Finally. It has been nearly five years since the $62.5 billion Reserve Primary Fund couldn’t maintain its fixed $1 a share net asset value thanks to its losses on Lehman Brothers debt. The fund’s “breaking the buck” prompted a scramble by investors to pull their capital out of money market funds, which in turn helped to paralyze credit markets at the height of the financial crisis.
Since that time, regulators and some investor groups have pushed for an overhaul of the rules governing money market mutual funds. The industry has pushed back, arguing vehemently that any changes to the rules would dampen investors’ willingness to invest, resulting in a reduction in the amount of overnight funding available to borrowers.
That opposition was too much for the last SEC chair, Mary Schapiro, to overcome. Schapiro couldn’t get her reform push to the point where the SEC could publish proposed changes. She announced last summer she would have to abandon the effort. But it seems that her replacement, Mary Jo White, wasn’t daunted by the challenge. (After all, White oversaw the prosecution of Mafia dons and those responsible for the 1993 World Trade Center bombings; by comparison, standing up to some irritable financial services companies must feel like a vacation.) Now White has received unanimous approval from her fellow SEC commissioners for an overhaul of money market rules, and a two-part proposal is now public and open for comment for the next 90 days.
What changed between last August and today? It’s hard to know how much to attribute to the change at the top – Schapiro let it be known that she would be stepping down after last November’s election, and may not have been able to command enough support from the other four commissioners in light of that fact. Then, too, that failure made other parts of the financial market sit up and take notice. Just what did it say about the credibility and effectiveness of the SEC that the agency wasn’t able even to propose specific measures in an area of the market that nearly everyone agreed had to be reformed in some way to prevent a recurrence of the toxic credit squeeze of 2008?
The Financial Stability Oversight Council leapt into the breach, putting out its own proposals for comment, while all 12 regional Federal Reserve bank presidents signed off on a public letter to regulators, urging them to concentrate on areas “where the greatest credit risk can be taken and where financial stability risks consequently appear to be the greatest.”
That is, indeed, just what the SEC appears to have done. Rather than risk further public humiliation, its commissioners grabbed the lifeline extended to them by the Fed presidents and proposed two alternatives, which the agency said could be adopted together or individually. The key to the puzzle, as the Fed bankers said, is the so-called prime funds, which invest in a wide array of short-term debt issued not only by the government but also by corporations and financial institutions. These are the kinds of products most likely to be hit by volatility and by losses, both because of the kind of paper they hold and because of the kind of investors that use them: primarily institutional investors, who tend to be more active traders.
One possibility, the SEC suggested, is to have these prime funds move to a floating net asset value from the fixed $1 per share they currently maintain. Alternatively, the funds could maintain a stable NAV, but impose additional fees and limits on investors’ ability to withdraw assets, thus reducing the likelihood of a run. For instance, investors might be limited to daily redemptions of $1 million each, and/or face a 2 percent fee on any withdrawals, depending on the liquidity of the assets in the fund.
Money market funds also would have to disclose detailed portfolio information on a weekly basis, meaning that investors would have access to such data in something approaching real time rather than with a two-month delay, as is the case today. None of these rules would apply to funds that the regulators – and most of the rest of the world – view as lower risk in nature: retail funds (which already limit redemptions to $1 million daily) and those investing in government securities.
Ultimately, the SEC has addressed the conundrum of money market reform by using a kind of game theory. What will stop nervous investors from racing to be the first to redeem their holdings, and thus guaranteeing themselves the full $1 per share of a fixed net asset value? As things stand, there is an incentive for such “early redeemers” to act on their fears. Moreover, what will make investors realize that money market funds aren’t guaranteed investments – that, in spite of the fixed NAV, the real value of their holdings fluctuates over time? The proposal would lead to a market in which such market prices are reflected in the fund’s NAV.
It’s early to say how the industry will respond to these proposals, but odds are that even those opposed to very concept of new SEC rules will find a way to live with them. They address the part of the market that experienced trouble at the height of the financial crisis, and go squarely to the questions of risk and investor psychology. Deutsche Bank’s money management division, Deutsche Asset & Wealth Management, in a letter to its clients, hinted that this kind of approach is welcome. “Our belief remains that a diverse pool of investors, each with different goals and objectives, will benefit from an expanded range of investment solutions.” In other words: keep it flexible. The bank launched the first money market fund with a floating NAV in April 2011, so it has already had experience running just the kind of fund that the SEC proposes should become standard: instant liquidity, but no “guaranteed” NAV of $1 and thus no risk of breaking the buck and destroying confidence in the system overnight.
The formal comment period will last until September, meaning that that the “long journey” to which Mary Jo White referred in announcing the proposals isn’t yet at an end. Still, the less flexible and (in industry eyes) more draconian reforms favored by Schapiro are history, and even the likes of Fidelity may well want to settle for this kind of compromise. It’s clear to all that inaction isn’t acceptable to the Fed or to the administration – or, for that matter, to many of those who study financial market risk management. And if not delicious, the SEC’s proposed reforms should at least prove palatable to all.
