Money Market Funds, The Sec, And Grandma (Part I)

Do you recall the tongue-in-cheek Christmas song classic: “Grandma Got Run Over By a Reindeer”? That is the image that sprang to mind last August when the then U.S. Securities and Exchange Commission (SEC) Chair, Mary Shapiro, tried to force through a new regulation that (among other things) would compel U.S. money-market funds to move to a “floating price” system. At that point, intense pressure from the financial industry and opposition from a majority of her colleagues within the SEC killed Shapiro’s plan. For very personal reasons, I breathed a hearty sigh of relief – not so much because of strong convictions regarding the huge disruptive impact Shapiro’s policy would inflict upon U.S. cash management and the average U.S. investor/saver, but simply because of “Grandma” (my frail, struggling 95-year old mother).

Just one month before, I had sat in a bank conference room with her and a bank professional she has known and trusted for over 17 years, trying to help her understand the wisdom of the banker’s suggestion that she put all of her cash that exceeds three to four months of her average monthly expenses into a very short-term, conservatively managed bond fund.  Given the nearly 0% return that her (bank) money-market fund was earning, the nearly 1.5% that fund was yielding (at that time) was quite appealing.  Alas, no matter how hard I tried to rephrase and re-explain the wisdom of that strategy, she clung to what she was used to – an FDIC-insured, “principal safe” account.

Given that experience, I was not looking forward to the prospect of having another painful conversation with her, during which I would have to explain that the United States was requiring money-market accounts to be variably priced – in other words, she could lose money in them!  After a few moments of shock, her inevitable response would be: “Why?!” I know I could offer a long list of reasons for such a policy; however, to her, that wouldn’t do. In her eyes, Ben Bernanke has already reduced the annual interest income upon which she had, for three decades, counted upon to supplement Social Security and a pension. This new government mandate would only “add insult to injury”.

This is why I have paid particular attention to regulatory developments since August of 2012 (when Shapiro’s policy failed to pass). Given news developments and reports from this past week, it is worth taking a more detailed look at the U.S. money-market industry.

What is the central issue at hand regarding money-market funds?  From the start, U.S. regulators granted money-market funds a pricing “exception”: instead of daily pricing at net asset value (NAV), money-market funds are permitted to price at a “fixed” (or “constant”) NAV (CNAV). In theory, that is not a problem, since U.S. funds generally vary (much) less than 50/1000ths of a dollar from $1/share. Fund managers are strongly motivated to manage risk in ways that ensure the fund never falls below $0.9950 – at which point it would face liquidation.

The granting of this CNAV structure lent these money-market funds the supreme competitive advantage of apparent “safety” (as well as an interest rate generally higher than comparable bank rates). Therefore, the funds assumed a number of very constructive financial functions:

1)    Used by corporate treasurers as a tool in daily cash management;
2)    The average investor uses money-market funds as a “principal safe” means of saving for a home down payment, a vacation, or any relatively short-term goal.
3)   These funds are also commonly used as a holding place for monthly expenses and/or an “emergency fund.”
4)    One very common and convenient use of money-market funds is as a “linked account” within mutual fund or brokerage accounts

• Dividends and fund distributions flow into the money-market fund;
• New fund flows often start within a money-market fund;
• Proceeds from security sales flow into the money-market fund.

At the peak of its popularity, money-market funds held $4 trillion in assets (around the time of the Mortgage Crisis). To put that $4 trillion in perspective, as of last month, the huge ETF industry held just $1.5 trillion.  Currently, reports show an aggregated total of about $2.6 trillion in money-market funds. Since this financial instrument has so many amazing (even essential) purposes, what is the issue prompting regulatory concern? It is simple:

One of the most memorable developments related to the Mortgage Meltdown was the failure of the huge “institutional” (or “prime”) Reserve Primary Fund.  Reserve had a sizable allocation in the short-term debt of Lehman Brothers. You can imagine what happened: as Lehman descended toward bankruptcy, their debt became toxic and Reserve Primary Fund could not avoid “breaking the buck” on its fund. As a result, over $300 billion flowed out of the fund in only a few days, investors panicked, it became a full-fledged “run”, and the U.S. short-credit network “froze up”. The U.S. Treasury had to bail Reserve out.

IMAGE: the image to the left is of a home made gravestone of Lehman Brothers, created in the yard of a disgruntled observer. (Source: futureatlas.com, licensed through Creative Commons)

Because of this, the Dodd-Frank Act in 2010 mandated the review/reform of regulations regarding money-market funds. Some reforms were enacted at that point, but continuing concern regarding ways to further mitigate financial risk led to ongoing review by officials.

In August of 2012, then Chair of the U.S. Securities and Exchange Commission (SEC), Mary Shapiro, tried to push through a three-fold reform package that failed to receive a majority vote. The most controversial part of that package was a requirement that money-market funds move to a “floating” NAV structure (FNAV). Needless to say, the financial industry was outraged and was not shy about expressing their disdain for her policy viewpoint.

To be fair to Ms. Shapiro, it can be argued that a FNAV structure places “financial risk” on the shoulders of investors, instead of on the U.S. taxpayer (due to the lingering “implied backing” of the U.S. Treasury that resulted from the 2008 bailout of Reserve).

