In September 2008, when Lehman Brothers failed, money market investors fled funds in droves, exposing investors and capital markets across the globe to huge systemic risks.
Now, to better safeguard investors and prevent the commercial paper market from shutting down in future crises, SEC chairwoman Mary Schapiro is proposing to re-make the money market mutual fund industry in the image of banks.
The SEC staff is recommending money market funds set aside capital reserves, as banks are required to do, and fund sponsors issue stock or debt to bolster their positions as a "source of strength," as bank holding companies are expected to do.
Also, the staff recommended restricting redemptions under certain circumstances and potentially requiring funds to collect upfront fees to further cushion themselves in times of trouble.
Industry leaders immediately attacked the plan as an assault on their business. They're threatening to sue the SEC.
The battle ahead isn't just about changing an industry.
It is about reshaping modern finance, the future power of regulators, and the real world implications of moral hazard.
Money Market Funds ExplainedMoney market funds are mutual funds. Investors who buy shares are pro-rata owners of the underlying investments that funds hold.
Money market mutual funds are restricted by SEC rules under the Investment Company Act of 1940 to purchasing only the highest-rated debt of issuing companies. They also invest in government securities and repurchase agreements.
The duration of the debt instruments they hold cannot exceed 13 months and the average weighted maturity of their portfolios has to be 60 days or less. Additionally, funds can't hold more than 5% of one issuer, except for governments or repurchase agreements.
The first U.S. money market mutual fund, The Reserve Fund, was established in 1971 to directly compete with banks for investor deposits. At that time "Regulation Q" prohibited commercial banks from paying interest on checking accounts.
Money market funds quickly drew in investors looking to earn interest on cash positions.
By September 2008, the size of the oldest money fund in the U.S., the Reserve Primary Fund, was $64.8 billion. Total industry assets were $3.8 trillion.
Anatomy of a Money Market Fund PanicOn Sept. 15, 2008 Lehman Brothers filed for bankruptcy and everything changed.
"Breaking the buck" is a cardinal sin for money market funds. Whatever the mix of debts and maturities any fund holds, and no matter how little interest they pay, at an absolute minimum investors park their cash in these funds for safety. The measure of safety is every fund's ability to maintain at least a dollar per share par value.
When the buck was broken at one fund, money market investors at all "prime" funds panicked. Only one day later investor redemptions exceeded $169 billion.
While investors were panicking about the par value of their fund holdings, the Federal Reserve, the U.S. Treasury and world financial markets feared the collapse of U.S. money funds would take the global financial system over a cliff.
Since short-term government securities don't pay a lot of interest, portfolio managers juice up fund yields by buying commercial paper (short-term funding instruments issued by corporations and financial firms) with more attractive yields.
The crux of the crisis, which nobody saw coming, was that not only did banks and investment banks issue hundreds of billions of dollars in commercial paper, but their off-balance sheet "conduits" also known as SIVs (structured investment vehicles) were also issuing commercial paper to finance the purchase of hundreds of billions of dollars of mortgages and other asset-backed securities.
As investors pulled out of prime money market funds, commercial banks, investment banks, asset-backed holding vehicles and every top-rated corporation in the U.S. that relied almost daily on functioning commercial paper markets were all unable to finance themselves.
The panic in the money markets was driving America's corporate elite and the rest of American businesses to an abyss.
To stem the "run" on money market funds, the Federal Reserve announced the creation of the Commercial Paper Funding Facility (CPFF) on October 7, 2008. The CPFF effectively extended access to the Fed's discount window to issuers of commercial paper, including those not chartered as commercial banks, to act as their lender-of-last-resort.
In addition to directly lending to commercial paper issuers, the Fed introduced the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility and the Money Market Investor Funding Facility.
According to the Fed, "All three facilities supported short-term funding markets and thereby increased the availability of credit through various mechanisms."
In other words the Fed saved investors and credit markets from an almost certain death.
But, not much changed in the commercial paper market. The same contagion and systemic issues that led to the money market crisis are still inherent in the system.
Making Money Market Funds in the Image of BanksBehind the scenes, banks are now working to level the playing field.
Banks have restrictive capital reserve requirements; they have to pay FDIC insurance fees, and are subject to far greater scrutiny than funds.
They complain that money market funds don't have those restrictions and the full backing of the Fed affords funds an insurance backstop that they don't have to pay for, but benefit from because lower costs allows them to offer higher yields.
From the moral hazard perspective, critics point to the Fed's backstopping money market funds as a license for them to take more risks as they divert deposits from the more regulated banking system.
The SEC staff's proposals level the playing field between funds and banks by essentially requiring money market funds to re-make themselves more in the image of better regulated banks.
Although the recommendations are meant to lessen the likelihood of another taxpayer-funded bailout in the future, money market fund sponsors are up in arms that they are being disadvantaged by regulatory overreach.
Fund sponsors claim the future of the commercial paper market is at stake.
They say increased regulatory costs will raise financing charges for commercial paper issuers to the detriment of the entire economy and that their own businesses will be destroyed.
The battle ahead is bound to get ugly.
"Free market capitalists" (as "socialists" might call them) will make their usual case that if left alone, bruised fund sponsors and commercial paper issuers will adjust to the complex realities that nearly caused their collapse. And investors should be free to chase yield and face free market consequences for decisions they make based on their own due diligence. They will argue that moral hazard will disappear if individuals, businesses, and banks are allowed to fail.
Of course, the "socialists" (as "free market capitalists" might call them) who want the American financial system to be safe for everybody will point to how free market capitalists are the first ones to cry for bailouts when their greedy schemes overwhelm the economy's capacity to absorb their losses. And that bailouts, which are increasingly necessary because deregulation unleashed the wrong kind of animal spirits, are the root cause of moral hazard.
The battle for the soul of America's financial and economic future hangs in the balance.
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