SEC Commissioner Gallagher Advocates Right To Die On Wall Street

August 6, 2014

In keeping with the overall degeneration of collegiality in politics and the Supreme Court, for the past several years that trend has expanded to the Securities and Exchange Commission ("SEC"). Although never quite monolithic, much of the behind-the-scenes quibbling and jockeying for power among the commissioners and the chairs tended to stay just that: behind the scenes. Nonetheless, the fractious province of our state legislatures and city councils is now firmly entrenched in Washington, D.C.  Consider the recent history of the SEC's attempt to reform its money market fund rules. Those who favor the clash of ideas in the marketplace and champion a more aggressive style of advocacy will point to the amendments as a positive byproduct. Others will still admonish that we could have gotten to the same place without all the verbal fisticuffs. Pick whichever side of the debate you prefer.

A Reform . . . Finally!

On July 23, 2014, the Securities and Exchange Commission adopted new rules to aimed at reforming certain aspects of money market mutual funds: Money Market Fund Reform; Amendments to Form PF . As explained in the Summary to the Final Rule:

SUMMARY: The Securities and Exchange Commission ("Commission" or "SEC") is adopting amendments to the rules that govern money market mutual funds (or "money market funds") under the Investment Company Act of 1940 ("Investment Company Act" or "Act"). The amendments are designed to address money market funds' susceptibility to heavy redemptions in times of stress, improve their ability to manage and mitigate potential contagion from such redemptions, and increase the transparency of their risks, while preserving, as much as possible, their benefits. The SEC is removing the valuation exemption that permitted institutional non-government money market funds (whose investors historically have made the heaviest redemptions in times of stress) to maintain a stable net asset value per share ("NAV"), and is requiring those funds to sell and redeem shares based on the current market-based value of the securities in their underlying portfolios rounded to the fourth decimal place (e.g., $1.0000), i.e., transact at a "floating" NAV. The SEC also is adopting amendments that will give the boards of directors of money market funds new tools to stem heavy redemptions by giving them discretion to impose a liquidity fee if a fund's weekly liquidity level falls below the required regulatory threshold, and giving them discretion to suspend redemptions temporarily, i.e., to "gate" funds, under the same circumstances. These amendments will require all non-government money market funds to impose a liquidity fee if the fund's weekly liquidity level falls below a designated threshold, unless the fund's board determines that imposing such a fee is not in the best interests of the fund. In addition, the SEC is adopting amendments designed to make money market funds more resilient by increasing the diversification of their portfolios, enhancing their stress testing, and improving transparency by requiring money market funds to report additional information to the SEC and to investors. Finally, the amendments require investment advisers to certain large unregistered liquidity funds, which can have many of the same economic features as money market funds, to provide additional information about those funds to the SEC.

Down In Flames

The history of the amendments has been a difficult, often acrimonious path through the Chairs of Mary Schapiro to Mary Jo White. Perhaps no issue was more debated than the net asset valuation of the money market funds. READ: "SEC Chair Schapiro Fears Future Runs On Money Market Funds But Offers Hope" ( Blog, June 21, 2012), in which I noted, in part:

[S]chapiro 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.

Under the Schapiro SEC, the effort to reform money market funds crashed amid growing truculence among the commissioners. As I noted nearly two years ago in "Darrell Issa Challenges Mary Schapiro To Wall Street Jenga" ( Blog, August 28, 2012): 

Consider this Statement of SEC Chairman Mary L. Schapiro on Money Market Fund Reform (August 22, 2012) :

Three Commissioners, constituting a majority of the Commission, have informed me that they will not support a staff proposal to reform the structure of money market funds. The proposed structural reforms were intended to reduce their susceptibility to runs, protect retail investors and lessen the need for future taxpayer bailouts.

I - together with many other regulators and commentators from both political parties and various political philosophies - consider the structural reform of money markets one of the pieces of unfinished business from the financial crisis.

While as Commissioners, we each have our own views about the need to bolster money market funds, a proposal would have given the public the chance to weigh in with their views as well. However, because three Commissioners have now stated that they will not support the proposal and that it therefore cannot be published for public comment, there is no longer a need to formally call the matter to a vote at a public Commission meeting. Some Commissioners have instead suggested a concept release. We have been engaging for two and a half years on structural reform of money market funds. A concept release at this point does not advance the discussion. The public needs concrete proposals to react to. . .

