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Thursday, April 26, 2012

Money Market Funds: Success Must Not Go Unpunished

Money market funds have been in the news recently, as the Securities and Exchange Commission (SEC) has proposed new rules aimed at “strengthening” them. This has provoked substantial blowback on the part of both fund managers and customers. As this was written, the proposals were stalled by disagreements among SEC board members. A brief summary of the history of money market mutual funds and how they work, along with the proposed regulations, argues against all government regulation of these funds as unnecessary and destructive.

The first money market fund was established in 1971 as an innovative work-around for the benefit of savers who were stymied by the infamous Regulation Q, which limited the amount of interest banks were allowed to pay to their depositors. As inflation swelled, savers pinched by the ceiling looked for alternatives. They began buying Treasury bills, which kept up with inflation to some degree, but the Treasury was not eager to handle small orders and soon raised the minimum purchase to $10,000. (It has since been lowered.) The pioneering Reserve Primary Fund was a new form of mutual fund that invested in short-term, safe, highly liquid securities in a manner that allowed it to maintain a constant share price of one dollar. The Capital Preservation Fund followed in 1972, offering the first all-government fund. The charismatic Jim Benham launched the fund, fought a successful court case against state income taxes, and in his spare time let off steam leading his band, “Full Faith and Credit.”

Government regulation of money market funds was almost nonexistent at first. Only in 1983 did regulators place a limit on the average maturity that the funds could hold. Rules about credit quality were added later.

Short-term securities are issued in discount form. For example, you might buy a three-month Treasury bill for $9,950, wait for maturity, and then collect its $10,000 face value. The $50 difference is your interest, and the rate you get is 50/9950 = 0.5025 percent for the quarter, or an annual rate of about 2 percent. (This is just an example—short-term rates are now essentially zero!)

Day by day the value of a discount security grows as its maturity date nears. The $10,000 bill in our example would be worth $9,983.74 at 30 days from maturity, $9,994.58 ten days out, and $9,999.46 the day before maturity.

A portfolio of such securities will also grow day by day. This is the key to the one-dollar share price of money market funds. Rather than an increasing share price, investors get a daily share dividend. For example, if you hold 50,000 money market shares and the fund value increases by 0.01 percent overnight, you will get five more shares the next morning. Each share remains priced at a dollar.

The importance of the one-dollar share price can hardly be overstated. Investors treat their shares as substitute bank accounts. Fund managers oblige by offering checkbooks and, more recently, online transfers as a convenient way to redeem shares . So well established is this concept that small money-fund balances are included in the broad M2 category of money.

Can anything go wrong with this scenario of daily share dividends? Leaving aside misappropriation by criminal fund managers like Bernie Madoff, two things can go wrong: Interest rates can rise, and securities can deteriorate in quality.

Rising Interest Rates

Consider interest rates first. When market rates of interest rise, the prices of existing debt securities fall. Thirty-year bond prices are highly sensitive to interest rate changes. Short-term securities are relatively insensitive. A drastic overnight rise in market rates from 2 percent to 2.5 percent, for example, would hardly budge a short-term security price. Instead of the $0.54 gain that our $10,000 bond would otherwise realize between the 29th and 30th days before maturity, it would lose $3.34. If a money market fund had its average maturity at 30 days, its net asset value would decline by $0.000334, and that loss would disappear with rounding off to the nearest penny. But if under even more drastic circumstances the share price should drop to $0.99 or $0.95 or $0.90, there would be a problem. Not only would the next day’s share dividend be impossible, but the share price might have to drop. What to do?

The answer depends partly on accounting standards. A fund or any other institution that adheres to “mark-to-market” rules is supposed to adjust the value of the securities it holds as their market value fluctuates. This might seem to be a no-brainer. Isn’t more accurate accounting necessarily better?

Not necessarily. Some securities are very thinly traded, especially those nearing maturity. Or due to limited liquidity, bid/ask spreads may be wide. Do you mark to the bid or ask—or the midpoint? More important, it would be a huge waste of time to hunt for a market price of an asset that will be redeemed in full and with virtual certainty in a few days.

An alternative to mark-to-market accounting, and the current practice of most money funds, is for the parent firm to support the fund if it believes a slump in its net asset value is minor and temporary. It injects whatever funds are necessary to maintain the one-dollar share price and continues to redeem shares for a dollar apiece.

Breaking the Buck

If that practice were disallowed and the share value of a particular fund appears to have fallen rather than risen, two alternatives are possible. One is to announce a reduced share price, which is called “breaking the buck.” The other alternative is to issue a negative share dividend. In other words, your 50,000 shares might become 49,995 shares overnight. Shareholders might not even notice such a minor one-day loss if at the end of the month they found their share holdings had increased as usual. Sensible as it might sound, regulations don’t allow negative share dividends.

