SAC's Money Market LessonMatthew C. Klein
Bloomberg News reports that investors in SAC Capital, the $14 billion hedge fund recently indicted for encouraging insider trading, want to get their money out as soon as possible. They are worried that their funds might be seized by the government. However, SAC Capital is under no obligation to return investors' money before the end of the year because of a common hedge-fund practice known as "gating."
Investors in money-market mutual funds may soon be at risk for similar treatment. At least, that is the plan favored by the industry, which the Securities and Exchange Commission cautiously endorsed as one option in June. If the rule becomes official, a fund facing mass withdrawals could temporarily deny investors their money, or impose steep redemption fees. (For finance-history geeks, this would be very similar to what banks used to do in the days before the creation of the Federal Reserve and deposit insurance: "suspension of convertability.")
Money-market funds buy short-term debt issued by governments and big companies (mostly banks) and then sell shares to big and small savers that look a lot like checking accounts. In practice, money-market funds provide trillions of dollars of financing to investment bank prop-trading desks and rickety European lenders while acting as if they offer the safety and security of insured deposits.
During the financial crisis, losses at the Reserve Primary Fund, which owned $785 million in short-term debt issued by Lehman Brothers, sparked a run on specialized money-market funds that cater to corporate treasurers and other institutional savers. The bleeding only stopped after the government offered to guarantee the value of every dollar in every money-market account.
Since then, regulators have been trying to find ways to ensure that the funds can withstand another panic without a government backstop, which Congress has since prohibited. One proposal, which Bloomberg View's editors have endorsed, is a floating share price for money-market funds. Instead of being pegged at $1 a share, the net asset value would move up and down according to the value of the underlying assets backing a fund's shares. This was supported by SEC against fierce industry opposition, which favored gates.
Hedge funds use gates, along with conservative cash management and careful client selection, to manage the riskiness of borrowing short-term to buy assets that are relatively hard to sell on short notice. Banks face that problem as well, but they have the benefit of generous government guarantees including deposit insurance and access to the Federal Reserve, the lender of last resort.
Having lots of cash on hand makes it easier to deal with withdrawals without endangering the rest of the fund. Bridgewater Associates, where I once worked, kept billions of dollars in T-bills to ensure that any client could get its money out at short notice. But these cash piles don't generate returns, which is why most hedge funds prefer to rely on the other two methods.
The best way around the problem of panicked withdrawals is to be selective in whom you accept as a client. This means different things for hedge funds and money-market funds. Hedge funds exist to take risks that pay off over time, which means that the best clients are big institutions that could afford to endure temporary downturns in the market -- not skittish individuals.
Money-market funds, on the other hand, are supposed to be stable stores of value. Regular people probably don't understand the risks they are taking when they buy shares of money-market funds. They might even think that the value of their shares is guaranteed by the government. By contrast, sophisticated institutions are clever enough and informed enough to know that it's best to be the first out the door of a burning building. This might explain why, during the crisis, regular people were less likely to withdraw their money even as big institutions fled to T-bills.
Smaller hedge funds often can't afford to be choosy with their clients, however, which is why they like to use gates that limit how much can be withdrawn at any time. In theory, gates allow funds to get better prices when they sell assets than could be obtained during a fire sale. Even big funds such SAC Capital use gates, which are more attractive than holding a cash reserve.
Money-market mutual funds probably won't like the comparison with SAC Capital. However, their investors, like SAC Capital's, might have to learn the virtue of patience when asking to get their money back.
(Matthew C. Klein is a writer for Bloomberg View. Follow him on Twitter.)