Every once in a while the financial industry lives up to its critics’ worst expectations: that it operates against the interest of the investing public, in cahoots with captive regulators and Washington’s powerful elite.
This is exactly what happened Wednesday, when Securities and Exchange Commission Chairman Mary Schapiro had to cancel an Aug. 29 vote on sensible new rules to make money-market mutual funds safer. Although Schapiro had the support of Federal Reserve Chairman Ben S. Bernanke and leading conservative economists, she knew that three of the five commissioners would oppose her. This came after an intensive and often-misleading campaign by the $2.6 trillion money-fund industry to gloss over the inherent instability of the funds.
Among those swayed by the lobbying was Luis Aguilar, a Democratic commissioner (the other is Elisse Walter) who usually sides with Schapiro. Aguilar, a former general counsel of Invesco, one of the country’s major sponsors of money-market funds, met 11 times with industry lobbyists this year. Among his concerns was that additional rules might lead investors to funnel cash into shadowy, unregulated funds.
This incidentally is a claim of the Investment Company Institute, a mutual-fund lobbying group, which never offered persuasive evidence to back up the assertion. Enough had already been done, the ICI argued, citing modest changes made in 2010 requiring the funds to hold investments that could be quickly converted into cash.
Quite to the contrary. Money-market funds are almost as liable to blow up today as in 2008, when an investor run on the funds sent the financial crisis into overdrive.
A quick reminder of the dangers: In September 2008, the Reserve Primary Fund held $785 million in Lehman Brothers Holdings Inc. debt. When Lehman failed, the fund suffered losses.
If money-market funds operated like normal mutual funds, the loss would have been reflected in the share price. Investors could consider the stock price relative to other funds or even other investments. But money-market funds promise that share prices will never deviate from $1, ensuring that investors get a dollar back for every dollar invested.
Once Lehman collapsed, Reserve Primary’s assets were worth less than $1 a share, an event known as breaking the buck. Investors fled, hoping to get their money out, fearing there wouldn’t be enough assets in the fund to cover their withdrawals.
The panic infected much of the rest of the industry, which provides much of the short-term credit corporations use to meet payrolls and finance inventories. In a matter of days, investors yanked $300 billion from the funds, freezing U.S. credit markets. The run only ended when the Fed and Treasury Department stepped in with a $1 trillion guarantee, which they have been barred from doing again by the Dodd-Frank Act of 2010.
Schapiro’s solution was to require that money-fund share prices reflect the market value of their underlying assets. This would lower the hair-trigger incentive investors have to grab their money at the first sign of distress. Recall that the Reserve Primary run was kicked off because the losses on the Lehman debt amounted to just 3 cents a share.
The other ideas Schapiro proposed would have limited how much investors could withdraw on the spot and required funds to hold capital as a cushion against losses, much like banks do now.
These were reasonable proposals to enhance the funds’ soundness. Safer funds might be more attractive to investors, not less, as the industry contends.
With the SEC paralyzed, it may be up to the Financial Stability Oversight Council -- a panel of financial regulators, led by Treasury Secretary Timothy Geithner -- to devise rules to bolster the safety of the funds. One option for the council might be to deem the biggest funds as systemically important, along with the largest banks, leading to increased disclosure, capital, oversight and stress testing.
Meanwhile, individual investors might want to consider whether money funds are the ideal place to keep their cash. Big institutional investors and companies are more attuned to the vagaries of the market. In the panic of 2008, they were the first to flee, leaving small investors behind. If the government hadn’t stepped in, it’s clear who would have borne the brunt of the losses.
If the ICI and its backers want an industry that can still act as a tripwire for financial panic, they should be congratulated. For the investing public, former SEC Chairman Arthur Levitt say it all: The SEC’s inability to act is “a national disgrace.”
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