By Luigi Zingales
Regulatory meetings devoted to dire topics are rarely fun. The May 10 roundtable on “Money Market Funds and Systemic Risk,” hosted by the Securities and Exchange Commission, was an exception.
To be sure, the systemic risk posed by money market funds, or MMFs, is no laughing matter. Three days after the September 2008 bankruptcy of Lehman Brothers Holdings Inc., the $62.5 billion Reserve Primary Fund posted a 3 percent loss on debt issued by the bank and collapsed. This so-called breaking the buck, in which the fund’s underlying assets were valued at less than $1 per share, caused panicked investors to withdraw about $310 billion from all funds. The demands from investors to cash out their deposits forced the funds to reduce their holdings of commercial paper by $200.3 billion, or 29 percent, creating a major liquidity crisis among the prime borrowers in this market. Without the guarantee the government introduced at the end of that week, the leak would have turned into a flood. Had the Federal Reserve not stepped in to buy commercial paper, major U.S. employers would have been unable to meet payrolls, with potentially catastrophic consequences. The ripple effects were felt in Europe, where banks that borrow heavily in the U.S. commercial paper market were squeezed, too.
How can money market funds, considered among the safest investments, be so systemically dangerous? In fact, it is precisely because these funds try to be so safe that they make the rest of the system more unstable. One of the tenets of modern finance is that financial repackaging doesn't eliminate risk, it only reallocates it. The more you try to make the funds safe, the more risk you impose on the rest of the capital markets.
The inadvertent humor at the SEC roundtable was produced by lobbyists' attempts to rewrite history by minimizing the destabilizing effect of money market funds in the 2008 crisis. "To say that the Reserve Fund caused the run is very naïve," one fund manager said. "It paints a misleading picture to say that money market funds are susceptible to runs," added another. "The investments are very short-term. Their assets are 'money good.'"
Another ironic aspect of the roundtable was hearing Wall Street lobby for government intervention. That may be because money market funds owe much of their popularity to SEC Rule 2a-7, which allows them to deviate from mark-to-market, meaning they can claim their assets are always worth 100 cents on the dollar, even when they aren't. This isn't just a way to dilute gullible shareholders (the biggest customers are institutional investors). It allows the funds to legally qualify as riskless investments. As one roundtable participant said, “It's very important to us to be able to put a dollar in and to get a dollar out.”
Never mind that no other investment works this way. The closest substitute is a U.S. Treasury bill. The U.S. government guarantees bank deposits of less than $250,000, yet it charges a fee for this privilege. Furthermore, to avoid the moral hazard risk that comes with the guarantee, the government also imposes heavy regulation. Money market funds don't like the fee or the regulation, but they do like to appear as safe as deposits.
To be sure, the funds are very safe. Even the Reserve Fund, whose breaking the buck started the run, lost only 3 cents on the dollar. Yet they are not perfectly safe. This pretense of full safety is the primary problem in this market.
The SEC amended Rule 2a-7 last year to reduce the systemic risk of MMFs. Some of these amendments -- such as the requirement for more timely disclosure of MMF holdings -- do little to solve the problem. Most investors hold MMFs overnight or for very short terms and don't want to spend resources to find out the true value, much as a store owner wouldn't want to worry about the value of the dollar bills tendered by customers. Before these investors start monitoring MMF holdings, they vote with their feet and move their money. As a result, the enhanced disclosure requirement could make runs more likely.
Other changes introduced in the amendment are more effective. MMFs are required to report an estimated net asset value, which could fall short of a true mark-to-market valuation. More importantly, the funds' boards now must conduct a periodic “stress test” of the ability of their funds to maintain a stable net asset value in certain hypothetical situations. The SEC expects (but does not require) that if an MMF's estimated value per share drops below $0.9975, the fund would conduct stress tests at least every week. The amendment also requires MMFs to have the capability to process sales and redemptions at a price based on current net asset values per share (rather than at the rounded value of $1 per share). Shockingly, many funds didn't have that capability.
But all these reforms fall short of what is really needed. Either we extend to MMFs the safety net -- and the regulation and fees -- that cover the banking industry or we recognize that the funds aren't the same as bank deposits and should be treated differently. In particular, the exemption from mark-to-market should be eliminated. It has no economic rationale. The funds have argued that requiring true mark-to-market would jeopardize not only their $3 trillion industry, but also the stability of the U.S. financial system. This is an implicit admission that the industry depends on regulatory protection for survival. That isn’t true: The industry, albeit on a smaller scale, would survive mark-to-market. If it didn’t, it wasn't worth saving.
(Luigi Zingales is a professor of entrpreneurship and finance at the University of Chicago Booth School of Business and a contributor to the Business Class blog.)