Money Market Funds on Life Support

Three years ago, I asked: Will Obama Kill Money Market Funds? He certainly is trying, but the MMF industry is not going down without a fight. It scored a victory in round one when SEC chairman Mary Schapiro gave up trying to persuade her fellow commissioners to support reforms that the industry argues would, in effect, eliminate MMFs as we know them. This battle has now moved to round two with Treasury secretary Timothy Geithner's request to the Financial Stability Oversight Council to pick up where the SEC has left off.

Geithner's request is probably more bark than bite. It would be imprudent for a novice regulator such as FSOC to test its new powers in a fight with industry and Congress (see Sen. Pat Toomey's comments) that it may lose. And if chairman Schapiro leaves the commission, which some have predicted, her replacement may take up MMF reform again, in which case FSOC action would not be needed.

At this point, the best bet might be that the SEC will revisit MMFs late this year or early in the next and issue a request for data on the potential effect of additional reforms. However, this will provide only a brief respite. Geithner has thrown down a gauntlet that promises an epic showdown between the banking and securities models of financial regulation that is likely to reach a boiling point in the next couple of years.

Financial Crisis Fallout
The MMF battle is a residue of the financial crisis. In September 2008, the failure of Lehman Brothers caused the Reserve Money Market Fund's per-share net asset value to drop below $1. The Reserve Fund's "breaking a dollar," along with the other stresses of the financial crisis, precipitated large withdrawals from that fund and other MMFs. Before the run on MMFs could metastasize, the Treasury Department announced that it would insure investors' MMF accounts, which calmed investors and stopped the exodus.

Banking regulators insist that the MMF run proved that MMFs present systemic risk to our financial markets. The Dodd-Frank Act of 2010 purported to address such systemic risks in part by creating the banker-dominated FSOC, which has the authority to brand nonbanks as systemically important financial institutions, or SIFIs. If the FSOC declared MMFs to be SIFIs, then they would become subject to oversight by the Federal Reserve.

Schapiro's SEC responded to systemic-risk concerns by adopting fairly draconian MMF reforms in 2010. Banking regulators were not satisfied, however, and demanded that the SEC take more extreme measures.

So Schapiro moved to propose further reforms that would require MMFs to choose between: 1) allowing their NAVs to float like any other ultra-short-term bond fund, or 2) keeping up to 1% of assets in reserve and holding back 3% of investors' assets for 30 days when they make withdrawals. When three of the five SEC commissioners declined to sign on, she criticized their decision in a public statement, which provoked sharp responses from her colleagues (here and here). In a clear invitation to federal banking regulators, Schapiro wrote:

Other policymakers now have clarity that the SEC will not act to issue a money market fund reform proposal and can take this into account in deciding what steps should be taken to address this issue.

But Geithner is not letting her off the hook. He has asked the FSOC to make a formal recommendation to the SEC to go back to work. He wants the FSOC to tell the SEC to propose at least three MMF reforms: Schapiro's two proposals cited above plus a third under which MMFs would be subject to "liquidity and enhanced capital standards, potentially coupled with liquidity fees or temporary 'gates' on redemptions."

In the event that the SEC does not get the message, Geithner also asked the FSOC to initiate parallel proceedings to declare MMFs to be SIFIs, though the FSOC's authority to do so is questionable. It may hesitate to court a legal showdown this early in its tenure. As a last resort, Geithner threatened to use banking regulators' existing powers to beat MMFs into submission, such as by banning them from tri-party repo transactions involving banks.

The same day that Geithner sent his letter, SEC commissioner Daniel Gallagher stated in an interview that the floating NAV "is an attractive option that I am likely to support." This seems a reversal of his August position that Schapiro's proposals:

were not supported by the requisite data and analysis, were unlikely to be effective in achieving their primary purpose, and would impose significant costs on issuers and investors while potentially introducing new risks into the nation's financial system.

He has not said whether he would now provide the third vote for Schapiro's proposal.

The Next Step
Some speculate that the Geithner letter and Gallagher switch will lead to a rule proposal, but the next step is more likely to be a request for information. Gallagher might not wish to flatly contradict his position that Schapiro's rule amendments "were not supported by the requisite data and analysis" and simply proposing them "could have harmful consequences." Also, collecting more data might temper increasing concerns in Congress, where criticism of SEC cost-benefit analysis has been heated, while also improving the SEC's chances of surviving an inevitable legal challenge from the MMF industry. The SEC's recent record in such court challenges has been abysmal.

