The Securities & Exchange Commission posted a paper entitled, "The Economic Implications of Money Market Fund Capital Buffers (Working Paper by Craig M. Lewis)," last week under the "What's New" section of its website (and under the "Comments on Proposed Rule: Money Market Fund Reform" page), we learned from Stradley Ronon's Joan Swirsky and John Baker. The SEC paper's Abstract says, "This paper develops an affine term structure for the valuation of money market funds. This valuation framework is then used to consider the economic implications of funds that are supported by a capital buffer. The main findings are twofold. First, relatively small capital buffers are capable of absorbing daily fluctuations between a fund's shadow price and its amortized cost. For example, a fund with a capital buffer of 60 basis points can absorb most day-to-day price risk. The ability to absorb large scale defaults, however, would require a significantly larger and more costly buffer. Second, because a buffer is designed to absorb credit risk, capital providers demand compensation for bearing this risk. The analysis shows that, after compensating capital buffer investors for absorbing credit risk, the returns available to money market fund shareholders are comparable to default free securities, which would significantly reduce the utility of the product to investors."
Lewis, of the SEC's Division of Economic and Risk Analysis, writes in the "Introduction, "U.S. money market funds are open-end investment management companies that are registered under the Investment Company Act of 1940. The principal regulation underlying money market funds is rule 2a-7 under the Investment Company Act, which was promulgated in 1983 and most recently amended in 2010. A mutual fund chooses whether or not to comply with rule 2a-7. A fund that does so may represent itself as a money market fund, rather than, for example, an ultra-short-term bond fund. All other funds are prohibited from suggesting that they are money market funds. Under rule 2a-7, a money market fund must satisfy constraints on portfolio holdings related to liquidity, maturity, and portfolio composition, as well as satisfy a number of operational requirements."
It continues, "Compliant funds also are permitted to use amortized cost accounting when valuing their portfolios rather than market-based valuations. Using amortized cost valuation allows a money market fund to value its assets at acquisition cost, adjusting for any premium or discount over the bond's life. A fund also must calculate its mark-to-market value on a per-share basis, which is commonly referred to as the "shadow price." The price per share of a money market fund share can be rounded to $1.00 provided the shadow price is within one half penny of $1.00. The ability to price at a stable $1.00 is an important distinguishing feature of money market funds compared to other mutual funds."
The SEC report says, "The opportunity for investors to sell assets at amortized cost provides them with an embedded put option to sell assets for $1. That is, since redeeming shareholders settle at amortized cost, any capital losses or liquidity discounts are borne by the remaining investors rather than those redeeming their shares. This wealth transfer to liquidating from remaining shareholders creates an incentive to be the first to redeem shares when asset values drop. Financial turmoil in 2007 and 2008 put money market funds under considerable pressure, which culminated the week of September 15, 2008 when Lehman Brothers Holdings Inc. (Lehman Brothers) declared bankruptcy.... The capital loss associated with the failure of Lehman Brothers caused the [Reserve] Primary Fund to "break the buck."
It explains, "During the week of September 15, 2008, investors withdrew approximately $300 billion from prime (taxable) money market funds, or 14 percent of all assets held in those funds. The heaviest redemptions generally came from institutional funds, which placed widespread pressure on fund share prices as credit markets became illiquid. A Study by the U.S. Securities and Exchange Commission's Division of Economic and Risk Analysis (DERA Study) documents that most of these assets were reinvested in institutional government funds. The DERA Study concludes that this behavior is consistent with a number of alternative explanations that include flights to quality, transparency, liquidity, and performance. It also discusses the possibility that redemption activity may have been partially caused by shareholders exercising the redemption put associated with stable dollar pricing."
The paper comments, "The SEC's response to the market events of 2008 was to initially propose (June 2009) and later adopt (February 2010) amendments to Rule 2a-7. The amendments tightened the risk-limiting conditions of Rule 2a7 by, among other things, requiring funds to maintain a portion of their portfolios in instruments that can be readily converted to cash, reducing the maximum weighted average maturity of portfolio holdings, and improving the quality of portfolio securities. Against this backdrop, the U.S. Securities Exchange Commission is considering additional options to further reform the MMF industry to address potential problems associated with investor tendencies to redeem shares during periods of stress. Concerns about the effect of heavy redemptions on short-term funding markets have prompted the Financial Stability Oversight Council (FSOC) to recommend a number of regulatory alternatives in a report issued in November 2012, which include, among other items, a floating net asset value alternative and two capital buffer alternatives. The first capital buffer alternative recommends a stand-alone 3.0% buffer; the second recommends a 1.0% buffer plus a minimum balance at risk requirement."
