While we've yet to find many other comment letters to the SEC on the Treasury Department's Office of Financial Research recent controversial "Asset Management and Financial Stability" study, we just noticed that one has been posted on the SEC's "Comments on Proposed Rule: Money Market Fund Reform; Amendments to Form PF" website. The prolific John D. Hawke, Jr., Arnold and Porter, LLP on behalf of Federated Investors, Inc. writes, "Enclosed for filing in the above-referenced docket [Release No. S7-03-13] is a copy of comments submitted last week on behalf of our client, Federated Investors, Inc., in the comment docket for a recent report by the Treasury Department's Office of Financial Research ("OFR") entitled "Asset Management and Financial Stability." The OFR Report, which was prepared at the request of the Financial Stability Oversight Council, provides insights into the views of those advising FSOC on the need for structural changes to money market funds ("MMFs")."
He tells us, "The Commission has based its proposed "Alternative 1" for MMF reform upon the FSOC position that MMFs which seek to maintain a stable NAV of $1 per share are vulnerable to a so-called "first mover advantage" and destabilizing "runs" by redeeming shareholders which can only be remedied by forcing all MMFs to move to a floating NAV. The OFR Report takes the position that variable NAV mutual funds are also vulnerable to the "first mover advantage," and to destabilizing "runs" that create systemic risks. The OFR Report assertion undermines the credibility of the OFR and FSOC on asset management issues, including MMF structure and regulation, as well as the purported intellectual underpinnings for the movement of MMFs to a variable NAV as proposed by the FSOC and included in the Commission's Alternative 1. The Report views investment funds and investment management activities through the lens of bank regulation, leading to serious analytic flaws that we have detailed in the enclosed letter. The OFR Report should give pause to those in the investment management industry and the Commission who believe that FSOC will be satisfied with changes only to MMFs."
Hawke's 38-page submission explains in the inside cover letter, "We are writing on behalf of our client, Federated Investors, Inc. and its subsidiaries ("Federated"), to provide comments in response to the Securities and Exchange Commission's (the "Commission's") request for public feedback on the September 2013 report of the Treasury Department's Office of Financial Research ("OFR") entitled "Asset Management and Financial Stability" (the "Report"). The Report was prepared at the request of the Financial Stability Oversight Council ("FSOC")."
He says in the "Introduction," "The Report contains a number of analytical flaws, as discussed further below. Taken as a whole, the Report views the securities markets through the lens of a bank regulator that shows an inability or unwillingness to understand the fundamentals of how markets work and the role of an investment manager as agent and fiduciary for its clients. Investors make investment decisions to further their interests and investment objectives. Investment managers act as agents seeking to take action for their clients to further their clients' interests and investment objectives. Investment managers do not act to further the policy objectives of the Federal Reserve System or the Treasury Department by making or staying in investments to further the common good as determined by federal government officials. When there are more buyers than sellers at a price, prices go up. When there are more sellers than buyers at a price, prices go down. Not everyone makes the same decisions, or makes their decisions at the same time, or receives the same price."
Hawke continues, "The Report identifies these characteristics of markets and investment managers as flaws which create undefined "systemic risks" that need to be corrected by structural changes. The reality is these attributes are the core strengths of a market-based economy. A. The OFR Report fails to take fundamental structural differences between asset managers and banks into account. Investment management is an agency activity. Investment managers do not guarantee returns. The Investment Advisers Act prohibits investment advisers from guaranteeing results to their client-investors. The value of a client's investments managed by an investment manager are not tied to the financial health of the investment manager. Investment managers do not act as principals in managing the investments of their clients. If the clients' investments decrease in value, the investment manager does not lose money and is not liable to the client for the loss in value."
He writes, "In contrast, banks intermediate financing primarily by accepting deposits from their customers and making loans or investments. In each case the bank acts as principal for its own account. The deposit is a debt obligation owed by the bank to the depositor. The loan or investment is a debt obligation owed to the bank by the borrower or issuer. If the loan or investment declines in value, the bank still owes the depositor 100 cents on the dollar plus interest and must repay the depositor according to the timing specified in the deposit contract. Although the OFR Report acknowledges this key point in the introduction, it proceeds to ignore the distinction and analyze investment managers as if they were, and should be, acting as principals and guarantors of their client-investors' investment positions."