Commissioner Luis Aguilar supports issuing a request for information, though he might be less cooperative after having been thrown under the bus for opposing Schapiro's proposal. After The New York Times excoriated him for opposing Schapiro's plan, a popular blog reported that the "industry got to him" and called for "replacing turncoat regulators" as a "top priority" for President Obama.

Ironically, Aguilar has actually been the current SEC's strongest investor advocate. Indeed, he was the lone opponent of Schapiro's recent proposal to allow hedge funds (including unregulated MMF surrogates) to publicly offer their shares without complying with any of the investor protections that apply to MMFs. Even Geithner conceded in his letter that the SEC must consider the potential for MMF reforms to drive cash to "unregulated cash-management products."

The risks of MMF money flowing to hedge funds will only increase because the SEC's proposal will allow them to engage in public advertising. The SEC has taken the position that it is not required to consider the increased retail investor risk created by letting hedge funds loose in the mutual fund space. However, it now may find it necessary to consider the systemic risk of its hedge fund advertising proposal if it expects its MMF reforms to survive.

The shoe yet to drop is the systemic risk created by driving MMF cash to banks, rather than to hedge funds. Placing additional burdens on MMFs will undoubtedly drive more cash to banks, over 3,000 of which have failed (compared with one retail MMF) since MMFs were first offered. Contrary to popular belief, banks pose risks for savers. Just ask retail depositors in the failed--but "insured"--IndyMac Bank who lost about 50% of their deposits above $100,000. They would have been far better off with a 1% loss in the Reserve Fund--which lost more money than any MMF in history.

Geithner wants the FSOC to focus on MMFs when it has not even gotten around to declaring American International Group (AIG)--the archetype of too-big-to-fail systemic risk--to be a SIFI. He sees a huge threat in virtually risk-free MMFs while proposing no steps to deal with the fact that four firms-- Bank of America (BAC), Wells Fargo (WFC), Citigroup (C), and J.P. Morgan Chase (JPM)--control more than half of all bank holding company assets.

It is banks, not MMFs, that are the epitome of the moral hazard model we should be devising ways to dismantle, not encourage. The Dodd-Frank Act increased moral hazard by raising the insured deposit limit from $100,000 to $250,000 (non-interest-bearing accounts still have unlimited insurance), while doing nothing to shrink too-big-to-fail banks. The hard question that the SEC should tackle, but that it is likely to dodge, is whether driving MMF assets to banks would create more systemic risk, not less.

The Ideological Divide
The MMF battle reflects the economist's conceit that fixing the last crisis is simply a matter of finding the right formula. Basel III will correct the deficiencies of Basel II. The Volcker rule will prevent speculative trading. The Titanic will never sink. And Schapiro's 1% capital reserve coupled with a 3% redemption holdback will prevent another run on MMFs. No matter that a Fed study found that past bailouts of MMFs have exceeded 6% of assets. After the next run, we will simply increase the reserve requirement to 7%.

The ultimate solution to panics such as the MMF run of 2008 has been the same as long as governments have coined money. Restoring confidence during financial panics requires a reliable source of infinite liquidity. Currently, the markets believe that the Fed has infinite liquidity (which depends entirely on the strange loop of our believing that it does).

Yet it appears that the only regulatory model under which banking regulators can imagine resorting to the promise of infinite liquidity is their own, where taxpayer-guaranteed deposits are invested by banks in illiquid, long-term, risky assets. Notwithstanding the extraordinary safety record compiled by MMFs investing in liquid, short-term, safe assets--backed by only an implicit government guarantee--banking regulators are only able to see the Reserve Fund's failure and the MMF run that it triggered. MMFs' short-term asset structure has proved to be a better, safer way to manage government-backstopped cash accounts than banks' long-term asset structure.

The MMF battle embodies the central ideological divide in financial-services regulation. Banking regulation promotes the socialization of risk and thrives on secrecy. Securities regulation promotes the decentralization of risk and thrives on disclosure. Banking regulation places the highest value on a communitarian ethic of systemic safety and soundness, whereas securities regulation exalts an individualistic ethic of risk and reward. Banking regulation fosters the expansion of government power while securities regulation inevitably weakens it. These are the battle lines in the fight over the future of MMFs.