It adds, "In June 2013, the Commission proposed a rule that considers two separate reform options. The first is the so-called floating net asset value option which requires funds to price securities at their market values but permits "basis point" rounding (round to $1.0000) at the portfolio level. The second option recommends the use of liquidity fees and redemption gates once certain liquidity thresholds are breached. Additionally, the proposal recommends enhanced diversification disclosures, and stress testing requirements, as well as reporting in Forms N-MFP and PF. The release also considers the two capital buffer alternatives suggested by FSOC and concludes that they are too costly relative to the proposed alternatives. The purpose of this paper is to illustrate the economic effects of requiring a money market fund to be supported by a capital buffer."
Lewis tells us, "Specifically, I document the risk and return characteristics of MMFs associated with a capital buffer, assess the differences between market and amortized cost valuations, and characterize the economic implications of capital buffers. Section 2 describes the valuation of fixed income securities. Section 3 describes the econometric approach used to estimate the stochastic properties of interest rates and credit risk. It also describes the data used to perform these estimates and provides parameter estimates. Section 4 explains my valuation model. In Section 5, I provide Monte Carlo simulation evidence of how MMFs perform under the current regulatory baseline. Section 6 considers the economic implications of a capital buffer. Section 7 offers conclusions."
The paper's Conclusion says, "The topic of money market regulation is the subject of much debate. The objective of this paper is to illustrate the economic effects of requiring a money market fund to be supported by a capital buffer. To put my findings into context, it is important to understand that a capital buffer can be designed to satisfy different potential objectives. One possible objective is to design a buffer so that it is able absorb day-to-day variations in market value relative to the amortized cost of the underlying portfolio assets. My examination of this design strategy demonstrates that a 60 basis point buffer would be sufficient to provide price stability under normal market conditions. Although a 60 basis point buffer is able to withstand most day-to-day price variation, it would most likely fail if a concentrated position, of say 5%, were to default."
It continues, "A larger buffer could protect shareholders from losses related to defaults in concentrated positions, such as the one experienced by the Reserve Primary Fund following the Lehman Brothers bankruptcy. However, if complete loss absorption is the objective, a substantial buffer would be required. For example, a 3% buffer would accommodate all but extremely large losses. A limitation of a large buffer is that the cost of providing this protection would be borne at all times even though it is likely to be significantly depleted only rarely. While a capital buffer would make a money market fund more resilient to deviations between the shadow price and amortized cost, it may be a costly mechanism from the perspective of the opportunity cost of capital. Those contributing to the buffer deploy valuable scarce resources that could be used elsewhere. Moreover, because the capital buffer absorbs fluctuations in the value of the portfolio, much of the yield of the fund will be diverted to funding the capital buffer, which, in turn, will reduce fund yield. Put another way, to the extent that the capital buffer absorbs default risk, those contributing to a capital buffer will demand a rate of return that compensates them for bearing this risk. Since, by construction, a capital buffer absorbs defaults until it is fully depleted, money market funds will allocate that portion of the returns associated with credit risk to capital buffer "investors" and only will be able to offer MMF shareholders returns that mimic those available for government securities. This effectively converts MMFs into "synthetic" Treasury funds."
Finally, Lewis' paper adds, "My findings may have broader implications for capital formation. Many investors are attracted to money market funds because they provide stability but offer higher rates of return than government securities. Since these higher rates of return are intended to compensate for exposure to credit risk and to the extent that fund managers are unable to pass through enhanced yields to MMF shareholders, fund managers may be less willing to invest in risky securities such as commercial paper or short-term municipal securities, particularly if these securities increase the probability that a buffer is depleted. An inability to materially differentiate fund performance on the basis of yield would significantly reduce, but not necessarily eliminate, the utility of money market funds to investors."
