The Securities and Exchange Commission conducted a round table in Washington, D.C., on “Money Market Funds and Systemic Risk” May 10, to see if more regulation is needed, and the Investment Company Institute trade association held its own Money Market Funds Summit in Washington, D.C., May 16.
At issue is what to do about a money market fund’s share price. Should money market funds be able to continue to claim safety of principal, based on a steady per-share price of $1, even though that $1-per-share is not guaranteed and during the financial crisis one money market fund fell below it?
RepoWatch readers have a special interest in what happens to money market funds, because they’re the largest category of repo lender. When nervous money market funds withdrew from the repurchase market in 2007 and 2008, that helped trigger the run on repo, which caused the credit crisis, which forced the taxpayer bailout of the giant banks.
Many Americans know that frightened investors withdrew a lot of money from money market funds during the financial crisis. Few know that money market funds were one of the key players that triggered that crisis in the first place, by withdrawing their repo loans. None of the press reports linked to this story mention repurchase agreements.
This is a tumultous time for money market funds.
–Rock-bottom interest rates continue to decimate returns for fund investors.
–Beginning July 11 commercial banks will be able to pay interest on business checking accounts for the first time, because of a new rule in The Dodd-Frank Act. This could cost money market funds “potentially significant outflows,” as businesses switch to the safety of FDIC-insured (up to $250,000) bank accounts, according to Melanie L. Fein, former senior counsel to the Board of Governors of the Federal Reserve System, writing in the American Banker .
–Regulators are threatening to require that fund shares trade at market value, which would fluctuate, rather than at a steady, no-loss-of-principal $1 per share, so investors will better understand the true risk they take when they buy money market fund shares.
The $1 price implies a safety that does not exist, said FDIC Chairman Sheila Bair and former Federal Reserve Chairman Art Volcker at the SEC meeting May 10, according to Bloomberg.
This was proven in 2008 when the September 15 failure of Lehman Brothers triggered losses in the Reserve Primary Fund and Reserve’s shares fell to 97 cents, they said. That, in turn, triggered a run on all money market funds, as frightened depositors withdrew about $310 billion from prime money market funds, or 15 percent of assets, during the week of September 15, according to the President’s Working Group on Financial Markets. A prime money market fund is one that invests in corporate as well as government securities.
From Bloomberg reporter Christopher Condon, reporting on the May 10 meeting:
Federal Deposit Insurance Corp. Chairman Sheila Bair called money-market mutual funds “destabilizing” to the financial system and said investors would be served just as well if share prices floated.
“Money-market funds are maintaining a fiction of a stable” net-asset value, as shown by the September 2008 failure of the $62.5 billion Reserve Primary Fund, Bair said yesterday at a round-table meeting of fund-company executives and regulators arranged by the U.S. Securities and Exchange Commission in Washington. “That is skewing investment dollars into a structure that is highly unstable in a crisis.”
Former Federal Reserve Chairman Paul A. Volcker called a floating share price the “simplest” solution to the risk posed by money funds, which trade at a constant $1 a share.
SEC Chairman Mary Schapiro also seemed to favor a floating share price at the May 10 meeting, according to Securities Technology Monitor reporter Tom Steinert-Threlkeld:
Schapiro, for her part, seemed to suggest that the floating of values of shares in money market funds, every day, would actually have the desired result. Because the promise of funds would still be that their contents were as safe as cash, floating the value would force managers to compete to create the most conservative investment vehicle possible, under this construct.
Other groups came to the May 10 meeting with some ideas to preserve the $1-per-share price, which is very popular with U.S. savers, reported Securities Technology Monitor:
The Investment Company Institute, which represents the money market fund industry, has proposed the creation of a state-chartered bank or trust company that would act as an emergency liquidity facility in the event of a crisis. The facility would be capitalized through a combination of contributions from prime fund sponsors and ongoing commitment fees from member funds. Additional capacity would be gained from the issuance of time deposits to third parties. Plus, the facility would have access, under the ICI proposal, to the discount window of the Federal Reserve.
Separately, mutual fund giant Fidelity Investments has recommended that money market funds be mandated into putting aside reserves for a rainy day. The reserve would be funded by a holdback of a portion of a fund’s income. And asset manager BlackRock has suggested the sponsor or investment manager, not the money market fund itself, be regulated as a special purpose entity (SPE) and be required to hold sufficient capital to withstand shocks.