We mentioned deterioration of quality as a second hazard. It is conceivable but highly unlikely that a bond issuer will enter bankruptcy without warning and compromise the holdings of a money market fund. There are almost always warning signs long before a firm enters bankruptcy, allowing fund managers, who must be quite careful about quality, to avoid such risky securities. But the unlikely happened to the Reserve Primary Fund in 2008: It got caught by a federal government head fake. The Bear Stearns bailout had led most market participants to believe Lehman Brothers would also be rescued. It was not, and the Reserve Primary Fund had to write off its Lehman holdings and break the buck. Shareholders had to settle for 99 cents on the dollar, hardly a catastrophe, though there was some delay in paying claims.

When a fund breaks the buck or when large numbers of shareholders fear for the safety of their investment, the fund may be hit with substantial redemption orders. Such events are comparable to bank runs, but with one important difference. In a classic bank run depositors literally run to be first in line to withdraw their funds. Those at the head of the line get all their money and the rest get none. In contrast, if a money fund breaks the buck, all shareholders receive the same treatment—a reduced share price and a likely delay.

Most money market mutual funds are issued by large financial institutions such as Vanguard, Fidelity, Schwab, or Merrill Lynch. These funds are not so much a profit center as a convenience for their customers, perhaps even a loss leader. Brokerage firms offer customers the option of sweeping their investment income into a money market fund, where it becomes available via check-writing or online transfers. Customers like this option, and so firms are highly motivated to maintain the integrity of their money markets even if they must absorb some losses to do so.

Before the Reserve Primary Fund’s one-penny tragedy, there was only one incident of breaking the buck. In 1994 a fund that was available only to institutional investors had accumulated too many adjustable-rate securities, which backfired. Shareholders had to settle for 96 cents on the dollar.

That’s it. Out of all the trillions of dollars that have flowed in and out of money market funds over the course of some 40 years, through the European crisis of the last two years, and with no insurance and minimal regulation during most of that time, there were just these two mild, nay trivial, incidents.

A Tortured History

But a crisis is a terrible thing to waste, as an Obama administration insider famously said. In 2008 the feds instituted a temporary guarantee of money market funds. In 2010 they raised credit standards and shortened maturities. A spokesperson for the Investment Company Institute, a mutual fund trade group, told me those new regulations did nothing to improve the soundness of money funds. In fact, she said, these last four years have been “a long tortured history” for money market funds. [Editor’s note: See comment section.]

Several new proposals have been floated. One would allow shareholders only 95 percent of any redemption request in cash. They would have to wait 30 days for the rest. In a poll 23 percent of customers said they would close their money market funds should this happen. Another change would require mark-to-market accounting and a variable share price. This could drive almost all the remaining customers away because the stable one-dollar price is crucial to them. A third proposal would require funds to raise and maintain additional capital. In today’s bizarre zero-interest world, money market firms are hard pressed to earn any net income. So the call for more capital is like asking a starving man to forgo some of his meager rations and stash away more food reserves.

The mutual fund industry is objecting vociferously. The Investment Company Institute has issued several press releases warning of the aforementioned problems and adding others, like the necessity for shareholders to track their cost basis and pay capital gains tax. Also, some institutions would be required by regulation or their charters to close their money market accounts if a variable share price were adopted.

It looks for all the world like somebody wants to kill money market mutual funds. But who? Senator Pat Toomey (R-Penn.), a Wall Street veteran and a member of the Senate Banking Committee, thinks he knows who. In remarks before the U.S. Chamber of Commerce in February, he said, “I think there is a concerted effort to impose very, very troublesome regulations that . . . threaten the viability of the product itself. . . . Several regulatory bodies are pushing this. . . . [T]he Fed is one of them.” Fed Governor Daniel Tarullo has said that, in the absence of new regulations, money market funds could be deemed a Systematically Important Financial Institution (SIFI). Although large individual banks have gotten this “too big to fail” label, it would be an ominous extension of the concept were the feds to slap the SIFI label on an entire industry segment.

Why would the Fed and some other regulators and their congressional enablers want to kill the funds? A possibility: The funds have been successful with minimal regulation. Regulators thrive on fear mongering. Firms that succeed outside their grasp undermine their scare tactics and must not be tolerated.

If there were no regulations at all, would shareholders be helpless? It might seem so. Most people are not as astute as readers of The Freeman and could not comprehend the analysis presented here, much less analyze the holdings of a particular fund. But of course, there are free-market alternatives available to consumers faced with all sorts of complex choices: reputations and expert analyses. An unsophisticated would-be shareholder could ask his neighbor’s opinion, check online for five-star ratings, or consult a trusted investment adviser. These personalized alternatives are far superior to one-size-fits-all regulations that are vulnerable to regulatory capture (by the targeted industry) and whose minimum standards tend to become maximum standards when regulation reduces incentives for prudence. On the supply side, fund management firms, eager to enhance and maintain their reputations, could actively seek certification or ratings by independent auditing firms or evaluations like those that Morningstar and others provide for stock mutual funds.

The proposed new regulations would kill money market funds, with ill effects spreading throughout the economy. This is the wrong way to go.

  • Warren Gibson teaches engineering at Santa Clara University and economics at San Jose State University.