Note: Thanks to everyone who attended our 4th annual Crane's Money Fund Symposium in Pittsburgh! ... Yesterday morning, U.S. Securities and Exchange Commission Chairman Mary Schapiro gave testimony before the Committee on Banking, Housing, and Urban Affairs of the United States Senate on "Perspectives on Money Market Mutual Fund Reforms". She says, "Thank you for the opportunity to testify about the Securities and Exchange Commission's regulation of money market funds. The risks posed by money market funds to the financial system are part of the important unfinished business from the financial crisis of 2008. One of the seminal events of that crisis occurred in September, after Lehman Brothers filed for bankruptcy and the Reserve Primary Fund "broke the buck," triggering a run on money market funds and freezing the short-term credit markets. Although the Commission took steps in 2010 to make money market funds more resilient, they still remain susceptible today to investor runs with potential systemic impacts on the financial system, as occurred during the financial crisis just four years ago. Unless money market fund regulation is reformed, taxpayers and markets will continue to be at risk that a money market fund can "break the buck" and transform a moderate financial shock into a destabilizing run. In such a scenario, policymakers would again be left with two unacceptable choices: a bailout or a crisis. My testimony today will discuss the history of money market funds, the remaining systemic risk they pose to the financial system even after the 2010 reforms, and the need for further reforms to protect investors, taxpayers and the broader financial system."
Schapiro's statement continues, "Despite these risk-limiting provisions, money market funds can -- and do -- lose value. When, despite these risk-limiting provisions, money market fund assets have lost value, fund "sponsors" (the asset managers -- and their corporate parents -- who offer and manage these funds) have used their own capital to absorb losses or protect their funds from breaking the buck. Based on an SEC staff review, sponsors have voluntarily provided support to money market funds on more than 300 occasions since they were first offered in the 1970s. Some of the credit events that led to the need for sponsor support include the default of Integrated Resources commercial paper in 1989, the default of Mortgage & Realty Trust and MNC Financial Corp commercial paper in 1990; the seizure by state insurance regulators of Mutual Benefit Life Insurance (a put provider for some money market fund instruments); the bankruptcy of Orange County in 1994; the downgrade and eventual administrative supervision by state insurance regulators of American General Life Insurance Co in 1999; the default of Pacific Gas & Electric and Southern California Edison Co. commercial paper in 2001; and investments in SIVs, Lehman Brothers, AIG and other financial sector debt securities in 2007-2008. In part because of voluntary sponsor support, until 2008, only one small money market fund ever broke the buck, and in that case only a small number of institutional investors were affected."
She says, "The amount of assets in money market funds has grown substantially, and grew particularly rapidly during recent years from under $100 million in 1990 to almost $4 trillion just before the 2008 financial crisis. This growth was fueled largely by institutional investors, who were attracted to money market funds as apparently riskless investments paying yields above riskless rates. By 2008, more than two-thirds of money market fund assets came from institutional investors, which could wire large amounts of money in and out of their funds on a moment's notice. Some of these institutional assets were what are known in the business as "hot money" -- assets that would be quickly redeemed if a problem arose, or even if a competing fund had higher yields. To compete for that money, some money market fund sponsors invested in new, risker types of securities, such as "structured investment vehicles." The larger amount of assets in money market funds contributed to the likelihood that a credit event would create stresses on one or more funds, and that fund sponsors would not have access to a sufficient amount of capital to support the funds."
Schapiro explains, "Implicit sponsor support as a mechanism to maintain a stable $1.00 share price increasingly came under strain as the size of money market funds grew into a several trillion dollar industry. The Reserve Primary Fund broke the buck after it suffered losses its sponsor could not absorb. The Reserve Primary Fund, a $62 billion money market fund, held $785 million in Lehman Brothers debt on the day of Lehman Brothers' bankruptcy and immediately began experiencing a run -- shareholders requested redemptions of approximately $40 billion in just two days. The Reserve Primary Fund announced that it would re-price its shares below $1.00, or break the buck."
She adds, "Almost immediately, the run on the Reserve Primary Fund spread, first to the Reserve's family of money market funds, and then to other money market funds. Investors withdrew approximately $300 billion (14%) from prime money market funds during the week of September 15, 2008. Money market funds met those redemption demands by selling portfolio securities into markets that were already under stress, depressing the securities' values and thus affecting the ability of funds holding the same securities to maintain a $1.00 share price even if the other funds were not experiencing heavy redemptions. Money market funds began to hoard cash in order to meet redemptions and stopped rolling over existing positions in commercial paper and other debt issued by companies, financial institutions, and some municipalities. In the final two weeks of September 2008, money market funds reduced their holdings of commercial paper by $200.3 billion, or 29%."
Schapiro's comments tell the Senate panel, "More than 100 funds were bailed out by their sponsors during September 2008. But the fund sponsors were unable to stop the run, which ended only when the federal government intervened in an unprecedented manner. In September 2008, the Treasury Department temporarily guaranteed the $1.00 share price of more than $3 trillion in money market fund shares and the Board of Governors of the Federal Reserve System created facilities to support the short-term markets. These actions placed taxpayers directly at risk for losses in money market funds but eased the redemption pressures facing the funds and allowed the short-term markets to resume more normal operations. Because the federal government was forced to intervene we do not know what the full consequences of an unchecked run on money market funds would have been."