Attending the SEC rountable were regulators, industry representatives, academics and institutional investors.
Money market funds have historically played an important role as lenders in securitized banking, where institutions borrow on the repurchase market to finance much of their securities portfolio as well as their business of securitizing loans. Money market funds needed a safe, liquid place to put their investors’ money and earn a little interest, and they came to view overnight repo loans as an alternative to bank deposits. Repo loans paid better than deposits, and they were felt to be safer than deposits that exceeded the FDIC limit, because repo loans are collateralized.
Before the financial collapse, money market funds also were the biggest investors in asset-backed commercial paper (ABCPaper), which off-the-books businesses sold to help fund the business of securitizing loans.
The Lehman Brothers’ failure was triggered by money market funds and others withdrawing their repo loans. When the investment bank was unable to roll over its repo funding, it quickly became insolvent. That insolvency, in turn, caused the Reserve Primary Fund’s stress because the fund held $785 million in Lehman Brothers’ unsecured commercial-paper debt. When the Reserve fund shares fell below $1, investors began pulling out of all money market funds, especially prime funds.
At that time, federal officials took two unprecedented steps to save money market funds. They:
–guaranteed the share price of money market funds, thus extending FDIC-type insurance beyond commercial banks for the first time, even though the money market funds had never before paid insurance premiums as commercial banks and their depositors are supposed to do. The Temporary Guarantee Program for Money Market Funds lasted from September 2008 to September 2009
– -lent to commercial banks and bank holding companies so they could buy ABCPaper from money market funds. This amounted to opening the discount window to money market funds. The Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility operated from October 2008 to February 2010.
These actions make money market funds appear to be backed by a U.S. taxpayer guarantee, according to a Wall Street Journal analysis:
In the wake of Reserve’s failure, the U.S. Treasury slapped a taxpayer guarantee on the entire money fund market. Treasury collected more than $1 billion in premium payments from the industry before letting the program expire in the fall of 2009.
Yet the implicit guarantee remains, exposing taxpayers to potential losses in the future. That’s because Washington is still allowing money funds to use a novel accounting method enabled by a 1983 SEC rule. This allows funds to claim that each share is worth $1, even if that’s not exactly true based on market prices of the underlying assets. As long as the market price of the underlying securities doesn’t stray too far from the claimed asset value, the funds can maintain for investors a picture of stability.
The rule has helped the industry promote funds as stable, ultra-safe investments akin to bank savings accounts but with a higher yield. Last year the SEC did tweak its rules to require that funds publish the actual market value of fund assets, but the information is only released on a 60-day delay.
The better approach is honest accounting in real time. Allowing the funds’ net asset values to float every day would condition investors to accept some minor ups and downs and ensure that “breaking the buck” is not viewed as a cataclysmic event triggering panic and encouraging a federal rescue.
One reason repos and ABCPaper were popular with money market funds leading up to the crash was that the SEC required the funds to invest largely in short-term securities, to help ensure they could live up to their $1-per-share promise. That rule had a couple of unintended consequences.
-It drove money market funds to repos and ABCPaper, so the funds could enjoy the higher yields of long-term mortgages while technically investing in short-term instruments.
-It meant that when money market funds seized repo collateral during the crisis, they had to sell the securities immediately because they weren’t allowed to hold longer-term investments. The ensuing fire sales drove down prices throughout the financial markets.
Since the crisis, the SEC has doubled down on the situation, passing new rules in January 2010 that require money market funds to keep even more short-tern investments, with at least 10 percent of their assets in securities they can sell in one day and 30 percent in securities they can sell in one week.
The new rules also made changes to repo lending. The new rules say the funds can only accept cash or government securities as repo collateral , as opposed to the old rule that simply required collateral to be highly rated, and the funds must evaluate the creditworthiness of the repo borrower, not just depend on the collateral in analyzing the risk of the repo loan.
The new rule restricting repo collateral to cash and government securities could limit repo lending by money market funds if federal agencies like Freddie Mac and Fannie Mae ever stop insuring mortgage-backed securities. Currently, one-third of the repo borrowing done in the U.S. by the largest dealers is collateralized by federal agency-insured mortgage securities, according to the Federal Reserve Bank of New York’s weekly report of activity by its primary dealers. These are the 20 dealers approved to repo with the Fed. They’re thought to represent roughly half of the U.S. repurchase market. (Update: In June 2012 the New York Fed said primary dealers represent about 90 percent of the U.S. repo market.)