As we mentioned last week, Eric Rosengren, President & CEO of the Federal Reserve Bank of Boston gave a speech entitled, "Towards Greater Financial Stability in Short-Term Credit Markets where he "discuss[ed] the role that MMMFs play in providing short-term funding, including serving as an important source of short-term financing for European banks [and] highlight[ed] that the current structure makes MMMFs particularly susceptible to credit shocks that can turn into liquidity problems for the whole industry -- and ... suggest[ed] some ways that the industry could be made more resilient." Today, we focus on his comments on possible future regulatory changes, and we quote from some unfavorable industry reaction.

Rosengren says, "No one wants to see a repeat of 2008, nor should we. The industry and all participants can get to a better place. For example, an examination of the publicly available monthly reports on portfolio holdings of MMMFs highlights that a few MMMFs hold financial paper that has not been downgraded but nonetheless is seen by the market as posing more credit risk than could seem appropriate for entities that are allowed to maintain a fixed net asset value. MMMFs have been required to provide a monthly report of holdings and have increased their liquidity. Still, we are passing the three-year anniversary of the failure of Lehman and the run on the MMMFs and it remains important to explore the ways that the industry, which plays a pivotal role in short-term credit markets, can address its susceptibility to a credit shock that could in turn be transmitted to short-term financial markets. I am not saying anything that has not been expressed before, but want to highlight the opportunities we all have to move thoughtfully but expeditiously to a more stable place."

He continues, "Given all this, I believe a more proactive regulatory approach may be necessary. While the monthly reporting has been helpful, given the very short maturity of many of the assets, I believe the reporting should be more frequent to avoid the possibility of "window dressing" at the end of the month. Also, reducing a fund's maximum permissible exposure to any one firm could reduce the potential loss that would occur from a credit event involving only one counterparty. Consideration might also be given to whether the assets of riskier firms (for example those with very high market credit default swaps ('CDS') prices are appropriate investments for MMMFs, which are expected to maintain a low risk profile."

Rosengren explains, "There have been a variety of proposals recommending more substantial changes in this arena. However, three years after a systemically significant episode, no one proposal has been settled on. My own preferred approach would be to require MMMFs to have a meaningful capital-like buffer that exceeds, for example, their single-issuer concentration exposure limits -- perhaps on the order of 2 to 3 percent -- that, if violated, automatically leads to a fund' s conversion to a floating net asset value. Examples of how to structure such a buffer include having the MMMF's sponsor directly fund the creation of the buffer, or creating a separate class of loss-absorbing shares that could be marketed to investors willing to bear some risk in exchange for a higher return than that provided by the stable value shares. If in some appropriate period of time a satisfactory plan for such a capital buffer is not produced and accepted, then those prime funds would be required to float their net asset value."

Finally, he adds, "All in all, though, given the systemic importance of the MMMF industry, it is critical that one way or another we make the industry less susceptible to credit shocks and liquidity runs. While many in the MMMF industry have been reducing their exposure to troubled financial institutions, some continue to take what some observers might consider outsized credit risks. The experience of 2008 showed the potential for a MMMF's problems to precipitate redemptions that are ultimately destabilizing to short-term credit markets, and contribute to economic difficulties. I am certainly not predicting any such outcome but noting that policymakers, market participants, and the industry can and should make steady progress on these matters."

J.P. Morgan Securities' Alex Roever, Teresa Ho, and Chong Sin comment in this week's "Short-Term Fixed Income," "Eric Rosengren has positioned himself as a voice in favor of curbing systemic risk in the money markets. As the head of the Boston Fed during the 2008-09 market meltdown, he oversaw the administration of the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) which arguably was the single most effective tool in arresting the precipitous run on money funds that took place following the collapse of Lehman Brothers. Three years after Lehman, Rosengren is using some of his speeches to advocate for further reform of money markets and money market funds."

