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BLOG OF THE DAY: Why Not Just Let Money Market Funds Fail?

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By now, BankThink readers are well aware that Jerry Hawke thinks money market mutual funds require no further regulation. Most of you have probably read that the SEC disagrees, and has an extensive reform proposal in the works (against which the money fund industry is mobilizing). Here’s a third view.

David Merkel at Aleph Blog pans the SEC’s plan to require capital buffers for money market funds, restrict redemptions, and ditch their fixed $1 share price for a floating net asset value. The regulator wants to avoid runs and bailouts on these vehicles. So does Merkel. But rather than try to make money market funds safer, he essentially wants everyone to recognize and admit and deal with the reality that they aren’t safe.

"Let there be stable net asset values, freedom in investment guidelines, but the possibility of credit events," Merkel writes. In other words, investors in the funds should know going in they might lose money. If a fund breaks the buck – that is, if the market value of its holdings falls significantly below par – Merkel says it should tell investors they’ve taken a hit. The share price could remain at $1 but the number of shares would be reduced, so the investors would no longer be able to withdraw a dollar for every one they put in. In return for sacrificing safety (or, rather, the illusion of it), money market funds would be allowed to take more risk, and potentially generate higher returns. No false sense of security, no federal backstop.

Merkel, an asset manager, first floated (so to speak) this idea in October 2008, shortly after the Reserve Primary fund broke the buck, triggering a run on money funds and leading to a bailout for the sector. In a post today, he maintains that his plan is better than the SEC’s.

And for a moment, Merkel sounds a little bit like Hawke, a former Comptroller of the Currency, and now outside counsel to Federated Investors, a big sponsor of money funds. "Why are we going after money market funds?" Merkel asks. "When they fail, the cost is pennies on the dollar, and it rarely happens." Also like Hawke, Merkel notes that banks "fail far more frequently, with much larger losses."

But unlike money fund industry advocates, Merkel does not want to preserve the status quo. He quickly adds: "I say let money market funds fail, and do not increase regulations on them. Regulate the banks tightly, but let money market funds go free, but advertise that losses are more than possible."

Marc Hochstein is the Executive Editor of American Banker

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The Shadow Financial Regulatory Committee issued a similar statement last year. I hope that readers find it helpful:

Systemic Risk and Money Market Mutual Funds
Shadow Statement No. 309
Committee | Shadow Committee Statements
February 14, 2011



The financial crisis has highlighted the institutional features of our financial system and regulatory policies that unexpectedly resulted in financial instability. One of these is the failure of money market mutual funds to use traditional net asset value (NAV) accounting, which contributed significantly to the problems experienced by these funds.

Many investors and money market mutual fund managers were not prepared for the effect that the bankruptcy of Lehman Brothers had on the value of money market mutual funds fixed-income holdings. For example, the Reserve Fund needed to "break the buck" under the Securities and Exchange Commission rules for money market mutual funds because its underlying valuation moved more than 1/2 percent below the fixed $1 NAV used by its funds. This led to a dramatic "run" on money market mutual funds in the aftermath of the collapse of Lehman Brothers by fund investors.

The SEC has recently moved to require monthly disclosure of shadow asset values for large money market mutual funds. While the resulting transparent price signal may lead to greater market discipline on funds, it also could amplify the danger of a run by investors anxious to exit ahead of any actual revaluation of the fund. In contrast, if fund valuations were marked to market immediately using the full NAV approach--as required for other types of mutual funds--this type of run would not have occurred, and there would not have been a strong economic incentive for money market mutual funds to liquidate positions.

Money market mutual funds that cater to institutional investors are especially vulnerable to runs. The "run" experienced during September 2008 at the Reserve Fund, the oldest institutional money market mutual fund, reflects this vulnerability, which then precipitated a broader run on money market mutual fund shares.

The policy response to the instability the occurred during fall 2008 was to provide federal insurance of pre-existing balances in money market mutual funds on a "temporary" basis. In order to stem the run on money market fund balances and preserve the potential for funding commercial paper through these funds. This insurance represented a new major federal commitment, and left little doubt that in the event of another fund crisis the federal government would step in to protect money market mutual fund investors.

The Shadow Committee believes that this extension of the federal safety net would be unnecessary if the SEC shifted to the floating NAV model for institutional money market mutual fund products. The relative sophistication of wholesale investors (compared to their retail counterparts) and their heightened tendency to run, as reflected in the 2008 crisis,1 would be greatly moderated. In fact, adhering to the semi-guaranteed par asset value arguably suggests that money market mutual funds should be regulated as banks. It may also be time to rethink our regulatory approach to retail money market mutual funds.

Indeed, the overall spirit of our suggestions is broadly consistent with proposals made by the President's Working Group last fall. One of the major lessons of the financial crisis has been the importance of internalizing the costs of risk bearing and controlling moral hazard, which is also the basis of our proposal.









Posted by kaneeb | Thursday, February 09 2012 at 5:22PM ET
Marc Hochstein, Executive Editor, American Banker: Edward, that is very interesting, thank you for sharing. Just to be clear, Merkel's proposal would technically keep NAV stable, except it would be "re-normalized" in the event of breaking the buck. I avoided getting into those mechanics in my post. I think the spirit is the same as what the SRC suggests: "internalizing the costs of risk bearing." This debate will be a lot more interesting if more than one alternative to the status quo gets serious consideration.
Posted by Marc Hochstein, Executive Editor, American Banker | Thursday, February 09 2012 at 6:24PM ET
My proposal on money market funds is a minimal solution that will prevent runs, allow freedom of fund management, and acknowledge that perfection is impossible -- there will be MMFs that fail. So if they fail, we want them to fail well. My solution reduces units when there is a credit event, not the NAV.

My proposal does not require extensive analyses, capital, etc. MMFs act like ETFs, they are pass-through vehicles, holders should benefit from and suffer from their management.

Thanks for the exposure of my proposal, I appreciate it. It is not hard to safeguard money market funds -- the short maturities help insure it.

One note: publishing fair value NAVs is a dumb idea. It will lead to speculation against MMFs. But, if you like that idea, why not do the same thing for banks? I am sure that they will love to publish negative net asset values during the depths of crises.

Remember, banks are the real problem. MMFs are just pass-through vehicles, like ETFs. Banks go broke, often with large losses. MMF losses are small, when they rarely occur.

The problems of MMFs are small, and can easily be solved in the way I have described. Why listen to ideologues that hate MMFs because the ideologues serve the banks? It is not intellectually honest.
Posted by David M | Saturday, February 11 2012 at 12:44AM ET
MMFs are no more than a "repo" without margin.

When the collateral of a Repo loses value the borrower "the manager of the fund" has to put up additional collateral.

Why should we allow the owners of a MMF management company profit from managing these repos without requiring them to put initial capital (like any repo) and mark to market the portfolio?


Jorge H Coloma
Posted by jhcoloma | Monday, February 13 2012 at 11:39AM ET
If MMFs had a minimum of 2% equity in them, publishing a fair NAV should not create any problems. If there are any loses, the capital can absorb it. Management company would have to maintain the minimum capital if they want to stay in business, If not, then liquidate. 2% equity, based on past history and combined with the investment restrictions promulgated by the SEC should make investors whole.

One note: I'm on the side of "let's get this financial system back together". Time is overdue for MMFs to start playing under the same rules as everyone else.

Not having any capital to back their business is just not right!!
Posted by jhcoloma | Tuesday, February 14 2012 at 5:31PM ET
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