June 21, 2012
On June 21, 2012, Securities And Exchange Commission Chair Mary Schapiro testified about "Perspectives on Money Market Mutual Fund Reforms" before the Committee on Banking, Housing, and Urban Affairs of the United States Senate. In somewhat chilling remarks about today's roughly $2.5 trillion money market funds, Schapiro dragged out the bloody corpse of the Reserve Primary Fund, which in September 2008 "broke the buck" and set off a cascade of panic that swept through other money market funds and flooded the short-term credit markets.
SIDE BAR: If money market funds comply with the Investment Company Act Rule 2a-7 (which basically limits money market funds' investments to short-term, high-quality securities on the assumption that such instruments are relatively stable), they are able to avail themselves of exemptions from a number of Investment Company Act provisions that generally pertain to mutual funds. Among the more notable benefits of such compliance is permission to maintain the stable $1.00 net asset value per share ("NAV"), for which such funds are best known and by which they are frequently marketed to the public. In accordance with this valuation leeway, money market funds are able to use rounding to maintain that $1 NAV - however, if the mark-to-market per-share value falls over 1/2% (below $0.9950), that convention goes by the wayside and results in what has become known as "breaking the buck."
Breakin' the Buck
Schapiro noted that on more than 300 occasions since the launch of money market funds in the 1970s, fund sponsors have had to step in with their own funds to shore up the one-dollar valuation. Although such sponsor efforts were generally effective over the years, the breadth, depth and celerity of the 2008 market break tested the industry's resolve.
Pointedly, the losses sustained by the Reserve Primary Fund as a result of its ownership of $785 million in Lehman Brothers debt overwhelmed the sponsor's ability to maintain the buck - all the more exacerbated when the once $62 billion fund was swamped with nearly $40 billion in redemption demands during a two-day period.
Having breached the walls at Reserve, the money market panic spread to the withdrawal of some $300 billion during the wek of September 15, 2008, or nearly 14% of the market's assets. As a result of defensive measures taken to preserve assets and cull out threatened performers, by the last two weeks of September 2008, money market funds had reduced their holdings of commercial paper by $200.3 billion, or 29% - which then presented the credit markets with additional pressure, and some would say effectively froze them and shut them down.
Schapiro asserted that during the financial crisis of September 2008, over 100 funds were bailed out by their sponsors. This investor run was only calmed when the Treasury Department and the Federal Reserve stepped in to offer temporary guarantees of $1.00 NAV for $3 trillion in money market fund shares, and supported the short-term credit markets. Schapiro ominously warns that because "the federal government was forced to intervene we do not know what the full consequences of an unchecked run on money market funds would have been."
I thank the SEC Chair for that candid and frank assessment. Too often what comes to us from those in regulation is spin and false assurances. Schapiro is absolutely correct to warn that just because we survived the 2008 market break does not mean that we will do so under similar situations in the future. Moreover, she is spot on when she admonishes us that we should not take false comfort at having repelled the money market run because that was achieved through extraordinary government intervention, which may not be available the next time around. There are only so many Persian attacks that Leonidas and his Spartans can repel. At some point, it's game over.
Consider these jarring candor in Schapiro's remarks to the Senate committee:
The experience of shareholders of the Reserve Primary Fund, however, is instructive about the impact of an unchecked run on investors. While some observe that shareholders in the Reserve Primary Fund ultimately "lost" only one penny per share, this ignores the very real harm that resulted from shareholders losing access to the liquidity that money market funds promise. They were left waiting for a court proceeding to resolve a host of legal issues before they could regain access to their funds. In the meantime, their ability to make mortgage payments, pay employees' salaries and fund their businesses was substantially impaired, and Reserve Fund investors were left in a sea of uncertainty and confusion. Some of their money is still waiting to be distributed.
The next run might be even more difficult to stop, however, and the harm will not be limited to a discrete group of investors. The tools that were used to stop the run on money market funds in 2008 are either no longer available or unlikely to be effective in preventing a similar run today . . .
Some Lessons Learned
On a modestly positive note, Schapiro allows that during the Summer of 2011 market stress, various money market reforms instituted in 2010 seemed to have held up in the face of another spate of heavy redemptions, which were, thankfully, substantially less severe than those of 2008. For example, during the three-week period beginning June 14, 2011, investors withdrew approximately $100 billion from prime money market funds versus the two-day panic in 2008 in which over $300 billion was redeemed.
From her perspective, Schapiro seems to have concluded that money market funds remain vulnerable to investor psychology that prompts redemption runs. In explaining some of the elements that have fueled such panics, she cites the "Misplaced Expectation" of a stable $1.00 NAV, which, when broken or fears arise of that event, fuels the investors' rush to the doors. Pointedly, Schapiro observes that a domino effect is likely to occur when one fund's NAV comes into question, leading investors at other funds to assume the worst and try to get out before it's too late.
