability, this change may make it problematic for investors to continue to treat money market funds as cash instruments if a fund can shut itself down without prior notice and enter an unwind mode as the Reserve funds have done."
Donohue said he was disappointed that the working group's report didn't address the negative consequences of a stable NAV, such as the "hugely problematic" issue of the implied guarantee.
"When investors believe in it, it's great, but when they don't, it's terrible," Donohue said.
George Gatch, CEO of JPMorgan Funds Management, said there is no indication that a floating NAV would stop a future run on a money market fund.
"The French floating NAVs lost more than half their assets in a short period of time," he said. "The steps we have taken have reduced potential risk, but I have no doubt we will experience another liquidity crisis, probably in the next five to 10 years. Can we create any financial products that can weather that storm?"
ICI President and CEO Paul Schott Stevens suggested the SEC ought to focus on making the money markets work more effectively, not just money market funds.
"The stability of the NAV is but one attribute of 2a-7 and was never a guarantee," Donohue said. "If the dollar was that sacrosanct, investors would go somewhere else, like to a 3c-7 fund."
"But that would solve none of these issues; it would just make them more obscure," Stevens retorted.
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