[Senate Hearing 112-740]
[From the U.S. Government Publishing Office]
S. Hrg. 112-740
PERSPECTIVES ON MONEY MARKET MUTUAL FUND REFORMS
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HEARING
before the
COMMITTEE ON
BANKING,HOUSING,AND URBAN AFFAIRS
UNITED STATES SENATE
ONE HUNDRED TWELFTH CONGRESS
SECOND SESSION
ON
EXAMINING THE HEALTH AND STABILITY OF MONEY MARKET MUTUAL FUNDS
__________
JUNE 21, 2012
__________
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COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS
TIM JOHNSON, South Dakota, Chairman
JACK REED, Rhode Island RICHARD C. SHELBY, Alabama
CHARLES E. SCHUMER, New York MIKE CRAPO, Idaho
ROBERT MENENDEZ, New Jersey BOB CORKER, Tennessee
DANIEL K. AKAKA, Hawaii JIM DeMINT, South Carolina
SHERROD BROWN, Ohio DAVID VITTER, Louisiana
JON TESTER, Montana MIKE JOHANNS, Nebraska
HERB KOHL, Wisconsin PATRICK J. TOOMEY, Pennsylvania
MARK R. WARNER, Virginia MARK KIRK, Illinois
JEFF MERKLEY, Oregon JERRY MORAN, Kansas
MICHAEL F. BENNET, Colorado ROGER F. WICKER, Mississippi
KAY HAGAN, North Carolina
Dwight Fettig, Staff Director
William D. Duhnke, Republican Staff Director
Charles Yi, Chief Counsel
Laura Swanson, Policy Director
Dean Shahinian, Senior Counsel
Jana Steenholdt, Legislative Assistant
Levon Bagramian, Legislative Assistant
Andrew Olmem, Republican Chief Counsel
Mike Piwowar, Republican Chief Economist
Dana Wade, Republican Professional Staff Member
Dawn Ratliff, Chief Clerk
Riker Vermilye, Hearing Clerk
Shelvin Simmons, IT Director
Jim Crowell, Editor
(ii)
C O N T E N T S
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THURSDAY, JUNE 21, 2012
Page
Opening statement of Chairman Johnson............................ 1
Prepared statement........................................... 26
Opening statements, comments, or prepared statements of:
Senator Shelby
Prepared statement....................................... 26
WITNESSES
Mary L. Schapiro, Chairman, Securities and Exchange Commission... 1
Prepared statement........................................... 27
Nancy Kopp, Treasurer, State of Maryland
Prepared statement........................................... 32
Paul Schott Stevens, President and Chief Executive Officer,
Investment Company Institute
Prepared statement........................................... 43
J. Christopher Donahue, President and Chief Executive Officer,
Federated Investors, Inc.
Prepared statement........................................... 110
Bradley S. Fox, Vice President and Treasurer, Safeway, Inc.
Prepared statement........................................... 123
David S. Scharfstein, Edmund Cogswell Converse Professor of
Finance and Banking, Harvard Business School
Prepared statement........................................... 126
Additional Material Supplied for the Record
Prepared statement submitted by the Financial Services Institute. 137
Letter submitted by Michele M. Jalbert, Executive Director--
Policy and Strategy, The New England Council................... 140
Prepared statement submitted by Jeffrey N. Gordon, Richard Paul
Richman Professor of Law and Co-Director, Center for Law and
Economic Studies, Columbia Law School.......................... 143
(iii)
PERSPECTIVES ON MONEY MARKET MUTUAL FUND REFORMS
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THURSDAY, JUNE 21, 2012
U.S. Senate,
Committee on Banking, Housing, and Urban Affairs,
Washington, DC.
The Committee met, pursuant to notice, at 10:04 a.m., in
room SD-538, Dirksen Senate Office Building, Hon. Tim Johnson,
Chairman of the Committee, presiding.
OPENING STATEMENT OF CHAIRMAN TIM JOHNSON
Chairman Johnson. I call this hearing to order. Today we
will examine the health and stability of money market mutual
funds, the impact of 2010 reforms, and the potential positive
and negative consequences of additional proposed reforms from
the perspectives of the industry's regulator, the industry
itself, users of the industry's products, and an academic
expert. I look forward to hearing the testimony and
recommendations as the Committee continues its oversight of the
financial markets.
Because we are anticipating a series of 11 votes starting
in an hour, we are going to forgo opening statements from the
Committee's Members in order to begin the questioning of our
witnesses. I will remind my colleagues that the record will be
open for the next 7 days for opening statements and any other
materials you would like to submit. I will also ask everyone to
stick to 5 minutes for your questions.
On today's first panel we have the Chairman of the
Securities and Exchange Commission, Chairman Mary Schapiro.
Chairman Schapiro, please begin your testimony.
STATEMENT OF MARY L. SCHAPIRO, CHAIRMAN, SECURITIES AND
EXCHANGE COMMISSION
Ms. Schapiro. Chairman Johnson, Ranking Member Shelby, and
Members of the Committee, I appreciate the opportunity to
testify about money market mutual funds and the continuing
risks they pose to our financial system.
As we all know, during the financial crisis a single money
market fund known as the ``Reserve Primary Fund'' broke the
buck, triggering a run not only on that fund but on funds
across the market. Within a matter of days, investors had
withdrawn about $300 billion from prime money market funds, or
14 percent of those funds' assets. It was one of several
destabilizing events during the crisis.
To meet their customers' redemption demands, money market
funds began selling portfolio securities into markets that were
already under stress, further depressing the value of those
securities and creating a vicious cycle. Soon, other funds
holding those same securities were struggling to meet the
demands of their customers and found themselves at risk of
breaking the buck.
The shock waves were widespread. Money market funds began
hoarding cash and stopped rolling over existing positions in
commercial paper and other debt issued by companies, financial
institutions, and municipalities. This dramatically reduced the
cash and liquidity available for those entities. In the final 2
weeks of September 2008, money market funds reduced their
holdings of commercial paper alone by more than $200 billion.
The runs on money market funds ended only after the
Treasury Department took the unprecedented step of using the
Exchange Stabilization Fund to guarantee more than $3 trillion
in money market fund shares. While this step dramatically
improved the market, it also put U.S. taxpayers directly at
risk for money market fund losses.
In the wake of the financial crisis, many have rightfully
asked where were the regulators and why didn't they do more to
address systemic risks. Having reviewed this issue closely and
methodically since my arrival in 2009, I have come to
understand that money market funds pose such a risk and others
agree. Current and former regulators of both political parties
have raised flags about the risks posed by money market funds
and the need for reform, as has the Financial Stability
Oversight Council.
Two years ago, we at the SEC passed a series of measures to
increase the resiliency of money market funds by instituting
liquidity standards, reducing maturities, and improving credit
quality, all important reforms and one of the first significant
responses to the financial crisis by any Government regulator.
But while these steps have been widely hailed, I said then and
still believe that more needs to be done. That is because the
incentive to run clearly remains. And since Congress
specifically prohibited the use of the Exchange Stabilization
Fund to again guarantee money market funds, this core part of
our financial system is now operating without a net.
There are several features of money market funds that can
contribute to destabilizing runs. First, the stable $1 share
price, together with a history of sponsor support, has fostered
an expectation of safety. Based on a staff analysis since money
market funds were first introduced, fund sponsors have stepped
in with their own capital at least 300 times to absorb losses
or protect their funds from falling below $1. When a sponsor
does not or cannot support a fund, investors lose confidence
and rush to redeem.
Second, because an early redeeming shareholder can receive
their full $1, investors have an incentive to redeem at the
first sign of problems in a fund. Because large, sophisticated
institutional investors are more likely to be closely
monitoring investments and can move large sums of money very
quickly, the slower-moving retail investors and small
businesses will bear the full loss.
And, third, if too many investors redeem at the same time,
the fund can be forced to sell securities at fire sale prices,
causing the fund to break $1 and depressing the broader short-
term credit market. This spreads the contagion to other funds.
It is for these reasons that I asked the staff to explore a
number of structural reforms, including two in particular that
may be promising. The first option would require money market
funds, like all other mutual funds, to simply set their share
prices based on the market value of the fund's underlying
assets. But understanding that the dollar is important to
investors who use this product, a second option would be to
allow money market funds to maintain a stable value, as they do
today, but require the funds to maintain a capital buffer to
support the funds' stable values and to impose restrictions on
redemptions.
On many occasions, Members of this Committee have
appropriately noted the importance of capital buffers. Here, a
capital buffer would increase money market funds' ability to
suffer losses without breaking the buck and would permit, for
example, money market funds to sell some securities at a loss
to meet redemptions during a crisis. If a large credit event
occurred, the buffer could help manage the loss, and additional
redemption restrictions or fees could slow the run, possibly
supplement the capital and dramatically reduce the contagion to
other funds and the system.
These ideas and others are the subject of continuing
analysis and discussion at the Commission. Of course, if the
Commission were to propose reforms, there would be an
opportunity for public consideration and comment. That would
trigger a meaningful and informed public debate on this
critical issue for the Nation's investors, taxpayers, and the
financial system at large. It is essential that we address this
risk now rather than waiting until the middle of the next
crisis.
Thank you, and I am, of course, pleased to answer your
questions.
Chairman Johnson. Thank you, Chairman Schapiro.
We will now begin the questions. Will the clerk please put
5 minutes on the clock for each Member's questions?
Chairman Schapiro, as a result of the 2010 reforms, funds
now publish the assets they hold in their portfolios. What does
the SEC know about money market funds that they did not know
before the crisis? How has this new information informed the
SEC's views on the risk of money market funds?
Ms. Schapiro. Senator, I would say that the transparency
initiatives that the SEC undertook in this connection have been
extremely useful to us in monitoring the risks that money
market funds are taking. I will also say anecdotally that every
morning when I pick up the newspaper and read about an
earthquake in Japan or problems in European financial
institutions, the first question I ask our staff is: What is
money market fund exposure to these incidents and to these
institutions?
What the data has done is it has given us a window into
those exposures in a much more granular way, but it also helps
us understand the risks that exist within fund portfolios. We
have, in fact, hired a former money market fund portfolio
manager to help us work through this data.
I will say, we have noticed some interesting things, such
as some fund managers are taking on significantly greater risk
than others, although all their share prices are still priced
at $1. We have also learned that while most funds significantly
reduced their exposures to European banks in light of all the
problems in the eurozone, some funds did not. These funds were
actually able to capture higher yields, which is very enticing
to investors but, again, shows you that the $1 share price can
be a little bit misleading.
The risks that funds are taking are not prohibited by our
rules, but it is very important, obviously, for us to have a
good handle on what those risks are. So we look at the data
very carefully, and we worry about some of it.
Chairman Johnson. Which one or two provisions in the 2010
reforms do you believe have been most beneficial? What analysis
has the SEC conducted on the full impact and effectiveness of
the 2010 reforms? And has such analysis informed your view on
what worked well?
Ms. Schapiro. Sure. Well, of course, we have studied the
2010 reforms very carefully. I would say from my perspective,
the most valuable reforms have been the liquidity
requirements--the requirement for 10 percent daily liquidity
and 30 percent weekly liquidity, which are, in fact, exceeded
on average by funds. But those have been the most helpful in
meeting redemptions, particularly high numbers of redemptions
that we saw, for example, this past summer.
We have analyzed the 2010 reforms carefully. We believe
they have served their purpose quite well. They do not solve
for the problem we are most concerned with right now, which is
the potential for a money market fund to suffer a severe loss
as a result of a credit event and not be able to absorb that
loss, and the propensity for there to be runs on money market
funds. But that said, we think the 2010 reforms were extremely
positive, and if we put out a release recommending further
reforms, we will include in that a careful analysis of the 2010
reforms and why we believe we need to go further.
Chairman Johnson. There are pros and cons with any policy
proposal. What would be the impact of additional reforms such
as floating net asset value, capital buffer, or redemption
restriction on those who use and rely on money market funds,
including municipalities, companies, and retail investors, if
implemented? And do you agree with some who have suggested that
additional reforms may cause investors to move assets out of
the money market funds?
Ms. Schapiro. Well, Senator, that is a question that I
could answer over a very long period of time, but I think
clearly additional reforms in this area will have costs
associated with them, and we would intend in our release to
fully analyze not just operational administrative costs, which
could come from systems programming or other kinds of changes,
but also competitive issues and opportunity costs and the full
range of costs and benefits.
But I believe the costs would be far, far outweighed by the
benefits of forestalling another potentially devastating run,
as we saw in 2008 when Reserve broke the buck. We will also try
to measure the 2008 costs, but they are the costs of damaged
investor confidence. They are the costs of funds frozen in
order to liquidate and investors not having access to their
accounts during that period. They are the costs of a short-term
credit market freezing up and public companies and others not
being able to issue commercial paper or have their commercial
paper rolled over. They are the costs of small businesses and
individuals not being able to access their cash management
accounts and make payrolls or tuition payments.
The implications of another run for our economy are very
broad and very deep, and so those are costs we need to take
into account as well as the costs, of course, of any proposed
changes, whether it is floating NAV or capital.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you.
Chairman Schapiro, in your written testimony, you mention,
and I will quote you, ``runs with potential systemic impacts on
the financial system'' as a justification for additional money
market fund regulation. Has the Financial Stability Oversight
Council designated any money market funds or activities as
``systemically important''?
Ms. Schapiro. Senator, as you know, in the annual report of
the Financial Stability Oversight Council, money market funds
were discussed at length as a weakness and potential systemic
risk for the U.S. financial system. The FSOC has not designated
any institutions at this point as systemically important
financial institutions.
Senator Shelby. Yesterday the Wall Street Journal reported
that a new SEC study has found that money market mutual funds
received financial support from their sponsors more than 300
times since the 1970s, and that is about 100 more times than
previously reported. Did the Commission, Madam Chairman, review
or approve this study? And if so, could you provide a copy of
the study to this Committee? And how many times, if I could
add, have money market funds required sponsor support since the
2010 reforms? Is that too much? That is a lot.
Ms. Schapiro. It tests my ability to remember, but I hope
that you will remind me of any pieces of this that I have
forgotten.
Senator, the staff did a tabulation, essentially--not
really a study--a tabulation of occasions where sponsor support
has been given to money market funds. It does not even include
all kinds of sponsor support, so I actually believe that the
number may be conservative. But essentially it is a tabulation
of many instances where people came to us in order to get
authority to do sponsor support because what they wanted to do
was an affiliated transaction, which would be a violation of
the SEC rules.
I would be more than happy to provide the information to
the Committee. As I said, it is likely a conservative number
because those instances that came to the Commission staff's
attention because relief was sought or we were notified about
the support that was given.
I believe that Moody's reported a number somewhere in the
vicinity of 200, and I do not know exactly what data looked at
and over what period of time. I know our staff reviewed
everything back to the inception of money market funds in the
1970s.
I will say, just as an example that our staff may have had
a different baseline at Moody's, that Moody's reported that
during the financial crisis, 62 money market funds required
support from their sponsors, but they looked only at the 100
largest funds as an example. Our staff looked at everything
back to the inception of money market funds in the 1970s.
Senator Shelby. Madam Chairman, did the SEC work with the
Federal Reserve in developing the 2010 money market fund
reforms? And if so, would you explain to us the Fed's
involvement, if any?
Ms. Schapiro. Senator, I would be happy to supplement the
record with the specific but I am not sure to what extent the
staff consulted with or talked with the Federal Reserve Board
staff with respect to the 2010 reforms. They may well have. I
just do not know the extent of it.
Senator Shelby. Is the SEC currently working with the
Federal Reserve in developing further reforms?
Ms. Schapiro. Yes, our staffs have had lots of
conversations about the potential reforms.
Senator Shelby. OK. Chairman Schapiro, multiple Fed
officials have included discussions of the risks posed by money
market funds in recent speeches on shadow banking. Are money
market funds so-called shadow banks?
Ms. Schapiro. I am not a big fan of the expression ``shadow
banks.'' I would say money market funds----
Senator Shelby. How do you define it, too, right?
Ms. Schapiro. Right, exactly. I would say that money market
funds are hugely important and popular investment products in
our economy, and they are important for millions of investors,
and they have generally been well and responsibly managed. So
this is not in any way about ``shadow banks'' or negative
connotations. This is about my belief that their structure
presents systemic risk that, as Chairman of the SEC, I think it
is important we talk about and debate openly and publicly.
Senator Shelby. Should the Fed be the primary regulator of
money market funds?
Ms. Schapiro. I think the SEC is a fine regulator of money
market funds. I think they are at the end of the day--and this
is part of what is lost in this discussion--investment
products. And the SEC is truly the Federal Government's expert
on investment products.
The confusion or the complication is that their value does
not fluctuate like investment products can, should, and do
because we have the fiction of the stable net asset value.
Senator Shelby. Thank you, Mr. Chairman.
Chairman Johnson. Senator Reed.
Senator Reed. Well, thank you, Mr. Chairman. I want to
commend you and Ranking Member Shelby for holding this hearing
because, looking back over the last several years, there were
many, many issues that had potential dire consequences to the
financial system which were not examined, even though they were
small risks, it appeared, but the consequences were, as we
discovered in 2008 and 2009, extraordinary. So I think this is
a very, very important topic.
Let me follow up a question that Senator Shelby posed; that
is, the Financial Stability Oversight Council has not
designated a mutual fund as systemically important and subject
to regulation, but they can do that. Is that correct?
Ms. Schapiro. I believe that we could designate individual
funds as systemically important or the activity of maturity
transformation or credit intermediation or whatever as
systemically important activities.
Senator Reed. And that raises a possibility that if the SEC
does not promulgate a rule which would apply to all mutual
funds, then the FSOC could pick out, presumably, the largest
funds and impose restrictions or impose operating procedures on
them under their authority. Is that a fair estimate?
Ms. Schapiro. I think that is right. We are working to
refine what criteria would be used for asset managers in
designating them as systemically important. But I believe that
is right.
Senator Reed. So you could have essentially a system in
which some are regulated and some are not. I would presume
anything the SEC did under the Investment Act would apply to
every mutual fund equally.
Ms. Schapiro. It would apply to all 2a-7 money market
funds, and the risk of having some designated and some not
designated is that, of course, a run can start on a particular
fund, but the contagion spreads it very quickly across many
money market funds because, frankly, there is no incentive not
to run. If you can get your dollar out as an early redeemer,
why would you take the chance and stay in a fund and
potentially have to bear the losses?
Senator Reed. And as you point out, most of the
institutional investors have the most connectivity to the fund,
they monitor it on an individual basis, unlike retail
investors, and they typically under the present rules could
withdraw their funds at the full NAV, the dollar NAV, and then
at the end of the line, others might get less. Is that correct?
Ms. Schapiro. That is right. The tendency is for the losses
to be concentrated in the remaining or the slower-moving
shareholders, which are always retail investors and, small
businesses, not the largest institutions, that are, in fact,
monitoring their funds.
Senator Reed. One of the issues that was also raised by
Senator Shelby is that your testimony about 300 essentially
situations where the sponsor of the fund stepped in and
provided capital, which raises the issue, if that is the norm,
if they have both the intent and the capability of doing that,
then essentially the funds can police themselves. But that
raises another issue about both the capacity of these funds and
their willingness. And perhaps the notion in terms of the--is
there any consideration to--I know stress-testing of the
financial companies are popular now, but looking at the
capacity of funds to be able to support--or sponsors to be able
to support their funds as something that you would consider?