In tandem with this expectational issue is what Schapiro sees as the perception by investors that there is a benefit to be among the first to redeem - the expectation that you will at least get the buck rather than something less if you wait too long. Unfortunately, the understandable human response to smell smoke and not wait for signs of fire, may cripple otherwise stable funds caught up in the whirlwind. In an interesting aside, the SEC Chair notes that since institutions tend to have access to more timely market news than the average retail investor, the advantage of getting out first would likely go to the big boys, putting the small fry at a disadvantage during such a critical time.
Finally, Schapiro looks at bigger picture and warns that
[M]oney market funds offer shares that are redeemable upon demand, but invest in short-term securities that are less liquid. If all or many investors redeem at the same time, the fund will be forced to sell securities at fire sale prices, causing the fund to break a dollar, but also depressing prevailing market prices and thereby placing pressure on the ability of other funds to maintain a stable net asset value. A run on one fund can therefore create stresses on other funds' ability to maintain a $1.00 stable net asset value, prompting shareholder redemptions from those funds and instigating a pernicious cycle building quickly towards a more generalized run on money market funds.
Given the role money market funds play in providing short-term funding to companies in the short-term markets, a run presents not simply an investment risk to the fund's shareholders, but significant systemic risk. No one can predict what will cause the next crisis, or what will cause the next money market fund to break the buck. But we all know unexpected events will happen in the future. If that stress affects a money market fund whose sponsor is unable or unwilling to bail it out, it could lead to the next destabilizing run. To be clear, I am not suggesting that any fund breaking the buck will cause a destabilizing run on other money market funds-it is possible that an individual fund could have a credit event that is specific to it and not trigger a broad run-only that policymakers should recognize that the risk of a destabilizing run remains. Money market funds remain large, and continue to invest in securities subject to interest rate and credit risk. They continue, for example, to have considerable exposure to European banks, with, as of May 31, 2012, approximately 30% of prime fund assets invested in debt issued by banks based in Europe generally and approximately 14% of prime fund assets invested in debt issued by banks located in the Eurozone.
Addressing the scary history of 2008 and 2011, and apparently aware of the lack of effective reform, Schapiro underscores the need to meaningfully address the weakness in the regulatory scheme for money market funds. First, she notes the option of requiring money market funds to abandon the $1 NAV and to act more like traditional mutual funds, which peg valuation on a floating basis. Second, she muses as to whether the implementation of an enhanced capital buffer would offer another sound response. Finally, Schapiro raises the prospect of some limits on redemptions, which I suspect may not prove particularly welcome among investor advocates but is, nonetheless, an appropriate topic to raise for consideration.
Bill Singer's Comment
Readers of "Street Sweeper" know that I am a vocal opponent of ineffective Wall Street regulation and inept regulators. I have carried that standard for over two decades and my advocacy for effective reform is a matter of record. Unfortunately, in criticizing the failed regulatory institutions that litter the federal, state, and self-regulatory landscape, I am often forced into the uncomfortable position of naming names and taking folks to task. I have often gone to great pains to assert my personal belief that the overwhelming number of men and women in regulation are sincere and dedicated - but I will not engage in such fawning as to pretend that the sweep of the brush covers everyone.
Truly, there are some very bad individuals engaged in regulating Wall Street. There are also too many fools, idiots, and cronies. Alas, that is not the unique failure of Wall Street's regulators but a common problem even in the private sector. One only need look at recent events that have engulfed Goldman Sachs, JP Morgan, Morgan Stanley Smith Barney, Citigroup, MF Global, and other firms to recognize that human folly is a universal malady.
Admittedly, I have not always been a vocal fan of Mary Schapiro - sometimes a tepid one but more often than not a critic. Not because I have ever viewed her as incompetent but because I have had the privilege of knowing her for many years and I recognize that she is an individual of intellect and talent. It is the realization of her capabilities that I often agonize over.
I will not pretend that Schapiro and I are friends or even close acquaintances. While we might well recognize each other at an industry function and share an aside, we do not count each other among our respective confidants. My role is not to be a cheerleader for Wall Street but to be a persistent gadfly and voice for reform.
All that being said, Schapiro's remarks are refreshing and I would welcome them as a new point of departure. I have long tired of the rah-rah that comes out of the mouths of too many political appointees and I have long hoped for some push-back by regulators against the inane demands of politicians who draft incomprehensible laws that leave all the hardwork of drafting rules and regulations to the overwhelmed subordinate agencies.
For me, Dodd Frank is garbage and nonsense. Not because of its aspirations but in spite of them - it's all reach and no grasp. It is an effort at reform that burdens too many SEC employees with research and drafting, when those industry cops should be building anti-fraud cases. To some degree, Dodd Frank is little more than pandering. It is a roadmap lacking the names of cities, towns, or streets.
Accordingly, for a rare instance, I take my hat off to Mary Schapiro and applaud her blunt remarks and fair warnings. If nothing else, she has warned us!