Comment letters on the President's Working Group Report on Money Market Funds are still being posted to the the SEC's website under "Other Commission Orders, Notices, and Information". The most recent is one from John McGonigle, Vice Chairman of Federated Investors, which takes issue with some of the points made by three late comment letters from Rene Stulz of the Squam Lake Group, Paul Volcker, and the Shadow Financial Regulatory Committee. McGonigle says, "We are writing to address certain proposals made in three comment letters regarding the President's Working Group on Financial Markets' study of possible money market fund reforms."
He explains, "Although Federated Investors, Inc. has already commented on the proposals made in the PWG Report and by the Squam Lake Group, we consider it important to point out some critical errors made in their analysis of money market funds and problems with the Squam Lake Group's proposal in particular. We realize that while these letters were prepared by distinguished public servants and academics, the authors are not familiar with the management and operation of money market funds. Their lack of familiarity with these matters has led them astray, both in terms of their assessment of the potential for systemic risk and in their proposals for reform."
McGonigle continues, "We will try not to reiterate points made in our previous letters. Our first letter explains, among other matters, why the proposal to eliminate money markets (by forcing them to 'float' their share price) would be unwarranted and detrimental to investors, the capital markets and the U.S. economy as a whole. Our second letter explains the adverse implications of encouraging shareholder dependence on managers providing financial support to their funds, as proposed by the Squam Lake Group. This letter will identify some of the errors made by the commenters in the arguments supporting their proposed reforms."
He says, "One of the commenters characterized money market funds as 'unsupervised.' There is no basis for this assertion. As the Commission knows, it carefully supervises money market fund and other investment companies. Moreover, the Commission has substantially increased its supervision of money market funds by requiring monthly reports of detailed portfolio information on Form N-MFP. As noted in our previous comment letter, the Commission has shown demonstrably more success in its supervision of money market funds than any other regulator has shown in its supervision of banks.... The recent amendments to Rule 2a-7 have further strengthened board supervision by requiring that funds conduct regular stress tests and report the results to their directors. Perhaps the commenter meant 'little or no ... supervision' by the Board of Governors of the Federal Reserve. There is no reason to assume, however, that such additional supervision is warranted, and the commenter does not offer any justification for Fed supervision."
McGonigle adds, "All three commenters express concern that the Treasury's Temporary Money Market Fund Guarantee Program has created a moral hazard.... The possibility of another Temporary Guarantee Program will not encourage money market fund managers to take such risks or investors to accept them. First, the temporary guarantee was extended only to those funds that had not already been forced to drop their share price below $1.00 (also known as 'breaking a dollar'). It did not protect shareholders in the Reserve Primary Fund.... Second, the Temporary Guarantee Program required the liquidation of a fund before guarantee payments would be made to its shareholders.... Being put out of the business of managing money market funds should be an adequate deterrent to any theoretical moral hazard that the prospect of federal protection might otherwise generate."
He explains, "All three commenters state or imply that shareholders will 'run' from a money market fund in an attempt to recover their investment before the fund breaks a dollar. They claim that this creates a systemic risk to the financial system, insofar as the threat of breaking a dollar could trigger massive redemptions from money market funds, which would in turn force funds to engage in a 'fire sale' of their holdings and to stop providing short-term financing to the government, financial institutions and corporations. As evidence of this risk, they cite the large-scale redemptions from prime money market funds that occurred in the wake of the Reserve Primary Fund breaking a dollar. This 'run on the funds' scenario presumes that there is some time between an event triggering the redemptions and the fund breaking a dollar. However, ... [of] the sixteen events identified in the report as prompting manager support, twelve were isolated credit events. Such credit events are, by their nature, unanticipated (otherwise the funds would not be holding the securities when they defaulted). As a result, these events produce sudden decreases in the funds' shadow prices that require an immediate response from the funds' manager. In other words, in the absence of manager support, an adverse credit event should cause a money market fund to break a dollar immediately, without providing its shareholders with an opportunity to redeem in advance of the event. 'Running' will not protect money market fund shareholders from the consequences of an isolated credit event, so it is not surprising that none of these events triggered wide-scale redemptions. We must therefore look to other events for evidence of shareholders propensity to run from troubled money market funds."
McGonigle mentions, "The events in September 2008 unfolded too rapidly for anyone to attempt education or outreach efforts, and it is unlikely that such efforts would have succeeded. The Lehman Brothers bankruptcy was preceded by the government takeover of Fannie Mae and Freddie Mac, and coincided with the government rescue of AIG and the acquisition of Merrill Lynch by Bank of America. At the time, there were serious questions regarding the viability of Citicorp, Goldman Sachs, Morgan Stanley and many other major U.S. financial institutions. This uncertainty caused the credit markets to 'freeze up,' as few were willing to provide liquidity for any instruments other than U.S. government obligations."
"Under these extreme conditions, it should not be surprising that some money market fund shareholders were concerned about further defaults in their fund's portfolio and the possibility that such defaults would eventually overwhelm the manager's capacity to support a stable price.... If our analysis of September 2008 is correct, then there is no reason to believe that the Reserve Primary Fund breaking a dollar would have led to wide-scale redemptions by itself. The historical evidence strongly indicates that shareholders would have responded to the failure by determining what other funds were exposed to Lehman Brothers and whether their managers had provided support. Shareholders would not have reflexively redeemed from funds without any exposure or that had received manager support, so there would not have been large-scale redemptions from these funds. Put differently, the evidence indicates that the 'run' in September 2008 was a consequence of systemic risks already present in the financial system, namely the belief that the same forces that caused Lehman Brothers to fail and required AIG and Merrill Lynch to be rescued also might lead to the failure of other major financial institutions. Money market funds were not, however, an independent source of systemic risk," he writes.
McGonigle writes, "Our analysis also has important implications for the reforms being considered by the Commission. If runs are a response to other systemic risks in the system, then floating the share price will not stop runs. Shareholders will want to get their money out before 'something else happens,' and these redemptions will eventually force funds to sell their securities into a distressed market. The Squam Lake Group's buffer also will not help the situation, because it is only available to cover losses, not to provide liquidity to the funds."
His conclusion says, "As we have shown, the recommendations made in these comments letters are based on a superficial analysis of money market funds and their shareholders. They criticize the fact that funds are not supervised in the same manner as banks, without recognizing the historical effectiveness of the Commission's and directors' supervision of the funds. They raise the specter of moral hazard without considering the actual terms of the Temporary Guarantee Program. They speculate on shareholders motivations for redeeming from the funds in September 2008 without regard for numerous events during the preceding three decades that did not lead to widespread redemptions. Finally, the Squam Lake Group failed to consider the necessary consequences of its proposed buffer (more frequent and arbitrary fund liquidations) or estimate the enormous cost of a buffer relative to the fees earned for managing money market funds. Once these points are analyzed in greater depth, it becomes clear that the commenters have not provided a convincing case for their proposed reforms. We continue to believe that the Commission would be better advised to focus on the reforms supported by an overwhelming majority of the comment letters -- namely the creation of an emergency liquidity facility."
