As we mentioned yesterday, the posts keep coming on the SEC's "President's Working Group Report on Money Market Fund Reform (Request for Comment)" website. The latest is from Columbia University Law Professor Jeffrey Gordon, who recently submitted his oddball ideas to the Senate Banking Committee's "Perspectives on Money Market Mutual Fund Reform" and who recently appeared at the AEI's "Do money market funds create systemic risk?" webinar. Gordon writes, "I have studied the money market fund problem since the fall of 2008. `This has resulted in two detailed comment letters to the SEC, one in September 2009 and the other in August 2011, both of which are attached to this submission. A co-author and I have also conducted empirical analysis of the relative run risks of floating vs. fixed net asset value ("NAV") funds, based on a "natural experiment" involving off-shore dollar-denominated money market funds during "Lehman week" in September 2008. These self-regulated funds generally follow the SEC rules on portfolio composition but are available in both fixed and floating NAV. We find that the fixed/floating distinction does not explain the variation in the run rate across funds; rather, the relative risk of the fund, proxied by yield prior to Lehman week, is the crucial fund-level explanatory variable. (We are in the process of finishing a draft of this research, which should be public shortly.)"
He continues, "For the record, none of my research in this area has been supported by any party other than Columbia Law School as part of the customary research funding it provides to faculty members. Based on this cumulative work, my views are the following: Money Market Mutual Funds ("MMFs") are like banks, except they have no provision for bearing loss and internalize none of the systemic risk costs of their activities. MMFs present a unique "two-sided" run problem that makes them an unstable source of credit. Since most MMF credit is now extended to banks, this makes MMFs a significant vector for financial crisis. These problems can be addressed through requiring MMF investors to acquire bundles of Class A/Class B shares, in which fixed NAV is preserved for the Class A shares."
Gordon writes, "First, a money market mutual fund is like a bank in that it holds a portfolio of risky assets (non-U.S. Treasury), yet, unlike a bank, holds no capital nor any other first-loss protection. Its NAV will fall below $1 upon the default of virtually any appreciable portfolio holding, unless the sponsor decides to step in to cover the loss. The fact that sponsors frequently have provided such support provides no assurance that a particular sponsor(s) will have sufficient resources or willingness to provide support in the midst of a financial crisis. The Reserve Primary Fund illustrates the problem of sponsor incapacity for a large fund, and at only $60 billion, this fund was hardly the largest."
He adds, "Second, the lack of capital or any other first-loss protection means that MMFs are exposed to a "two-sided run problem." One side of the run problem is well understood: MMF fund investors who perceive a risk of default will want to be first in line at the withdrawal window. If other investors perceive a similar risk, the best strategy is to withdraw first and ask questions later, producing a run. The second side of the run problem is less well-understood but equally important. MMFs provide short term finance to financial institutions (especially banks) as well as to non-financial commercial paper users. Precisely because they have no first loss protection against default of portfolio securities, MMFs will be extremely sensitive to the risk of default by the parties they finance. This means, for example, if a bank runs into financial distress, MMFs will either shorten the maturity of the obligations from this counterparty or refuse to rollover the obligations altogether. In other words, because of the first run problem, the MMF depositor run risk, MMFs in turn create a run problem for parties that depend on MMF financing. Because of the threat that depositors will run on the MMFs, the MMFs may run on their counterparties."
Gordon tells the Senate panel, "Third, the two-sided run problem has very important (negative) macro implications. A little background is necessary. The main function of MMFs currently is to provide diversified portfolios of credit-screened short-term claims on financial firms to cash-holding institutions seeking safety and liquidity. For example, an operating company with large cash reserves could deposit the funds in a bank or itself assemble a portfolio of money market instruments. An MMF is better than these two alternatives, because a diversified portfolio of financial firm claims is safer than a deposit in a single bank (given the cap on deposit insurance), and the MMF can achieve scale economies in producing diversified, screened portfolios of such claims. In the evolution of MMFs from the 1980s until the present, the largest users have become institutional, and the mix of MMF assets has moved overwhelmingly to claims on financial firms (and related financing entities).... Two implications follow. First, MMFs have become a major vector for financial sector distress. Because the credit-worthiness of financial firms is highly correlated, if a single financial firm defaults on its money market issuances, MMFs will take this as a signal of the likelihood of other defaults in the financial sector and will thus run on many other financial firms by refusing to roll over credit."
He explains, "Here is the policy-relevant structural point: A significant fraction of this particular vicious circle is the direct result of the fragility of the MMFs themselves as presently designed. To repeat: The MMFs have no capacity to bear default on any portfolio security. Thus, much of the wholesale short term funding mechanism dances to the MMFs' short-rigged tune. Fourth, it is possible to design an MMF that will preserve the benefits currently associated with MMFs but reduces some of the systemic risk and other negative effects. My August 2011 comment letter extensively presents such a proposal. The main feature is this: Institutions that invest in MMFs buy two classes of MMF stock, Class A and Class B, as a Class A/Class B bundle, in a ratio of roughly 95% to 5%. Class A shares carry fixed NAV and thus can be used transactionally without tax or accounting consequences; Class B may float in value and may bear loss. An investor can withdraw Class A shares at will. Class B shares can be withdrawn only upon a 7-day (or 30-day) lag, a holdback.... Other details are spelled out in the comment letter."
Gordon posits, "There are three advantages. First, this arrangement significantly enhances MMF stability, which will reduce not only their systemic risk potential but will also change MMF behavior in periods of financial stress, like right now. Because MMFs will have first loss protection, their own funding decisions need not be on hair trigger, with positive effects throughout the short term funding process. This may encourage bank extensions of credit to non-financial borrowers. Second, the structure of the Class A/Class B bundle protects not only against portfolio defaults but also against run risk. That is because a Class A holder also owns Class B. Class A holders will therefore be far less likely to run, because a run that leads the MMF to sell assets at fire-sale values and thus to break the buck will be costly for the holder's Class B shares. Before a run was "free" to the holder; now there will be potential costs."
Finally, he writes, "Third, the cost of this arrangement is borne by the MMF users, not the sponsors or the taxpayers. This proposal will not drive the MMF industry out of business. The fact is, institutional MMF investors have no better alternative. Short term bond funds, of course, have floating NAV. Bank deposits carry risk if uninsured. This proposal merely requires institutional MMF investors to internalize the cost of systemic stability for MMFs rather than relying on implicit guarantees from the rest of the financial sector and the U.S. government (and the taxpayers)."
