new money market fund regulations

Yesterday, the SEC announced new rules for US money market funds, which in the aggregate hold $2.6 trillion in investors’ money.  Of that amount, two-thirds is in funds catering to institutions and high net worth individuals; one-third is in funds serving the mass market.

Why the need for new rules?  

Two reasons:

–today’s aggregate money market assets are large enough to be a risk to the overall financial system if something goes badly wrong, and

–the funds are typically sold as being just like bank deposits, only with higher yields.  However, like most Wall Street claims that  “x is just like y, only better,” it’s not really true.  The differences only become important in times of market stress, when normally sane people do crazy things, and when “yes, but…” is a sign for panic to begin.  So there’s a chance that “badly wrong” can happen.

The differences?    …bank deposits are backed by government insurance that insulates depositors from investment mistakes a bank may make.  Also, the Fed stands ready to rush boatloads of cash to a bank if withdrawals exceed the money a bank happens to have on hand.  Money market funds have neither.

Yet many holders are unaware that it’s possible for a money market fund’s net asset value to fall below the customary $1.00 per share, or that a fund might be overwhelmed by redemptions and forced to sell assets at bargain-basement prices to meet them.

the fix

Fixing this potential vulnerability has two parts:

–giving the finds the ability to halt or postpone redemptions during financial emergencies, and

–requiring funds to have floating net asset values, not the simple $1.00 a share.  This would mean marking each security to market every day.  …which would likely require hiring a third-party to price securities that didn’t trade on a given day.

The first of these would avoid the government having to step in the case of a run on a fund.  The second should reinforce that money market funds aren’t bank deposits.

the new rules

Of source, the organizations that sell money market funds have been strongly opposed to anything that would ruin their “just like…, but better…” sales pitch.  Their lobbying has blocked action for years.

So it should be no surprise that yesterday’s SEC action was a compromise measure:

–all funds will be able to postpone redemptions in time of emergency, but

–only funds that cater to big-money investors will have to maintain a variable NAV.

Personally, I don’t understand why money market funds that serve ordinary investors should be exempt from having to calculate a true daily NAV.  You’d think that this is the group that most needs to understand that the (remote) possibility of loss is one of the tradeoffs for getting a higher yield.  Arguably, sophisticated investors already know.  But the financial lobby is incredibly powerful in Washington, and this may have been the price for getting anything at all done.



regulating money market funds

In the aftermath of the financial crisis, the government has been considering the risks to financial stability posed, not only be banks but also by asset management firms.  As part of this effort, the SEC is about to set new regulations for money market funds this week.

what money market funds are

One of the most important economic (and stock market) trends of the past half-century has been the emergence of focused single-purpose entities to compete with large conglomerates.  In retail, specialty firms selling jewelry, toys, household goods or electronics have offered an alternative to department stores.

In finance, money market and junk bond mutual funds, have offered alternatives–to borrowers and savers alike–to commercial banks.

Money market funds have several important characteristics:

–they provide short-term, working capital-type loans to borrowers

–as mutual funds, they promise to accept daily subscriptions from savers and allow daily withdrawals in unlimited amounts

–they have typically offered higher yields than bank savings accounts–sometimes far higher yields

–they can offer the ability to write checks against deposits

–they promise, at least implicitly, to maintain net asset value at a stable $1 per share.  In other words, they promise that, like a bank deposit, you won’t lose any of the principal or interest you have in the fund

–because a money market fund is not a bank, its deposits are not government insured.  The “no loss” promise relies solely on the good will and financial strength of the investment company offering the product.

the risks

According to the Investment Company Institute, US money market funds currently hold $2.57 trillion in assets.  That’s a lot of money.

In times of stress, the warts in money market funds begin to show.

