Note: The following is excerted from the article "Sauter: Don't Confuse Liquidity With Credit," which appeared in our most recent Money Fund Intelligence newsletter.... We spoke this month with Vanguard Managing Director & Chief Investment Officer Gus Sauter, who discusses the recent release of information from the Federal Reserve on support programs for the money market. He also comments on the Liquidity Exchange Bank and on the future of money funds in general.
We ask, "You've had some issues over recent reporting and wanted to clarify some things. What are your concerns?" Sauter tells MFI, "With the release of [info on] the Fed Liquidity Programs, a lot of commentary is confusing a liquidity issue with a credit issue. A report might start describing that these liquidity facilities were put in place to alleviate some of the problems with liquidity in the marketplace, and then switch to a reference about credit issues. In reality, the liquidity facilities ... were not designed to enhance credit. They were only intended to break up the logjam in the marketplace.... I believe that the changes made to rule 2a-7 have already largely addressed those concerns -- the liquidity requirements of 10% in one day and 30% in a week. I think those are positive changes and really address the issues that confronted money funds two years ago."
MFI then asks, "You see these really big numbers. How much was really at risk? He answers, "In fact, none of it was at risk. It turns out the Fed is not allowed to take credit risk. They were really only allowed to provide liquidity to the marketplace.... A lot of the commentary says, 'Well, the Fed bailed out money market funds.' [But] they were actually working to get the markets moving again. The markets were completely frozen.... They were just trying to get things moving again, and I think they were very effective in doing that.... So it wasn't a bailout of money market funds. It was really just the facilitation of market liquidity.... All the money was repaid with interest to the Federal Reserve," he adds.
We also ask, "In your FSOC comment letter, you point out that the banks should be to blame for the problems. Is this true? Sauter says, "When the banks pulled the credit availability, it created gridlock. Dealers were afraid to put money at risk when they were uncertain about their short-term financing ability.... That's when the Fed stepped and provided financing to the marketplace. Then, things started to roll again. I think it was an important move by the Federal Reserve and I think it was very effective. It didn't cost the taxpayers any money. It certainly was a tumultuous time. But the negative impact to money market funds was from a liquidity crisis, not a credit crisis. That's the important thing that a lot of people are forgetting."
Next, MFI asks, "Can you update us on the Liquidity Exchange Bank concept? Sauter responds, "I think it's a viable proposal. Some people are concerned that in the early days ... it's not going to have much funding. So in the initial stages, it's really not going to be able to provide perhaps enough liquidity to break up a freeze like we had a couple of years ago. I think that's true in the short run. But I think over time it will grow to sufficient size to provide appropriate liquidity. So I think it's an effective proposal that helps to ensure liquidity. Not only do you have the changes to rule 2a-7, which requires more immediately liquid investments, but I think the Liquidity Exchange Bank, once it achieves critical mass, would also provide appropriate liquidity to the marketplace."
"Now the LEB would also not be able to take credit risk. So it's also not designed to alleviate credit problems in a money market fund and it should not be designed for that. The money market funds themselves should be managed in a prudent fashion as required by 2a-7 so they're not exposed to undue credit risk. But if the fixed-income marketplace, the money market marketplace, is not functioning correctly and liquidity dries up, that's when it steps in. That's where we do need that type of facility," he says.
MFI asks, "Q: Where does that process stand?" Sauter tells us, "The President's Working Group came out balanced in its view of the Liquidity Exchange Bank. We're in a comment period now and waiting for the SEC to analyze the comments before any decisions will be made.... I don't know how to handicap the likelihood that it will be a provision. But I do believe it would be a nice enhancement to the changes already made."
Finally, we ask, "Q: How important are money funds to Vanguard, to the economy and to investors? Are you concerned about the future? He answers, "I think money funds are extremely important to both the investing public and businesses.... They provide a liquid investment option that is very important to investors. At the same time, money funds provide relatively cheap short term financing to businesses and the public sector.... Without the existence of money market funds you'd see corporate financing costs at much higher levels. So you have both the borrowers and the lenders benefiting quite significantly from the existence of money funds."
Finally, Sauter says, "We do worry that if money market funds are changed in a significant fashion, specifically if the NAV were allowed to float, that investors would view them very differently. They ... would not want to keep transactional balances there. Likely that would lead to a very different role for money market funds in the future.... Writing checks on a money market fund that has a floating NAV could be somewhat of a tax nightmare at the end of the year. It risks upsetting the balance between the desire for a stable, liquid investment by investors and low cost short-term financing by corporations.... [But] I still have confidence that the changes already made to 2a-7, combined with a Liquidity Exchange Bank, will lead to money funds being even bigger and better 10 years from now."
