The SEC finished overreacting to a side effect of Lehman Brothers’ bankruptcy on Wednesday, passing long-awaited reforms of money market funds. As with most of the regulatory moves aimed at preventing a repeat of 2008, the new rules (and the nearly six-year debate preceding them) are largely an exercise in futility, but as far as unintended consequences go, we’ve seen worse. They might not make the financial system “safer,”[i] as some have suggested, but they shouldn’t materially impact retail investors or the many corporations who rely on these funds for financing.
For those who haven’t followed closely (and we envy you), the saga started on September 16, 2008, the day after Lehman’s bankruptcy, when a $62 billion money market fund called Reserve Primary “broke the buck.” Or, translated from bankerspeak, its share price fell below $1. Most folks think this shouldn’t happen to a money market fund, which is designed to be a higher-yielding cash alternative. But money funds get this higher yield by investing in a smorgasbord of short-term debt, including T-bills, commercial paper (short-term debt issued by banks and other firms) and repurchase agreements. Which all carry at least some risk. And Reserve Primary—which, despite its name, was not run or guaranteed by the Federal Reserve—owned some commercial paper from Lehman. Which, naturally, tanked after Lehman went bankrupt, driving Reserve Primary’s share price down to 97 cents.
Times of panic being what they were, investors freaked and fled—even “cash” wasn’t safe! The run spread throughout the money market fund universe, threatening to freeze corporate financing and ultimately forcing the Fed to backstop the entire industry. Soon after, with bailouts widely seen as a scourge on society, regulators started knocking heads to figure out how to keep this from happening ever again.
Now, if you’re thinking, “hey, this all seems like a really overblown reaction to a freak one-time thing,” well, you’re right. But politicians generally aren’t so sensible, and politicians appoint regulators, so, you know. They had to do something.
The first “doing something” happened in 2010, when the SEC enacted new limits on the amount of certain “riskier” securities money funds can hold. But they punted the more contentious issues, like whether to limit redemptions or force institutional-class funds (available only to companies, pension funds or individual investors with ginormous money fund holdings) to float their share price.
After four years of hemming, hawing and personnel changes, the SEC voted 3-2 to do both on Wednesday. Starting two years from now, institutional funds will have to let their share price “float”—instead of displaying a stable $1 per share, they’ll have to allow the share price to move with the market and round it to the nearest fourth decimal place. So, if the value moves from $1.00014 to $1.00015, the displayed share price will have to move from $1.0001 to $1.0002. Retail funds aren’t affected—they already float, with their share prices rounded to the nearest second decimal place. That’s how Reserve Primary broke the buck. Institutional funds are really just playing catch-up here, with some stricter rounding requirements. They now just have to formally acknowledge that they, like retail money funds, are really just short-term debt funds whose managers try to target a share price of a dollar or so while earning higher interest than your typical bank account. Totally benign.
Now, the SEC seems to think this is an important step to preventing a fund run when times get tough. Even though institutional funds didn’t break the buck in 2008, investors still fled—they questioned the value of the funds’ underlying assets and feared a collapse. By forcing the fund to float[ii], regulators are injecting some transparency, which they believe will help investors get used to volatility and accept the occasionally lower share price—and thus feel more comfy hanging in if the money fund world wobbles again.[iii]
But just in case, they added another wrinkle: Funds (retail and institutional alike, we presume, based on the limited communiques issued so far) will have the ability to charge redemption fees up to 2% or cap withdrawals if their level of super liquid assets “falls below a certain threshold.”[iv] So, basically, if the fund managers don’t believe they can meet redemption requests without selling some of their less liquid securities and incurring losses, which is widely viewed as a not so good thing to do, they can either charge investors to get out or just say no.
On one hand, this is a solution in search of a problem. Money funds are supposed to be highly liquid. This is why they’re a cash alternative. If you limit withdrawals, they’re less liquid. And if you tell investors they’ll face limits if things go south, investors have an incentive to a) not buy the fund in the first place or b) get out if there is even a ghost of a chance things go south. Neither is really good. The first scenario means less assets in money market funds, which means fewer buyers for short-term corporate debt, which makes corporate America’s life difficult. The second scenario means regulators probably create the fund runs they’re trying to prevent.
On the other hand, by making this provision voluntary, the SEC watered it down pretty hard. It’s mostly window dressing. Some funds probably comply. Others probably see a competitive advantage in advertising their noncompliance. Investors will pick the one they want, and the market will sort it out.
In short, we don’t see anything here that puts investors in money market funds at an automatic disadvantage. Investors still have plenty of good reasons to own money funds, which should keep demand firm and allow fund managers to keep buying commercial paper and other short-term corporate debt. The circle of funding should remain intact.[v]
Of course, none of this will prevent another fund from breaking the buck in the future, nor will it prevent runs for all time. Both goals are just impossible—investors should never expect any supposedly safety-enhancing measure to be an actual failsafe. Failsafes don’t exist in finance. What matters more is whether regulators’ attempts to fix some things cause problems elsewhere, and when it comes to Wednesday’s money market fund reforms, this doesn’t appear to be the case.
[i] Really, you’d have a better shot at finding the Holy Grail or the Ark of the Covenant than making the financial system safer. No security or investment product under the sun is truly safe.
[ii] Some sources report that the SEC will allow a parent company to inject cash into a fund to boost the share price back to a buck. Which, if true, may bizarrely reduce transparency and even inject a dose of counterparty risk as big shareholders assess a parent firm’s ability to inject capital into a fund. Bizarre, no?
[iii] The Wall Street Journal is (unintentionally?) funny here, interpreting this rule as an effort to “train” investors to accept volatility. Like, the SEC is giving companies treats and pats on the head every time they stay still when the fund value drops. We enjoyed the mental imagery.
[iv] The SEC’s fact sheet, reprinted here, calls the redemption limits “gates.” Some outlets described this as “lowering gates” on redemptions, which confused us at first since garden gates tend to swing open. Then we remembered castle gates drop down. Money funds are castles!