Planting the Seeds for the Next Financial Crisis: Gutting Money Market Reform
After several years evaluating proposals, the SEC is reaching the conclusion of its attempt to better regulate the pricing of money market funds. The industry must be putting champagne on ice, because it is very possible that after four years of lobbying they will kill all the reform proposals. I wrote about the debate about ten months ago (“Killing Fundamental Reform: Money Market Funds [October 31, 2012]. At this point, the reforms have been whittled down, and the mutual fund industry and corporations and municipalities (issuers of short-term debt) have inundated the SEC with self-serving commentary.
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The SEC’s two potential major changes only apply to institutional mutual funds. They propose having the value of the fund (NAV) float and/or the construction of a gate that would limit redemptions in the event of liquidity crisis. Retail mutual funds would not be affected, so the $1.00 NAV would remain in place. There’s a bit of a debate about the definition of what would constitute a retail fund. In addition, institutional funds consisting of treasuries and other government securities would also be exempt from any reform measures.
I spent some quality time reading through several hundred pages of industry comments, and both of the SEC’s proposals are heavily attacked. Interestingly Vanguard, the giant shareholder-owned fund complex, supports the floating NAV for institutional funds. I tend to agree with critics that a gating mechanism that suspends or limits withdrawals is not a very good idea, because in a crisis it will tend to create more anxiety and panic, thereby exacerbating the crisis.
As far as I am concerned the floating NAV is the only viable alternative, since the SEC previously withdrew its proposal to require mutual funds to establish reserves. In my view, either the floating NAV or capital reserve should apply to retail funds as well as their institutional brethren. The industry seems to have convinced the SEC that the appropriate test for regulation is whether a particular type of money market fund faced mass liquidations (in essence a run) during the credit crisis. Since the institutional Reserve Funds, which held Lehman paper, experienced a run, institutional funds are the only ones ripe for enhanced regulation.
This logic totally misses the point. In the wake of the credit crisis and the government’s willingness to prop up the Reserve Fund, retail and institutional investors alike found out that the Federal Reserve implicitly guarantees the value of all money market funds. The Federal Reserve set up programs and issued press releases in the fall of 2008 that basically told all money market investors that their cash was safe. Thus under current policy, the taxpayer ultimately stands behind the NAV of money market funds. It is this implicit guarantee that needs to be expunged because it has created moral hazard among all of us who invest in money market funds, the corporations and municipalities that borrow from mutual funds, and the money managers that operate them. If there isn’t an implicit guarantee then we have to believe that retail investors are so dumb and/or complacent that they won’t stampede to get their cash back during the next financial crisis.
If investors want to protect their deposits, they should put their money in an FDIC insured institution. The institution, a bank, is required to maintain reserves and remind investors that there is limit to the amount of insurance. On the other hand, the money market fund turns out to be a lightly regulated bank with no reserve requirement. If investors, whether they’re institutions or retail investors, want to invest in a money market fund they should either take the risk that they won’t get their dollar back or earn a lower return because there is a liquidity buffer in the form of a reserve.
Instead of creating a proper regulatory framework, the mutual fund industry is planting the seeds that will sprout in the next crisis. Taxpayers will suffer pain, and money managers will go about their business of making money for themselves.