Ms. Schapiro. We do have stress-testing now as part of the
2010 reforms, but it is really stress-testing the portfolio of
the funds as opposed to testing their capacity and willingness
to step in and support a fund that is in danger of breaking the
dollar.
The real concern about that is not that it is necessarily a
bad thing to have sponsor support and prevent a fund from
breaking the dollar. It is that there will come a time when a
fund will not have, as you say, either the capacity or the
willingness to step in and support its fund, and investors
believe that there will be support because history has shown us
that in hundreds of instances funds have stepped in to do that.
And, of course, history has shown us that when things got very
bad, the Federal Government stepped in to do that. So
experience is trumping their theoretical understanding that
these are at risk.
Senator Reed. A final question. I am concerned about the
impact on municipal participants. Many municipalities, State
and local governments, use money market funds in a very
efficient way to manage their case. Are you looking seriously
at any impact that that could have on municipalities,
particularly at a time when, frankly, they are all under real
siege because of the local and national economy?
Ms. Schapiro. Absolutely. We obviously have concerns. We
have listened carefully to State and local governments and
their concerns about money market funds. It has really come
from two perspectives. One is that they use them as cash
management vehicles and they need a stable-value product to do
that, which is one reason we have an option for capital which
would allow the product to stay a stable-value product. Their
other concern is whether money market funds will continue to
exist and be able to buy municipal securities.
I would note that only about 10 percent of the total
municipal securities are held by money market funds. It is a
larger percentage for very short-term paper, but I believe
money market funds will continue to exist, and they will
continue to invest in municipal securities. But if a municipal
treasurer cannot bear the risk of loss of even a penny a share
in their cash management account, one has to wonder whether a
money market fund really is the right place for them to be in
the first instance because they do have that risk if the fund
breaks the buck.
Senator Reed. Thank you.
Thank you, Mr. Chairman.
Chairman Johnson. Senator Toomey.
Senator Toomey. Thank you, Mr. Chairman, and I, too, would
like to thank you for having this hearing, and the Ranking
Member as well. This certainly is a very, very important topic,
and I appreciate the chance to have this discussion.
Thank you, Madam Chairman, for being with us today. In a
footnote on the first page of your testimony, you acknowledge
that the views of your testimony are your views and not the
views of the Commission.
Ms. Schapiro. That is right.
Senator Toomey. Is it fair to say that the views that you
have expressed, in fact, do not represent the majority of the
Commission?
Ms. Schapiro. Senator, I guess I would not say that.
Clearly the Commission as a whole has not joined me in this
testimony. I think that some would tell you that they still
have open minds and they want to engage with the document from
the staff when it is circulated, see what the proposals are,
see what the cost/benefit and other analyses are. But you are
right that some of them have expressed their views that nothing
more needs to be done, that the 2010 reforms were sufficient.
But I am hopeful that we will have the debate that I think we
need to have.
Senator Toomey. I will go out on a limb. It seems to me
that there is a majority on the Commission that does not share
your view on this. But we will see how this develops.
I also want to make the point that the disclosure that
there were 300 instances in which there was some voluntary
support succeeded in getting some sensational stories written.
But the fact that it came without the accompanying analysis and
without the accompanying data so that people really cannot
evaluate is it pretty unfortunate because there are--I have
seen articles in which people leap to conclusions that may not
be supported by the data. And I would like to drill down a
little bit into this topic since you have raised this and seem
to be making this an important basis for suggesting that we
need some really extraordinary new regulations.
The Boston Federal Reserve Bank recently cited that there
were 47 instances of direct support between 2007 and 2010. In a
recent speech, Federal Reserve Governor Tarullo referred to
around 100 instances between 1989 and 2003. Moody's reported in
2010 that there were 181 cases between 1980 and August of 2009.
My first question is: Is everybody using the same
definition of what constitutes support?
Ms. Schapiro. They may not be, and they may not also be
looking at the entire universe of money market funds, as I said
earlier.
Senator Toomey. Right. OK. So could you tell us what is the
definition that you have used to define an instance of this
voluntary support that gets you to this count of 300?
Ms. Schapiro. Yes, I believe we have used, a pretty
conservative evaluation, looking at those instances for example
where money market funds came to the staff of the SEC and
sought authority to essentially violate the affiliated
transactions rules by making a contribution to the fund. We
have generally talked about it as buying out distressed paper,
entering into a capital support agreement, or a letter of
credit. We did not count renewals of capital support
agreements, and we did not count other types of potential
contributions.
Senator Toomey. OK. So a credit agreement is essentially a
conditional support. If that was never drawn on, does it still
count toward the 300?
Ms. Schapiro. Yes, because it still shows up as a liability
on the balance sheet.
Senator Toomey. OK, but there was no credit event that
occurred, there was no adverse outcome for the fund; it was
simply an arrangement that was made and was never used in that
case.
Another question: Do you distinguish between significant
and de minimis amounts of support?
Ms. Schapiro. No, and I do not actually think that it is
necessarily relevant to distinguish between them. If a fund is
going to break the buck, it is going to break the buck, and
capital support is there. It contributes to the understanding
of investors.
Senator Toomey. Well, I mean, if it is a de minimis
arrangement, then it is not clear that the consequence would be
breaking the buck. But let me ask another question.
In the event that a sponsor had an agreement to purchase
securities and the securities eventually paid in full, would
that still count as one of these instances?
Ms. Schapiro. Yes, it would.
Senator Toomey. OK. How about the number of instances since
the 2010--precisely how many of the 300 occurred after the new
regulations were imposed in 2010?
Ms. Schapiro. My understanding is that since 2010 there
have been three sponsor support occasions that were necessary
because of the downgrade of a foreign bank. I believe it was a
Norwegian bank.
Senator Toomey. But it is very hard for us to evaluate when
you say ``necessary'' without--I mean, we just went through a
number of examples in which support is defined in ways that
certainly would not suggest to me or I think to many people
that there was any real danger. And my concern is that this is
the impression that is being created, that these are all
instances about which we should be very concerned, when, in
fact, it sounds as though many of them are not terribly
disturbing.
Ms. Schapiro. Senator, as I said, I am more than happy to
provide the background information to you, but I think it is
also important to note that money market funds come to us and
ask us for the authority to enter into these arrangements. So
these are not generated by the SEC. These are generated----
Senator Toomey. No, I understand. They are heavily
regulated, and they are forced to come to you for permission to
do many things. But that does not mean the thing they are
forced to request permission for are necessarily disturbing or
evidence that there is a problem here.
So you will give us public release of all the data and the
analysis that accompanied it. When do you expect we would be
able to get a chance to look at that?
Ms. Schapiro. I would endeavor to get it to you as quickly
as possible, in the next couple weeks.
Senator Toomey. OK. I just would like to make the general
point and just wrap up my time. Your testimony, which I read
closely, in my view you are portraying an industry that is
extremely vulnerable, that has all these risks of runs, and I
really find that extraordinary in light of the actual history.
When you think of the way this industry has thrived for
decades, that have seen so many extraordinary events, serious
recessions, bouts of inflation, the crash of the S&L industry,
all kinds of devastating natural disasters, 9/11, all the while
prior to the financial crisis of 2008 there were thousands of
bank failures, individual years in which hundreds of banks
failed, and during all that time one money market fund broke
the buck. There was no run, there was no contagion, and
investors got 96 cents out of every dollar.
Then along comes the financial crisis. It is the worst
since the Great Depression. Investment banks go down in smoke.
Commercial banks crumble. An entire industry is wiped out. The
big wire house broker-dealers no longer exist, all either
forced to be bought or convert their charter. And while the
entire financial services sector is virtually collapsing and
seizing up, the panic that seized this whole sector did, in
fact, affect some of the money market funds somewhat; one of
them broke the buck, extraordinary measures were taken. I
understand all that.
And then you impose new regulations that you talked about:
liquidity and maturity and credit enhancement and more
transparency. And since then, we have had another round of real
stresses, you know, an ongoing terrible recession, European
credit crisis, downgrade of the U.S. Government, considerable
redemption pressure, and not a single problem in this whole
industry. No one gets in trouble. And now without having had a
chance to look at this data that you cite and citing the very
characteristics that have been in place from the very first day
of this industry, you are telling us that this is a very
vulnerable industry and there are great threats of a run and
using that to justify regulations that I think threaten the
very existence of this industry.
Chairman Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. Madam Chair,
thank you for your service. I am not sure which analysis you
are referring to that you are going to make public, because I
had a line of questions about your analysis process, and for
which reforms are you talking about?
Ms. Schapiro. Sure. I was asked by Senator Shelby and
Senator Toomey to provide the background on the 300 occasions
where there has been capital support provided to money market
funds.
Senator Menendez. OK. So my question then is: Have you at
the SEC studied the impact of the SEC's 2010 changes on money
markets?
Ms. Schapiro. Yes, we have. And in the release, if we
publish one, laying out potential further reforms, we would, of
course, lay that full analysis out. But I will tell you we
believe the 2010 reforms worked extremely well for what they
were designed to do, which is to assure that there is
sufficient liquidity in money market funds to meet heavy
redemptions. And as we saw through last summer in Europe when
there was a period of extraordinary redemptions, they performed
very well. But even during that 3-week period from June 14th
on, about $100 billion was withdrawn from money market funds.
That compares to $300 billion withdrawn from money market funds
in just a few days after Reserve broke the buck.
So I would disagree that there was no run. There was
clearly a run in 2008. The goal here is to not demonize an
industry. As I said, this is an industry that has performed
very well, has structural weakness----
Senator Menendez. I do not want to spend my time with you
answering Senator Toomey.
Ms. Schapiro. I am sorry. I apologize.
Senator Menendez. I appreciate that you want to do that,
but that is good for Presidential debates.
[Laughter.]
Senator Menendez. Let me ask you this: Are you going to
release the impact of the 2010 changes before you move on to
your next set of reforms? I mean, I think some of us would like
to know what in essence those 2010 changes did before you move
on to a next set of reforms to get a sense here of the impact?
For example, you know, how much have they reduced systemic
risk, the 2010 reforms? Have they reduced systemic risk? And if
so, by how much?
Ms. Schapiro. We could certainly do that, and as the
Chairman has said, the record will be open for a period after
the hearing. We could provide that in the form of a response on
the record.
Senator Menendez. OK.
Let me ask you this: Have you done an analysis of your
proposed reforms that are coming down the pike that you can
share with us?
Ms. Schapiro. Well, that would be in the form of a proposed
rule recommendation with lots of alternatives and options and
lots of questions. That would include a compliance cost/benefit
analysis of the proposed options, floating net asset value or
capital buffer with redemption restrictions, and also a cost/
benefit analysis compared to what the costs are of a run to our
economy, and all the alternatives, where money might flow if it
were to flow out of money market funds as a result of any
reforms.
So we have quite a detailed cost/benefit and economic
analysis in the proposing release.
Senator Menendez. In that analysis, are you going to define
the reforms both on safety and soundness but also on whether
investors will be willing to invest in these funds?
Ms. Schapiro. Yes, we would look at what the competitive
impacts might be of any reforms.
Senator Menendez. And do you believe--I have heard some
criticism that there is not a wide enough array of options
being considered.
Ms. Schapiro. Well as you might recall, the President's
Working Group in 2010 published a report that laid out more
than half a dozen options for reform, including capital and
floating NAV, but also a liquidity facility, converting money
market funds into special-purpose banks, and there were four or
five other recommendations there.
Senator Menendez. Well, I am concerned about the net asset
value of fluctuation, and that is one that I think is
problematic, and I think we have written to the Commission,
along with others, expressing that view.
How much would capital buffers cost, and how much would
they reduce systemic risk?
Ms. Schapiro. Well, it depends on obviously how you
structure a capital buffer. I think that a quite small capital
buffer coupled with limitations or fees on redemptions would
permit you to have a small buffer, and yet require redeeming
shareholders to bear the loss, some of the loss, some of the
costs of their redemptions. At the same time, the small buffer
would allow you to have fluctuations that could be absorbed on
a day-to-day basis. So we will try to cost out in our release
what the cost of capital would be.
Senator Menendez. But right now you cannot tell us how much
that would reduce systemic risk, what you are proposing?
Ms. Schapiro. Well, I think that is part of our analysis,
but I think a capital buffer would allow the money market fund
to maintain the stable value, as it does today, but support it
through the absorption of relatively small mark-to-market
losses that occur without breaking the buck.
Senator Menendez. Thank you, Mr. Chairman.
Chairman Johnson. Senator Crapo.
Senator Crapo. Thank you, Mr. Chairman. And, Chairman
Schapiro, I want to follow up a little bit on Senator
Menendez's questions about the analysis that you have made. It
is my understanding that if money market funds were forced to
float their net asset value, there is a great concern about the
fact that the flow of hundreds of billions of dollars of both
corporate and municipal financing would be severely disrupted.
Have you or your staff undertaken any studies as to how the
reforms that you have floated might affect the ability to
investors to continue to use money market funds as an effective
cash management tool?
Ms. Schapiro. Absolutely, part of our analysis is the
impact on State and municipal governments' use of money market
funds for cash management, and we understand that many of them
operate under legal requirements to utilize a stable-value
product. That is one reason we are proposing alternatives. If
you need to use a stable-value product, then there is a capital
alternative that would allow the money market fund to still
price at $1. But we will look at the cost implications for
municipalities of both the cash management aspect of money
market funds but also their capacity to buy State and local
paper.
Senator Crapo. But at this point have you reached any
conclusions as to what kind of disruption might be caused in
the economy if you--in the development of capital in this
context?
Ms. Schapiro. We have obviously had conversations with
State and local governments. We held a roundtable last year
where we had participation from State and local governments
talking about the issues and their concerns. Will they need to
have additional staff? Will they have to change their programs?
Senator Crapo. And what conclusions have you come up with
from those conversations?
Ms. Schapiro. Well, part of our release is to seek specific
economic data about what those costs would be and then be able
to compare those costs against the costs of the potential for a
run that freezes money market funds, suspends redemptions, and
gives them no access whatsoever to their cash management
vehicle.
Senator Crapo. OK. In April, a committee of the
International Organization of Securities Commissions issued a
report on the money market funds that included proposals to
float the net asset value or imposed other varieties of capital
buffers. Three of the five SEC Commissioners issued, I think, a
rare statement that said that that report does not reflect the
views and input of a majority of the Commission.
My question is: Who at the SEC did provide the input on
this report? And were the three dissenting Commissioners
consulted?
Ms. Schapiro. The staff works with IOSCO on an IOSCO
committee that was dealing with these issues. The Commissioners
did disagree with the conclusions. Those disagreements were
registered at the highest levels of IOSCO. The paper was
published prematurely, quite honestly, through a genuine
miscommunication in the process at IOSCO, before the Commission
was able to register that there was not a majority of the
Commission's support. But I should emphasize this was a
consultative staff paper seeking comment on a broad range of
potential options.
Senator Crapo. All right. Thank you.
Professor James Angel from Georgetown University makes the
point that it is extremely important to distinguish between a
destabilizing run and an orderly walk. In a run, apparently, as
he says, the funds are forced to sell assets at potentially
distressed prices, potentially destabilizing money markets. In
a walk, the funds can be used in a normal cash-flow manner from
maturing assets to meet redemptions.
Are you focusing on that kind of distinction? Do you agree
with that distinction in the first place? And do you think that
the reforms that you are talking about properly take into
account that kind of distinction?
Ms. Schapiro. I think the reforms do take into account that
kind of distinction. Our concern is the propensity to run. Our
concern is not to keep money market funds in business or to
limit people's ability to withdraw and move their money from
fund to fund, but our concern is the destabilizing run such as
we saw in 2008. And we are very focused on that. We have had a
number of our staff look at Professor Angel's report. I think
it contains assertions and conjectures and, frankly,
qualitative statements, but not the kind of quantitative data
and analysis that we would expect to include along with our
reform proposals.
Senator Crapo. So although you may disagree with his
analysis, you do agree with the distinction that there is a
difference between a run and an orderly walk, as the term has
been used?
Ms. Schapiro. I think when a fund breaks the buck, it is
very hard to have an orderly walk because a fund is likely to
suspend redemptions, which freezes everybody in place,
including people who need access to their funds for cash
management purposes--payrolls, tuitions, mortgage payments. And
so my concern is about the potential to break the buck because
of the brittleness of the $1 value and that leading to a run.
Senator Crapo. Thank you.
Chairman Johnson. Senator Warner.
Senator Warner. Thank you, Mr. Chairman. Let me also thank
you and the Ranking Member for holding this hearing.
I want to go back to some of the comments that Senator Reed
and Senator Toomey made. You know, I share, Chairman Schapiro,
your concern that if you have got to have an intervention and
whether that intervention is de minimis or larger, if it is
breaking the buck, it has the potential of starting and
unraveling.
The interesting thing, though, is that when we look at the
FSOC, normally we go after the largest systemic important
institutions. My sense is--and I am anxious to see the data as
well--that the largest money market funds are probably the
safest in terms of shoring up if they get into this gray area,
and it really is the smaller ones, the ones on the fringe that
may be providing the most threat to the system. And I guess
this again goes back to--I want to comment a little bit more
about Senator Reed's questions about--and I know there is not
an equivalency of some type of stress test or analysis. Could
you speak to that a little bit more?
Ms. Schapiro. Sure. I think the stress test is an
interesting idea, the stress test with respect to the capacity
to provide capital. I think the problem is if there is going to
be capital support, it ought to be explicit capital support.
Investors ought to be able to know that it will be there when
it is needed, not be left to wonder whether the sponsor is
still capable of providing that support, or still willing to
provide that support. And I think that is why my view is that
we need to move forward with a rule that would require either a
floating net asset value or a capital buffer coupled with some
kind of redemption fee or limitation in order to ensure that
those who redeem early are bearing some of the costs----
Senator Warner. So in a sense no differentiation between
those money market funds who have had long, stable relations,
everybody would be in the same pot, right?
Ms. Schapiro. Well, I think----
Senator Warner. And with the capital buffer, if we are
going to go on the capital buffer, would the capital buffer be
for, you know, a Lehman-style collapse? Or would the capital
buffer be just kind of in the normal course to have a small
reserve here so that if there was something that kind of got
you near that de minimis cushion?
Ms. Schapiro. I think one of the----
Senator Warner. Or would that be part of the review and
analysis you are trying----
Ms. Schapiro. Well, that is certainly part of the analysis,
the Reserve Fund was about a $62 billion fund, but I do not
believe a household name. They held only about 1.2 percent of
their assets in Lehman paper, a $785 million investment. When
they broke the buck, yes, admittedly it was at a time of
general crisis in the economy, but it spread rapidly to many,
many other money market funds. And if you read former Secretary
Paulson's book, he talks about really standing on the edge of
the cliff, hearing from money market fund managers who just did
not know what was going to happen to them because redemptions
were going through the roof. And if they were going to have to
sell securities into this very depressed market in order to
meet redemptions, they were going to create this spiraling down
that would be very, very difficult to stop, which is why
Treasury did step in and, to the tune of more than $3 trillion,
guarantee all money market funds.
Senator Warner. But if you had to put a capital buffer to
be in place for that level of potential contagion, wouldn't you
potentially really disrupt this whole----
Ms. Schapiro. I think a capital buffer to contain that
level would be prohibitively expensive and probably does not
make sense, which is why you could have a much smaller capital
buffer if it is coupled with some kinds of limitations on
redemptions so that at least the losses are borne by all
redeemers, not just those who are left at the end of the day.
