Money market funds are the stepchildren of finance. Though they manage more than $4 trillion in assets, they have not gotten much attention recently. Sen. Chris Dodd's regulatory reform proposal does not even mention money market funds. Is the omission justified?
If you analyzed the track record of money market funds up to 2007, you would think that Sen. Dodd is right. Money market funds are simple structures; some may even call them boring. They collect deposits and invest them in (almost) riskless money market instruments. In doing so, they earn a small yield while making sure the fund does not lose any money or, in Wall Street parlance, "never breaks the buck." For this reason, many investors think of money market deposits as the big brother to bank deposits. The only difference between the two is that money market deposits have no Federal Deposit Insurance Corp. guarantee.
However, if you analyze the performance of money market funds during the financial crisis, you would find that their omission from the Senate legislation is a glaring mistake.
Before the crisis, money market funds were considered a safe haven in which to hide from turmoil during times of stress. Since their inception in the 1970s, no fund of significant size ever broke the buck. Thus, it is not surprising that in 2007, when the crisis started, many money market funds had significant inflows from investors seeking safety.
This perception changed dramatically after Lehman's bankruptcy in September 2008. A consequence of the bankruptcy was that a large money market fund, the Reserve Primary Fund, which had invested $750 million of its $62 billion portfolio in Lehman commercial paper, promptly broke the buck. As a result, investors started pulling out their money; within a day the Reserve Primary Fund faced redemption requests of more than $20 billion. That's just too much for any fund to repay at short notice, and the fund's managers told investors to sit tight.
Obviously, investors did not like that, and once the word got out, the crisis quickly spread to other money market funds. Within two days, the entire industry was engulfed in a run, with investors trying to pull out more than $300 billion.
Facing a panic, the government acted promptly. Three days after the start of the run, it announced that all money market funds would be guaranteed. This announcement stopped the run, but it also meant that the government was on the hook for potential losses on more than $3 trillion of assets. That is a big number, almost one-quarter of country's gross domestic product.
What does this all mean for regulation? In effect, the lack of a guarantee for money market deposits was an illusion. A large-scale run on the sector is almost sure to motivate the government to step in and bail out money market depositors. The money market fund industry is simply too large and too important for the economy to let it go down, no matter what politicians say beforehand.
Though the Senate legislative proposal does not address money market funds, a proposal by the Securities and Exchange Commission recognizes that this (implicit) guarantee creates the same old moral hazard problem noted in connection with the largest commercial banks. Hence, the SEC proposes limiting risky investments by money market funds. Though this is a step in the right direction, we do not think it is enough. Many money market funds satisfied this criterion before the crisis but still faced investor withdrawal demands in September 2008.
We therefore believe that the government must explicitly acknowledge that money market funds will get such support during times of crisis. Though this may be unpopular in policy circles, it is an honest thing to do. Once the government acknowledges this readiness to provide support, it can openly discuss how to structure it.
Once a government guarantee is acknowledged, money market funds must be regulated to contain their risk to the economy. We believe two options exist to deal with money market funds.
The first would be a Volcker-rule equivalent for money market funds. The basic idea is that money funds, having been given a guarantee, must be charged a fee for it.
Such a fee would rise depending on the fund's risk. If a portfolio holds only Treasuries, the fee would be negligible. If the fund only holds longer-maturity commercial paper, the fee would increase substantially. The fee would still be smaller than the premium for FDIC insurance, since the guarantee would only cover a systemic run (when the entire industry is in turmoil), not the default of a single fund.
The second option would be a discount-window equivalent for money market funds. The Federal Reserve would set up liquidity facilities against which to lend in times of crisis. The government would charge a hefty interest rate and impose a haircut to ensure that it does not take a loss on its lending. Some money market funds would still break the buck under these conditions, and there would have to be a quick way to dissolve such funds.
The key is to set up the liquidity facilities in such a way that the government does not underwrite another blanket guarantee if times get really rough. This option would not necessarily require a fee beforehand but could be costly for funds afterward.
We understand that both options have their pros and cons and deserve more discussion than can be provided here. However, the important point is that the government needs to acknowledge the elephant in the room. Otherwise, we are poised for a re-run during the next crisis.