University of Mary Hardin-Baylor Assistant Professor Larry Locke wrote late last year on "The SEC's Attempted Use Of Money Market Mutual Fund Shadow Prices To Control Risk Taking By Money Market Mutual Funds" (see our Sept. 4, 2012 Crane Data News piece, "Locke Study Shows No Investor Reaction to Low Shadow NAV Prices"). Locke wrote us again recently, describing what he calls, "The Forgotten Alternative to Money Market Reform." He tells us, "The Security and Exchange Commission's money market fund reform proposal is due any day now and their list of possible structures has been narrowed through a lengthy tug of war with the industry. Unfortunately, all the proposed structures from which the SEC is crafting its new regulatory scheme appear to have a common problem -- they all involve coopting the market into preventing money fund failures."

Locke writes, "The reform effort dates back to September 2008 when the Reserve Primary Fund became the first money market fund in over a decade to "break the buck" -- allow its real net asset value to fall below $0.995 per share. That failure contributed to a short-term credit market freeze that had the potential to shut down the entire U.S. financial system. The resulting backstops put in place by the Treasury and the Fed put hundreds of billions of dollars of taxpayer money at risk to restore investor confidence."

He continues, "Just as in Newton's Third Law of Motion, for every governmental action there is an equal and opposite reaction. In the case of money market funds, the reaction to the 2008 bailout has been an ongoing demand by the Financial Stability Oversight Council and the SEC to make money market funds less dangerous to themselves and others. After bouncing around the regulatory landscape for the last four years, the issue is finally coming to a head and the whole industry is waiting nervously to see what the SEC will propose for the new product structure."

Locke explains, "Sadly, the proposals discussed so far have a common flaw -- they are all based on encouraging the market to accurately assess money market risk. The theory is that if investors appreciated the risk of owning money funds, they would expect to sometimes sustain losses and not start a run on funds at the first sign of trouble. Therefore, if money funds can be structured so as to accurately communicate that risk, it will discourage runs by investors and money funds will be much less likely to fail and contribute stress to the short-term credit market. Prior SEC proposals to increase real NAV reporting, to force money funds to float their NAV (instead of being fixed at $1), and to hold back investor funds upon redemption, are all designed to highlight the risk of owning money funds and discourage investors from withdrawing cash from their funds during times of falling share values."

He adds, "The problem with all of these plans is that investors can prove very hard to manipulate. Recent research indicates that investors pay little attention to the reports of real money fund share prices already mandated by the SEC. It is easy to understand why. Historically, money fund failures are very rare and people, generally, aren't good at evaluating remote possibilities. (How many people do you know who bought an overpriced warranty on their new washing machine or new set of tires?)"

The professor writes, "Money market investors, as a group, have not demonstrated superior risk assessment skills than the general population. According to the ICI Fact Book, there were 548 taxable money market funds at the start of 2008. That means if you randomly invested a dollar in a money fund at that time you would have a 1 in 548 chance of putting your money in the Reserve Primary Fund. On the other hand, if you allowed the market to choose your fund (incorporate Reserve Primary Fund's market weighting into the process -- approximately $64 billion in a $2.6 trillion market) your chance of being in the fund that was about to fail would rise to approximately 1 in 41."

Finally, Locke says, "A more precise, and more economic, way of dealing with these types of remote possibilities where people tend to mistake the risk of loss is through insurance. Insurance regimes take the assessment of risk out of the hands of investors and entrust it to actuaries, who can translate the risk into a premium that can then be assessed against everyone entering the market. It is the same method we currently use in the U.S. for bank failures. A money fund insurance regime would be far cheaper than insuring commercial bank deposits not only because money fund failures are more rare than bank failures but also because the losses they ultimately incur are on the order of only 1%. A money market fund analog to the FDIC could be funded from investor returns generated by money funds, themselves, rather than with taxpayer dollars. The assessments could even be designed to increase as the risks thrown off by a particular money fund increased. A government-sponsored insurance regime would combine the power of the government to calm turbulent markets with the political necessity of avoiding another federal bailout."

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