Tackling money market funds’ hidden risks
Everyone seems to have the same list in mind of threats to our financial security: big, stupid banks; arrogant, dumb derivatives traders; a stock market operated entirely by, and for the benefit of, Cylons.
So praise is due Securities and Exchange Commission Chairwoman Mary L. Schapiro for focusing more attention on a greater threat nestled within the portfolios of millions of American investors.
We’re talking about money market funds. Small investors have gotten used to thinking of these popular mutual funds as if they’re interchangeable with bank checking accounts, merely convenient parking lots for cash that might be needed at a moment’s notice. The money market funds sold to retail investors typically come with withdrawal slips that look like checks and can be used almost anywhere.
Schapiro believes money market funds, which hold commercial paper, short-term bonds and other assets with maturities of a year or less, could destabilize the financial system like the bad old days of 2008 because they’re vulnerable to bank-style runs.
They’re uninsured, for one thing. For another, their share price, which is pegged at $1, is fictional — the real net asset value fluctuates, sometimes by a few tenths of a cent. She’s proposed a raft of new regulations to supplement more modest rules the agency imposed in 2010.
Money funds have legal dispensation to trade at $1 as long as their real value is within about a half-cent of that, but nothing would keep a savvy big investor sensing trouble in the portfolio from bailing out early, capturing the fake higher price for himself and sticking other investors with disproportionate losses. That process increases the chance that problems in one fund will radiate to others.
“They’re a clear and present danger to financial stability in their current form,” Morgan Ricks, a former Treasury Department official now teaching at Harvard Law School, told me not long ago.
The money fund industry’s guardians in Congress have leaped staunchly to its defense. When Schapiro’s new proposals came out in April, Reps. Spencer Bachus (R-Ala.) and Jeb Hensarling (R-Texas), the chairman and vice chairman of the House Financial Services Committee, wrote her to gripe about her misplaced “priorities.” They cited all the deadlines for implementing regulations under the Dodd-Frank financial regulatory act that the SEC had thus far missed. (This may be the only moment in recorded history when Republicans demanded more, rather than less, action on Dodd-Frank.)
Securities and investment industry campaign contributions to Bachus and Hensarling combined, 2008 to present: $1 million.
Money funds were introduced in the U.S. in 1971, but they really hit the big time toward the end of that decade, when oil-driven inflation sent interest rates sky-high. Americans got hooked on money market fund yields as high as 17% and abandoned the stock market, prompting Business Week to proclaim “The Death of Equities” on its cover. At its peak, the industry managed assets worth $4 trillion.
Today the annual yield on a standard money fund is effectively zero, but the category still accounts for about $2.5 trillion in assets. Two-thirds of this sum comes from institutions presumably using the funds as switchyards for dollars on their way from one investment to another. The rest is from retail investors, some of whom may be too lazy or terrified to shift their money into an investment that might pay more.
Money fund customers are encouraged to think they incur no risk of loss, unlike in a stock fund or brokerage account, where your shares could go from $20 to $3 in the blink of a Cylon’s eye. Fund sponsors, which include the biggest mutual fund companies, will move heaven and Earth to avoid “breaking the buck” — that is, letting big losses pile up to the point that the $1 price has to be abandoned.
Yet surreptitious rescues aren’t all that rare. At least 47 money market funds received sponsor bailouts totaling at least $3.2 billion from 2007 through 2010, according to the Federal Reserve Bank of Boston. The SEC puts the total number of rescues at more than 300, going back to the industry’s creation.
The money market fund lobby is fond of pointing out that only one fund has “broken the buck” in recent years. The culprit was the $62-billion Reserve Primary Fund, which was (as it happens) the nation’s very first money market fund. Among its assets were $785 million in Lehman Bros. debt. Immediately after Lehman filed for bankruptcy in September 2008, investors staged a run on Reserve Primary and sank the fund.
The industry line is that Reserve’s investors eventually got back 99 cents on the dollar — no blood, no foul. But it’s proper to look closely at everything that had to happen before that recovery took place.
First, to keep the run from spreading, the U.S. Treasury had to guarantee the $1 share price for $3 trillion in fund holdings industrywide. The Federal Reserve had to intervene with a liquidity guarantee. Both actions put the U.S. taxpayer on the hook for industry losses. (Don’t hold your breath for a “thank you.”)
The entire short-term credit market froze solid, throwing a multitrillion-dollar monkey wrench into the world economy.
As for Reserve Primary Fund’s investors, they got 99 cents on the dollar of what was left after the Lehman blowup — about $50 billion. And they had to wait as long as 15 months to get that recovery. I doubt they feel they were made whole. The fund’s sponsors are scheduled to go to trial on federal fraud charges in October.
Setting aside the industry’s apparent position that this all somehow ranks as a good outcome, what about its contention that the modest regulatory changes imposed since then are all that are needed?
Malarkey. The most important changes actually increased risk: After the 2008 bailout, Congress forbade the Treasury to use its stabilization fund to bail out the money market funds ever again. The Fed’s money market liquidity fund expired on Feb. 1, 2010, and hasn’t been renewed. So the next time there’s a 2008-style run on the funds, they’ll be on their own.
Among other things, the SEC’s 2010 rules mandated that 30% of a fund’s assets must be convertible into cash within a week, and 10% within a day; cut in half, to 5%, the amount that could be held in illiquid securities; and cut way back on a fund’s ability to invest in longer-term maturities.
Funds also have to provide a “shadow” net asset value, or NAV, showing how far that value has strayed from $1. But the shadow NAV is reported to the public with a 60-day lag, making it impossible to track a fund’s performance in real time.
Schapiro says these rules have still not addressed the structural dangers posed by the industry. As she told the Senate Banking Committee in June, the $1 share price is still a fiction, and could still encourage nimble institutional investors to flee a fund early, triggering a run and leaving everyone else with the losses.
Even more important, as long as all shares can be redeemed by investors on demand, but a fund’s assets can’t be liquidated on demand, the danger exists that the collapse of one fund can precipitate an epidemic.
Schapiro has made clear that her preferred solutions include requiring funds to trade according to real, floating NAVs, like other mutual funds; to substantially increase their required cash reserves to cover higher redemptions; and to restrict redemptions under certain conditions. The industry hates all these.
Paul S. Atkins, a Bush-era SEC commissioner now working for the industry, wrote recently that the agency should show “conclusive proof” that the 2010 reforms are insufficient before making new “risky and disruptive changes.”
What would this “conclusive proof” consist of, one wonders? A $2.5-trillion blowup might do it, though that price seems a teensy bit high. History might provide a better clue. What it shows, conclusively, is that when regulatory reforms are passed through the regulated industry’s lobbying wringer, they always end up being insufficient.
Now that the money funds have had their say, the SEC should do the right thing, and ignore them.
Michael Hiltzik’s column appears Sundays and Wednesdays. Reach him at mhiltzik@latimes.com, read past columns at latimes.com/hiltzik, check out facebook.com/hiltzik and follow @latimeshiltzik on Twitter.
