A Proposal for Money Market Fund Reform

There were two major areas of financial regulation that Dodd-Frank left rather conspicuously unaddressed: the GSEs, and money market funds (MMFs). The reason they omitted GSE reform is obvious: GSEs are a fiercely partisan issue, and including GSE reform could easily have — and, I think, almost certainly would have — killed the entire financial reform package. (Yes, the GSEs are that toxic.)



There were two reasons the administration omitted MMF reform: one, the SEC was already in the process of adopting substantial new regulations for MMFs, and two, there was nothing approaching a consensus on MMF reform. With other areas of financial reform, there was generally broad consensus on what needed to be done: an FDIC-like resolution authority, a systemic risk regulator, central clearing for standardized derivatives, a CFPB, etc. But with MMFs, no one really knew what to do yet (myself included). So the administration directed the President's Working Group on Financial Markets (PWG), which consists of the Treasury Secretary, and the Chairmen of the Fed, SEC, and CFTC, to prepare a report on MMF reform options. I give the administration credit for acknowledging that they simply didn't know what to do about MMFs yet.



The PWG released its report on MMF reform options last month. (The author of the report seems to share my title-writing abilities, as the report is creatively titled, "Money Market Fund Reform Options.") The report presents a menu of reform options, some better than others.



I want to endorse one reform option in particular: option (f), which proposes a two-tier system of MMFs, with stable NAV MMFs reserved for retail investors, and institutional investors limited to floating NAV MMFs. One of the main problems was that MMFs' ability to use "stable" NAVs — that is, to round their NAVs to $1 — fostered a perception among investors that MMF NAVs don't fluctuate. MMFs only have to reprice their NAVs (i.e., their share prices) if the mark-to-market per-share value of the fund's assets (known as its "shadow NAV") falls more than 0.5%, and doing so is known as "breaking the buck." (In MMF-land, 0.5% is a substantial loss.) Investors were blissfully unaware of any losses that were smaller than 0.5%.



As the PWG report notes: "By making gains and losses a regular occurrence, as they are in other mutual funds, a floating NAV could alter investor expectations and make clear that MMFs are not risk-free vehicles. Thus, investors might become more accustomed to and tolerant of NAV fluctuations and less prone to sudden, destabilizing reactions in the face of even modest losses."



Reinforcing the idea that MMFs are not risk-free is, I think, crucial. So why not move all MMFs to floating NAVs? Why only require institutional investors to use floating NAV funds? Well, for one thing, institutional investors were the problem in the financial crisis. I can't emphasize this strongly enough. The problem wasn't those supposedly-flighty, oh-so-irrational retail investors. It was the institutional investors. During the week of September 15, 2008, outflows from prime MMFs totaled roughly $300 billion, according to the ICI. Institutional investors accounted for over 90% of those redemptions. What's more, institutional MMFs have always had more volatile cash flows than retail MMFs. According to the ICI, between July 2007 and August 2008 — that is, from roughy the time the institutional investor-dominated ABCP market started blowing up to the time Lehman failed — MMFs received inflows of roughly $800 billion, over 80% of which, or $650 billion, came from institutional investors. This is, as they say, "hot money," and it comes from institutional investors.



In short, it was the institutional investors who panicked and fled the ABCP market in 2007, who panicked en masse again in September 2008, and who are most likely to panic again if one of their stable NAV MMFs "breaks the buck." They are the ones who need to be restricted, not the retail investors. Institutional investors are also the ones with the resources to closely monitor floating NAVs. They don't need to be protected by a stable NAV, nor should they.



One of the main arguments against limiting institutional investors to floating NAVs, which I find utterly unconvincing, is that internal investment policies may prohibit some institutional investors from investing in floating NAV funds. OK, then change your internal investment policies. It's not the SEC's job to make sure that its regulations don't conflict with investors' internal policies. If your internal investment policies conflict with the SEC's regulations, then that's your problem. Switching to a floating NAV doesn't make an MMF any more risky; the assets are still exactly the same. So if an investor's internal policies deem stable NAV MMFs to be appropriate investments, then there's absolutely no reason why the investor should be precluded from investing in floating NAV MMFs.



The biggest unsolved problem with MMFs is still discretionary sponsor support. MMF sugar-daddies sponsors have repeatedly bailed out their MMFs, thus preventing them from breaking the buck. For example, banks like BofA and Wachovia bailed out their MMFs that had invested in SIVs and ABCP in 2007, and JPMorgan, Legg Mason, and Northwestern Mutual all bailed out their MMFs in September 2008. In fact, after Lehman failed, pretty much every major MMF sponsor had to bail out their MMFs. As the PWG report notes, "more than 100 MMFs received sponsor capital support in 2007 and 2008 because of investments in securities that lost value and because of the run on MMFs in September and October 2008." (Guess who didn't have a sugar-daddy sponsor? That's right, the Reserve Primary Fund!) For investors, the repeated bailouts from MMF sponsors have clearly created an expectation of sponsor support. This needs to be dealt with as well, though the solution is not straight-forward.



Probably the best way to deal with discretionary sponsor support is for sponsors' primary regulators to impose punitive (and automatic) penalties on any form of sponsor support. For example, punitive capital charges, or a 12-month moratorium on dividends. Something like that.