A 1968 battle for a South Vietnamese provincial capital, Ben Tre, gave rise to one of the most famous quotations of that unfortunate war. “We had to destroy the town in order to save it,” a U.S. Army major reportedly told Associated Press reporter Peter Arnett.
Securities and Exchange Commission Chairman Mary Schapiro seems determined to take a similar approach to “fixing” money market funds.
Money market funds were invented about 40 years ago to provide investors with a safe place to park cash. They offer quick access to funds without penalties for early withdrawal, unlike bank certificates of deposit, and better yields than banks typically pay. The funds make very short-term loans, typically no more than two or three months and often just for one to seven days, to large corporations, financial institutions, and government entities and agencies.
Unlike other mutual funds, money market funds maintain a constant share price of $1 per share – or at least they try to, and they almost always succeed. Out of hundreds of funds across the last four decades, there have only been two instances in which a fund “broke the buck” by allowing its value to fall below $1 per share. The more recent instance was in the fall of 2008, at the height of the financial crisis, when the Reserve Primary Fund broke the buck because it had invested a lot of money with Lehman Brothers shortly before that firm failed.
A stable share price allows investors to treat money market fund shares much like cash. The fixed share price is also what Schapiro hopes to do away with. She has suggested far-reaching new regulations that would, among other things, require money market funds to vary their share prices, or net asset values. Such “floating” net asset values would rise and fall with the value of a fund’s portfolio, making money market funds more or less identical to other short-term bond funds.
Schapiro and other advocates of floating net asset values argue that fixed share prices create the illusion that money market funds are risk-free, as good as cash, when this is not the case. A President’s Working Group report that came out in October 2011 provided one of the first proposals for creating variable prices, arguing that such floating quotations would make “gains and losses a regular occurrence, as they are in other mutual funds, [which could] alter investor expectations that [money market fund] shares are risk-free cash equivalents.”
These concerns are more than just hypothetical. When the Reserve Primary Fund broke the buck in 2008, the result was an atmosphere of panic. The federal government was forced to temporarily guarantee holdings in most other money market funds in order to prevent a bank run.
Since then, reforms have been implemented to make money market funds safer. The new measures now require funds to be more selective in the types of entities to which they lend money and to keep more of their money in shorter term loans so that they can more easily return investors’ cash in the event of a run. These reforms will limit the funds’ yields, but they serve an important role in ensuring that money market funds live up to their reputation as nearly risk-free investments.
But eliminating the funds’ fixed share price is a step too far, creating a cure worse than the disease. If money market fund share values are forced to float, even by typically tiny amounts (as will almost certainly be the case), investors will be forced to track the cost of each share and the proceeds received upon its redemption, just as with a stock or a conventional mutual fund. For those who use money market funds as an alternative to checking or savings accounts, this would mean having to record and report each deposit and withdrawal on tax returns. On the funds’ side, the added accounting burden would cut into operating margins that are already almost non-existent as a result of ultra-low interest rates.
Currently, money market funds hold 16 times more assets than floating-value short-term bond funds despite the bond funds’ higher yields, according to the Investment Company Institute, an industry trade group. This clearly illustrates consumers’ strong preference for the convenience that comes with fixed value shares. If funds are forced to use floating net asset values, many investors will just move their money into bank accounts. That’s good for the banks, but bad for the businesses and government agencies that turn to money markets for short-term financing. The overall effect will be an unneeded drag on the economy in exchanged for little practical benefit.
Industry groups have come out strongly against the proposal for floating net asset values. In April the U.S. Chamber of Commerce, which represents both financial institutions and corporations that rely on money market funds to manage cash flow, launched a highly targeted advertising campaign opposing the plan, blanketing the walls and even the floors of the subway stop that many SEC employees use to get to and from work.
In a Feb. 29 letter to shareholders, F. William McNabb, III, Chairman and CEO of Vanguard – which as of that date held more than $130 billion of the country’s over $2 trillion in money market assets – warned of the dangers of floating net asset values. He wrote that, while “much progress has been made during the past few years as stronger regulations have benefited the industry,” further changes, such as the implementation of floating net asset values, “could do irreparable damage to portfolios that have served savers and the U.S. economy well over the past 25 years.”
Despite these warnings, Schapiro has refused to back down. In a speech in April, Federal Reserve Chairman Ben Bernanke indicated that he is on her side. “The risk of runs created by a combination of fixed net asset values, extremely risk-averse investors and the absence of explicit loss-absorption capacity remains a concern,” he said.
Schapiro and Bernanke miss the point. New regulations have already addressed the shortcomings that led the Reserve Primary Fund to break the buck four years ago. More broadly, the crisis in 2008 arose because Bernanke and then-Treasury Secretary Henry Paulson declined to step in to prevent Lehman Brothers’ abrupt failure, which triggered intense fear across the financial system. Nobody knew which institution was going to be the next to go under. It was not a money market fund problem; it was a financial system problem. The only way floating share prices for money funds could have made a difference would have been if, as a result of the floating prices, too few investors had been using money funds to matter.
In effect, that’s what Schapiro’s defense of the money market fund represents: the idea that we can solve the problem of potential runs on money market funds by making them so unattractive that nobody uses them in the first place. The strategy might work, but it’s still going to leave us with a pile of rubble where the village once stood.