Yet another late entry on the SEC's "Comments on Proposed Rule: Money Market Fund Reform; Amendments to Form PF" has been posted, this one from Jeffrey N. Gordon, Professor of Law, Columbia Law School. Gordon, a long-time opponent of money funds, writes, "This letter is submitted by me personally in connection with the request for comments by the Securities Exchange Commission in response to its Money Market Fund Reform Proposals of June 5, 2013. I am the Richard Paul Richman Professor at Columbia Law School and co-director of the Millstein Center for Global Markets and Corporate Ownership. I have submitted two comments in response to prior SEC releases, an invited written submission in connection with the June 2012 hearings on money market fund reform held by the Committee on Banking, Housing, and Urban Affairs of the U.S. Senate, and a comment on the Financial Stability Oversight Council Proposed Recommendations on November 2012, which is attached hereto and made part of this comment. I have recently written a paper on money market fund policy questions entitled Money Market Funds Run Risk: Will Floating Net Asset Value Fix the Problem? (with Christopher M. Gandia), which is attached hereto and made part of this comment. My comments on the particular SEC proposals draw on analysis and findings in that paper. I am not retained by any party with a potential interest in these reform proposals nor have I received support for my research on money market funds from any such party."
He explains, "My summary responses to the proposed alternatives are as follows: 1. Floating NAV/ Proposal One. I do not favor the current floating NAV proposal, because it does not address the systemic run-risk problem of money market funds ("MMFs") and worse, will give the appearance of addressing those problems. 2. Gates/Redemption Fees/ Proposal Two. I do not favor Proposal Two, which will exacerbate the present run risks of MMFs by injecting a new source of uncertainty and instability without substantially changing the run risks of the present fixed NAV funds."
Gordon continues, "3. The SEC proposals fail to come to grips with the core problem of MMFs as presently constituted: they perform bank-like functions of liquidity and maturity transformation and they bear credit risk, all without any independent capacity to bear loss. Under either of the SEC proposals, the stability of the MMF sector will continue to depend upon implicit sponsor support, the same kind off-balance guarantees that proved to be insufficient in the 2007-09 financial crisis. Such conditional guarantees are an unacceptable safeguard for a multi-trillion dollar financial intermediary. Otherwise put, the SEC proposal relies on a future Federal Reserve bailout to protect the stability of the MMF sector."
He tells us, "4. The SEC should reconsider alternative proposals that provide for capital or other mechanisms of loss absorbency, such as Proposals Two and Three in the FSOC's Proposed Recommendations. Alternatively, in a prior submission, I have proposed a bundled Class A/Class B structure that provides a mechanism for loss absorbency and disincentives for runs."
On the Floating NAV proposal, Gordon comments, "The chief driver of MMF run risk is the response of safety-seeking MMF users in circumstances that threaten full payment of principal, not the desire to capture the small permitted spread between $1 reported NAV and $0.995 actual NAV. In a floating NAV structure, the incentive to run remains: In conditions of financial distress, today's exit price is almost certain to be higher than tomorrow's exit price. Money market instruments rarely trade and so today's apparent price does not reflect the likely future path of price changes in a distressed market. Sophisticated parties are well aware of this dynamic and will act accordingly. In short, the adoption of the floating NAV alternative would leave MMFs still highly exposed to run risk."
He adds, "For example, assume that Reserve Primary Fund had been a floating NAV fund in 2008. The default of Lehman Brothers would certainly have reduced the NAV of Reserve Primary Fund and every other fund that held Lehman paper, perhaps by the full amount of the fund's Lehman holdings. But the Lehman default also would have reduced the "true" NAV of virtually every MMF. This is because claims on financial institutions constituted the overwhelming share (> 85 percent) of the non-US government holdings of most MMFs, and the value of those claims were highly correlated because of the interlocks, contagion mechanisms, and parallel behavior in the financial sector. But because money market instruments rarely trade, their carrying value on the books of a MMF would have been "stale." A sophisticated party would have known that as more trading occurred, values would fall, thus today's NAV would be higher than tomorrow's NAV. In short, floating NAV would not have eliminated the first mover advantage."
Gordon writes, "The argument that floating NAV makes MMFs just like other mutual funds ignores the particular function of MMFs on both the liability side and the asset side. For many investors, particularly institutional MMF users, MMFs are a non-bank substitute for a bank transaction account. MMF users are generally seeking safety and liquidity. MMFs may improve on the safety of a bank transaction account because they assemble diversified portfolios of short term claims. But when safety and liquidity are at risk, MMF users can be expected to exit en masse, not exhibiting the pattern of holding or "slow" exits in other mutual funds."
He says, "Similarly, floating NAV as means to desensitize investors to fluctuating MMF valuations seems to misperceive what drives a systemic MMF run: It is not the breaking of the buck at any particular fund, but a high-enough probability that the underlying portfolio event(s) that produced a break will correlate across MMFs generally. The prior instance of buck-breaking, the Community Bankers Fund in 1994, provides an instructive example. The fund broke the buck because of valuation changes in a portfolio "unsuitably" concentrated (27 percent) in interest-rate sensitive structured notes. The fund was small (only $150 million), its portfolio concentration violated the SEC rule, and the securities did not default. The fund's idiosyncratic investment strategy (and small size) meant that the industry did not suffer a run. By contrast, the Reserve Primary Fund ($60 billion) held defaulted-upon securities of a large financial firm (Lehman) at a time of (i) high concentration of MMF assets in the financial sector and (ii) increasing and correlated instability among financial firms. In other words, it appears that the correlation of possible portfolio losses rather than the "focal point" effect of a buck-breaking was the main driver of the MMF run. A floating NAV fund is susceptible to these correlation concerns no less than a fixed NAV fund."
Gordon explains, "In a research paper that is included with this submission, Money Market Funds Run Risk: Will Floating Net Asset Value Fix the Problem?, a co-author and I take advantage of a natural experiment presented by European money market funds to provide empirical evidence on the run risk of floating NAV funds. Although all US MMFs are fixed NAV funds, money market funds offered in Europe come in both "stable NAV" and "accumulating NAV" varieties. A "stable NAV" fund is equivalent to the "fixed" US counterpart. An "accumulating" fund does not maintain fixed NAV, and while it does not fully "float," it does offer a useful proxy for the effects of a "floating NAV" fund."
He continues, "We examined the performance of these European MMFs during "Lehman Week" to test the factors that contributed to run propensity. Although virtually all funds experienced a significant run, the only internal factor that consistently predicted extra run propensity in our various models was ex ante risk, proxied by reported yield before Lehman Week. By contrast, the difference in run propensity between stable and accumulating NAV funds was not economically or statistically significant, indicating that NAV "fixedness" did not contribute to the run. In short, the best empirical evidence we have suggests that floating NAV will not reduce MMF run-risk during periods of financial distress."
Finally, Gordon writes, "There is perhaps $6 trillion in short term funds in the global financial system looking for safety and liquidity outside of the banking system. It is important to devise financial institutions that can manage such cash flows in a systemically robust way and that does not depend on a taxpayer subsidy for its rescue. The prior design of MMF was an experiment that produced a bad outcome. So we must experiment again, learning from experience and being willing to revise our institutions in light of new economic challenges. My apologies for the late submission of this comment. I respectfully ask that it be added to the record of these proceedings."