Hawke adds, "B. The failure to understand the differences between asset managers and banks led OFR to exaggerate the risks associated with asset management. The "vulnerabilities" identified in the Report are in fact (1) ordinary investment risks that are not specific to asset management (e.g., "reaching for yield"), (2) risks controlled primarily by clients of assets managers (e.g., use of leverage, which is a decision that investors make, through either financing for their investments or selection of investment funds that pursue leverage strategies), (3) incentives for asset managers to limit risk taking (e.g., avoiding redemptions by shareholders in order to preserve size of funds and asset-based fees) or (4) the reflection of a misunderstanding of the operations of asset managers (e.g., consequences of the failure of an asset manager, which are in fact much more limited for customers and counterparties because of the agency role of the manager than consequences of the failure of a bank)."
He tells us, "C. The failure to understand the fundamental differences between asset managers and banks led OFR to make misguided policy recommendations. The Report inappropriately takes a bank regulatory framework -- which is premised on the use of a large capital base to support principal positions and a supervisory structure designed to dictate most aspects of asset allocation and risk tolerance to protect that balance sheet and meet Federal economic policy objectives of making credit available to certain uses -- and applies it to other, very different types of firms, including investment managers and mutual funds whose role is to make investments for the benefit of client-investors to meet client directions and investment objectives. While its ultimate purposes remain vague, the Report appears designed to support a set of policy recommendations that would force asset management firms to be structured and operated like banks, hold capital against the investment positions of client investors, and make and maintain investments in times of economic uncertainty. These changes would not be made to meet client investment directions and objectives, but instead to support a Federal policymaker's objectives of attempting to regulate financial markets based upon its determination of the common good that it calls financial stability."
Hawke also comments, "D. The Report should be a wake-up call for anyone who did not see where the FSOC, Federal Reserve, and Treasury were headed. If the mind-set and intent of the FSOC, Federal Reserve and Treasury were not already clear by now, the Report, and the opinions issued in the FSOC's recent designation of the first group of non-bank systemically important financial institutions ("SIFIs"), should make clear the intent of these agencies is to break the long-standing structural models of non-bank financial firms and force them into bank-like capital structures. The Dodd-Frank Act does not grant any authority to the FSOC to regulate entire industries or to require the primary regulator to change the structure or regulations applicable to an industry. Section 113 of the Dodd-Frank Act provides authority for the FSOC (by a two-thirds vote) to designate only a few of the largest and most significant non-bank financial firms as SIFIs and subject them to supervision and regulation by the Federal Reserve under Title I and liquidation by the FDIC under Title II of the Act. Section 120 of the Dodd-Frank Act authorizes the FSOC only to make recommendations to other financial regulators on systemic risk issues, but not to force those regulators to make changes."
Finally, Hawke's letter concludes, "The OFR Report is lacking in both substance and depth of analysis. It appears designed to justify an FSOC and Federal Reserve role in fundamentally changing the structure and operation not only of investment managers, but also investors and markets. It is badly reasoned and poorly thought through. We appreciate and understand the concern of the Federal Reserve that federal financing policies and programs designed to stimulate economic activity may have unintended consequences in the markets. After all, that is a large part of what caused the 2007-2009 Financial Crisis. The appropriate response, however, is not to make securities markets less efficient, limit investor choice or seek to slow down capital mobility through regulations imposed on the investment management industry. A simpler and less intrusive fix is tightening the regulation of loans to finance risky investments. One hopes that the other regulators represented on the FSOC -- the Commission, CFTC and insurance regulators -- will begin to recognize a pattern to the lack of understanding at the bank regulators of non-bank financial services and their structure and regulation, a lack of concern for price discovery and efficiency in capital markets, and a movement towards regulating all nonbank firms and markets like banks. If the FSOC continues down this path, it will damage our economic system, capital markets, investors, and the public, with no offsetting benefits. We appreciate the opportunity to provide comments on the OFR Report."