A Victory Lap

In concert with the SEC's passage of the 2014 money market reform, SEC Commissioner Daniel Gallagher presented his Statement at SEC Open Meeting On Money Market Fund ReformI commend Gallagher's commentary to BrokeAndBroker Blog readers. Consider, for example, his observations below: 

[M]ake no mistake - money market mutual funds are not bank products.  However, because of the unintended, but perhaps predictable, consequences flowing from the Commission's adoption of Rule 2a-7 in 1983, today's multi-trillion dollar money market fund industry is viewed by many market participants as providing the functional equivalent of federally insured bank products.  And, of course, the 2008 Treasury money fund insurance program and related Federal Reserve commercial paper facilities did nothing to disabuse market participants of that perception.  The status quo of implicit guarantees for money funds is unacceptable, just as it was for Fannie Mae and Freddie Mac in the decades leading up to the crisis.  The difference though is that, today, the Commission is doing  for money market funds what precious few policymakers were willing to do with the GSEs before the crisis:  we are taking action to correct any misconceptions of federal backstops and bailouts for money funds.  Addressing a three decade old error in a nuanced and tailored manner to reinstate market-based pricing should not be seen, as some have argued, as a heavy-handed act of government.  This is especially true when the fix will positively impact investor behavior and eliminate the perception of taxpayer support.

Like other mutual funds, money market funds should be risk-taking ventures borne of the capital markets, where we want investors, whether retail or institutional, to take risks - informed risks that they freely choose in pursuit of a return on their investments.  Today's reforms squarely address and put investors on notice of this distinction, and I applaud the Commission and staff for resisting outside pressure to apply a bank regulatory paradigm to a product that is so integral to the functioning of the capital markets.  Many forget, sometimes all too conveniently, that this agency came very close to imposing a capital buffer on money funds.  This was a big-government, bank-regulator preferred proposal that would have crippled the industry.  I take great pride in my successful efforts to kill that misguided proposal.

The Commission does not have oversight authority over banks or bank products, and we do not have access to the tools available to the prudential regulators who do.  There should be no confusion about that, now or ever, and the agency learned no tougher lesson from the events of 2008.  The Commission is an appropriated independent agency without a Treasury line of credit or a balance sheet.  We cannot bail out any firm or product, and that is the proper order of things.  Our oversight should be focused on market-based valuations and strict capital standards employing those valuations, and in the case of failure, we should be expert in the wind-down process.  As I have said so many times recently, we should be the morticians, not the ER doctors. . .

It Ain't Money In The Bank

Commissioner Gallagher does a public service by reminding investors what Wall Street brokerage firms too often try to disguise: money market funds are NOT bank products. Sure -- investors often assume that their available funds, which are frequently swept into money market funds, are pretty much the equivalent of cash sitting in a federally insured bank products - and the securities industry's display of a SIPC imprimatur and the lack of meaningful disclosure to the contrary all further that false impression. As such, Gallagher oddly trumpets some of former SEC Chair Schapiro's similar prior concerns that there is a danger - a moral hazard, if you will - with fostering that lack of distinction between bank and securities products. 

No Safety Net

Gallagher properly protests that the "status quo of implicit guarantees for money funds is unacceptable, just as it was for Fannie Mae and Freddie Mac in the decades leading up to the crisis." Ultimately, he advocates pulling the rug out from under by making it clear, quite clear, that there is no guaranteed back-stop for money market funds and that, once and for all, we must "eliminate the perception of taxpayer support." Yes, there is risk even in money market funds. Embrace it. Accept it. But factor that into your investment.

The SEC Morgue

I applaud Commissioner Gallagher for getting it right - in a way that many of his colleagues, past and present, have not. The SEC was never intended to be anything other than a regulator. It is not an ATM for failing securities offerings or for ailing brokerage firms. Consequently, the commissioner is spot on when he admonishes: 

We cannot bail out any firm or product, and that is the proper order of things.  Our oversight should be focused on market-based valuations and strict capital standards employing those valuations, and in the case of failure, we should be expert in the wind-down process.  As I have said so many times recently, we should be the morticians, not the ER doctors. . .

In fairness, I have often been quoted complaining that Wall Street's regulators are too often consigned to nothing more than "reading the toe tags in the morgue." I imply with that barb that effective anti-fraud regulation must be more pre-emptive. Consequently, Commissioner Gallagher and I use the imagery of the morgue in addressing two very different roles for the SEC, and, as such, we are both right.  When policing Wall Street and walking the beat, the SEC must not read toe tags in the morgue, as was the case with both Madoff and Stanford. We needed a more active form of community policing. In contrast, when a cadaver is, in fact, brought under regulatory scrutiny, the SEC needs to do its job in that regard and let us know what went wrong in order to prevent a recurrence - as has been somewhat sadly lacking in responding to numerous market crashes caused by technological glitches or, as Commissioner Gallagher notes, when promulgating the wind-down process for a failed product or failing firm.  

There are times when the SEC's role is to call the time of death and perform the autopsy. Such a protocol will inculcate the investing public with the understanding that some investments are doomed and it is not the role of the SEC to play god and try to breathe life into something that is stone cold. That harsh reality may encourage some investors to be more realistic when handing over their life savings, even if those bucks wind up in a supposedly sacrosanct money market fund. Commissioner Gallagher urges that some products and firms on Wall Street must be permitted to die. That is a harsh and likely frightening reality; but it is the natural order of things in life, and as it should be in the securities industry.