Senator Warner. But, again, your notion here on these
reforms would be systemwide, not with some analysis of those
funds that are graded stronger versus those that are more on
the periphery?
Ms. Schapiro. I think it needs to be explicit. I think
investors need to understand will the capital be there or will
it not be there, and a uniform capital requirement or capital
buffer or NAV buffer has that benefit to it. Just to assume
that because a sponsor never had to support its money market
fund in the past means it never will in the future would be
very concerning to me because, in fact, that is what----
Senator Warner. Let me just ask one last question. Is there
any sense of--since you have seen improvements since the 2010
reforms, have you looked at other things in terms of additional
liquidity requirements as opposed to some of the reforms you
are looking at? Are there other ways to get at this protection
without looking at the two options you have looked at so far?
Ms. Schapiro. We have. As I said, the President's Working
Group published a paper that laid out lots of different
options: a liquidity facility, converting these to bank
products, special-purpose banks, a two-tiered money market fund
structure where you would have tighter restrictions on a stable
value fund and less tight on a floating rate fund. There were
several other alternatives. We took comment on those. We also
held a roundtable on those. And we are open--and I should say
this adamantly--we are open to continuing to discuss options.
We have had lots of very constructive conversations with
industry, but I think we have to get at the structural
weakness, and I am not sure just enhanced liquidity
requirements going to 50 percent weekly liquidity, for example,
rather than 30 percent would get us there.
But, again, if we can put a release out, we can have this
discussion in far more concrete and specific terms with some
economic analysis to accompany it.
Senator Warner. Thank you, Mr. Chairman.
Chairman Johnson. Senator Bennet.
Senator Bennet. Thank you, Mr. Chairman, and I thank you
and the Ranking Member for having the hearing. And, Madam
Chairman, it is nice to see you again. Thank you for your
service.
I have actually lived this as a former school
superintendent. I have seen the huge importance of money market
funds to school districts and to municipalities, both for cash
management but also for financing. And I also saw the
challenges that arise when there is a run, and it is hair
raising.
But I think we need to be really cautious about this
because I think the costs are potentially very real and very
large for municipalities, for school districts, for local
government, and there has been a lot of general talk about that
today. I wonder, have you done specific analysis yet on the
potential costs to these local governments?
Ms. Schapiro. Yes, our release will talk about, to the
extent we have data on the potential costs to municipalities
and State issuers, as well as on them and their capacity using
these vehicles for cash management. But we will also seek
additional data and input on those very issues. We recognize
this is not a costless proposition by any means. I spent time
with a number of members, from Colorado in particular, but
other States as well, after Reserve broke the buck and I was
brand-new at the SEC, and those members were frantic because
their local governments could not access their accounts at
Reserve.
Senator Bennet. I was there and I know it, and so having
lived it, I have seen it, and still I am deeply worried about
the unintended consequences that might arise here, because what
I know in our case is that the financing we were able to do
dramatically improved the conditions for kids in the Denver
public schools who for the first time actually in our history
are seeing resources added back to their classrooms, while
districts around us are having to cut back. And had the
transaction not been one that we could have done, that would
not be the case today.
So I guess my plea as you go forward is one for precision
and for paying very close attention to what effect this might
have on liquidity at the local level, not for the
municipalities themselves, not for the school districts
themselves, but for the people that we serve in those places.
Ms. Schapiro. Absolutely. We recognize that these are
incredibly valuable tools, and our goal is to make them
stronger and better able to withstand----
Senator Bennet. I wanted to ask a question that I heard a
little earlier, maybe in a different way, and it is a hard one,
sort of, because it asks you to look back. But if you look back
to--you know, had the Dodd-Frank Act law been in place and had
the 2010 reforms been in effect 4 years ago, what do you think
the likelihood is that the Reserve Fund would have broken the
buck? Is it possible that requirements under Dodd-Frank would
have reduced the likelihood that Lehman Brothers, in which the
Reserve Fund was heavily invested, would have been in such
terrible shape? Would the liquidity requirements and improved
credit standards in the 2010 reforms have affected the
wherewithal of the Reserve Fund under such circumstances?
Ms. Schapiro. I do not know that the 2010 amendments would
have been enough. I think they have been very valuable. I think
they have contributed to the resiliency of money market funds.
But they do not address a sudden credit event that causes a
loss, which is what we had in Reserve when Lehman declared
bankruptcy and the paper was valued at zero. Those reforms,
while they require more liquidity, they require shorter
maturities, they require higher quality, they do not address a
sudden credit event. They really do not address or alter the
incentive a shareholder has to run if they even fear losses
because there is no penalty to getting out quick. There is a
real penalty to hanging around, potentially.
I do not think they address the unfair results that can
occur when a sophisticated institutional investor gets out
quickly and losses are concentrated with retail investors or
retail investors are left in a frozen fund and cannot access
their liquidity.
So I do not think they would have been enough, and that is
really why we are here today.
Senator Bennet. Thank you, Mr. Chairman.
Chairman Johnson. Any additional questions for Chairman
Schapiro can be submitted for the record. You may be excused.
I will now ask the witnesses of the second panel to quickly
take their seats. We welcome you and thank you for your
willingness to testify before this Committee.
The Honorable Nancy Kopp is the treasurer of the State of
Maryland.
Mr. Paul Schott Stevens is the president of Investment
Company Institute, the national association for investment
companies.
Mr. Christopher Donahue is the president, CEO, and director
of Federated Investors.
Mr. Bradley Fox is vice president and treasurer of Safeway.
And, finally, we have with us Professor David Scharfstein,
the Edmund Cogswell Converse Professor of Finance and Banking
at Harvard Business School.
Because we are running short on time, we are going to move
right to questions of our second panel. Each of our witnesses
statements will be submitted for the record.
I will ask the clerk to put 5 minutes on the clock for each
Member's questions.
Professor Scharfstein, please describe the causes of the
run on money fund in September 2008 and the reasons why after
the 2010 reforms you recommend further reforms to preserve
financial stability?
Mr. Scharfstein. Thank you, Senator. The run on the money
funds in September of 2008 was triggered by the failure of
Lehman Brothers. Actually, in the months--in the year,
actually, leading up to the failure of Lehman Brothers, recent
research shows that not just their Reserve Primary Fund but a
whole host of other funds took the opportunity to increase risk
in their portfolios. There were stresses in those markets at
the time, increased yields on various forms of paper that was
issued by financial institutions, and those funds increased--
not all but quite a few--the risk of their portfolios.
And so there was a lot of exposure to risky paper in those
funds, and so when Lehman failed, there was a run on the
Reserve Primary Fund. Institutional investors--the run
basically occurred by institutional investors, not retail
investors--pulled their funds out.
The 2010 reforms are desirable. They go some of the way.
But I would say that they are not enough, and I think if you
look at the recent experience with the European sovereign debt
crisis, what we saw was a similar event that happened--not as
extreme. The run was not as quick. It was more a trot. What we
saw, though, was, again, funds increasing their risk and their
exposure to euro zone banks, and when the crisis escalated last
summer, what we saw was large withdrawals from those funds.
Those had implications for foreign banks, which are the main
users of the money funds. They are the main issuers into the
money funds as the foreign banks. And that created a dollar
funding problem for them, which spilled over and I think has
affected the ability of those banks to make loans to U.S. firms
and other companies that need dollar funding.
I would also say that the liquidity requirements as part of
that fund also kind of get in--are at cross-purposes with other
efforts that are in place to try to get U.S. banks to fund
themselves in a more long-term basis. If you require money
funds to hold short-term paper, that means that banks are going
to be issuing more short-term paper, and part of what we are
trying to do is get banks to fund themselves in a more stable
way as well.
Chairman Johnson. Ms. Kopp and Mr. Fox, what impacts have
the 2010 SEC reforms had on users of money market funds such as
State Governments and companies? Ms. Kopp, please begin.
Ms. Kopp. Thank you, Senator. As you know, the States and
local governments--and I am here representing 13 organizations
of State, local, and municipal governments--use money market
funds for liquidity, for money management, as well as for
financing. And the fact is that the increased tightening of the
credit standards, the shortening of the duration, the enhanced
disclosure of having on the Web site the total portfolio has
made it more possible for us to compare the sites, to compare
the funds, and to go where we have to go. But as you know, we
use these funds for daily liquidity, for managing our money,
and that is our main concern.
It has made it simpler. We think they have been very
important. We think there has not been a lot of time since 2010
to measure all of the impact. But what the professor called a
trot and the Senator called a walk, both I think are testament
to the fact that we have not had runs.
Chairman Johnson. Mr. Fox, what are your views?
Mr. Fox. I would agree as well. I think the money market
funds have been extremely efficient allocators of capital from
investors to borrowers. In the corporate marketplace, some 40
percent of all corporate commercial paper is purchased by 2a-7
money market funds. The improvements and the reforms from 2010
in liquidity, safety, and transparency have only enhanced the
role that they play in the marketplace, and, you know, I think
that is shown with the fact that there are $900 billion
invested currently in prime money market funds, 2a-7 prime
money market funds from institutional investors. So they have
proven very resilient in the face of very serious global market
turmoil from the European debt crisis.
Chairman Johnson. Senator Shelby.
Senator Shelby. Thank you, Mr. Chairman.
I will direct this question to Mr. Stevens and Mr. Donahue.
Some have argued that a product that seeks to maintain a stable
net asset value while investing in instruments that can decline
in value is essentially maintaining a fiction. Is the stable
net asset value money market fund a fiction? Mr. Stevens. And
if it is not, why not?
Mr. Stevens. It is clearly not, Senator.
Senator Shelby. OK.
Mr. Stevens. We have actually done a considerable amount of
empirical analysis of the variability of funds' net asset
values per share over extended periods of time. The degree to
which they fluctuate is really quite marginal. You can look at
it in periods of stress. You can look at it over long periods
of time.
Senator Shelby. Does it depend on what you are investing
in?
Mr. Stevens. Well, we invest--you are absolutely right. We
invest only in the shortest, highest-quality paper that is
available.
Senator Shelby. And that is the protection, is it?
Mr. Stevens. That is what under the structure of Rule 2a-7
permits funds to keep their net asset value per share with a
great deal of precision around $1.
Senator Shelby. Mr. Donahue, do you have any comment?
Mr. Donahue. We had a hearing back with the SEC, an
administrative law hearing, in the late 1970s on this exact
subject, and it was the same issues and the same question. The
SEC is in effect looking for a redo here. But the reason that
the NAV is solid at a dollar and not a gimmick or whatever is
precisely because of the portfolios and the credit work to hold
the maturity and all of the enhancements that were added in
2010, like Know Your Customer. So it is a solid thing that has
gone a great thing for the American public.
Senator Shelby. Ms. Kopp and Mr. Fox, have the disclosure
requirements improved your ability to manage cash? And would
your ability to manage cash, which is very important, be
further improved if the information was provided in real time
or near real time?
Ms. Kopp. Well, if you are talking, Senator, of going to a
floating rate NAV----
Senator Shelby. Right.
Ms. Kopp. ----when you are talking about real time, let me
just make it clear that, first of all, throughout the country
there are laws and ordinances, particularly with local
government, that require a stable-value vehicle. So they would
have to change all of those laws to pull out--or pull out their
money.
Last week, the GFOA, which met--the local finance people
met in Chicago, and there was a clear consensus, almost
unanimous, that they would simply be forced to move out, A,
because of the law; and, B, because their accounting systems
simply do not allow them to go to that system. So they would
have to go to banks, presumably, which are less transparent and
not safe.
Senator Shelby. Do you agree with that, Mr. Fox?
Mr. Fox. I think from a systems standpoint, it would be
very difficult to monitor a floating net asset value from money
market funds, and corporations would simply not use them as
investment vehicles. The transparency from the 2010 reforms has
been very helpful. We look at these portfolios. We understand
where they are invested, and we are comfortable with the stable
$1 net asset value.
Senator Shelby. I will direct this first to Professor
Scharfstein. What should be done to decrease the expectation of
another taxpayer-funded bailout of the money market fund
industry? Is it more capital? And how much capital?
Mr. Scharfstein. I would say it is more capital, and I
think that is the proper lens--I think it should be more
capital. I think that is the proper lens to look at this
through. You know, there was extraordinary support for these
funds during the crisis and the Treasury guarantee. You know,
calibrating the exact amount of capital is difficult. I do not
think it is going to be nearly as costly as people say. In
fact, if the industry is correct and there is not that much
risk in the funds, then having a subordinated share class, as
has been proposed, should really not be very costly at all.
Senator Shelby. Is the bigger the fund, the larger the
fund, the less likelihood of visiting the taxpayers? In other
words, you have got a lot of small money market funds that
operate everywhere, and some of them operate very well. But in
a time of crisis, do the big ones as a result have more
potential to save themselves than others?
Mr. Scharfstein. Well, certainly sponsors' support, you
know, is important, and that can be helpful. But I think clear
capital that is set aside in advance would be better.
Senator Shelby. What would you suggest about capital? Have
you got a figure in mind? We are talking about a lot of money
out there.
Mr. Scharfstein. That is right. I think if you had a
subordinated share class, you know, on the order of 3 percent,
I do not see that as being particularly difficult to do or
particularly costly.
Senator Shelby. Mr. Donahue?
Mr. Donahue. That just will not work. The math does not
work. The reason you do not hear proposals----
Senator Shelby. Tell us why it will not work.
Mr. Donahue. I will tell you. We have a $2.5 trillion
industry, and so if you say 3 percent of capital, that is $75
billion of capital. I do not know where you are going to get
$75 billion of capital. But assuming you can, that demands a
return on capital. Our cost of capital is like 11 percent. Let
us use 10 percent. It is easier numbers. That means you have
got to earn $7.5 billion to pay for the $75 billion. Where are
you going to earn that? From the $2.5 trillion in the industry.
That is 30 basis points. In today's way, it does not work.
We as an adviser in good times have revenues of 15 basis
points, so the numbers just do not work.
Senator Shelby. I understand to some extent the interest of
people and the use of money market funds. You know, it works
well. But I also sitting up here as a Senator want to make sure
that the taxpayers do not have to bail out anybody. We have
done that. We have been down that road. That is a bad road to
go down, as you well know.
Mr. Donahue. Senator the best part of Dodd-Frank is that
part that says you are not allowed to redo the insurance thing
for money funds, which we did not ask for and did not want.
Senator Shelby. Thank you.
Chairman Johnson. Senator Reed.
Senator Reed. Thank you.
Mr. Donahue, implicit in a lot of the questions and in the
operation of the funds is that the funds are prepared and have
the capacity to, at least on a temporary basis, go up and
maintain the dollar NAV. Is that a fair assumption?
Mr. Donahue. The way I would put it is because of the
construct of their portfolio, they are able to maintain a $1
NAV. But if they blow a credit and it is a franchise issue,
then it is not going to be a $1 NAV. Then you are going to have
the suspension of redemption and the orderly liquidation of the
fund. But notice you do not have a run because you suspend the
redemptions, the people do not run, and you have an orderly
liquidation, which is not what happened in the Reserve case and
which was improved in the 2010 amendments.
Senator Reed. But here is the situation. You have a
prominent fund that miscalculated, in the case of the
experience in 2008 where it held assets, Reserve had assets in
Lehman which were rated, I think, AAA 24 hours before they went
bankrupt. So, you know, they looked pretty good. And because of
the notoriety and also, I think, because of the assumption that
people have that a lot of mutual funds are basically sort of--
you know, their portfolios are fairly similar, that there was
this run.
So, I mean, your presumption would be that in a situation,
which might happen, that one fund could, in fact, break the
buck, stop redemptions, and that would have no spillover effect
on the funds. Is that the presumption? I just want to
understand.
Mr. Donahue. No. What I am saying is that because of the
2010 amendments, you will not have a run in the fund that
breaks the buck because you have got this other----
Senator Reed. Right.
Mr. Donahue. Now, what has happened in the 2010 amendments
is that you have more cash in the system. We are required to
maintain 30 percent weekly cash when 15 percent went out and
everybody is maintaining about 40. You have transparency, which
is the questions you have been asking already. People know what
is in the portfolio. They know whether you have this stuff. And
we have a Know Your Customer requirement, which means you have
got to know who is coming in and who is going out.
But more important than that, the key is do you have
liquidity in the system. The problem in 2008 was there was no
liquidity in the system. And when there was a deviation of net
asset value in 1994, it was no harm, no foul. Why? Because
there was liquidity in the system and things could work out.
But when the marketplace was shut down, you had a problem.
Senator Reed. But here, again, I think Senator Shelby's
comments go right to the heart of what our job is. We have to
contemplate, particularly after 2008, things that seem so far
removed from the day-to-day practice. There is a possibility,
given all these rules, that there could be a liquidity problem
in the overall system, not emanating from what you are doing,
but, you know, take a case where a European banking system,
where political and economic problems collide, and liquidity
starts freezing up, then it is not the question of how much
liquidity you are holding. You just cannot get access to a
sufficient liquidity to redeem, not in one fund or any fund.
Is that a possibility?
Mr. Donahue. That is a possibility, and specifically it is
addressed by Congress in Dodd-Frank, which directs the Fed, as
soon as practicable--I do not think it has been practicable
yet. They are supposed to come up with rules and regulations to
govern emergency lending that is supposed to ``add money and
liquidity to the financial system,'' not allowed to aid an
individual company or failing financial company, and it has to
be done in a way where they do not lose money, and it has to be
exited quickly. P.S., that is exactly what they did with the
AMLF which money funds back at that time.
Senator Reed. But that essentially--I mean, we are getting
to sort of what this all might ultimately rest upon--is the
Federal Reserve stepping in and declaring that this is not--we
know you cannot do it for an individual company, but that the
potential impacts of a failing fund could trigger failures in
other well-run funds; therefore, we are stepping in and using
Federal resources to support. Is that, Mr. Stevens--I am just
trying to figure out, you know, what is the assumption
underlying----
Mr. Stevens. Senator, if I might, what Chairman Schapiro's
testimony invites is to look at all 300 of those events through
the lens of what happened in September 2008. It is true Reserve
had a contagion effect on other money market funds, but it had
that effect in the context of a raging epidemic in the banking
system. And looking at it from the point of view of 2008, you
can also look at it from the point of view of 1994. That is the
only other time a fund broke a dollar. Actually, money fund
assets grew that month, and the world yawned. It did not have a
knock-on effect.
So I would invite you to scrutinize whether it is likely,
particularly with the enormous natural liquidity in these funds
today--prime money funds have today $600 billion in assets that
they can liquidate within a week to meet redemptions. Whether
we have done what the industry thinks we have to address in any
reasonable term the kind of crisis that we might meet without--
and, Senator Shelby, I agree with you--without any prospect of
our going to the taxpayer again, although taxpayers paid
nothing on that guarantee program, and they made a billion and
a quarter.
Senator Reed. But, again, I think your point is extremely
well taken. You know, we cannot ignore 1994, but we cannot
ignore 2008. We have to look at both.
Mr. Stevens. Agreed.
Senator Reed. We have to assess a probability. And then we
also have to, I think, probe, as I have tried to do--and thank
you, Mr. Donahue; you have been extremely helpful--what are the
underlying assumptions if we get into a 2008. Because in the
1994 situation, the markets sort of moved forward on their own,
and we just looked and nodded approvingly. But in the 2008
situation, I think we have to be very careful of probing what
are the assumptions, and getting back to Senator Shelby's
point, if there is one assumption that is worst, worst, worst,
worst, worst, worst case, 0.000001 probability, the Fed has
this general authority to come in now and move resources, at
least we have to have that on the table. I think that has to be
acknowledged.
