Fix Money-Market Funds Before the Next Crisis
The U.S. Securities and Exchange Commission blew a chance last year to reduce the odds that money-market mutual funds will play a starring role in another financial crisis, as they did in 2008.
The agency will take another swing at reform this week when it votes on a plan to make the funds less vulnerable to investor panics. Although the agency hasn’t released a draft proposal, Bloomberg News that the SEC will do away with the fixed $1 a share price for some money-market funds.
This is a step in the right direction, though there are several other measures the agency should consider to shore up the funds. Some might even garner support from the industry.
The idea behind the proposal is that share prices should be allowed to float based on the value of the assets the funds bought with investors’ money. This would help end an enduring yet flawed premise at the heart of the industry -- that cash in a money-market fund is as safe as an insured bank deposit. It isn’t. Once investors become accustomed to minor changes in money-market fund share prices, they will be less likely to race for the doors if they suspect they can’t redeem their shares for a dollar.
Or so the SEC’s thinking goes. The plan, however, wouldn’t apply to all funds, only so-called prime funds, which invest in short-term corporate debt and are considered riskier than funds that invest in government securities. Prime funds manage about a third of the $2.6 trillion held by money-market funds. Their customers tend to be large institutions, such as pensions and state and local government treasuries, rather than individuals. The stable $1 share price appeals to large investors, who tend to use the funds for managing their cash.
The agency’s thinking is shaped by the 2008 collapse of the Reserve Primary Fund, a money-market fund that held $62.5 billion in assets and had invested in short-term debt issued by Lehman Brothers Holdings Inc. Once Lehman filed for bankruptcy, Reserve Primary “broke the buck,” as its shares lost 3 cents each in underlying value. Investors raced to withdraw their money faster than the fund could liquidate its other investments to meet redemptions. The run quickly spread to other money-market funds.
The shock wave soon reached major corporations, many of which finance payrolls and inventories by selling short-term debt to money-market funds. Once the funds stopped buying, U.S. credit markets froze. That placed the entire economy at risk. It took a lifeline from the Federal Reserve and the U.S. Treasury -- a recourse that has since been banned by the Dodd-Frank Act of 2010 -- to ensure the industry’s solvency.
Not all money-market investors panicked, though. The stampede was concentrated among large, institutional investors who are attuned to financial markets and economic conditions. They yanked their cash from the prime funds and put their money into funds that invest in government securities, which served as a haven during the financial crisis. This is why the SEC plan takes aim at the prime funds.
Most retail investors, meanwhile, stayed put. Yet, it is a mistake to assume they will be so quiescent in the next crisis. Nor can there be any guarantee that money-market funds that invest in government securities will always be so stable. In another panic, a sharp rise in interest rates could rapidly erode the value of their holdings. There also is the possibility that institutional investors will seek to avoid the share-price fluctuations of the prime funds and shift their money to those with fixed share prices.
The agency might be able to prevent this by placing limits on the size of investments in these funds. Rather than trying to close off one escape hatch after another, though, the SEC should extend floating share prices to the entire money-market industry.
Still, even if floating share prices blunt the incentive for investors to bolt at the first sign of crisis, they won’t eliminate it.
What might enhance stability are gates that would temporarily halt or limit customer withdrawals. Gates are neither complicated nor particularly controversial. Many hedge funds have them, and invoked them during the financial crisis. As a result, few hedge funds endured chaotic failures.
Redemption gates would have another virtue: The industry, which helped scuttle last year’s floating share proposal, backs them.
Money-market funds have grown from nothing 40 years ago to occupy a vital place in the U.S. financial system. Regulations to ensure safety and soundness haven’t kept pace. After the failing to adopt new regulations last year, the SEC was told to try again by the Financial Stability Oversight Council, a board of senior regulators established by Dodd-Frank to contain excessive risks. In this case, the law worked. Now it’s up to the SEC to finish the job.
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