They come in two related varieties:

–as a practical matter, many funds are so large that they might not be able to meet redemptions if large numbers of shareholders lost faith in either the industry or a particular fund and headed for the exits,

–because money market funds compete with each other primarily on yield, inevitably someone (or more than one) will hold his nose and make a sketchy loan simply because the interest payments are high.  In a crisis, such loans may not be worth what a fund paid for them; in the worst case, the borrower will default.    In past crises, including 2008-09, there have been times when dud loans are big enough to make it questionable whether the real NAV of a given fund should still be $1.00 and not $.99.  These situations have typically been resolved by the management company that offers the fund buying the securities in question from its money market fund at face value.  But there’s no guarantee this will happen in the future.  And a single fund that “breaks the buck” by writing down assets in a crisis could easily spark an industry-wide panic.

new rules

This week the SEC is expected to issue new money market rules to meet these concerns.  They’ll include:

–many money market funds that don[‘t exclusively own Treasury securities will be required to have a floating NAV, and

–funds will have the ability to suspend redemptions in times of financial stress and/or impose withdrawal fees on those wishing to get their money back.

my take

I think new rules will have their greatest impact on the investment practices of money market funds.  They’re now generally regarded as a utility-like service that requires little investment skill or management oversight to run.  That will change.  No firm will want to be the first to impose withdrawal fees or suspend redemptions.  Certainly, no one will want to destroy their reputation for financial integrity by recording an NAV different from $1.00.  As a result, management oversight will increase and investing practices will become more conservative.

For all practical purposes, NAVs will remain stable at $1.00.

For savers, the FDIC insurance offered by bank deposits will become a bit more attractive.  Since, however, 2/3 of money market shares are held by institutions, I don’t think there will be a massive shift away from money market funds when the new rules take effect.

European money market funds–charging to hold your money?

That’s what the Financial Times suggests is about to happen, based on what the largest European money market fund managers have told them.

money market funds

Money market funds are a kind of mutual fund that specializes in holding very short-term government and corporate debt.  They became popular as a much higher-yielding, but safe alternative to bank deposits well over a quarter-century ago.  Although not insured by governments in the way bank deposits are, their investing operations are designed to preserve net asset value at a constant level.  That’s usually $1 or €1.  Interest is paid in new shares.

defending net asset value

Over their entire lifespan, there have been only a small number of incidents, involving a small minority of funds, where investors have received less than their initial purchase price when redeeming shares.  There have been cases–only a few–where funds have made imprudent investments stretching for yield.  But the financial conglomerates sponsoring the wayward managers have invariably made investors whole, typically by buying the dud paper at the initial purchase price.

today’s situation in the EU

Why is today any different in Europe?  Two reasons:

–the European Central Bank has recently reduced the interest rate it pays on overnight deposits from 0.25% to plain old zero.  And it says it might reduce rates further, meaning it will begin to charge banks for holding their money.

–the long-running EU debt crisis has created a two-tier structure of sovereign borrowers, haves and have nots.  Interest rates on short-term French and German notes are already negative (meaning you lend €1 to either country and get €0.995 or so back when the note comes due).  Yes, a money market fund can get a positive yield by lending to Spain or Greece, but only by taking on extra risk.  Also, once your clients learn what you’re doing, they’ll probably move their funds elsewhere.

A manager can, of course, think about buying longer-dated securities that do pay interest.  But he takes on interest rate risk by doing so.  Just as important, the fund’s charter will doubtless bar, or at least limit, such investments.

To sum the situation up, money market funds promise safety + a better yield than bank deposits.  In today’s EU, they can’t deliver both.

plans being considered

According to the FT, some fund sponsors are toying with the idea of keeping the net asset value constant, but charging the negative interest rate to accounts by decreasing the number of shares an investor holds.  Others appear to be considering levying charges in some form, but outside the fund, so that neither the asset value nor the number of fund shares will be affected.

bank accounts must be in the same situation

Given that money market fund managers are usually much more efficient than their bank counterparts, the banks themselves are likely beginning to lose money on savings accounts.  So it’s possible that in the stronger EU nations, banks will begin to charge customers a monthly fee to safeguard their money.

more than an oddity

I think the most important information to take from this discussion is that the money market fund sponsors don’t expect the situation to change any time soon.  If they thought that negative returns on government notes were a three- to six-month aberration, they might quietly suffer through the losses.

But they’re not.  They’re planning on the current situation being around for a long time.