She states, "The next run might be even more difficult to stop, however, and the harm will not be limited to a discrete group of investors. The tools that were used to stop the run on money market funds in 2008 are either no longer available or unlikely to be effective in preventing a similar run today. In September 2008, the Treasury Department used the Exchange Stabilization Fund to fund the guarantee program, but in October 2008 Congress specifically prohibited the use of this fund again to guarantee money market fund shares. The Federal Reserve Board's Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility ("AMLF"), through which credit was extended to U.S. banks and bank holding companies to finance purchases of high-quality asset backed commercial paper ("ABCP") from money market funds, expired on February 1, 2010. Given the significant decline in money market investments in ABCP since 2008, reopening the AMLF would provide little benefit to money market funds today. For example, ABCP investments accounted for over 20% of Moody's-rated U.S. prime money market fund assets at the end of August 2008, but accounted for less than 10% of those assets by the end of August 2011."
Schapiro also says, "Shortly after I joined the Commission in 2009, I asked the Commission's staff to prepare rulemaking designed to address concerns about money market funds revealed by the 2007-2008 crisis. The staff, with assistance from a report prepared by the money market fund industry, quickly identified some immediate reforms that would make money market funds more resilient. I am proud of this initial reform effort, but it is important to recognize what it did and did not do. The initial reforms, adopted and implemented in 2010, were designed to reduce the risks of money market funds' portfolios by reducing maturities; improving credit standards; and, for the first time, mandating liquidity requirements so that money market funds could better meet redemption demands. The new reforms also required money market funds to report comprehensive portfolio and "shadow NAV" information to the Commission and the public."
She explains, "Given the role money market funds play in providing short-term funding to companies in the short-term markets, a run presents not simply an investment risk to the fund's shareholders, but significant systemic risk. No one can predict what will cause the next crisis, or what will cause the next money market fund to break the buck. But we all know unexpected events will happen in the future. If that stress affects a money market fund whose sponsor is unable or unwilling to bail it out, it could lead to the next destabilizing run. To be clear, I am not suggesting that any fund breaking the buck will cause a destabilizing run on other money market funds -- it is possible that an individual fund could have a credit event that is specific to it and not trigger a broad run -- only that policymakers should recognize that the risk of a destabilizing run remains. Money market funds remain large, and continue to invest in securities subject to interest rate and credit risk. They continue, for example, to have considerable exposure to European banks, with, as of May 31, 2012, approximately 30% of prime fund assets invested in debt issued by banks based in Europe generally and approximately 14% of prime fund assets invested in debt issued by banks located in the Eurozone."
Schapiro continues, "The Commission staff currently is exploring a number of structural reforms, including two in particular that may be promising. The first option would require money market funds, like all other mutual funds, to buy and sell their shares based on the market value of the funds' assets. That is, to use "floating" net assets values. Such a proposal would allow for public comment on whether requiring money market funds to use floating NAVs would cause shareholders to become accustomed to fluctuations in the funds' share prices, and thus less likely to redeem en masse if they fear a loss is imminent, as they do today. It would also treat all investors more fairly in times of stress."
She states, "A second option would allow money market funds to maintain a stable value as they do today, but would require the funds to maintain a capital buffer to support the funds' stable values, possibly combined with limited restrictions or fees on redemptions. The capital buffer would not necessarily be big enough to absorb losses from all credit events. Instead, the buffer would absorb the relatively small mark-to-market losses that occur in a fund's portfolio day to day, including when a fund is under stress. This would increase money market funds' ability to suffer losses without breaking the buck and would permit, for example, money market funds to sell some securities at a loss to meet redemptions during a crisis."
Schapiro tells the Senate panel, "As described above, many money market funds effectively already rely on capital to maintain their stable values: hundreds of funds have required sponsor bailouts over the years to maintain their stable values. Requiring funds to maintain a buffer simply would make explicit the minimum amount of capital available to a fund. Today, in contrast, an investor must wonder whether a sponsor will have the capital to bailout its fund and, even if so, if the sponsor will choose to use it for a fund bailout. Limits on redemptions could further enhance a money market fund's resiliency and better prepare it to handle a credit event. `Restrictions on redemptions could be in several forms designed to require redeeming shareholders to bear the cost of their redemptions when liquidity is tight. Redemption restrictions could be designed to limit any impact on day-to-day transactions."
Finally, she writes, "These ideas and others are the subject of continuing analysis and discussion at the Commission. If the Commission were to propose further reforms, there will, of course, be an opportunity for full public consideration and comment. In addition to a detailed release seeking comment on the likely effectiveness and impacts of the proposed reforms, the proposal will also include a discussion of their benefits, costs, and economic implications. In closing, money market funds as currently structured pose a significant destabilizing risk to the financial system. While the Commission's 2010 reforms made meaningful improvements in the liquidity of money market funds, they remain susceptible to the risk of destabilizing runs. Thank you for the opportunity to testify on this important issue. I am happy to answer any questions that you might have."