Mr. Stevens. The Fed has on numerous occasions taken steps
to make sure the commercial paper markets in the United States
are functioning effectively. That is its job for the future as
well.
Senator Reed. I just want to make sure that we all
understand that it is explicit, it is not implicit, because
down the road, you know, if the Fed does take a move like this,
you know, I do not--I think we all want to have said, well, we
knew we had that authority and this is not one of these
unauthorized bailouts, et cetera. But thank you. Your testimony
has been extremely helpful.
Chairman Johnson. Senator Toomey.
Senator Toomey. Thank you very much, Mr. Chairman.
I would like to direct several questions to Mr. Donahue.
Thanks to all of you for being here today. But the first
question would be in response to Chairman Schapiro's points.
You know, one of the central arguments that she seems to be
making is that the past instances in which sponsors provided
some degree of voluntary support to their money funds means
that these funds are not as safe as they appear. I think that
is one of her central arguments. Could you respond to that
premise?
Mr. Donahue. Yes, Senator. We create a lot of funds. I am
one of 13 kids. I have eight of my own. And we create a lot of
children, too, and you are forever supporting them. And so the
idea that you support funds--and you look at any other kind of
products. People are supporting their products. What are they
trying to do? They are making independent, voluntary,
marketplace analysis and judgments about what to do with the
product.
So, you know, I do not know anything about the 300 or the
200. None of that really matters. What matters is that you have
good, solid people deciding whether or not and what to do to
help shareholders. And I think that what the support shows is
the inherent resiliency of the funds. When you have $2.6
trillion in these funds with no interest and lots of regulatory
abuse, that is really an accomplishment. And it is because the
people want the cash management system.
And if you talk about support in terms of what was done
that the Chairman was talking about, how about the support that
every single one is doing 100 percent on waiving investment
advisory fees in order to keep the funds going during these
low-interest times?
So I look at support as something that is not unlike having
a family. You birthed the fund. Well, what are you going to do
about keeping it going?
Now, we also merge funds out of existence. We buy other
funds and put them out of existence. But, overall, we are
trying to enhance the relationship with the clients, some of
whom are at this table, in the way they deal in the
marketplace.
Senator Toomey. So would it be fair to say that in many
instances, these--many of the instances that she is citing are
really manifestations of the strength of an industry rather
than weakness?
Mr. Donahue. They are manifestations of the strength and
they are manifestations of the judgment people make about why
to do something. For example, there may be a reputational
issue. The customers may be somewhat uncomfortable with a name,
even though it is going to pay off on time and in full. There
may be questions that you want to improve things. So there
could be a lot of reasons. You may have individual customers
that you are trying to deal with. And so there are a lot of
reasons other than you had to buy the Lehman paper out for
doing that. And there are different elements to it. But I think
it shows a strong dynamism in the industry to be able to see
the variety of moves that people have made to support these
strong products.
Senator Toomey. The same question I have also for Mr.
Donahue is that some have suggested that having a fixed net
asset value is somehow unfair to investors because investors do
not really understand and they think that this is really akin
to a bank deposit and a guaranteed thing. That strikes me as a
rather surprising argument, but it appears frequently. I think
a variation on that is in Chairman Schapiro's testimony. What
is your reaction to that?
Mr. Donahue. We have 5,000 institutional clients and
millions of individual investors behind that. Most of our
institutional investors deal with us in one account. I assure
you they understand what a money market fund is. And if there
was any good thing to come out of Reserve Fund, which there
really was not, the one good thing is they realized that the
investors bore the loss and there was no bailout of a money
fund.
So people understand it. Fidelity has run a good survey of
their retail base and said they understand what the lay of the
land is. And I think one of the things about all this
regulatory noise on money funds has done is re-emphasize what
we put on the front page of every prospectus and every annual
report, that these things are not guaranteed, they are not
backed by the FDIC, and you may lose money.
Senator Toomey. Thanks very much. Mr. Chairman, I would
just like to ask unanimous consent to submit for the record a
statement from the Financial Services Institute.
Chairman Johnson. Without objection.
Senator Toomey. Thank you very much.
Ms. Kopp. Mr. Chairman, could I just add on behalf of many
of the investors--we do represent millions--we do read the
prospectus, and we know it is an investment. It is not a
savings account. And the reforms of 2010 and the experience of
2008 I think has brought that home very clearly. So I think
treating us sort of like children is really not appropriate.
Chairman Johnson. Senator Menendez.
Senator Menendez. Thank you, Mr. Chairman. I want to be
succinct. I would have so many questions for all of you, but
the vote is going to expire that is presently going on. So let
me concentrate on two, Mr. Donahue, that you raise in your
testimony which caught my attention as I was reading it. And I
am going to give you the headings, and I would like you to give
me the why you make that proposition.
On page 11 [Page 116 below], you say, ``Reforms currently
under consideration are fundamentally at odds with the nature
of money market funds and the needs of their shareholders.''
Why?
Chairman Johnson. Excuse me. My staff is informing me that
we are all needed on the floor for the first vote. Because of
this, I will remind my colleagues if they have more questions
for our witnesses, they can submit them for the record.
I apologize to panel two that we were unable to finish. I
want to thank our witnesses for their thoughtful testimony
today and their cooperation in answering the written questions
that my colleagues will be sending them.
This hearing is adjourned.
[Whereupon, at 11:26 a.m., the hearing was adjourned.]
[Prepared statements and additional material supplied for
the record follow:]
PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON
Today, we are here to review the current state of regulations
responsible for providing stability to the money market mutual funds
and protecting investors. More than 50 million municipalities,
companies, retail investors, and others use money market mutual funds.
There are $2.6 trillion invested in these funds, which are often viewed
as convenient, efficient, and predictable for cash management,
investment, and other purposes. With Americans so heavily invested in
these funds this Committee has a responsibility to conduct oversight to
see to it that the Securities and Exchange Commission is doing its part
and has the resources and authority necessary to effectively regulate
this critically important financial market.
Market uncertainty during the financial crisis in 2008 destabilized
the money market mutual fund industry, prompting the Treasury
Department to temporarily guarantee funds' holdings. That 1-year
guarantee prevented a potential systemic run on the money market mutual
fund industry.
In response, the SEC adopted significant new rules in 2010 designed
to increase the funds' resilience to economic shocks and to reduce the
risks of runs. The key reforms required funds to shorten maturities of
portfolio holdings, increase cash holdings, improve credit quality, and
report their portfolio holdings on a monthly basis.
The adoption of these rules has no doubt improved investor
protection, but questions still remain about what risk the funds
present to investors and the American economy, and whether more action
needs to be taken to address that risk.
Some regulators and economists have raised concerns that money
market funds pose significant risks to financial stability, and have
argued for further structural changes in addition to the 2010 reforms.
They have proposed floating the net asset value, requiring a capital
buffer and imposing redemption restrictions.
At the same time, some funds and users, including municipalities,
corporations and retail investors, have urged caution, arguing that
further reforms should wait until the impact of the 2010 reforms can be
more fully studied. They have raised concerns that new regulatory
changes might increase risks or disrupt or damage their operations.
Recognizing the diversity of views on this topic, today's hearing
is an opportunity to examine the SEC's current regulation of the funds,
including the impact of the 2010 reforms, and to better understand
whether additional regulations are needed.
Our witnesses today represent many interested parties and a broad
range of perspectives, including the industry's regulator, the industry
itself, users of the industry's products, and an academic expert.
I hope to hear from our witnesses about the health and stability of
money market funds today, the impact of the 2010 reforms, the potential
positive and negative consequences of the additional proposed reforms,
and how funds have performed during recent severe economic events such
as the European debt crisis.
I look forward to hearing their testimony and recommendations as we
continue our rigorous oversight of the financial markets.
______
PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY
Thank you, Mr. Chairman.
Today the Committee will hear a range of perspectives on money
market fund reform.
Since their introduction 40 years ago, money market funds have been
an important source of short-term financing for businesses, banks, and
State and local governments.
Money market funds have offered investors a low-cost means to
invest in money market instruments and provided them with an efficient
cash management vehicle.
But, unlike other mutual funds, money market funds are permitted by
the SEC to maintain a stable net asset value (NAV).
The stable NAV feature of money market funds offers investors the
convenience and simplicity of buying and selling shares at a constant
one-dollar per share.
However, because the market value of the instruments held by the
funds can decline, the stable NAV gives the impression that money
market funds are without risk and guaranteed to never ``break the
buck.''
Indeed, investment management firms have intervened several times
with capital contributions and other forms of support to prevent their
money market funds from breaking the buck.
According to the SEC, U.S. money market funds received financial
support from their sponsors hundreds of times before the financial
crisis. During the crisis, firms provided financial support dozens of
times.
One notable exception is the Reserve Primary Fund, which broke the
buck in September 2008 because of its exposure to Lehman Brothers.
Shortly thereafter, the Treasury Department and the Federal
Reserve, concerned about runs on money market funds, put the U.S.
taxpayer in the position of guaranteeing that no other money market
fund in the country would break the buck.
The Treasury Department instituted a temporary guarantee program
and the Federal Reserve opened emergency lending facilities to help
money market funds meet their redemption requests.
These actions have increased the expectation that the Federal
Government will support the money market industry again with taxpayer
dollars in times of crisis.
In 2010, the SEC adopted several rules to reduce the risk of runs
on money market funds.
The rules imposed minimum liquidity requirements, higher credit
quality limits, and shorter maturity limits. The SEC also imposed new
stress test requirements and disclosure requirements to improve the
transparency of fund portfolio holdings.
By all accounts, money market funds, thus far, have been able to
withstand the ongoing European crisis without any risk of runs.
For this reason, some say that the SEC's 2010 money market reforms
are sufficient.
I look forward to hearing from the two industry witnesses and the
two treasurers representing users of money market funds on why they
believe that additional reforms are not warranted.
Others, including Chairman Schapiro, say that the SEC's 2010 money
market reforms have not gone far enough.
I would like Chairman Schapiro to tell us what analysis the SEC has
done to conclude that additional reforms are necessary, and how the SEC
determined that the three proposals currently under consideration--a
floating NAV, redemption restrictions, and a capital buffer--are the
right solutions for the problems they are intended to solve.
I also look forward to hearing from Professor Scharfstein regarding
his academic group's capital buffer proposal.
The loudest voices advocating additional money market fund reforms,
however, have come from inside the Federal Reserve.
Fed Chairman Bernanke, Fed Governor Tarullo, and multiple regional
Fed Presidents have given speeches in which they raise the issue of so-
called ``structural vulnerabilities'' to highlight the need for
additional reform.
Further, according to the minutes of the Financial Stability
Oversight Council (FSOC) meeting held last February, Fed staff
participated with SEC staff in a discussion of money market funds.
Unfortunately, the Fed is not represented in today's important
hearing and they should be.
Perhaps, Mr. Chairman, we can leave the record open and give the
Fed an opportunity to submit testimony for the record. I would be very
interested in learning what analysis it has done to conclude that
additional money market reforms are necessary.
Thank you, Mr. Chairman.
______
PREPARED STATEMENT OF MARY L. SCHAPIRO
Chairman, Securities and Exchange Commission
June 21, 2012
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee: Thank you for the opportunity to testify about the
Securities and Exchange Commission's regulation of money market funds.
\1\ The risks posed by money market funds to the financial system are
part of the important unfinished business from the financial crisis of
2008. One of the seminal events of that crisis occurred in September,
after Lehman Brothers filed for bankruptcy and the Reserve Primary Fund
``broke the buck,'' triggering a run on money market funds and freezing
the short-term credit markets. Although the Commission took steps in
2010 to make money market funds more resilient, they still remain
susceptible today to investor runs with potential systemic impacts on
the financial system, as occurred during the financial crisis just 4
years ago. Unless money market fund regulation is reformed, taxpayers
and markets will continue to be at risk that a money market fund can
``break the buck'' and transform a moderate financial shock into a
destabilizing run. In such a scenario, policy makers would again be
left with two unacceptable choices: a bailout or a crisis.
---------------------------------------------------------------------------
\1\ The views expressed in this testimony are those of the
Chairman of the Securities and Exchange Commission and do not
necessarily represent the views of the full Commission.
---------------------------------------------------------------------------
My testimony today will discuss the history of money market funds,
the remaining systemic risk they pose to the financial system even
after the 2010 reforms, and the need for further reforms to protect
investors, taxpayers and the broader financial system.
Background
Money market funds are important and popular investment products
for millions of investors. They facilitate efficient cash management
for both retail and institutional investors, who use them for
everything from making mortgage payments and paying college tuition
bills to the short-term investment of cash received through business
operations until needed to fund payrolls or pay tax withholding. Money
market funds bring together investors seeking low-risk, highly liquid
investments and borrowers seeking short-term funding. With nearly $2.5
trillion in assets under management, money market funds are important
and, in some cases, substantial providers of credit to businesses,
financial institutions, and some municipalities who use this financing
for working capital needs and to otherwise fund their day-to-day
businesses activities.
Money market funds are mutual funds. Like other mutual funds, they
are regulated under the Investment Company Act of 1940. In addition,
money market funds must comply with Investment Company Act rule 2a-7,
which exempts money market funds from several provisions of the
Investment Company Act--most notably the valuation requirements--to
permit them to maintain stable net asset values per share (NAV),
typically $1.00. Under this special rule, money market funds, unlike
traditional mutual funds, can maintain a stable value generally by
using an ``amortized cost'' accounting convention, rather than market
values, when valuing the funds' assets and pricing their shares. The
rule essentially permits a money market fund to ``round'' its share
price to $1.00, but requires a money market fund to reprice its shares,
if the mark-to-market per-share value of its assets falls more than
one-half of one percent (below $0.9950), an event colloquially known as
``breaking the buck.''
The Commission adopted rule 2a-7 in 1983 with the understanding
that the value of the short-term instruments in which the funds invest
would rarely fluctuate enough to cause the market-based value of the
fund's shares to deviate materially from a fund's typical $1.00 stable
value. Rule 2a-7 limits money market funds' investments to short-term,
high-quality securities for this very purpose.
Despite these risk-limiting provisions, money market funds can--and
do--lose value. When, despite these risk-limiting provisions, money
market fund assets have lost value, fund ``sponsors'' (the asset
managers--and their corporate parents--who offer and manage these
funds) have used their own capital to absorb losses or protect their
funds from breaking the buck. Based on an SEC staff review, sponsors
have voluntarily provided support to money market funds on more than
300 occasions since they were first offered in the 1970s. \2\ Some of
the credit events that led to the need for sponsor support include the
default of Integrated Resources commercial paper in 1989, the default
of Mortgage & Realty Trust and MNC Financial Corp commercial paper in
1990; the seizure by State insurance regulators of Mutual Benefit Life
Insurance (a put provider for some money market fund instruments); the
bankruptcy of Orange County in 1994; the downgrade and eventual
administrative supervision by State insurance regulators of American
General Life Insurance Co in 1999; the default of Pacific Gas &
Electric and Southern California Edison Co. commercial paper in 2001;
and investments in SIVs, Lehman Brothers, AIG and other financial
sector debt securities in 2007-2008. In part because of voluntary
sponsor support, until 2008, only one small money market fund ever
broke the buck, and in that case only a small number of institutional
investors were affected.
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\2\ Forms of sponsor support include purchasing defaulted or
devalued securities out of a fund at par/amortized cost, providing a
capital support agreement for the fund, and sponsor-purchased letters
of credit for the fund. Sponsor support does not include a sponsor
taking an ownership interest in (i.e., purchasing shares of) a money
market fund.
---------------------------------------------------------------------------
The amount of assets in money market funds has grown substantially,
and grew particularly rapidly during recent years from under $100
million in 1990 to almost $4 trillion just before the 2008 financial
crisis. This growth was fueled largely by institutional investors, who
were attracted to money market funds as apparently riskless investments
paying yields above riskless rates. By 2008, more than two-thirds of
money market fund assets came from institutional investors, which could
wire large amounts of money in and out of their funds on a moment's
notice. Some of these institutional assets were what are known in the
business as ``hot money''--assets that would be quickly redeemed if a
problem arose, or even if a competing fund had higher yields. To
compete for that money, some money market fund sponsors invested in
new, riskier types of securities, such as ``structured investment
vehicles.'' The larger amount of assets in money market funds
contributed to the likelihood that a credit event would create stresses
on one or more funds, and that fund sponsors would not have access to a
sufficient amount of capital to support the funds.
The 2008 Financial Crisis
Implicit sponsor support as a mechanism to maintain a stable $1.00
share price increasingly came under strain as the size of money market
funds grew into a several trillion dollar industry. The Reserve Primary
Fund broke the buck after it suffered losses its sponsor could not
absorb. The Reserve Primary Fund, a $62 billion money market fund, held
$785 million in Lehman Brothers debt on the day of Lehman Brothers'
bankruptcy and immediately began experiencing a run--shareholders
requested redemptions of approximately $40 billion in just two days.
The Reserve Primary Fund announced that it would reprice its shares
below $1.00, or break the buck.
Almost immediately, the run on the Reserve Primary Fund spread,
first to the Reserve's family of money market funds, and then to other
money market funds. Investors withdrew approximately $300 billion (14
percent) from prime money market funds during the week of September 15,
2008. Money market funds met those redemption demands by selling
portfolio securities into markets that were already under stress,
depressing the securities' values and thus affecting the ability of
funds holding the same securities to maintain a $1.00 share price even
if the other funds were not experiencing heavy redemptions. Money
market funds began to hoard cash in order to meet redemptions and
stopped rolling over existing positions in commercial paper and other
debt issued by companies, financial institutions, and some
municipalities. In the final two weeks of September 2008, money market
funds reduced their holdings of commercial paper by $200.3 billion, or
29 percent.
Money market funds were (and are) substantial participants in the
short-term markets--in 2008 they held about 40 percent of outstanding
commercial paper. The funds' retreat from those markets caused them to
freeze. During the last 2 weeks in September 2008, companies that
issued short-term debt were largely shut out of the credit markets.
Cities and municipalities that rely on short-term notes to pay for
routine operations while waiting for tax revenues to be collected were
forced to search for other financing. The few companies that retained
access to short-term credit in the markets were forced to pay higher
rates or accept extremely short-term--sometimes overnight--loans, or
both. All of this occurred against the backdrop of a broader financial
crisis, which was exacerbated by the growing credit crunch in the
short-term markets.
More than 100 funds were bailed out by their sponsors during
September 2008. But the fund sponsors were unable to stop the run,
which ended only when the Federal Government intervened in an
unprecedented manner. In September 2008, the Treasury Department
temporarily guaranteed the $1.00 share price of more than $3 trillion
in money market fund shares and the Board of Governors of the Federal
Reserve System created facilities to support the short-term markets.
These actions placed taxpayers directly at risk for losses in money
market funds but eased the redemption pressures facing the funds and
allowed the short-term markets to resume more normal operations.
Because the Federal Government was forced to intervene we do not know
what the full consequences of an unchecked run on money market funds
would have been.
