Wells Fargo Advantage Funds' David Sylvester spoke Monday at Crane's Money Fund Symposium and discussed ideas recently proposed his recent paper, "Money Fund Reform: A Third Way." He suggested the possibility of a third option between the incremental reforms of the ICI and the radical and dangerous changes proposed by some with the concept centering on the creation of a Fed liquidity facility similar to the AMLF.
Sylvester says in his paper, which is reprinted in our Symposium conference binder, "Money funds have historically been popular choices for conservative investors seeking safety of principal and liquidity. The global credit crunch over the past year-and-a-half has exposed two main risks in the current model for 2a-7 money market funds that previously had been discounted as being muted or non-existent heretofore: credit risk and liquidity risk. These risks continue to worry investors, fund managers and regulators, and they also pose systemic risks to the entities that rely on money funds for credit, and to the banking system as a whole. This awareness and concern has prompted proposed reform of the current 2a-7 money fund model. Current reform efforts are centered on two proposals. In this paper, David Sylvester, head of money markets at Wells Capital Management, outlines his ideas for a 'third way,' with the intention of promoting further discussion in the industry on this very important topic of money market reform."
He explains, "All money funds attempt to balance their primary objectives of a stable NAV and liquidity to meet shareholder demands, and a competitive yield. Different types of shareholders place a different degree of emphasis on each of these objectives. Furthermore, the importance of each objective can change quickly in the mind of each shareholder and, perhaps more important, within different classes or types of shareholders. When market conditions are unsettled, these shifts can occur rapidly, perhaps almost instantaneously. Attempts by money funds to reposition their portfolios in order to address these shifting priorities can trigger systemic risks that endanger funds, investors, and borrowers. A look at the events of the past year-and-a-half reveals how quickly these systemic risks can arise."
Sylvester describes the existing reform proposals, saying, "The Group of Thirty proposal would destroy the money fund business as it now exists, though some might argue that is their point. The alternatives suggested by the Group of Thirty -- banks and variable NAV funds -- exist now. Surveys and empirical data suggest that investors want the stability of a constant net asset value (CNAV) money fund as an investment choice. The demise of money funds would lead to other undesirable systemic risks. Many investors who previously favored money funds would choose to move their money into insured deposits in U.S. banks, shifting the credit risk from the investors to the government, at the expense of those sectors to which the money funds now offer credit, such as foreign banks and the ABCP market. It is likely that U.S. banks would receive the bulk of this inflow of funds from money funds in the form of insured deposits. This would not be a universally desirable outcome from the banks' standpoint, as some are already flush with deposits while others might not want to raise the additional capital against the loans made with these monies at a time when their need to raise capital is already posing a challenge."
He continues, "The ICI proposals change little and largely codify the existing practices of many large money funds today. The 5 percent/20 percent liquidity requirements suggested by the ICI pale against the 35 percent drop that was seen in prime money fund assets in the month following the Lehman collapse. As to 'best practices' for credit risk assessment, it was the large fund complexes after which these practices are modeled that bought SIVs and Lehman paper. It is simply not clear to us that one can make bad credit decisions go away through increased regulation."
Sylvester concludes, "The ICI proposals provide a good initial starting point, and they should be adopted to the extent that they relate to credit, price and maturity risk. Money funds should shorten their WAMs, standards should be set for WAM to final maturity, Second Tier (A2/P2) paper should be prohibited, and portfolios should be appropriately tested under a variety of scenarios. However, the ICI proposals regarding liquidity do not seem to address the systemic risks associated with liquidity in money funds and bear closer scrutiny."
He says, "The ultimate backstop is for money market funds to be given access to the central bank. A secured lending facility at the Federal Reserve Bank, modeled on the discount window for depository institutions and the Primary Dealer Credit Facility, would allow U.S. money funds to obtain secured financing from the Federal Reserve by pledging their assets and paying a rate set by the Fed.... Typical, low risk, money fund investments, such as First Tier commercial paper, CDs and government securities, could be pledged to the Fed as collateral, with an appropriate haircut, in return for advances made at a market rate for the purpose of funding shareholder redemptions.... The introduction of a permanent credit facility through the Fed would undoubtedly lead to additional regulation of money funds that some may resist, but as long as the regulators' activities are complementary and not contradictory, this should be seen as an acceptable trade-off to the stability and safety provided by such a facility."
Note: For those that were unable to attend, a full PDF document of the Powerpoints and papers that were distributed at the Money Fund Symposium will be available for sale to non-attendees for $250 starting tomorrow. Contact us to purchase copies or more details.
