As we mentioned last week, Robert Plaze, Associate Director for Regulation of the Division of Investment Management of the U.S. Securities and Exchange Commission recently presented to the SEC's Investor Advisory Committee on the history and current state of money market funds, regulations, and the concept of the floating NAV. (See the full Webcast here, click "Afternoon" and see our previous Crane Data News piece, "Floating NAV Won't Solve Problems Says SEC's Plaze to Committee".) The archived webcast should be required viewing for students of money market funds, but we excerpt more of Plaze's comments below. (Email Crane Data to request our transcript.)
Plaze told the Committee, "I thought I might get some basics first of why this is an issue, of why this is important issue. A money market fund is just another form of mutual fund, subject to all the regulations and laws of mutual funds are plus some. That plus is called Rule 2a-7 which is alluded to, I see, in a resolution which you might have heard, or read about in articles on front pages of papers where you would never have seen those words [a couple of] years ago. Money market funds invest in short term, dollar denominated securities and typically purchase them at discount. They accrue income each day typically in small amounts."
He continued, "The Investment Company Act requires funds to calculate their net asset value daily by taking the value of all of the securities they hold, subtracting the liabilities, and dividing by the number of securities share outstanding. The question is what is the value of those securities? IN most cases, a mutual fund's net asset value will change daily with the value of the underlying securities, just like a stock.... A money market funds' portfolio will change in value on a day to day basis principally based upon changes in interest rates, and if there are any credit events that affect the value of the securities held by the money market funds."
Plaze explained, "Because the funds hold securities with very high quality and short term, that change in value is much smaller than, let's say, a longer term bond fund. But nonetheless, without Rule 2a-7, there would be small changes, maybe not daily but periodically, in a money market fund portfolio.... In order to avoid that from happening, Rule 2a-7 allows money market funds to use something called the amortized cost value evaluation, which means a fund can indulge in the presumption that the portion of the discount that accrues daily throughout the life of the fund accrues on a straight line basis. In other words, it allows the fund to maintain its stable net asset value at essentially par at a dollar at all times."
He added, "To prevent the amortized cost value of the share, of the dollar, from getting out of 'whack' with the true value of the portfolio securities, money market fund managers are required to do something called 'shadow price' the portfolio. This means they actually go into the market to get 'bids' on the portfolio securities and compare them to the amortized cost. If the deviation, when you add up all of the securities of the portfolio, is less than 1/2 of 1 percent, which is half a penny on a dollar money market fund, the fund managers are obligated to re-price the portfolio's securities, which in commerce parlance is called 'breaking a buck'. That is what happened in September 2008 with the Reserve Fund, not so much because of the change interest rates, but because they had a valuation event."
Plaze explained, "The fund held a 785 million dollar position in Lehman Brothers, which went bankrupt the previous day and essentially became nearly worthless.... Only about a dozen funds actually held Lehman Brothers at the time, most of the money market funds had stopped, rolled off Lehman Brother years before. The idea of a money market fund is, because you have short term positions, if a particular credit is weakening then a money market fund can roll out of that credit in an orderly way. That is the way for 30 and more years money market funds have remained fairly stable. Most high quality commercial paper issuers don't go 'belly up' every night."
Finally, he said, "The other way money market fund have been able to maintain a dollar for over thirty years ago is when an event did occur, most of them that occurred were isolated credit events.... Funds were able to maintain a stable net asset value by drawing on capital of sponsor of the money market funds. When you had, in Orange County for example, when it lost the ability to repay, went essentially bankrupt. It had issued paper that was held by a number of municipal funds that was unable to pay on a timely way. Those funds would've broken the dollar but for the fact that ... they had affiliates that went in and bought out the paper from the money market fund at par.... In most cases, the affiliates recouped those losses over time because Orange County did end up paying on that money."