The experience of shareholders of the Reserve Primary Fund,
however, is instructive about the impact of an unchecked run on
investors. While some observe that shareholders in the Reserve Primary
Fund ultimately ``lost'' only one penny per share, this ignores the
very real harm that resulted from shareholders losing access to the
liquidity that money market funds promise. They were left waiting for a
court proceeding to resolve a host of legal issues before they could
regain access to their funds. In the meantime, their ability to make
mortgage payments, pay employees' salaries and fund their businesses
was substantially impaired, and Reserve Fund investors were left in a
sea of uncertainty and confusion. Some of their money is still waiting
to be distributed.
The next run might be even more difficult to stop, however, and the
harm will not be limited to a discrete group of investors. The tools
that were used to stop the run on money market funds in 2008 are either
no longer available or unlikely to be effective in preventing a similar
run today. In September 2008, the Treasury Department used the Exchange
Stabilization Fund to fund the guarantee program, but in October 2008
Congress specifically prohibited the use of this fund again to
guarantee money market fund shares. \3\ The Federal Reserve Board's
Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity
Facility (AMLF), through which credit was extended to U.S. banks and
bank holding companies to finance purchases of high-quality asset
backed commercial paper (ABCP) from money market funds, expired on
February 1, 2010. Given the significant decline in money market
investments in ABCP since 2008, reopening the AMLF would provide little
benefit to money market funds today. For example, ABCP investments
accounted for over 20 percent of Moody's-rated U.S. prime money market
fund assets at the end of August 2008, but accounted for less than 10
percent of those assets by the end of August 2011.
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\3\ See, Emergency Economic Stabilization Act of 2008, Public Law
110-343, 122 Stat. 3765 131 (``The Secretary is prohibited from using
the Exchange Stabilization Fund for the establishment of any future
guaranty programs for the United States money market mutual fund
industry.'').
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The 2010 Reforms
Shortly after I joined the Commission in 2009, I asked the
Commission's staff to prepare rulemaking designed to address concerns
about money market funds revealed by the 2007-2008 crisis. The staff,
with assistance from a report prepared by the money market fund
industry, quickly identified some immediate reforms that would make
money market funds more resilient. I am proud of this initial reform
effort, but it is important to recognize what it did and did not do.
The initial reforms, adopted and implemented in 2010, were designed to
reduce the risks of money market funds' portfolios by reducing
maturities; improving credit standards; and, for the first time,
mandating liquidity requirements so that money market funds could
better meet redemption demands. The new reforms also required money
market funds to report comprehensive portfolio and ``shadow NAV''
information to the Commission and the public.
The 2010 rules made money market funds more resilient in the face
of redemptions by requiring them to increase the liquidity of their
portfolios. But the amendments did not (1) change the incentives of
shareholders to redeem if they fear that the fund will experience
losses; (2) fundamentally change the dynamics of a run, which, once
started, will quickly burn through the additional fund liquidity; (3)
prevent early redeeming, often institutional investors from shifting
losses to remaining, often retail investors or (4) enable money market
funds to withstand a ``credit event'' or the loss in value of a
security held by a money market fund, precisely what triggered the run
on the Reserve Primary Fund.
That money market funds were able to meet redemptions last summer
when the markets were under stress suggests the 2010 reforms have
helped address the risks they were designed to address. However, the
reforms were not designed to address the structural features of money
market funds that make them susceptible to runs, and the heavy
redemptions of 2011 were (1) substantially less than in 2008, (2) made
over a longer period of time, and (3) not accompanied by losses in fund
portfolios. During the 3-week period beginning June 14, 2011, investors
withdrew approximately $100 billion from prime money market funds. In
contrast, during the 2008 financial crisis, investors withdrew over
$300 billion from prime money market funds in a few days. These are
significant differences. If there had been real credit losses last
summer, the level of redemptions in some funds could very well have
forced a money market fund or funds to break the buck, leading to the
type of destabilizing run experienced in 2008.
The events of last summer demonstrate that money market fund
shareholders continue today to be prone to engage in heavy redemptions
if they fear losses may be imminent. About 6 percent of prime fund
assets were redeemed during a 3-week period beginning June 14, 2011,
and one fund lost 23 percent of its assets during that period even
though the funds involved had not experienced any losses. The incentive
to run clearly remains in place notwithstanding the 2010 reforms.
Susceptibility to Runs
Money market funds are vulnerable to runs because shareholders have
an incentive to redeem their shares before others do when there is a
perception that the fund might suffer a loss. Several features of money
market funds, their sponsors, and their investors contribute to this
incentive.
Misplaced Expectations. The stable $1.00 share price has fostered
an expectation of safety, although money market funds are subject to
credit, interest-rate, and liquidity risk. Recurrent sponsor support
has taught investors to look beyond disclosures that these investments
are not guaranteed and can lose value. As a result, when a fund breaks
a dollar, investors lose confidence and rush to redeem. Not only did
large numbers of investors redeem their shares from The Reserve Primary
Fund that held Lehman Brothers commercial paper, they also redeemed
from other Reserve money market funds that held no Lehman Brothers
paper, including a Government fund.
First Mover Advantages. Investors have an incentive to redeem at
the first sign of problems in a money market fund. An early redeeming
shareholder will receive $1.00 for each share redeemed even if the fund
has experienced a loss and the market value of the shares will be worth
less (e.g., $0.998). By taking more than their pro rata share of the
assets, these redemptions at $1.00 per share concentrate losses in the
remaining shareholders of a fund that is now smaller. \4\ As a result a
small credit loss in a portfolio security, if accompanied by sufficient
redemptions, can threaten the fund with having to break the buck.
---------------------------------------------------------------------------
\4\ Assume, for example, a fund with 1,000 shares outstanding with
two shareholders, A and B, each of which owns 500 shares. An issuer of
a security held by the fund defaults, resulting in a 25 basis point
loss for the fund--a significant loss, but not one that is large enough
to force the fund to break the buck. Shareholder A, aware of a problem
and unsure of what shareholder B will do, redeems all of his shares and
receives $1.00 per share even though the shares of the fund have a
market value of $0.998. The fund now has only 500 shares outstanding,
but instead of a 25 basis point loss has a 50 basis point loss and will
have broken the buck. Shareholder A has effectively shifted his losses
to Shareholder B.
---------------------------------------------------------------------------
Moreover, early redeemers tend to be institutional investors with
substantial amounts at stake who can commit resources to watch their
investments carefully and who have access to technology to redeem
quickly. This can provide an advantage over retail investors who are
not able to monitor the fund's portfolio as closely. As a consequence,
a run on a fund will result in a wealth transfer from retail investors
(including small businesses) to institutional investors. This result is
inconsistent with the precepts of the Investment Company Act, which is
based on equal treatment of shareholders.
Mismatch of Assets and Liabilities. Finally, money market funds
offer shares that are redeemable upon demand, but invest in short-term
securities that are less liquid. If all or many investors redeem at the
same time, the fund will be forced to sell securities at fire sale
prices, causing the fund to break a dollar, but also depressing
prevailing market prices and thereby placing pressure on the ability of
other funds to maintain a stable net asset value. A run on one fund can
therefore create stresses on other funds' ability to maintain a $1.00
stable net asset value, prompting shareholder redemptions from those
funds and instigating a pernicious cycle building quickly towards a
more generalized run on money market funds.
Given the role money market funds play in providing short-term
funding to companies in the short-term markets, a run presents not
simply an investment risk to the fund's shareholders, but significant
systemic risk. No one can predict what will cause the next crisis, or
what will cause the next money market fund to break the buck. But we
all know unexpected events will happen in the future. If that stress
affects a money market fund whose sponsor is unable or unwilling to
bail it out, it could lead to the next destabilizing run. To be clear,
I am not suggesting that any fund breaking the buck will cause a
destabilizing run on other money market funds--it is possible that an
individual fund could have a credit event that is specific to it and
not trigger a broad run--only that policy makers should recognize that
the risk of a destabilizing run remains. Money market funds remain
large, and continue to invest in securities subject to interest rate
and credit risk. They continue, for example, to have considerable
exposure to European banks, with, as of May 31, 2012, approximately 30
percent of prime fund assets invested in debt issued by banks based in
Europe generally and approximately 14 percent of prime fund assets
invested in debt issued by banks located in the eurozone.
Additional Needed Reforms
The Commission staff currently is exploring a number of structural
reforms, including two in particular that may be promising. The first
option would require money market funds, like all other mutual funds,
to buy and sell their shares based on the market value of the funds'
assets. That is, to use ``floating'' net assets values. Such a proposal
would allow for public comment on whether requiring money market funds
to use floating NAVs would cause shareholders to become accustomed to
fluctuations in the funds' share prices, and thus less likely to redeem
en masse if they fear a loss is imminent, as they do today. It would
also treat all investors more fairly in times of stress.
A second option would allow money market funds to maintain a stable
value as they do today, but would require the funds to maintain a
capital buffer to support the funds' stable values, possibly combined
with limited restrictions or fees on redemptions. The capital buffer
would not necessarily be big enough to absorb losses from all credit
events. Instead, the buffer would absorb the relatively small mark-to-
market losses that occur in a fund's portfolio day to day, including
when a fund is under stress. This would increase money market funds'
ability to suffer losses without breaking the buck and would permit,
for example, money market funds to sell some securities at a loss to
meet redemptions during a crisis.
As described above, many money market funds effectively already
rely on capital to maintain their stable values: hundreds of funds have
required sponsor bailouts over the years to maintain their stable
values. Requiring funds to maintain a buffer simply would make explicit
the minimum amount of capital available to a fund. Today, in contrast,
an investor must wonder whether a sponsor will have the capital to
bailout its fund and, even if so, if the sponsor will choose to use it
for a fund bailout.
Limits on redemptions could further enhance a money market fund's
resiliency and better prepare it to handle a credit event. Restrictions
on redemptions could be in several forms designed to require redeeming
shareholders to bear the cost of their redemptions when liquidity is
tight. Redemption restrictions could be designed to limit any impact on
day-to-day transactions.
These ideas and others are the subject of continuing analysis and
discussion at the Commission. If the Commission were to propose further
reforms, there will, of course, be an opportunity for full public
consideration and comment. In addition to a detailed release seeking
comment on the likely effectiveness and impacts of the proposed
reforms, the proposal will also include a discussion of their benefits,
costs, and economic implications.
Conclusion
In closing, money market funds as currently structured pose a
significant destabilizing risk to the financial system. While the
Commission's 2010 reforms made meaningful improvements in the liquidity
of money market funds, they remain susceptible to the risk of
destabilizing runs. Thank you for the opportunity to testify on this
important issue. I am happy to answer any questions that you might
have.
______
PREPARED STATEMENT OF NANCY KOPP
Treasurer, State of Maryland
June 21, 2012
Introduction
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, thank you for providing the National Association of State
Treasurers (NAST) the opportunity to testify on the issue of money
market mutual funds (MMFs). It is an honor and a privilege to be here
today. I am Nancy Kopp, the Treasurer for the State of Maryland and
chair of the NAST Legislative Committee.
NAST is a bipartisan association that is comprised of all State
treasurers, or State finance officials with comparable
responsibilities, from the United States, its commonwealths,
territories, and the District of Columbia.
I appreciate this timely hearing appropriately named ``Perspectives
on Money Market Reforms'' as I can assure you State Treasurers have a
unique perspective given their important role within the States of
ensuring proper cash flow management.
The Importance of Money Market Funds to the States
MMFs are a vital cash management tool for State Governments, their
political subdivisions, and their respective instrumentalities, all of
which rely upon them to manage short-term investments that provide
ready liquidity, preservation of capital, and diversification of
credit. There are few options that have the multiple features of
safety, return, liquidity and stable market history as MMFs and that is
why so many States and local governments choose this product for their
short- and mid-term investing and cash management needs. Additionally,
States rely on MMFs to buy short term securities issued by States,
local governments, and authorities. MMFs are by far the largest
purchasers of these bonds, and if capitalization requirements and other
restrictions put limits on their investment capital their demand for
these bonds will decrease, and costs to issue these bonds--borne at the
expense of taxpayers--would rise.
NAST Support for SEC Changes to Rule 2a-7 in 2010
Before the proposed SEC regulations are discussed, it is important
to note that NAST is on record supporting the amendments to Rule 2a-7
adopted by the SEC in 2010. The regulation of MMFs was brought under
scrutiny by regulators following the Reserve Primary Fund's NAV
dropping below $1.00, or ``breaking the buck'', during the global
financial crisis of 2008. The SEC appropriately responded by amending
Rule 2a-7 which strengthened MMFs by increasing liquidity and credit
quality requirements, enhanced disclosures to require reporting of
portfolio holdings monthly to the Commission, shortened portfolio
maturities, and permitted a suspension of redemptions if a fund has
broken the buck or is at imminent risk of breaking the buck.
NAST believes the Commission's amendments to Rule 2a-7 finalized on
May 5, 2010, have made MMFs more transparent, less subject to interest
rate risk, more creditworthy and less susceptible to redemption demand
pressure during periods of stress in the financial markets. However, we
are concerned that some Commissioners and members of the staff, as well
as other Federal regulators and officials, have publicly indicated
support for further amending Rule 2a-7 without taking into
consideration the effectiveness of the 2010 amendments. Such potential
changes to Rule 2a-7 that have been discussed recently include
restrictions on the redemption of MMF shares by investors, requiring
MMFs to adopt a floating daily net asset value (NAV), and/or mandating
that MMFs hold levels of capital similar to banking institutions.
In March 2012 at the NAST Federal Affairs Conference, NAST passed
its Federal Securities Regulation of Money Market Mutual Funds
Resolution which is included as an attachment to this testimony.
Specifically, there are three purported proposals from the SEC that
cause us concern:
Changing From a Stable NAV to a Floating NAV Feature
State Treasurers recognize that a floating NAV would increase
accounting work tremendously because it would require the daily booking
of the mark-to-market value of each fund. Being able to currently book
the value of the fund as a dollar in equals a dollar out without having
to note the daily fluctuations of its worth, is invaluable. When many
Governments are hard pressed to hire teachers and public safety
officers, it is difficult to see how States would be able to
appropriate funds for more accountants to do this work, which in the
end, would be of no value to the overarching issue as to whether it
would prevent a run on these funds. If the stable NAV is changed to a
floating NAV, we will have to look to other investment products to
avoid unnecessary accounting burdens. It is important to note that a
floating NAV would have negligible day-to-day changes, but the
accounting for these changes is significant. In addition, many
government jurisdictions are required by statute to invest only in
products with a stable NAV like MMFs. If the SEC changes the NAV to a
floating feature, these jurisdictions would be forced to find
alternative investments that are not as attractive as MMFs for a
variety of reasons discussed in this testimony.
The Importance of Liquidity
Another important feature of these funds is their liquidity. Often
State and local governments receive payments that can be placed in a
fund, sometimes as briefly as one night, because the funds are needed
in the morning. This feature allows State and local governments to
place these monies in a safe environment while still earning interest
for the taxpayers. Often payments come in later in the day and no other
product offers the ability to make an investment later in the day,
including bank deposits. It is this key cash management tool, which
attracts so many Governments--and other businesses--to these funds.
Placing Capital Requirements on Funds
The SEC is also looking at the possibility of placing capital
requirements on MMFs to be held against a possible run on MMFs. Again,
Treasurers are concerned that the additional costs of MMF operations
could result in lower yields--or eliminate these funds altogether--and
would push Treasurers into using other less attractive investment
alternatives. It is also unlikely that placing capital requirements on
these funds will actually prevent a run on these products, or otherwise
truly benefit the market.
Placing Redemption Requirements on Funds
As discussed previously, Treasurers use MMFs to move money in and
out on a daily basis in order to meet their cash management needs.
Requirements that would limit the amount that could be withdrawn from a
Government's MMF account would be highly disruptive. If money is held
back or delayed, State Treasurers would have to then create a system
and use precious resources to track these holdbacks and have to plan
for the future accordingly. If this becomes a requirement, Treasurers
will seek other investments to find more reliable forms of liquidity.
Additionally, this could be especially problematic for smaller
Governments whose investments may not be large enough to buffer these
requirements, and who need access to the full value of their account in
order to make various payments, including payroll.
State and Local Governments Organizations Standing Together
On March 8, 2012, NAST joined 13 other organizations representing
State and local governments in a joint letter to each of the SEC
Commissioners expressing concern over potential regulations presently
being considered. These organizations include the:
American Public Power Association
Council of Development Finance Agencies
Council of Infrastructure Financing Authorities
Government Finance Officers Association
International City/County Management Association
International Municipal Lawyers Association
National Association of Counties
National Association of Health and Educational Facilities
Finance Authorities
National Association of Local Housing Financing Agencies
National Association of State Auditors, Comptrollers and
Treasurers
National Association of State Treasurers
National Council of State Housing Agencies
National League of Cities
U.S. Conference of Mayors
The letter was intended to make clear to the SEC how vital MMFs are
for members of the listed organizations who utilize MMFs on a daily
basis. The cosigners also supported the changes to SEC Rule 2a-7 in
2010 and would support initiatives that would strengthen MMFs and
ensure investors are investing in high-quality securities. However,
these State and local organizations all recognized that if the
discussed SEC regulations were to require a floating NAV, it very well
could preclude State and local governments' ability to invest in these
securities. As the cosigning organizations include issuers of municipal
securities, a further concern that the SEC regulations would ``dampen
investor demand for the bonds we offer and therefore increase costs for
the State and local governments that need to raise capital for the
vital infrastructure and services.''
A letter to this Committee, outlining our concerns about possible
changes to MMFs from the State and local government community,
including NAST, is also included in this testimony.
Effect on the Municipal Securities Market
Money Market Mutual Funds are by far the largest purchaser of short
term municipal debt. If investors no longer use MMFs, then these funds
will not have the same purchasing power to buy our debt. That would
create a negative situation for State and local governments--a decrease
in demand for our debt means the cost of issuing that debt will
increase, on top of the likely increase in fees that would occur if
Governments would no longer be able to use MMMFs for their investment
and cash management purposes.
Finding Alternative Investments if MMFs Are Not Viable
One question that must be answered is why State Treasurers utilize
MMFs rather than bank deposits or investing directly in commercial
paper. First, Treasurers, as financial stewards of their respective
States, have been able to use the well regulated MMFs to improve
return. Banks are paying very little on deposits and deposits are only
insured up to $250,000. First tier commercial paper that is not asset-
backed pays slightly more than deposits, but less than MMFs. Commercial
paper also has transaction costs, custodial fees, less flexibility, and
importantly lacks the liquidity of MMFs as it does not have an active
secondary market. Finally, one critical distinction to be made between
MMFs and commercial paper is that MMFs allow for greater diversity of
exposure and lower credit risk. The same cannot be said of commercial
paper since it is an individual security with risked based on that
security alone. If, for example, a State had purchased Lehman Brothers
commercial paper in 2008 as an alternative to MMFs, it would have had
to absorb the entire loss of that particular holding.
Treasurer Kopp, State Treasurer of Maryland, Utilization of PMMF's
As Treasurer of Maryland I would like to convey how important MMFs
are to States that utilize MMF's by showing how MMFs are used in my
State. The State of Maryland uses MMFs to achieve the most efficient
liquidity while earning a modest return like most other governmental
entities throughout the Nation. The State of Maryland averages between
$250 and $350 million in MMFs deposits on a daily basis for the
operating fund depending on the fiscal year cycle. The State Debt and
Lease programs average an additional $100 million invested in MMFs. The
Maryland Local Government Investment Pool (LGIP) averages between $250
and $350 million in MMF deposits on a daily basis depending on the
total size of the pool which varies from $2.5 billion to $3.5 billion,
again depending on fiscal year cycle and available competing options.
