Flirting With Money-Market Madness; SEC proposals that would increase instability are worse than no reform at all

Flirting With Money-Market Madness

SEC proposals that would increase instability are worse than no reform at all.

ERIC S. ROSENGREN

Nov. 28, 2013 4:44 p.m. ET

Five years after the financial crisis, we know what caused much of the chaos. Many aspects of the financial system have been strengthened, reducing the likelihood of future problems. And yet for money-market mutual funds, fundamental reform has not been enacted. Unfortunately, some reforms proposed by the Securities and Exchange Commission might actually work against financial stability, instead of enhancing it.When Lehman Brothers announced bankruptcy in September 2008, one of the consequences was a run on “prime” money-market funds that buy corporate debt. Investors scrambled to pull their money out of funds holding—or simply thought to be holding—Lehman commercial paper that would now be much less than before the company’s bankruptcy. Only a day after the announcement, the Lehman-invested Reserve Primary Fund “broke the buck,” unable to keep its shares from falling below $1 a piece.

The run threatened to freeze short-term credit markets. Assets became more difficult to sell, and some funds risked not being able to give investors their money back in full. Squeezed by the run, the funds also had less money to buy debt instruments from commercial and financial firms, which posed problems for firms that rely on these instruments to finance their operations. Many companies faced liquidity challenges.

In response to the spreading contagion, the Treasury Department offered a temporary guarantee program to calm investors. The Federal Reserve created emergency lending programs to support liquidity. ButDodd-Frank

limited our ability to take similar steps in the event of another run on money-market funds.

Those policy limitations make the need for reform all the more pressing, as the problems during the crises were not limited to one fund. Researchers at the Federal Reserve Bank of Boston have documented 123 instances across 78 prime money-market funds from 2007 to 2010 when fund sponsors—both bank-affiliated and stand-alone asset managers—supported their fund by voluntarily purchasing troubled securities or providing a direct cash infusion. Sponsor support exceeded $4 billion. Absent this support, 21 funds would have “broken the buck,” like the Reserve Primary Fund.

The research shows these funds—about $1.5 trillion under management in total—need reform to ensure financial stability. The Financial Stability Oversight Council (FSOC) has made suggestions, including imposing capital requirements on the money-market funds, since they currently take risks against which they have no cushion. Similar proposals are under consideration in Europe.

The SEC, however, recently advanced two other proposals. The first, which the FSOC also supported, would treat money-market mutual funds like other mutual funds, allowing the value of a share to float with the value of the underlying assets. Investors run because they want to be the first one out of the fund if it looks like it’s about to break the buck and they won’t be able to redeem their shares at the $1 “fixed” price they expect. A floating price would let investors know all the time what the assets are worth. It would also mean that investors could not redeem their shares for more than the underlying value of the fund’s holding, which is the primary cause of runs in the current fixed price setup. This proposal was, by the way, supported by all 12 Federal Reserve Bank presidents in a comment letter sent to the SEC.

Unfortunately, the SEC’s proposal would only apply to institutional prime funds and not to the more widespread retail prime funds. This overlooks the fact that more than 30 of the retail prime funds received support from their sponsors during the financial crisis, and many retail prime funds sought liquidity from the emergency liquidity facility. While only institutional prime funds experienced significant investor runs in 2008, without the extensive support provided, retail funds may have suffered the same.

The more problematic SEC proposal would allow fund directors to charge an investor for redeeming from a prime money-market fund, and in some cases allow a director to temporarily suspend an investor’s access to their funds for up to 30 days. While the proposal aims to manage run-like outflows, “discretionary liquidity fees” and “temporary redemption gates,” as they are called, would only increase instability—which is worse than no reform at all. The liquidity fee would force an investor to take a haircut that might not correlate with any decrease in the underlying asset value. Temporary redemption gates could block investors’ access to their funds during a financial crisis—exactly the time they need liquidity most.

Redemption fees or gates might actually make runs even more contagious. If one fund announces a fee or gate, this sends a signal that its directors are worried about a run. Investors in other funds may become concerned about fees or gates and be more prone to run. Directors, nervous about a run, may then impose the very fees or gates the investors feared. The fear of fees and gates—just like the fears of runs—could lead to a self-fulfilling prophecy.

The better solution would be to treat all prime money-market mutual funds, including retail funds, like other mutual funds that set aside no capital and take credit risk. The value of these funds should reflect an accurate appraisal of the underlying assets, not a fictitious fixed number.

Reforming money-market mutual funds is overdue. We need to apply the lessons we learned from a profoundly damaging episode. Let’s not wait until the next crisis.

Mr. Rosengren is the president and CEO of the Federal Reserve Bank of Boston.