They say, "[Rosengren] acknowledges the reforms put in place by the SEC last year are helpful, but notes there's room for improvement around the edges. He suggests increasing the frequency of fund holdings reports (currently monthly) to help avoid month-end window dressing. Further limiting a fund's exposure to a single counterparty could help reduce loss upon default (prime funds are currently capped at a 5% max). He also suggests linking eligibility to an issuer's credit default swap pricing since MMMFs are supposed to maintain a low risk profile. While the first two of these options strike us as reforms that could work, the CDS tying idea is ill-considered. MMMF managers employ many experienced professional credit analysts as well as risk and portfolio managers that understand their products and limitations. Tying credit analysis to CDS -- markets that are often thinly traded and subject to speculators pushing a view that may or may not be valid -- both undermines money fund management and destabilizes borrowers' access to the markets. Such a rule could potentially cut off a firm's commercial paper funding just because some hedge fund manager gets bearish."

Roever and JPM add, "Versions of the buffer have been discussed between regulators and the industry for months, but Rosengren's description is the clearest unofficial articulation yet by someone on the regulatory side. We believe regulators are working towards introducing an official proposal for something quite like this in the next several months. Not surprisingly, the buffer idea is very controversial in the markets for several reasons. Let's consider a few of these: Existing reforms are working. Many MMMF managers have indicated the current set of rules have gone a long way toward mitigating systemic risks posed by money funds.... In the past year, the Japanese earthquake, the US debt debacle, and the ongoing Eurozone crises have all been major tests for prime funds and the funds have managed through $204bn of shareholder liquidations since March 2010 with no problems. Moreover, they have been proactively managing exposures to Eurozone banks lower for well over a year, albeit at a quickened pace during the last 3 months."

They continue, "A buffer won't eliminate credit shocks or liquidity runs. To some degree, all financial institutions are subject to credit shocks and liquidity runs. Focusing on "better credits" or shifting to a variable NAV format can't change this. Consider two recent examples. This past summer, between July 14 and August 1, taxable money funds backed by US government securities (about as risk-free an asset as there is ) experienced a liquidity run as result of heightened default concerns tied to the federal governments failure to raise it's statutory debt limit. Government funds saw 9% of their assets flow out in just about 3 weeks, as yields on government securities climbed. If constant NAV funds full of t-bills are subject to run risk, how can a fund full of marginally riskier assets not also be susceptible? So is variable NAV the answer? As the House Republicans have asked the SEC1, what empirical evidence is there that suggests a variable NAV will prevent on a run on money funds?"

The "Short-Term Fixed Income" piece adds, "The buffer is very costly. Implementing a buffer equal to 2-3% of assets will smother economic incentives for existing shareholders and fund sponsors, and may lead many to leave the prime fund business. The reforms that have already been implemented via the recent changes to rule 2a-7 have lowered risk and also lowered potential returns, and further risk-reducing reforms will do the same. In the current low interest rate environment the economics of adding a buffer funded by a third-party investor are highly suspect since the gap between the average prime fund's gross and net yields is below 20bp and falling as yieldy Eurozone bank paper continues to mature out of portfolios. If raised from outside sources, Rosengren's proposal implies the $1.5tn prime fund industry would need to raise $30-45bn of buffer capital. And given the probable timing of the reform, money funds may well have to compete with global banks that are simultaneously trying to raise capital."

It says, "As outlined by Rosengren this week, we are skeptical that a buffer of this scale can be implemented on an industry wide basis. If the regulators' fallback position is that, in lieu of a buffer, forcing prime funds to convert to VNAV will eliminate systemic risk in the funding markets, we think they are mistaken on a few fronts. First, faced with a choice between a VNAV prime fund and a CNAV government fund, we believe there will be massive flows into government funds. Indeed, since early August, we have seen a major rotation by institutional shareholders from prime funds into government funds, demonstrating shareholders' ability and willingness to shift. While other prime shareholders might try to shift to banks, most of the large banks they would shift to may not want their money given the high regulatory burden it brings. We do think there is a market for prime-like VNAV liquidity funds that will invest in the same sorts of credits prime funds invest in now. But we think this is much smaller than the existing prime fund market. As a result, banks and other borrowers relying on prime funds are likely to find credit greatly reduced. In this way, the buffer proposal may pose its own systemic risk."

Finally, they say, "The buffer is unlikely to substantially reduce credit or liquidity risks associated with prime funds. It's a fig leaf for regulators that will let them claim that they reduced systemic risk and without actually doing so. In the current environment, the buffer's cost is onerous and ultimately may only chase money and risk into less regulated corners of the money markets."

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