The Maryland State Retirement System had $1.569 billion of the $36.2
billion invested in MMFs as of May 31, 2012. Through the years the
State has relied on MMFs for a safe place to put unexpected deposits
that arrive late in the day until a more appropriate investment can be
purchased and for daily liquidity for unexpected outflows or to cover
failed delivery of expected incoming funds.
In 2008, the State of Maryland had over $230 million invested in
The Reserve Primary Fund. As we monitored the economic conditions and
the Reserve Prime Fund Portfolio, we determined that the risk of the
Primary Fund was more than we desired. So we transferred our investment
into the Reserve Government Fund. When the Reserve Primary Fund ``broke
the buck'' on September 16, 2008, our funds were safely invested in the
Government Fund. We had read the prospectus and knew that MMFs had the
option to delay return of investments in dire economic circumstances.
Therefore, we were prepared to wait for our investment to be returned.
Our total Reserve Government Fund investment was returned January 21,
2009, with interest. We had invested in the fund that matched our risk
tolerance.
The 2010 SEC reforms to MMFs were most welcome and thorough. Our
research of MMF portfolios (we are always looking for better investment
opportunities) has shown that since the implementation of the
enhancements overall, MMFs are safer and the participants are more
aware of the risks as well as the benefits of investing in these
instruments. While recognizing the importance of preventing systemic
and or idiosyncratic events, the stable NAV is critical to State and
local government participation. As Washington State Treasurer James
Mcintire pointed out in his letter to the SEC on November 15, 2011,
``Many local communities and special districts lack the financial
management and accounting resources to properly equip them to invest in
floating NAV funds.'' During the Government Finance Officers
Association's Conference in Chicago last week, the almost unanimous
consensuses was that if MMFs have floating NAVs most Government
entities will have to pull their money out. All are struggling with
budget issues and do not have the resources to enhance personnel or
systems to accurately account for a floating NAV. This will put further
strains on their cash management. Furthermore, the banking system is
not prepared to accept these additional deposits.
Conclusion
NAST believes that any of the suggested reforms mentioned above may
further lead to a contraction in the availability of short-term
financing and adversely affect the investment choices of public funds
and the continued ability of State Governments, their political
subdivisions and their respective instrumentalities to obtain financing
to support the implementation of a wide variety of public initiatives.
In effect, these regulations will increase costs and will not have the
intended effect of making MMFs more stable. Of course, additional costs
will be paid by investors and issuers alike, including the States and
their taxpayers.
Many State Treasurers also manage LGIPs, which are pooled
investment funds operated for the benefit of State or local government
units. By pooling assets from numerous State and local government
entities, LGIPs offer economies of scale, liquidity, and
diversification, thereby reducing costs for them and ultimately for
taxpayers. While LGIPs are not governed by Commission and Rule 2a-7,
the investment guidelines for LGIPs typically track the Rule 2a-7.
Therefore, any changes to MMF rules would also impact the governmental
entities that invest in LGIPs.
As State Government officials, State Treasurers have enormous
respect for and appreciate the responsibilities facing Government
officials and regulators. No investor or Government official wants to
again go through an experience as challenging as the financial crisis
in 2008. However, the rationale for changing MMF regulation should be
informed by the effectiveness of the amendments to Rule 2a-7 adopted in
2010 as well as the impact such changes may have on State and local
governments. We are also concerned about how the changes would impact
the ability of States to manage LGIPs.
These changes would simply increase costs to taxpayers by both
taking away a key investment and cash management tool used by thousands
of Governments, and possibly curtailing or eliminating the largest
purchaser of short term municipal debt. Both of these scenarios would
be the outcome of changing the stable NAV to a floating NAV, and one
the National Association of State Treasurers would hope leaders in
Washington, would try to avoid.
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PREPARED STATEMENT OF PAUL SCHOTT STEVENS
President and Chief Executive Officer, Investment Company Institute
June 21, 2012
Opening Statement
Good morning, Chairman Johnson, Senator Shelby, and Members of the
Committee. I very much appreciate the opportunity to appear today to
offer ICI's perspective on the State of the money market fund industry.
For almost 5 years, ICI has been deeply engaged in analysis and
discussion of events in the money market and the role of money market
funds. We take pride in the fact that our engagement helped produce the
first comprehensive regulatory reforms for any financial product in the
wake of the crisis--five months before the Dodd-Frank Act was passed.
The reforms for money market funds in 2010 benefit investors and
the economy by raising credit standards and shortening maturities for
funds' portfolios.
They remove incentives for investors to redeem rapidly, by
increasing transparency of fund holdings and authorizing an orderly
liquidation if a fund risks breaking the dollar.
And those reforms sharply reduce the spillover effects of money
market fund redemptions on the broader markets. As of December 2011,
prime money market funds held $660 billion in assets that would be
liquid within a week--more than twice the amount that investors
redeemed from prime funds in the week of September 15, 2008. Today,
prime funds keep more than 30 percent of their assets in liquidity
buffers composed primarily of Treasury and Government securities and
repurchase agreements--precisely the instruments investors were seeking
in 2008.
We didn't have to wait long to put these reforms to the test. In
the summer of 2011, markets were rattled by three significant events:
the eurozone crisis; the showdown over the U.S. debt ceiling; and the
historic downgrade by Standard & Poor's of U.S. Government long-term
debt.
Money market funds did indeed see large redemptions. From early
June to early August, investors withdrew 10 percent of their assets
from prime money market funds--$172 billion in all. During the debt-
ceiling crisis, prime and Government funds together saw an outflow of
$114 billion in just 4 trading days.
But this withdrawal from money market funds had no discernable
effects at all--either on the funds or on the markets. From April
through December, prime money market funds kept their daily liquidity
at more than twice the required level, and weekly liquidity stayed one-
third to one-half higher than required.
Among the prime funds with the greatest exposure to European
financial institutions, the average mark-to-market price of their
shares fell by nine-tenths of a basis point. On a $1.00 fund share,
that's nine one-thousandths of a penny.
It's clear from this experience that the reforms of 2010 have
worked--and that money market funds today are a fundamentally different
product than in 2008.
Unfortunately, that message hasn't gotten through to the regulatory
community. They tell us that money market funds are ``susceptible'' to
runs. They're worried that the Government can't ``bail out'' these
funds in a future crisis.
Both of these statements are based in myths.
Let's look at September 2008. Regulators talk about the
``contagion'' from Reserve Primary's failure. But Reserve Primary broke
the dollar in the middle of a raging epidemic of bank failures. In the
turmoil, banks were refusing to lend to each other, even overnight.
Two things stand out. First, Reserve Primary's breaking the dollar
did not trigger the tightening of the commercial paper market--
investors of all types began abandoning that market days before Reserve
Primary failed. Second, investors did not flee from the money market
fund structure. Rather, they fled from securities of financial
institutions and sought the refuge of U.S. Treasury securities--by
buying shares in money market funds invested in Government securities.
Assets of taxable funds--prime and Government--declined by only 4
percent in the week of September 15.
The Treasury and the Federal Reserve stepped in to restore the
financial markets. Let me be clear: money market funds received no
financial support from the Federal Government. The Treasury guarantee
program never paid a dime in claims--instead, it collected $1.2 billion
for the taxpayers. It's quite a stretch to call that a ``bailout.'' The
Federal Reserve's facilities were designed to use money market funds to
access the markets and pump in needed liquidity. That's Central Banking
101.
Our shareholders realize that money market funds are investments--
and they bear the risk of loss. No one in the investment community
believes that these funds carry a Government guarantee--and no one in
our industry wants one. Period--full stop.
In conclusion, let me address the issue of sponsor support for
funds. Since the 1970s, advisers to money market funds have on occasion
chosen to address credit or valuation issues in their portfolios and
support their funds. They did so with private resources--not taxpayer
dollars. And they did so for business interests--to protect their brand
or preserve their fund's rating.
The SEC hasn't released any data to back its claims about sponsor
support. We can say, however, that we know of only one instance of
sponsor support since the 2010 reforms, and that in that case the
security in question was in no danger of defaulting.
Yet the SEC suggests that every case of sponsor support should be
seen as a repeat of September 2008. They suggest that without sponsor
support, money market funds would have triggered runs.
Decades of experience with these funds suggest just the opposite.
Before the latest financial crisis, there was only one occasion when a
money market fund broke a dollar, in 1994. The world yawned.
Persistently viewing money market funds through the narrow prism of
2008, the SEC clings to plans to impose structural changes that would
destroy money market funds, at great cost to investors, State and local
governments, business, and the economy. That is an outcome that we must
avoid.
Thank you, and I'm happy to take your questions.
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PREPARED STATEMENT OF J. CHRISTOPHER DONAHUE
President and Chief Executive Officer, Federated Investors, Inc.
June 21, 2012
Opening Statement
I would like to briefly respond to the major points made in
Chairman Schapiro's testimony.
First, the Chairman is primarily concerned that a credit event will
cause a money market fund to break a dollar. Rule 2a-7 already makes
sure these are rare events with minimal impact, but it cannot prevent
them altogether. We are investment professionals at managing risks, not
magicians who make risks disappear. The President's Working Group
acknowledged this when it observed that: ``Attempting to prevent any
fund from ever breaking the buck would be an impractical goal that
might lead . . . to draconian and--from a broad economic perspective--
counterproductive measures.''
Yet this is precisely what a capital requirement attempts to do--
prevent a fund from ever breaking a dollar. The Chairman knows that
raising capital directly from third parties is impractical, that
sponsors cannot afford capital and that, at current market rates, funds
do not have the income to build their own capital cushion. Even at
normal interest rates, it would take over a decade for funds to build
even a 1 percent capital cushion on their own. A 1 percent capital
cushion would not have prevented the Reserve Primary Fund from breaking
a dollar, so clearly capital will not prevent funds from ever breaking
a dollar. It may lull shareholders into a false sense of security,
however, and increase their expectations of a bailout. In short,
requiring capital would be counterproductive.
Second, the Chairman asserts that small investors will bear the
loss from a credit event, because large institutional shareholders will
redeem before the fund breaks a dollar. This ignores the responsibility
of the fund's directors in protecting the interest of all shareholders.
In fact, if you listened only to the Chairman's speeches and testimony
on money market funds, you would never know that funds have directors,
a majority of whom are independent of the fund's manager, or that Rule
2a-7 has always required them to prevent material dilution or other
unfair results to shareholders.
The contrast between the actions of the directors of the Reserve
Primary Fund and the directors of the Putnam Prime Money Market Fund
during the financial crisis is instructive. The Reserve Fund directors
allowed shareholders to continue redeeming for a dollar for more than a
day after the Lehman bankruptcy, even though Reserve did not provide
any concrete support to the fund. They may have done this because, at
the time, directors could not suspend redemptions without first
obtaining an order from the Commission. Notwithstanding this, when
faced with redemption requests in excess of their fund's liquidity, the
Putnam Fund directors suspended redemptions until they could arrange a
merger with a Federated advised money market fund which had access to
the Federal Reserve's liquidity program for asset-backed securities. By
making their shareholders' interest paramount to all other
considerations, the Putnam Fund directors protected their shareholders,
large and small.
Despite her professed concern for small investors, the Chairman has
never mentioned any reforms that would make it easier for directors to
protect them or that would help directors prepare for an event that
might threaten their fund's $1 NAV.
Third, the Chairman persists in assuming that a money market fund
breaking a dollar will cause a run by its shareholders, which will lead
to a fire sale of the portfolio, which will result in a downward spiral
of asset prices and a credit crunch. Her assumptions are based on the
behavior of prime fund shareholders during the greatest financial
crisis since the Great Depression; a crisis that was fully underway
before the Reserve Fund broke a dollar. She ignores the fact that none
of these things occurred when the Community Bankers fund broke a dollar
in 1994, when the market was not undergoing a liquidity crisis.
The Chairman did announce yesterday, with much fanfare, that
sponsors have had to step in 300 times to prevent their funds from
breaking a dollar. While I share Senator Toomey's skepticism as to how
her staff arrived at this figure, I also wonder what we are supposed to
conclude from this number. She admits that sponsor support is not
necessarily a bad thing. She cannot be suggesting that funds are
regularly on the verge of breaking a dollar--her written statement says
that these 300 ``occasions'' relate to about a dozen credit events over
a span of three decades. I think that the ability of sponsors to handle
nearly all of these events without Government intervention demonstrates
the inherent strength and resilience of money market funds. I bet the
FDIC would be envious of this record.
Tellingly, the Chairman ignores how the reforms adopted in 2010
addressed all of her assumed problems.
Funds that break a dollar can now suspend redemptions and
liquidate without a Commission order, so funds can stop a run
by their shareholders.
Investors can see all of their fund's holdings, so they
would know that other funds are not at risk of breaking a
dollar.
Funds currently have three times the liquidity needed to
handle the level of redemptions experienced during the
financial crisis, so funds would not need to conduct fire sales
and would not cause asset prices to spiral downward.
After the 2010 reforms, there is no reason to suppose that a fund
breaking a dollar will snowball into some sort of credit crunch.
Fourth, the Chairman's dogmatic belief in the systemic risks of
money market funds will necessarily taint any cost/benefit analysis of
her proposed reforms. If she begins by assuming that a fund breaking a
dollar will cascade into a full scale financial crisis of the magnitude
experienced in 2008, then the case for reform is a foregone conclusion.
In other words, she would make perfection the enemy of the good. If it
adopts reforms on this basis, the Commission will sacrifice real,
quantifiable benefits to millions of shareholders and borrowers for
speculative and unsubstantiated reductions in supposed systemic risks.
This approach to risk/reward analysis would be like requiring
passengers on a cruise ship to spend the trip in the life boats: you'd
be safer in theory, but it would defeat the purpose. Ironically, if (as
every survey indicates) her proposed reforms will drive shareholders
out of money market funds and into the largest banks, then they will
increase systemic risk and make credit markets more fragile.
Finally, the Chairman calls for an honest, public debate of her
proposed reforms. Federated already tried the case for a stable NAV in
an evidentiary heading before an administrative judge in the 1970s,
which the Commission settled by issuing the original exemptive orders
permitting use of amortized cost valuation. More recently, the
Commission requested comment on a floating NAV in both the reforms
proposed in 2009 and in connection with the President's Working Group
report. No one, apart from members of the Federal Reserve and
academics, supported this proposal. Essentially, the Chairman is
insisting that the debate on floating the NAV continue until she gets
the answer she wants.
Regarding her alternative reforms, I have explained why it is not
feasible to impose a meaningful capital requirement. Although the
Chairman did not say much about redemption restrictions, she knows that
there are insurmountable legal and operational obstacles to such
restrictions. She has no reason to believe that investors will continue
to use funds subject to these restrictions. Therefore, all of the
Chairman's proposals would have the same result--the effective
destruction of money market funds.
I look forward to answering your questions.
Prepared Statement
Chairman Johnson, Ranking Member Shelby, Members of the Committee,
I want to thank you for providing me the opportunity to appear at
today's hearing. I am the President and CEO of Federated Investors,
Inc. (Federated), the third largest manager of money market funds
(MMFs) in the United States. Our MMFs currently have assets of
approximately $240 billion, with millions of individual and thousands
of institution shareholders for whom we provide investment management,
including corporations, Government entities, insurance companies,
foundations and endowments, banks, and broker-dealers. Federated has
1,450 employees.
Federated has provided extensive data and commentary to the
Securities and Exchange Commission (SEC), in response to its request
for comments on the Report of the President's Working Group on
Financial Markets regarding possible changes to MMFs (the ``PWG
Report'') \1\ and to the Financial Stability Oversight Council (FSOC)
and banking regulators in connection with rule making proposals to
implement Titles I and II of the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the ``Dodd-Frank Act''). A list of links to
Federated's comment letters is included at the end of my statement.
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\1\ The PWG Report was published for comment in Release No. IC-
29497, ``President's Working Group Report on Money Market Funds'' (Nov.
3, 2010), available at http://www.sec.gov/rules/other/2010/ic-
29497.pdf.
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We are concerned that, based upon recent speeches by the SEC
Chairman and a number of members of the Federal Reserve Board, key
regulators have largely disregarded the comments received in response
to the PWG Report--not only Federated's comments, but also others who
pointed out errors underlying, obstacles to and unintended consequences
of possible reforms. More disturbingly, although as of this date
neither the SEC nor FSOC have proposed rules or other action
specifically targeting MMFs, key members of both agencies have
continued to pursue reform proposals heedless of the PWG Report's
important warning that ``[a]ttempting to prevent any fund from ever
breaking the buck would be an impractical goal that might lead . . . to
draconian and--from a broad economic perspective--counterproductive
measures . . . '' \2\ Their attempt to eliminate risk from MMFs has
resulted in draconian proposals that would eliminate MMFs, if not
altogether, then as a meaningful component of the U.S. cash markets.
---------------------------------------------------------------------------
\2\ PWG Report at 13.
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Let us remember that money market funds did not cause the recent
financial crisis. \3\ They were simply not immune to the largest
financial crisis since the Great Depression. Yet instead of targeting
the causes of the crisis, the SEC Chairman and certain members of the
FSOC have threatened ill-conceived reforms whose demonstrable costs far
outweigh any plausible benefits. Indeed, even the existence of a
benefit from the proposals being discussed is debatable when a full
accounting of the impact on the banking system and the expansion of the
Federal safety net are taken into account. The flawed process leading
to this outcome--where bank regulators now dictate the content of
securities law without meaningful dialog with those affected or serious
study of unintended consequences--does not embody the best traditions
of Government. It is therefore incumbent upon all of us, regulators,
industry and Congress, to bring perspective and rationality to the
debate. It is our obligation to weigh the enormous benefits of MMFs
against a realistic assessment of the speculative benefits, and
evidence of significant adverse economic consequences, that the various
``reform'' proposals would bring. We strongly endorse Congressional
efforts to clarify the SEC's statutory obligation to perform cost/
benefit analysis and to commission a thorough evaluation of the need
for additional reform to money market funds. Such a study should not
only include an evaluation of the impact of the 2010 reforms to MMF
regulations, but also should factor in the reforms adopted in the Dodd-
Frank Act. Americans deserve a regulatory process that can hear their
voice: they would prefer to keep the massive efficiency gains with the
current system and accept the risk of a very high quality, tightly
regulated investment product, rather than turn back the clock and
return to a world even more dominated by the largest banks.
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\3\ ``Dissecting the Financial Collapse of 2007-2008: A Two-Year
Flight to Quality'', May 2012, available at http://www.sec.gov/
comments/4-619/4619-188.pdf.
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Setting the Record Straight on Money Market Funds
Before addressing these threatened reforms, I would like to dispel
some myths regarding MMFs that purport to justify the need for further
reforms.
Myth: The $1 share price of MMFs is a ``fiction'' or ``gimmick.''
Fact: The stable $1 price is real--MMFs have redeemed their shares for
at a stable $1 price for over 40 years, with only two exceptions.
Every day, for over 38 years, Federated's MMFs have redeemed shares
at a stable $1 value. This is true of every other MMF currently in
existence. During the past 40-plus years, only two MMFs have redeemed
shares for less than a $1, known as ``breaking a dollar.''
