Chuck Jaffe: Will money funds be safe when rates rise?
You’d think no one would give a hoot about an investment earning virtually nothing.
But at a time when money-market fund yields are virtually zero, politicians, regulators and fund company executives are fighting awfully hard to decide how rules over these safe-haven cash-parking spots will work in the future.
Following the financial crisis of 2008, money funds went through significant reforms in 2010, and there was talk of much more, but an effort led by Mary Schapiro, then-chairwoman of the U.S. Securities and Exchange Commission stalled, due largely to the lobbying efforts of the fund industry.
When Schapiro stepped down, it was widely assumed in the industry that further reform efforts were, effectively, dead.
That assumption came to a sharp end recently when the presidents of all 12 Federal Reserve Banks submitted a joint letter to the Financial Stability Oversight Council supporting further reforms to the money-market fund business, reigniting the discussion and bringing some new conditions into focus.
Ironically, what regulators and the bank presidents want to protect investors from now isn’t a default or a bankruptcy, but from the side effects of an increase in interest rates.
To see why, let’s dig in.
Money-market funds are supposed to be boring, pain-free investments, a safe place to park cash.
Shares are priced at a constant $1; any interest the fund earns that would otherwise raise the price gets shaved off and reinvested to keep the value stable.
In 2008, the nation’s oldest and largest money fund, Reserve Primary, “broke the buck” in the wake of the Lehman Brothers’ bankruptcy.
The $64 billion fund was stuck holding $785 million in Lehman paper; the news started a run of investors fleeing money funds, a dangerously destabilizing event for the entire economy.
Investors who stuck with Reserve Primary through the troubles ultimately lost 3 percent in an investment they figured would never lose money; the much bigger fear was the resulting economic chaos that was borne out by the financial crisis of 2008.
As a result, the SEC in 2010 adopted rules requiring greater transparency and forcing money funds to invest in more liquid assets with higher credit ratings and shorter maturities. The fund industry supported that move.
Regulators, however, wanted to go further; fund companies didn’t.
Regulators are considering a floating share price — rather than the stable $1 — based on a fund’s net asset value, and/or forcing funds to keep capital buffers to offset small losses, and more.
Floating share values mean that investors would have no incentive to rush the exit at the first sign of trouble, trying to get their $1 before the problems hit home.
Capital buffers, meanwhile, are a form of self-insurance against loss, although shareholders pay that price in even-lower returns.
Last year, Schapiro said there had been more than 300 documented cases where mutual-fund advisers stepped in to buy problem paper to keep their money funds from breaking the buck; in every case except Reserve — where the failure was too severe — firms made that move because they could not have survived the bad press that comes with letting your safest funds hurt fearful investors.
The 2008 crisis was so severe that most observers don’t believe the 2010 reforms would have stopped it. Neither would the new proposals.
That’s why it’s safe to assume that the Fed presidents and regulators see the next problem as something completely different.
Instead of worrying about a default or bankruptcy, they’re focused on the next time interest rates rise.
“Money market mutual funds have no explicit capacity to absorb losses in the event of a decrease in the value of assets held within the fund’s portfolio,” said the Fed leaders in their joint letter. “This structure gives rise to a risk of destabilizing money market mutual fund runs by creating a first mover advantage.”
When rates go up, bond prices fall. Money-market funds are, effectively, ultrashort term bond funds; the fear is that the instant rates go up, big institutions parked in money funds bail out, to get the cash working elsewhere; money funds, in turn, must liquidate assets to meet redemptions just at the time when bond prices are falling, thus locking in losses that the fund sponsor either pays for or passes on to shareholders.
Worse, in that scenario, there’s not really any buyer for the distressed money-market securities, sending their value plummeting to where it, again, endangers the overall safety of the economy.
Much as reform is about trying to make sure that the government won’t have to step in, that kind of scenario almost certainly would force the government and/or the Fed to say they will back the worrisome paper.
In short, the reforms likely won’t prevent the problem they are now aiming to stop.
The fund industry — which thought it had this battle won — now appears to be expecting to fight it anew once both the SEC and the Financial Stability Oversight Council have new leadership in place.
The compromises fund firms might be willing to strike include redemption fees applied to some money funds — institutional share classes — and higher allocation requirements to government securities; expect the business to fight all other proposals.
In the end, resolution may not solve anything, as it’s hard to fight the next crisis before you know what it actually will look like.
What’s clear is that the battle is not over.
“People have been preaching that changes are either imminent or dead ever since the last reforms were made in 2010,” said Peter Crane of Crane Data, which researches money funds.
“What’s clear is the fat lady hasn’t sung yet, and that every time this stuff comes up again, we move closer to seeing some sort of change. What’s unclear — and will be until it is tested in a crisis — is whether any of this will make investors or the economy safer,” Crane said, adding:
“Investors don’t care now because money-market rates are horrible, but someday when rates are higher again, people will care if reforms cut their returns or if a lack of reforms makes them feel unsafe.”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright, 2013, MarketWatch