U.S. money market mutual funds, haunted by the 2008 collapse of a single fund and the ensuing panic, are wrestling with regulators over ways to safeguard the $2.65 trillion business without killing it.
The Securities and Exchange Commission enacted a raft of new rules in 2010, and the industry next faces a review by the Financial Stability Oversight Council, a body created by last year’s Dodd-Frank Act. The council is expected to decide this year or early next whether to call for restrictions that fund-company executives say would destroy their product.
“A lot has been done to make money funds safer and more robust, and still no one has found a way to guarantee that a run won’t happen again,” said Joan Swirsky, an attorney at Philadelphia law firm Stradley, Ronon, Stevens & Young LLP who specializes in money fund oversight. “The fate of the funds hangs in the balance, and no one knows what’s going to happen.”
Money market funds, once considered among the safest investments, gained sudden prominence following the bankruptcy of Lehman Brothers Holdings Inc. The investment bank’s collapse roiled money funds, temporarily crippling the ability of thousands of companies and banks to raise short-term debt in the commercial paper market. Regulators and industry leaders have since collaborated and clashed over how to respond.
All sides want to prevent a repeat of September 2008, when the $62.5 billion Reserve Primary Fund became only the second money fund to “break the buck,” or expose shareholders to a loss, and close. The fund held $785 million in Lehman-issued debt that became almost worthless.
Money market funds were among several financial intermediaries, collectively known as the shadow banking system, that attracted intense government scrutiny during and after the financial crisis. The group, which also included investment banks, hedge funds and insurance companies, matched lenders and borrowers outside the regulatory framework that governs traditional deposit-taking banks.
During the crisis, panicked institutional investors withdrew $230 billion from the industry over three days, fearing other money funds might also be exposed to Lehman. That forced money funds, the largest collective buyer of unsecured short-term loans known as commercial paper, to stop purchasing and start selling, shutting off the cash flow at many companies.
The run abated after the Treasury Department stepped in to guarantee money funds against default and the Federal Reserve began purchasing assets at full value to help funds meet redemptions.
“Regulators were startled at the size and impact of the shadow banking system,” said Peter Crane, president of Crane Data LLC, a research firm in Westborough, Massachusetts. “Money markets, in general, had never needed a dime of support and suddenly they were maybe asking for trillions.”
The SEC responded in January 2010 by enacting tougher versions of several industry recommendations. The rules forced funds to shorten the average maturity of their holdings, keep 30 percent of their assets in securities convertible to cash within seven days and disclose holdings monthly. The new rules also allow fund boards to more quickly suspend redemptions in an emergency.
The liquidity requirement means funds can come up with almost $800 billion in cash for redemptions within a week without having to sell holdings. Fund executives including Robert Brown, head of money funds at Fidelity Investments, have said holdings disclosures greatly reduce the likelihood of a run by giving clients more information about what the funds own. Boston-based Fidelity, with $423 billion in money market assets, is the largest U.S. manager, according to Crane Data.
In October, the President’s Working Group on Financial Markets, an advisory body to the Obama Administration, published a series of options for further regulating money funds. These included a proposal that funds abandon their stable share price.
Unlike bond funds that mark holdings at current market prices, money market funds value their investments according to their expected payoff at maturity, allowing them to maintain a steady $1 share price. Returns on investment are credited to customers and distributed monthly as cash or new shares.
The stable price is a central selling point for the funds. It also makes them more vulnerable to runs, according to critics like former Fed Chairman Paul Volcker, who say it encourages investors to flee after even small losses reduce a fund’s net-asset value.
Floating Share Price
Paul Schott Stevens, president of the Investment Company Institute, a Washington-based trade group, said in testimony before the House Committee on Financial Services on June 24 and on several earlier occasions that a floating share price would destroy money funds’ appeal for investors and jeopardize the short-term financing they provide.
The Working Group also considered requiring an industry financed liquidity backstop, regulating funds as special purpose banks and creating an insurance system for the funds.
Barbara Novick, vice-chairman and co-founder of New York’s BlackRock Inc., said in a June 22 speech in Philadelphia that regulators will likely reject the proposed liquidity backstop because that would include access to the Fed’s discount window. Novick also said regulators are leaning against a floating share price.
‘An Impossible Mission’
Judith Burns, an SEC spokeswoman, declined to comment on Novick’s remarks. “The commission is exploring all of its policy options,” she said.
A proposal put forward by Fidelity Investments in January, would require shareholders, on a fund-by-fund basis, to finance capital buffers that would be used to absorb losses on defaulted holdings.
The issue now rests with the Dodd-Frank-created Financial Stability Oversight Council, headed by Federal Reserve Chairman Ben S. Bernanke and whose members also include Treasury Secretary Timothy Geithner and SEC Chairman Mary Schapiro.
“It’s taken so long because they’ve chosen an impossible mission,” Crane said. “They want to prevent a widespread run without the government being allowed to step in.”