This record of stability is the result of the high quality and
short-duration of MMF portfolios, not accounting wizardry. Regulations
require MMF portfolios to consist of a diversified cross-section of the
highest quality debt instruments available in the market. The market
values of these instruments rarely deviate significantly from their
amortized cost. Federated regularly monitors the estimated market value
of its MMFs (known as their ``shadow prices''), which typically do not
deviate by even a tenth of a cent from $1 (i.e., 10 basis points). An
Investment Company Institute (ICI) sampling of the shadow prices of
other MMFs shows that this is common throughout the industry. \4\
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\4\ ``Pricing of U.S. Money Market Funds at 4'', ICI Research
Report (Jan. 2011), available at http://www.ici.org/pdf/
ppr_11_mmf_pricing.pdf.
---------------------------------------------------------------------------
Such small shadow price deviations do not affect a MMF's ability to
operate at a stable value because portfolio instruments quickly return
to their amortized cost. MMFs typically maintain an average maturity of
between 30 and 50 days. This makes it easy for MMFs to wait for
investments to mature, rather than selling them at a gain or loss.
MMFs also avoid gains and losses by maintaining more than enough
liquidity to meet anticipated shareholder redemptions. This ``best
practice'' was codified in the regulatory reforms adopted in 2010. The
MMFs' record for managing liquidity is exemplary--no fund has ever
broken a dollar because a fund failed to maintain sufficient liquidity
to meet redemptions. The capacity of some MMFs to maintain daily
liquidity was tested again in the summer of 2011, and every fund
answered the challenge without any disruption to the market.
On a related point, critics sometimes assert that the $1 share
price misleads investors into believing that MMFs are like banks. These
critics overlook the fact that most of the money held in MMFs comes
from sophisticated institutional investors, who surely appreciate the
differences between MMFs and banks. Recent surveys show that most
retail investors also appreciate that their MMF can break a dollar and
that no one has promised to protect them from any losses. \5\ These
critics further ignore the bold face disclaimer on the front of every
Federated MMF prospectus and advertisement: ``Not FDIC Insured--May
Lose Value--No Bank Guarantee.'' Thus, MMFs fully disclose the risk
that they may break a dollar and the overwhelming majority of MMF
shareholders understand and accept this risk.
---------------------------------------------------------------------------
\5\ ``The Investor's Perspective: What Individual Investors Know
About the Risks of Money Market Mutual Funds'', FMR LLC (Apr. 2012),
available at http://www.sec.gov/comments/4-619/4619-170.pdf.
Myth: MMFs have only been able to maintain a $1 share price due to the
---------------------------------------------------------------------------
support provided by their managers.
Fact: Over 90 percent of MMFs have maintained a $1 share price without
any support from their managers.
At the beginning of 2007, there were 728 MMFs. The Federal Reserve
has recently asserted that, from 2007 to 2010, approximately 50 MMFs
received support from their manager. \6\ This means that over 90
percent of MMFs maintained a $1 share price throughout the recent
financial crisis without any support from their managers. All of
Federated's MMFs maintained a $1 share price without any support from
Federated during the period. Historically, managers have provided
support to their funds in part because they typically do not incur any
losses as a result of the support. This explains why managers commonly
find it in their interest to protect their MMFs' shareholders at no
material cost to themselves. Although no manager promises to provide
support for its funds, mutually beneficial support arrangements should
be appreciated as an indication of the resilience of MMFs rather than
as a weakness.
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\6\ Presentation by Federal Reserve Bank of Boston President
Rosengren (Apr. 11, 2012), available at http://www.frbatlanta.org/
documents/news/conferences/12fmc/12fmc_rosengren_pres.pdf.
---------------------------------------------------------------------------
Myth: MMFs are susceptible to runs.
Fact: In over 40 years, there has been only one run on prime MMFs and
it was a consequence of a general flight to safety at the height of the
financial crisis.
As I noted, there have been two instances of a MMF breaking a
dollar. The first, in 1994, did not produce a run on MMFs. In fact, it
went largely unnoticed. The second, the Reserve Fund, coincided with
the redemption of approximately 15 percent of the assets held by prime
MMFs during the week of September 15, 2008.
So far as I know, the SEC has not attempted to study why breaking a
dollar in 1994 had no impact on other funds, while prime MMFs
experienced substantial redemptions at the time the Reserve Fund broke
a dollar. The SEC appears to assume that, because the run on MMFs
coincided with the Reserve Fund breaking a dollar, the Reserve Fund
caused the run. A comparison of the market conditions in 1994 and 2008
refutes this assumption.
In 1994, the Community Bankers MMF broke a dollar because it held
derivative securities that the SEC found ``were too risky and volatile
for a money market fund.'' \7\ The credit market was operating
normally, so there were no concerns about the availability of
liquidity. The market therefore viewed Community Bankers as an isolated
incident, with no implications for other MMFs or for the market in
general. Shareholders did not run from other MMFs because they had no
reason to suspect that another MMF would break a dollar.
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\7\ In the Matter of Craig S. Vanucci and Brian K. Andrew,
Investment Company Act Release No. 23638 (Jan. 11, 1999), available at
http://www.sec.gov/litigation/admin/33-7625.txt.
---------------------------------------------------------------------------
In contrast, 2008 was marked by a complete loss of confidence in
the financial system. The run on MMFs coincided with the rescue of AIG,
the arranged merger of Merrill Lynch with Bank of America and many
other financial shocks. Many investors were uncertain as to whether
other financial institutions would fail and whether they would receive
Government support. Rather than risk a default, these investors sought
to shift their cash to Government securities, draining liquidity from
the credit market. The credit market was completely frozen before the
Reserve Fund tried to liquidate its portfolio.
Other MMFs were not immune to this market turmoil. Their
shareholders also fled to Government securities, as evidenced by the
fact that nearly two-thirds of the assets redeemed from prime MMFs were
added to Government MMFs. This also shows that redemptions were
motivated by concerns regarding the credit market generally and not
MMFs themselves. This suggests that the shareholders would have
redeemed regardless of whether the Reserve Fund broke a dollar, in
order to eliminate credit risk by shifting their cash to Government
securities.
Thus, the record over the past 40 years includes one fund that
broke a dollar without causing a run, and one run that coincided with a
MMF fund breaking a dollar but was largely caused by a flight to safety
in response to an unprecedented financial crisis. That certainly does
not qualify MMFs as ``susceptible'' to runs. There is no reason to
project that an event in the future that causes one or more MMFs to
break a dollar would prompt shareholders to redeem from other MMFs not
affected or threatened by the event. Indeed, in light of the
significant enhancements in transparency and liquidity of MMFs
following the 2010 reforms, MMF investors should be even less likely to
run.
Myth: Taxpayers rescued MMFs in 2008.
Fact: We did not ask for or need the Treasury's Temporary Guarantee
Program (the ``Treasury Program'') and no claims were made under the
program.
MMFs required liquid markets, not tax dollars, to weather the
financial crisis in 2008. Their portfolios were sound, but the global
liquidity crisis impacted MMFs just as it did virtually all other asset
classes.
Due the lack of market liquidity, we requested liquidity, rather
than Federal insurance, for our MMFs in response to the financial
crisis. During our discussions, the Treasury told us that the Treasury
Program was going to be announced; we never asked for it. We did not
think that the Treasury Program addressed the real problem--the need to
reassure shareholders that MMFs had enough liquidity to continue to
redeem their shares for $1.
In my view, the Federal Reserve's Asset-Backed Commercial Paper
Money Market Mutual Fund Liquidity Facility (AMLF), \8\ rather than the
Treasury Program, restored confidence in MMFs. AMLF provided funding to
banks and other institutions to buy asset-backed commercial paper from
MMFs. AMLF ultimately funded sales of approximately $220 billion, a
small fraction of the massive liquidity the Federal Reserve pumped into
virtually every corner of the financial markets during the crisis.
---------------------------------------------------------------------------
\8\ Information on AMLF can be found at http://
www.federalreserve.gov/newsevents/reform_amlf.htm. Another liquidity
facility, the Money Market Investor Funding Facility was established
but never utilized.
---------------------------------------------------------------------------
AMLF was announced on the same day as the Treasury Program--
September 19, 2008. By the second week of October, prime MMF assets had
stabilized. Although some would attribute this to the combination of
AMLF and the Treasury Program, it is noteworthy that prime fund assets
grew continuously throughout the rest of 2008, even though the Treasury
Program only covered balances held on September 19th, so these
additional assets were not guaranteed. Moreover, the Treasury Program
was limited to $50 billion, which was just over 1 percent of the
September 19th MMF assets. Thus, within four weeks of the onset of the
financial crisis, investors were confident enough to invest in prime
MMFs without reliance on a Federal guarantee.
Regardless of the reasons, it cannot be disputed that confidence in
prime MMFs was fully restored without any Federal expenditures. In
fact, the Treasury kept all $1.2 billion of premiums paid under the
Treasury Program without paying any claims. All of the paper sold under
AMLF was repaid in full, with interest, when due.
The recovery of prime MMFs with a relatively minor liquidity
program is a testament to the inherent resiliency of MMFs. If banks and
other financial institutions had responded as well to their support
measures, which included trillions in additional Federal deposit
insurance, multiple liquidity programs and the investment of hundreds
of billions under TARP, the financial crisis would have been resolved
before the end of 2008. MMFs were the last institutions to require a
liquidity program and the first to recover--a mark of resiliency and
not of ``fragility.''
The 2010 Reforms Addressed the Need for Liquidity During a Financial
Crisis
MMFs were not only the first to recover from the financial crisis;
they also were the first to adopt reforms to prevent a recurrence of
problems encountered during the crisis. In March 2009, the ICI provided
the SEC with proposed regulatory reforms. Using the ICI's report as a
starting point, the SEC proposed reforms in June of 2009 and adopted
final rules in February 2010. Most of the reforms were implemented by
May 2010 and the balance by the end of that year. No other industry
responded as promptly or adopted such far-reaching reforms as MMFs.
Four of the reforms targeted liquidity. First, the SEC adopted a
new rule, 22e-3, permitting a MMF's board of directors to suspend
redemptions while liquidating a fund. This gives directors two options
if a MMF breaks a dollar. If there is adequate market liquidity, the
fund can operate with a fluctuating NAV and sell its portfolio to pay
for redemptions. If markets are frozen or it would otherwise serve the
shareholders' interest, the directors can suspend redemptions and
distribute payments from the portfolio as it matures. As I mentioned,
MMFs historically maintain average maturities of 30 to 50 days, so
shareholders would receive most of their money back within this period.
The maximum permitted maturity is 397 days, so the liquidation would
not take much longer than a year to complete.
Rule 22e-3 gives directors the power to prevent a run from a MMF
that has broken or threatens to break a dollar. It also prevents a fire
sale of the portfolio into an illiquid market. The result is that every
MMF, not just the largest, already has the type of orderly resolution
plan contemplated by Title II of the Dodd-Frank Act, except that the
plan does not require a Federal receiver or Federal insurance.
The second reform was to increase transparency. Every MMF must post
its entire portfolio on its Web site as of the end of each month. This
allows the public and regulators to identify which MMFs are affected by
a credit or other adverse event Although affected MMFs may need to
address the event, shareholders in unaffected funds will not face the
same uncertainty as investors in banks and other less transparent
institutions. They should not have any reason to redeem from MMFs that
they know to be sound and unimpaired by the event.
The third reform codified an industry practice of knowing your
customers and monitoring their share activity. This requires that a MMF
manager monitor and prepare for the risk of large shareholder
redemptions, taking into account current market conditions. This is
designed to assure that MMFs remain prepared to meet their
shareholders' liquidity needs.
The final reform deals with the possibility that some shareholders
may nevertheless redeem from MMFs on the occurrence of certain market
events, regardless of their actual risks. The reform established
liquidity floors: minimum amounts of liquidity that each MMF must be
able to generate on a daily and weekly basis without selling anything
other than Treasury and other Government securities. The floors are 10
percent for daily liquidity and 30 percent for weekly liquidity.
Remember that 15 percent of prime fund assets were redeemed during the
week of September 15, 2008, so the weekly liquidity floor is twice the
level of redemptions experienced during that period. In these still
uncertain times, prime MMFs are maintaining an average weekly liquidity
of 43 percent, nearly three times the level of the 2008 redemptions.
\9\
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\9\ ICI summary of data from Form N-MFPs as of April 30, 2012.
---------------------------------------------------------------------------
These reforms were tested during the summer of 2011. In response to
concerns about European banks and whether Congress would raise the U.S.
debt ceiling, shareholders redeemed over 10 percent of prime MMF assets
during the period from June 8 through August 3, 2011. \10\ As you would
expect, redemptions were higher in some prime MMFs than in others. None
of the MMFs had trouble meeting these redemption requests and there was
no impact on the overall market. Throughout the period, average weekly
liquidity in prime MMFs remained at 40 percent or more, so the funds
covered these redemptions without tapping into their liquidity cushion.
The new reforms clearly passed this real-life stress test.
---------------------------------------------------------------------------
\10\ ``ICI Summary: Money Market Funds Asset Data'', available at
http://www.ici.org/info/mm_summary_data_2012.xls.
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Certain members of FSOC and the Chairman of the SEC contend that
more must be done to prevent a recurrence of the redemptions
experienced in September 2008. Apart from ignoring the fact that prime
MMFs are already prepared to handle significantly larger redemptions,
their contention also ignores how the redemptions resulted from a
general financial panic. No reform of MMFs can prevent shareholders
from seeking a safe haven during such a complete loss of investor
confidence. Efforts to eliminate all risks from MMFs will not prevent a
future crisis; they will only eliminate MMFs.
Reforms Currently Under Consideration Are Fundamentally at Odds With
the Nature of Money Market Funds and the Needs of Their
Shareholders
Investors use MMFs to obtain stability and daily liquidity with a
market rate of return. Each of the reforms that the SEC Chairman has
recommended: a floating NAV, redemption restrictions and capital, would
eliminate one of these essential elements. The consequences of these
reforms would therefore be, from an investor's perspective, the
elimination of MMFs as a viable alternative for cash investment. This
is confirmed by surveys and other data, which suggest that the
threatened reforms would drive upwards of three-quarters of their
assets from MMFs.
(a) MMF NAVs Should Only Float When Necessary To Protect Shareholders
MMFs already have floating NAVs, as demonstrated by the fact that
funds have broken a dollar. The question is how often the NAV should
float. Under current regulations, directors must float the NAV when
necessary to protect shareholders from excessive dilution or other
unfair results. Dilution is presumed to be excessive when the shadow
price deviates from $1 by more than half a cent, although directors
retain some latitude for judgment even in this circumstance.
The threatened reform would require the NAV to float regardless of
the shareholders' interest. Studies of historical shadow prices show
that share prices would fluctuate infrequently, with periods of several
years between price fluctuations. Moreover, the price changes would
typically not amount to more than one or occasionally two-tenths of a
percent and would not last for longer than several weeks. The potential
fluctuations would require shareholders to monitor, calculate and
record infinitesimal and ephemeral gains and losses on cash investments
for accounting and tax purposes. From a shareholder's perspective,
dealing with these potential price fluctuations would result in
enormous costs.
Surveys show that investors would rather move their money elsewhere
rather than deal with such pointless fluctuations. \11\ Many
fiduciaries will not have a choice, as statutes or trust instruments
may require investment of cash in stable value investments. Therefore,
eliminating the stable value that, under normal circumstances,
shareholders want and MMFs deliver will eliminate MMFs as a viable
alternative for most cash investors.
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\11\ ``The Investor's Perspective: What Individual Investors Know
About the Risks of Money Market Mutual Funds'', supra note 5, and
``Money Market Fund Regulations: The Voice of the Treasurer'', Apr.
2012, available at http://www.ici.org/pdf/
rpt_12_tsi_voice_treasurer.pdf.
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(b) Redemption Restrictions Could Be Worse Than Floating NAVs
Shareholders object to redemption restrictions even more strongly
than they do to a floating NAV. This is understandable: although a
floating NAV would cause share prices to fluctuate needlessly, the
fluctuations would be infrequent and temporary. Redemption
restrictions, on the other hand, would continually disrupt a
shareholder's access to his or her cash in order to address an event
(the fund breaking a dollar) that might occur once in 20 years, if it
ever occurs at all. Their reaction is similar to passengers on a cruise
who have been asked to confine their activities to the lifeboats just
in case the ship hits an iceberg.
In addition to shareholders' rejection of redemption restrictions,
there are no practical means of implementing them. Although the SEC has
not provided any details of the redemption restrictions under
consideration, as a general matter they must involve: (1) setting aside
a certain percentage of shares or proceeds from the redemption of
shares for a period of time and (2) charging any losses incurred by the
fund during the period against the shares or proceeds set aside. Fund
organizational documents and share trading systems were not designed to
do these things. Therefore, implementing redemption restrictions would
entail completely rewriting every fund's organization documents and
getting shareholders to approve the changes, and reprogramming every
trading system for fund shares. The transition costs would be
staggering, as would the ongoing operational cost of tracking and
restricting shares or proceeds. Many intermediaries would probably stop
offering MMFs rather than bear these costs.
(c) Reguiring Excess Capital Would Prevent Money Market Funds From
Offering a Market Rate of Return and Introduce Moral Hazards
Even the SEC Chairman and members of the FSOC seem to have realized
that forcing MMFs to raise subordinated capital from third parties or
their managers would make the fund unduly complicated and impractical.
I will therefore assume that the only capital proposal still under
consideration would be for MMFs to build up capital over time through
retaining a portion of their earnings. From a shareholder's
perspective, this form of capital requirement would impose a certain
loss--in the form of reduced returns--in order to reduce the risk of a
speculative loss--the possibility that the fund might break a dollar.
It also would take an exceedingly long time to build up a
significant capital buffer. With interest rates currently near zero,
MMFs do not have any income to retain for a capital buffer. Even in
normal market conditions, the yield on a prime MMF averages only 18
basis points more than the yield on a Government agency MMF. Assuming
for purposes of analysis that the difference is constant, which it is
not, and that shareholders would continue to use prime MMFs if this
spread was cut in half, which they may not, it would take over 11 years
for a prime fund to build a 1 percent capital buffer through retained
earnings.
This analysis does not include the taxes imposed on the fund's
retained income. After factoring in State taxes, close to half of any
earnings reduction will go to the Government rather than building a
capital buffer for the shareholders. Federal corporate income taxes
alone, at current rates, would increase the time required to build a 1
percent capital buffer to more than 17 years.
Capital buffers also could create a moral hazard by leading MMF
shareholders to believe that they will not bear the risk of portfolio
losses. This can only increase expectations that a MMF should be bailed
out if its losses exceed the capital buffer, as Federal regulators
would have represented to the public that their capital requirements
were sufficient to make MMFs safe. The financial system will be better
off if the hint of protection from a capital buffer does not dilute
current warnings that MMFs are not guaranteed and may lose money.
Once we understand that MMFs are investments, we should realize
that MMFs are already funded entirely by shareholder capital.
Shareholders receive higher yields to compensate them for the risk of
their MMF breaking a dollar, which has proven to be a highly profitable
arrangement for MMF shareholders.
Destruction of Money Market Funds Will Injure the Economy and Increase
Systemic Risks
As I noted, the best available estimates suggest that requiring a
floating NAV or redemption restrictions will drive upwards of three-
quarters of the assets out of MMFs. At current asset levels, this would
comprise more than $2 trillion. It is harder to estimate the impact of
capital requirements, insofar as we do not know the elasticity of
demand for prime MMFs relative to their spread over Government MMFs.
Reduced returns will surely translate into reduced assets, however.