On the other hand, there is strong reason to believe that a FNAV structure would eviscerate the appeal of this instrument for individual investors and corporations:

1)   The “safety” label so essential for “Grandma” and so important for short-term saving (home down payments, emergency fund, etc.) would be severely impaired;
2)    Floating pricing introduces new complexity for all investors:

• Accounting issues for corporations.
• Tax issues (countless gains/losses on transactions) for both individuals and corporations.
• A recent poll by Fitch Ratings of European corporate treasurers discovered that fifty percent of them cited simple tax and accounting treatment (ie. “Constant” NAV) as the primary strength of money-market funds.

3)    The current unassailable advantages of using money-market funds as a “linked” account in connection with brokerage and fund accounts would be significantly undermined.

Given the current focus on various government agencies (IRS, CIA, Justice Department, etc.) it is interesting how non-SEC government officials have responded to the money-market fund issue. The Financial Stability Oversight Committee (FSOC – created by the Dodd-Frank Act, chaired by the U.S. Treasury Security and composed of the U.S. Comptroller, seven leaders from financial agencies (including the SEC), and an insurance expert appointed by the President) weighed in last November and recommended three non-exclusive options: a) Floating NAV; b) Stable NAV, but including an accumulated reserve (at least 1%) to serve as a “buffer” for the NAV, combined with a “minimum balance at risk”; c) Stable NAV, a 3% NAV “buffer”, and other measures.  Then, earlier this year (and not hiding their willingness to become politically vocal) twelve regional Federal Reserve presidents endorsed a Floating NAV.

This past week (June 5) the new SEC Chair, Mary Jo White, announced her agency’s new (revised) money-market fund policy proposal.

IMAGE: the image to the left depicts Mary Jo White, who was installed just months ago as chair of the U.S. Securities Commission. (Source: blackstonetoday.blogspot.com)

The most fascinating aspect of this new policy is how White has “learned” from the prior failure of her predecessor, as well as industry reaction to the “kibitzing” by the FSOC and the regional Fed presidents. Despite political pressures from other regulators and incredibly heavy lobbying by the financial industry, White seems to have developed a path of compromise worthy of the legendary wisdom of Solomon.

Although this proposal is in no way “fixed and final” (it is subject to a period of “public comment”, after which the SEC will review all comments and consider revisions), the broad outline of the proposal poses two alternatives for money-market management (options that could be adopted separately or combined into a unified reform package). The alternatives are:

1)    All institutional/prime money-market funds must be structured with a “Floating” NAV (FNAV). As we indicated earlier, it was the “institutional”/”prime” type fund that failed in 2008. That category of fund has ever since been the primary focus of SEC concern and scrutiny. It constitutes about 55% of the total money-market asset base. The other category (retail and government security money-market funds) composes about 45% of the industry.
2)    Imposition of a “fees and gates” policy on nongovernmental money-market funds whenever a fund’s liquid assets fall below 15% of total assets.

The proposal also includes a few more minor and (largely) noncontroversial provisions, such as:

a)    the tightening of diversification requirements;
b)    an enhancement of disclosure requirements;
c)    the strengthening of stress testing;
d)    an improvement in reporting requirements.

Why do I consider White’s proposal a Solomon-like compromise? Several key elements of the proposal reflect her political skill and credibility, including the following: 1) the decision to exempt “retail” and government money funds from the FNAV requirement; b) offering an intriguing way to let funds (to an extent) “self-select” whether they are “institutional” or “retail” (the key differential is whether the fund imposes a $1 million redemption limit — a limit under which I can certainly manage my affairs!); and 3) the incorporation of the “fees and gates” concept[1] — an extremely “fund industry friendly” element,  since it is a tool already in use by many funds. Needless to say, the response from the financial industry to White’s proposal has carried a quite positive tone (especially in contrast with the vitriol directed at Shapiro since last August.)

In particular, here are some of the comments from within the industry regarding Chairman White and her work:

• According to J. Christopher Donahue of Federated Investors, Inc.: “So far, I think [Ms White's ] approach is very good. She has intellectual strength and will come at things in a thorough, do-your-homework way.”
• Joan Ohlbaum, legal counsel for Stradley Ronon Stevens and Young LLP, tactfully praises White and pans Shapiro with this observation: “Mary Jo White's brings lighter baggage to her relationship with the industry on the issue… Mary Shapiro's views were more baked in. She took money funds as a signature issue — and she pushed for reform in August when other commissioners did not support reform.”
• The Investment Company Institute released a statement on June 5^th indicating that it appreciated the “extensive research” the SEC has undertaken on money-market fund reforms.

In addition, the ICI was “particularly pleased that the commission recognized the effectiveness of liquidity fees and gates in addressing risks that might arise in a widespread crisis. We also welcome the inclusion of fees and gates as a standalone option in the proposal.”  Finally, the ICI went on to affirm that the SEC “has the regulatory expertise to address the vital issues involved” (which addresses its preference for White’s ideas over those from the FSOC and the regional Fed presidents).

Let me re-emphasize that none of this is yet “official policy”. There are many details to hammer out, including how the key elements in the proposal could be systemically integrated into the existing U.S. money-market network. In addition, the SEC has openly solicited public feedback regarding how best to manage financial risk within the “non-institutional” side of the money-market industry.

Therefore, stay tuned for further developments. Many experts project that the soonest any final proposal could be developed, polished, and adopted would be this fall or early winter.  Until then, investors do not need to take any action (including having a challenging conversation with “Grandma”).  However, as we’ll cover in a much briefer Part II, you may find it beneficial to begin exploring some alternatives to your money market fund(s).

Submitted by Thomas Petty MBA CFP

 

Related Posts