Inside Financial Services

The S.E.C. Needs To Get A Handle On Money Market Funds

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I’m not normally the type to plump for more regulation of the financial services industry, but the S.E.C.’s failure to tighten the rules surrounding money market funds has me mystified. Anyone who saw what happened following Lehman Brothers’ collapse understands the risk the funds pose. After Lehman imploded, a fund called the Primary Reserve Fund (which owned a small amount of Lehman paper) broke the buck, which in turn set off a run on the entire $2.7 trillion market. Soon demand for commercial paper (of which money market funds are the primary buyers) fell to basically zero. Companies that fund themselves via CP (General Electric, for one) faced insolvency. The entire financial system was set to collapse. It wasn’t until the federal government stepped in to backstop the market that order was restored.

So this is an industry that can stand tighter oversight. And yet, inexplicably, the S.E.C. can’t bring itself to act. The main proposal the agency was considering was a mandate that funds move away from their current “stable value” standard, wherein the net asset value of a fund’s share by definition equals $1, to a floating NAV, which is how every other kind of open-ended fund works. Under stable value, it’s easy to see why Primary Reserve holders panicked: early redeemers stood to receive 100 cents on the dollar regardless of the value of the fund’s underlying portfolio, while later redeemers would only get whatever was left. Thus a single defaulting sliver of a single portfolio in single fund sent the financial system into a tailspin. That’s crazy.

Besides, the whole notion of a stable-value fund makes no sense. “The asset values already float, but we just hide it,” Vanguard founder Jack Bogle told the A.P. last week. “There is not the kind of safety that people assume there is. . . . Investors are relying on this illusion that the asset value is fixed. We ought to do away with the illusion.” Recall that Vanguard is the largest mutual fund manager and runs $150 billion in money market funds, so Bogle knows what he’s talking about. And he’s right. In the investment world, the notion of “stable value” is a myth-and in this case, a dangerous one.

Nor, for that matter, are money market funds the dazzling financial innovations their boosters make them out to be. The only reason the money fund industry even exists is because of an anomaly in bank regulation from the 1970s. Back in those high-inflation, high-interest rate days, the FDIC had a limit on what banks could pay on savings deposits that was well below the market rate. Money funds were invented simply as a way to circumvent bank regulation and provide savers with higher returns. But the FDIC’s rate cap has long since disappeared. Money funds are merely a vestige of obsolete bank regulation.

The Lehman experience is more evidence than anyone should need that regulation of money funds needs to be dramatically tightened. The main reason the S.E.C. hasn’t moved, from what I can see, is that the agency has been the object of relentless industry lobbying. The industry has a right to have its say, but the S.E.C. needs to look beyond its narrow concerns and act for the sake of the financial system. The status quo isn’t good enough. It needs to be changed.

What do you think? Let me know!

6 Responses to “The S.E.C. Needs To Get A Handle On Money Market Funds”

  1. slim

    I agree that, to the extent the current regime risks future runs on MMFs (which, therefore, means the MMF industry wiil, in a crisis, be backstopped by the federal government just like 2008), the regime should be changed. What no one has answered, however, is the practical effect of moving away from the stable value fiction. Will every check written on a MMF now result in a capital gain or loss, with the account holder issued a 1099-B at year end for all the checks written during the year? If this is the not the result: (1) please explain the mechanics of why this won’t result and (2) also explain why you are not simply replacing one accounting fiction with another. On the other hand, if this is the result, I expect it will be the death of MMFs (which given your comments, I suspect you would not mourn).

  2. Bill Dunnell/Seattle/page 124

    Here is the question: If money markets are regulated out of existance what should investors, who like to hold some cash in their accounts, do? To regulate them is to add more cost and risk to the providers. What is an alternative?

  3. Oy

    Oh, this is going to be fun. You’re sure to touch off a round of rants between diehards who are equally extreme in believing that any more regulations than those already imposed will destroy the business and those who think that would be a good thing. Personally, I like MMFs as a place to temporarily park cash, but the SEC’s mandate isn’t to guarantee employment for MMF managers. Some steps need to be taken to rein in the possibility of catastrophic runs.

  4. Steve

    I am surprised that you call for more regulation. Do you think they would get it right? The status quo is not good enough in regulation, or politics. They are all corrupt.

  5. Maybe4less

    I work for a large institutional asset manager with a sizeable money market fund business. We hear from our money market clients constantly that they will not invest in an MMF with a floating NAV. They only want a product that at least appears as stable as cash and are not interested in floating NAVs.

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