By Geri Westphal
Regulators have retreated for now but will likely pick up the fight again to further regulate money market funds.
Some might call it paranoia but there seems to be some truth to the fact that for more than two years, the Federal Reserve and members of the Securities & Exchange Commission have been on a mission to destroy the money market fund industry. That’s because the two watchdogs have made it no secret they believe these investment instruments are structurally flawed and a “fiction” and are part of what they describe as a shadow banking system that poses significant systemic risk. This even after 2010 fixes that made the assets safer.
Their proposals, in one form or another, include requiring MMFs to switch to a floating net asset value regime (vs. the fixed NAV), limits on withdrawals (allowing investors to withdraw 90 percent and requiring them to wait 30 days for the final 10) and capital buffers that would absorb portfolio losses. All of these were existential threats in the view of the MMF industry and other stakeholders.
So what’s been behind the push for these changes? Although the safety of the financial system is the stated goal, many see an underlying motive: to regulate the MMF industry into oblivion, so that the more than $309tn of funds currently held on deposit with MMFs will be driven back into (regulated) banks to help bolster banks’ competitiveness. The 2011 repeal of Regulation Q, a rule that had prohibited banks from offering interest-bearing business checking accounts, was seen as laying the groundwork for the move to banks.
circling the wagons
Of course the MMF industry has pushed back hard against these efforts. They tout the industry’s long history—it’s been around for more than 40 years—and its value as an indispensable tool in the business of daily cash management for corporate treasurers and pension fund managers alike.
And the regulators have seen pushback within their ranks. Three commissioners at the SEC have stood in support of MMFs, which is why a recent vote that required majority consensus was cancelled and the issue of further regulatory reform left unresolved. The infighting within the SEC is a story of its own, but suffice to say that commissioners Daniel Gallagher and Troy Paredes, who along with Commissioner Luis Aguilar opposed the SEC’s proposals, felt strongly enough about perceived derogatory comments made by SEC Chairman Mary Schapiro to publish their own statement clarifying their position on the MMF issue. In their words, “The current discourse about the Commission’s regulation of money market funds is rife with misunderstandings and misconceptions.”
“We are very encouraged to see the statement by Gallagher and Paredes because it shows that these two individuals understand the MMF industry and have listened to the feedback provided by market participants,” said Tory Hazard, COO/CFO of International Cash Distributors.
Schapiro’s inspiration
Much of Chairman Schapiro’s argument for systemic risk has to do with an event that occurred at the height of the 2008 financial crisis when the Reserve Primary Fund fell below the NAV of $1.00 as a result of a high volume of withdrawals over a very short period of time.
This event became known famously (or infamously) as the fund that “broke the buck,” and challenged one of the strongest attributes of the MMF’s basic structure. However, as Gallagher and Paredes go on to say, “the Reserve Primary Fund did not ‘break the buck’ in a vacuum, but rather in the midst of a financial crisis of historic proportions.”
Many believe Chairman Schapiro is taking this particular event out of context and using it as a basis for the proposed regulations that would kill the MMFs as we know them today.
A Trip Down Memory Lane
In understanding the issues, it’s useful to step back in time and remember the pre-crisis days of 2008. Many treasury professionals viewed the risk associated with a specific MMF by the overall rating it received by the rating agencies, with many funds carrying a Double-A or higher rating. At that time, fund purchase activity was limited or not available at all, so many relied on the sanctity of the rating to provide comfort with the investment.
Then it happened. The market endured a series of extraordinary events that occurred within a short period of time that changed the financial markets forever. The auction rate securities market was one of the first to be tested and we watched that market collapse in February 2008. The commercial paper market pressure of May 2008 left many well-capitalized corporations with the impossible task of placing their highly rated paper into the market.
Bear Stearns failed in March 2008. IndyMac, Washington Mutual and Countrywide experienced runs as their short-term funding failed and depositors fled, and very quickly, corporate treasurers and institutional fund managers were making defensive moves within their investment portfolios to protect against other possible extraordinary events.
Since the visibility into the specific MMF holdings was cloudy at best, many treasurers and fund managers made the decision to move from non-government funds to more conservative MMFs of US treasuries or other government assets. This popular defensive move did cause a strain on certain prime funds, but was not really a traditional “run,” as it was just a reallocation of assets in a stormy investment climate. Treasurers had to be conservative with their investment portfolios, and parking the funds in a US Government fund was a good way to protect these assets during the height of the storm. According to statistics from the ICD Intelligencer, an ICD publication, in the days following Lehman’s bankruptcy on September 15, 2008, investors, (mainly institutional) withdrew approximately $196bn from non-government funds and invested approximately $86bn in government funds.
Despite the increased activity of MMF withdrawals during this time, all but two MMFs stayed intact and continued to do business, which for those who support, shows that MMFs have a safety record far superior to banks. During the period 2008-2012 (Q1), four hundred twenty-four banks failed, while only two MMFs failed during this same period (see chart below). Despite the extensive government supervision, bank deposit insurance and access to Fed liquidity, banks continued to fail at an extraordinary rate, while MMFs weathered the financial crisis without access to the same financial safety nets. According to ICD research, MMFs gained approximately $750bn in net assets from January 2008 to January 2009.
It was clear that changes were necessary to provide greater stability and to bring some rationality back to the financial markets. In 2010, the SEC implemented amendments to Rule 2a-7 for MMFs that required funds to maintain a portion of their portfolios in instruments that could be readily converted to cash, and to reduce the maximum weighted average maturity of portfolio holdings. They were also mandated to improve the quality of portfolio securities. MMFs were now required to report portfolio holdings on a monthly basis to the SEC. Many believe these regulatory changes went a long way toward strengthening the MMF industry and that no further regulations are necessary.
Had the 2010 amendments been in place at the time of the 2008 “perfect storm,” MMFs likely would have been forced to maintain a more conservative investment profile with shortened duration and the mandatory asset reporting. These improvements could have helped fend off investor concern as asset holdings would have been visible to investors as part of the improved reporting and risky assets would have been highlighted well in advance, thereby potentially preventing the breaking of the buck as it occurred. With this improved reporting there is increased visibility into what assets are held within a particular fund, and treasurers and investment managers can more thoroughly assess the risk of any MMF and make more informed decisions about where their cash will be invested.
According to ICD, analysts within the SEC now pour through weekly portfolio data submitted electronically by all MMFs, looking for trends, red flags, and signs of risk and trouble. The interaction between the SEC and MMF managers is constant.
Too Much Intervention
The new proposed regulations include; floating NAV, capital buffers, and redemption restrictions, all of which would severely hinder the ongoing viability of MMFs and would place significant burdens on the practitioner to find alternative investments to serve their short-term needs as part of their daily cash management activities.
- Floating NAV. This would require MMFs to value their assets and report when any fund falls below the $1.00 threshold.
- Capital Buffers. This restriction would require MMFs to set aside additional capital to ensure sufficient liquidity. This particular amendment is of less concern to the investor, as long as yield is not reduced as a result of the additional capital restriction. According to ICD poll, just 36 percent of respondents stated they would either decrease or discontinue investing in MMFs if this amendment were approved.
- Redemption Restrictions. This restriction would require an MMF to hold back 3 percent (or more) of all redemptions for 30 days. This could prove to be the real MMF killer, with various surveys showing most users would decrease or discontinue use of MMFs if this rule were adopted.
ICD research suggests that if these proposed restrictions are implemented, it estimates a decrease of approximately $714bn in MMF investments. This is not an insignificant number and would have severe consequences to the financial investment market, but, this is not the only impact. MMFs are also large purchasers of common investment classes.
That means the market could expect to lose a very large buyer in the daily commercial paper market, with an estimated impact of $110bn, or 27 percent of the total market. It is fair to say that corporates would experience a harder time placing their paper into the markets on a daily basis with such a large market participant now gone. MMFs also purchase approximately $89bn (12 percent of the total market) of US Treasury Securities, and $103bn (37 percent of the total market) of US Government Agency Securities.
Killing the MMF industry also kills a very large market participant and the unintended consequences would certainly have a negative impact on the stability and growth of our financial system.
“Financial professionals indicate that implementation of some or all of [SEC] proposals may cause…organizations to stop investing in MMFs and liquidate some, if not all, of their current MMF holdings,” the AFP noted in a 2012 Liquidity Survey.
Live to Fight Another Day
As a part of the Dodd Frank regulations, a new oversight committee was formed to identify risks and respond to emerging threats to financial stability. The Financial Stability Oversight Council (FSOC) is a collaborative body chaired by the Secretary of the Treasury that brings together the expertise of the federal financial regulators, an insurance expert appointed by the President, and state regulators.
The FSOC has the authority to designate a nonbank financial firm for tough new supervision and therefore avoid the regulatory gaps that existed before the recent crisis. They also play a significant role in determining whether action should be taken to break up those firms that pose a “grave threat” to the financial stability of the United States. These specific mandates could be at the center of the next round of assaults, according to those close to this issue.
As the mandate is written, the FSOC could deem specific MMFs as systemically risky thereby requiring increased capital requirements and a much higher level of scrutiny. According to ICD’s Mr. Hazard, the power given to the FSOC is a concern, as the regulator could still potentially achieve the general outcomes of the proposed regulations, despite the cancelled vote due. “They could move forward to overrule the SEC and implement the floating NAV, increased capital buffer and withdrawal restrictions if they deem MMFs to be a ‘grave threat’ to financial stability,” he said.
Geithner, Bernanke and Schapiro et al continue to express strong opinions about the ongoing viability of MMFs. And although the MMF industry is breathing a collective sigh of relief with the cancellation of the SEC’s vote, it remains vigilant and will stay active in the conversation. It may have won the battle with the vote, but it is still very much engaged in fighting the war.