Where would all this money go? Very large institutional investors,
those with over $100 million in investments who could qualify for the
Rule 144A safe harbor, might invest directly in the same instruments as
MMFs. They would have to hire managers for these investments, who would
be unlikely to have as many resources or as much experience as those
who currently manage MMFs. The portfolios would not be as well
diversified as MMFs. A better alternative for these institutions might
be to invest in a private MMF, completely unregulated by the SEC. Thus,
one consequence of the threatened reforms would be to reduce the SEC's
oversight and regulation of participants in the money markets.
Other institutional investors, and nearly all retail investors,
would have to move their cash to banks. This would increase systemic
risks in several respects. First, bank holding companies already
designated as systemic risks under the Dodd-Frank Act control over half
of MMF assets. \12\ This suggests that most of the money driven out of
MMFs will end up in banks that are already too big from a systemic risk
perspective.
---------------------------------------------------------------------------
\12\ Crane Data.
---------------------------------------------------------------------------
Second, much of the retail and some of the institutional money will
end up in insured accounts, increasing the size of the Federal safety
net. Banks will also need to raise additional capital for these
deposits, at a time when they are already straining to comply with the
new Basil III requirements.
Third, to limit the need for additional capital, banks are unlikely
to use the new funds to make commercial loans. Unlike prime MMFs, which
have to put every dollar to work, banks have the option of leaving
funds in their Federal Reserve accounts. Banks may also find it easier
to invest in Treasury and Government agency securities. To the extent
that banks choose to make commercial loans, the absence of competition
from MMFs will allow them to charge higher interest rates. Hence, the
reduction in prime MMF assets will produce a corresponding reduction in
credit to the private sector and an increase in the cost of such
credit. If we consider that prime MMFs hold over 40 percent of the
outstanding commercial paper, we can appreciate the potential impact of
this on the economy.
The credit impact on municipalities will be even worse. Most
municipalities rely on loans from tax-exempt MMFs to bridge the period
between expenditures and periodic tax collections. Before MMFs, banks
provided this financing, charging municipalities the prime rate for
their working capital. Assuming banks will return to this role, the
additional interest charges will place a considerable drag on already
over-burdened municipal budgets.
The reforms will destroy MMFs in a more fundamental sense as well.
As I observed, investors look to MMFs for stability and daily liquidity
with a market rate of return. A floating NAV would prevent MMFs from
offering stability, redemption restrictions would prevent them from
offering daily liquidity, and capital requirements would prevent them
from offering a market rate of return. Therefore, all of the reforms
are designed to eradicate MMFs as we now know them, rather than to
``shore up'' the funds as asserted by the SEC's Chairman.
The SEC Should Conduct a Thorough Study of Money Market Funds, Their
Shareholders and the Effects of the 2010 Reforms and the Dodd-
Frank Act Before Proposing Any Further Reforms
Previous reforms to MMF regulations involved careful examinations
by the SEC staff of the performance and operations of MMFs, including
on-site visits and face-to-face discussions with fund managers. In the
case of the 2010 reforms, the SEC staff had the benefit of a report and
recommendations from the ICI's Money Market Fund Working Group. The
Working Group was composed primarily of portfolio managers who had
hands-on experience in guiding their MMFs through the 2008 financial
crisis. This put them in the best position to know what tools and
changes might serve to avoid or manage another crisis. The SEC gave
serious consideration to the reforms proposed by the ICI Working Group.
Although the reforms adopted by the SEC in 2010 went further than
Federated thought was warranted, the reforms were largely consistent
with the information provided in the Working Group's report.
Such due diligence and interaction has been lacking in this
``second phase'' of the reform process. So far the process has
consisted of a series of trial balloons floated by the regulators and
shot down by the industry, representatives of MMF shareholders and
organizations concerned with the efficiency of short-term credit
markets. The SEC staff has not made any efforts to look beyond
industry-level data and examine what happened to individual funds and
shareholders during September 2008, or to establish what changes might
be realistic from a performance or operational perspective.
The 2010 reforms require MMFs to file a monthly report with the SEC
containing volumes of information regarding their portfolios. The SEC
staff has yet to use this information to provide any public assessment
of the impact of the 2010 reforms on the risks and character of MMFs.
In addition, the SEC staff has not attempted to analyze whether the
``know your customer'' requirements of the 2010 reforms have affected
fund cash flows.
As a first critical step in their cost/benefit analysis of possible
reforms, the SEC staff must identify the benefits of MMFs to investors,
capital formation and market efficiency, and quantify these benefits to
the fullest possible extent. They must quantify how the proposed
reforms would jeopardize these benefits. As numerous commenters have
documented significant adverse consequences, the SEC must thoroughly
evaluate the associated cost and risk to the capital markets and
economy, including the substantial risk of the loss or increased cost
of credit to the many borrowers who rely on MMFs for short term
funding.
The SEC staff also must demonstrate and measure any purported
reduction in systemic risk of a proposed reform. The SEC may not, as
Commissioner Gallagher aptly put it, ``simply hand-wave and speak
vaguely of addressing `systemic risk' or some other kind of protean
problem.'' \13\ I hope that the Committee agrees that any further
reforms of MMF regulations should comply with the same rigorous
standards for cost/benefit analysis that the SEC has represented it
will apply to regulations mandated by the Dodd-Frank Act.
---------------------------------------------------------------------------
\13\ ``SEC Reform After Dodd-Frank and the Financial Crisis'',
speech by Commissioner Daniel M. Gallagher before the U.S. Chamber of
Commerce (Dec. 14, 2011), available at http://www.sec.gov/news/speech/
2011/spch121411dmg.htm.
---------------------------------------------------------------------------
The ICI, Federated, and other MMF managers, and other organizations
have attempted to fill this information gap by sponsoring surveys and
preparing studies of the financial and operational impact of various
proposals. With the advent of FSOC, the SEC staff no longer appears to
give this information the same consideration that they gave to the ICI
Working Group report. Certainly the SEC Chairman continues to make
public statements that either are contradicted by these studies or fail
to acknowledge important issues raised by them.
Although I confess to being skeptical of the need for further
reforms, Federated is willing to consider and assist the SEC, the ICI
and the industry in assessing reform proposals that would enhance the
resilience of MMFs. I am asking this Committee to encourage the SEC to
do the research necessary to determine what changes, if any, are truly
needed, and to express its commitment to the continued vitality and
growth of this important investment product.
I look forward to answering your questions.
[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT]
PREPARED STATEMENT OF BRADLEY S. FOX
Vice President and Treasurer, Safeway, Inc.
June 21, 2012
The U.S. Chamber of Commerce is the world's largest business
federation, representing the interests of more than 3 million
businesses of all sizes, sectors, and regions, as well as State and
local chambers and industry associations.
More than 96 percent of the Chamber's members are small businesses
with 100 or fewer employees, 70 percent of which have 10 or fewer
employees. Yet, virtually all of the Nation's largest companies are
also active members. We are particularly cognizant of the problems of
smaller businesses, as well as issues facing the business community at
large.
Besides representing a cross-section of the American business
community in terms of number of employees, the Chamber represents a
wide management spectrum by type of business and location. Each major
classification of American business--manufacturing, retailing,
services, construction, wholesaling, and finance--is represented. Also,
the Chamber has substantial membership in all 50 States.
The Chamber's international reach is substantial as well. It
believes that global interdependence provides an opportunity, not a
threat. In addition to the U.S. Chamber of Commerce's 115 American
Chambers of Commerce abroad, an increasing number of members are
engaged in the export and import of both goods and services and have
ongoing investment activities. The Chamber favors strengthened
international competitiveness and opposes artificial U.S. and foreign
barriers to international business.
Positions on national issues are developed by a cross-section of
Chamber members serving on committees, subcommittees, and task forces.
More than 1,000 business people participate in this process.
Good morning Chairman Johnson, Ranking Member Shelby, and Members
of the Committee. Thank you for the opportunity to discuss the
potential impact that additional changes to money market mutual fund
regulation contemplated by the Securities and Exchange Commission (SEC)
would have on the business community.
My name is Brad Fox, and I am the Vice President and Treasurer of
Safeway Inc. Safeway Inc. is one of the largest food and drug retailers
in North America with 1,678 stores and $44 Billion in annual revenue at
year end 2011. We employ approximately 178,000 people in a geographic
footprint that includes the western and southwestern regions of the
U.S., the Chicago area and the mid-Atlantic region, with stores locally
here in the District of Columbia, Baltimore, and Northern Virginia
areas. I am also a Chairman Emeritus of the National Association of
Corporate Treasurers (NACT). I am here testifying on behalf of the U.S.
Chamber of Commerce and the hundreds of corporate treasurers who are
tasked with managing their companies' cash flows and ensuring that they
have the working capital necessary to efficiently support their
operations. I have been active in an advocacy role on money market fund
regulatory change since the fall of 2009, representing the interests of
Safeway and the membership of the NACT.
Key Points
There are several important points that I wish to stress to the
Committee:
Money market mutual funds play a critical role in meeting
the short-term investment needs of companies across the
country. According to May 2012 data from Investment Company
Institute, corporate treasurers with cash balances and other
institutional investors continue to have confidence in these
funds, investing up to $900 billion or approximately 65 percent
of the assets in prime money market funds because they provide
liquidity, flexibility, transparency, investment diversity, and
built-in credit analysis. There are no comparable investment
alternatives available in the marketplace today.
Money market funds also represent a significant source of
affordable, short-term financing for many Main Street
companies. Approximately 40 percent of all corporate commercial
paper in the market place is purchased by these funds.
Treasurers are extremely concerned that the changes to
money market mutual fund regulation would fundamentally alter
the product so that it no longer remains a viable investment
option. The significance of such a change cannot be overstated.
Should it happen, money market mutual funds would no longer
remain a viable buyer of corporate commercial paper, which
would drive up borrowing costs significantly and force
companies to fund their day to day operations in a less
efficient manner.
Some corporate treasures are already making plans to
withdraw funds from money market accounts to ensure full access
to their funds and avoid the proposed redemption holdback.
Also, floating net asset values for money market funds would
result in a significant accounting burden for companies across
America investing in this product. Most treasury workstations
built for managing corporate cash do not have accounting
systems to track net asset values (NAVs) on each transfer into
and out of money market funds. Putting the systems issue aside,
many treasurers would refrain from returning to money market
funds to avoid the significant time and effort required to
record the gains and losses on each investment and the
potential impact on quarterly earnings results. The NACT
believes that the SEC must carefully consider whether any
additional regulations are required, as the 2010 reforms seem
to be working even under the stress of the European sovereign
debt crisis. Additional regulations can make the capital
markets inefficient and drive up costs harming corporate growth
and job creation.
Why Money Market Mutual Funds Are Important
Money market mutual funds play a critical role in the U.S. economy
because they work well to serve the investment and short-term funding
needs of businesses across America. Corporate treasurers rely on money
market mutual funds to efficiently and affordably manage cash. Cash
balances for companies fluctuate on a daily, weekly, monthly, or other
periodic basis, and depending on the nature of the business, some
companies' cash levels can swing widely--from hundreds of dollars to
hundreds of millions of dollars. A corporate treasurer's job is to
ensure that there is sufficient liquidity to meet working capital
needs, and money market mutual funds are the most liquid, flexible and
efficient way to do that on the investment side. They are also an
important source of short term funding.
Money Market Mutual Funds as an Investment
There are many reasons why money market funds are an attractive
investment choice in the business community. For companies with cash
surpluses, money market mutual funds offer a stable $1.00 price per
share that allows for ease of accounting for frequent investments and
redemptions. They also offer market rates of return for cash that
typically get no interest earnings sitting in a commercial bank
account. Moreover, investments in money market mutual funds can be made
and redeemed on a daily basis without fees or penalty, providing the
liquidity needed to manage working capital needs.
These funds also offer a diversified and expertly managed short-
term investment vehicle. This allows companies to invest in one fund
while diversifying exposure to a number of underlying investments.
Additionally, investment advisors to money market mutual funds perform
the credit analysis of the underlying assets so that treasurers and
their staffs don't have to spend time and resources analyzing the
credit worthiness of multiple individual investments, but rather the
mutual fund itself.
It is important to note that corporate treasurers understand the
risk of investing in money market mutual funds. We are professional
stewards of our companies' cash and we take our responsibility
seriously. As a large food retailer, we have significant cash inflows
and outflows on a daily basis that need to be managed efficiently and
effectively. In the few instances when we have cash to invest, money
market mutual funds are attractive to us since they are subject to a
high degree of transparency, which means that we can easily ascertain
what investments are in each money market mutual fund and the degree of
risk associated with each fund.
Money Market Mutual Funds as a Financing Source
Money market mutual funds also represent a major source of funding
to the corporate commercial paper market in the U.S., purchasing
approximately 40 percent of all outstanding commercial paper. In April
2012, U.S. money market mutual funds held $380 billion in commercial
paper, according to iMoneyNet. This source of financing is vital to
companies across America as commercial paper is an easy, affordable way
to quickly obtain short-term financing. Without money market mutual
funds, the commercial paper market would be substantially less liquid,
forcing companies to turn to more expensive means of financing. Higher
financing costs will create a drag on business expansion and job
creation.
For example, Safeway is a business with significant swings in
weekly cash flows, so we have found it most efficient to manage our net
borrowing position in the commercial paper market. As our working
capital needs can change over the course of a week by as much as $200
million, the ability to borrow overnight in the commercial paper market
allows us to manage our position very efficiently. On a daily basis, we
collect all of our cash, checks, and payment card receipts from our
stores. We then review and pay all vendor and other operating and
capital expenses. The commercial paper position is then adjusted
accordingly through incremental borrowing or repayment to balance our
daily books and avoid holding excess cash.
If instead, we had to use our revolving credit facility with our
banks for overnight borrowings, those borrowings would be priced at the
Prime Rate, approximately 2.5 percent higher than where we can place
overnight commercial paper. To request a more comparable, LIBOR-based
funding from our bank group would require 3 days advance notice, be for
a minimum term of 14 days and still be at a rate about 0.25 percent
higher than our commercial paper for the same term. These borrowing
restrictions would inevitably lead to over or under-borrowed positions
because they will rely on longer term forecasts, further driving up
costs when compared to balancing at the margin using overnight
commercial paper. Our banks provide these credit facilities to serve as
backup lines for commercial paper issuance. Their preference is to not
fund these low-priced credit facilities to investment grade companies,
and to save their capital for loans to lower rated companies which do
not have the same access to public markets where they can earn higher
returns.
2010 Changes to Rule 2a-7
Before discussing possible further changes in the regulation of
money market mutual funds, it is important to emphasize that such
changes will not occur in a vacuum. Just 2 years ago, the U.S.
Securities and Exchange Commission made enhancements to money market
mutual fund regulation through Rule 2a-7. These changes greatly
strengthened these funds, but most importantly, increased their
liquidity requirements. Funds are now required to meet a daily
liquidity requirement such that 10 percent of the assets turn into cash
in one day and 30 percent within one week. This large liquidity buffer
makes it unlikely that large redemption requests--even at the rate seen
in the 2008 financial crisis--would force a fund to sell assets at a
loss prior to their maturity.
Despite the fact that the 2010 reforms have just been implemented,
advocates of further regulation have focused much attention on three
significant structural changes to money market funds--redemption
restrictions, a floating NAV and a mandatory capital buffer. As
discussed below, we believe each of these would have a significant
negative impact on the ongoing viability of these funds, and thereby
inflict collateral damage on the corporate commercial paper market.
Redemption Restrictions
There are serious concerns about the SEC's potential implementation
of redemption holdbacks or other restrictions on the ability to access
funds invested in money market mutual funds. Some corporate treasures
are already making plans to withdraw funds from money market accounts
to have full access to their funds and avoid the complexities of
monitoring simultaneous holdback positions on multiple transfers into
and out of money market funds.
The reasons for this should be obvious. If corporate treasurers
can't get access to cash investments, they would be forced to seek
alternative resources to meet working capital needs. This includes
issuing debt or drawing on our credit facilities, incurring additional
costs that may be deployed more efficiently elsewhere. Such actions are
imprudent and illogical. Let me be clear: a corporate treasurer's
number one priority is liquidity, so any kind of redemption holdback or
restriction will not work. We would take our money elsewhere.
Floating Net Asset Value
There are similar concerns among the treasurer community with
regard to the proposal to establish floating NAVs for money market
mutual funds. Most treasury workstations built for managing corporate
cash do not have accounting systems in place to track NAVs on each
transfer into and out of money market funds. Treasury workstations
would need to be upgraded to accommodate these changes, and that
investment would significantly lag behind the timing of implementing
floating NAVs. As a result, corporate treasurers would likely withdraw
money market fund investments until the systems issue is solved. On a
related note, the systems upgrade costs would force a reallocation of
capital expenditure away from more economically productive uses like
business expansion and job growth.
Even putting the systems issue aside, many treasurers would refrain
from returning to money market funds to avoid having to record the
gains and losses on each investment that would flow through quarterly
earnings results. Corporate treasurers diversify fund investments, and
as such, are typically in multiple money market mutual funds at any
given time. Tracking the capital gains and losses on each fund where
investments and redemptions occur frequently is very complex.
Treasurers currently don't have the manpower (or resources) to track
this, nor do we have the desire to expend limited resources doing so.
We would simply find other places for our cash.
In addition, many treasurers are precluded from investing in
variable rate instruments. Taken as a whole, the challenges associated
with investment in floating NAV funds would outweigh the potential
return for many treasurers.
Capital Buffer
One other proposal that the Securities and Exchange Commission has
publicly discussed is the implementation of some type of capital buffer
in an attempt to protect against losses. While this should sound
appealing to investors, the reality is it doesn't. If the capital
buffer is funded by the parent company, due to already thin profit
margins, it would drive some fund companies out of business, leaving
fewer choices for investors. Additionally, some costs may be passed on
to investors. If the capital buffer is built up over time by allocating
some of the fund's yield to the buffer, it would take too long to build
the necessary buffer to protect against losses. Similarly, the creation
of a subordinated class of shares to provide the buffer would require
additional returns to be paid to those shareholders, and given the near
zero interest rate environment, this could eliminate any remaining
returns for investors. Thus, increasing fees or reducing yields is
likely to deter many investors, including corporate treasurers, from
investing in money market mutual funds.
Summary/Conclusion
In summary, Corporate Treasurers are very concerned about a sizable
contraction of the 2a-7 money market mutual fund industry that is
likely to result from the changes currently contemplated by the SEC. On
the investing side, corporations would be forced to withdraw from prime
money market funds to ensure full access to their money and avoid the
accounting burden imposed by floating NAVs, and instead invest in less
flexible bank investment products, other unregulated funds, or
individual securities. In so doing, they would lose the liquidity and
risk diversification benefit of the 2a-7 structure and increase
individual counterparty risk. On the funding side, a decrease in 2a-7
capacity would lead to higher costs and less liquidity for commercial
paper issuers, and place greater stress on banks to make up the
difference with additional lending. There would be greater uncertainty
in the daily activities of treasury departments, and that uncertainty
would likely lead to more caution in planning capital investments to
grow businesses and create jobs.
Rule 2a-7 money market mutual funds have been the gold standard
structure around the world for many years. The question must be asked,
why make additional changes now? With the reforms implemented in 2010
to provide greater liquidity, safety and transparency, these funds have
proven to be very stable and attractive investments during a time of
great upheaval in global markets related to the European sovereign debt
crisis. Given this stress test and resulting strong performance by
money market mutual funds, we renew our advocacy position questioning
whether any further regulation of the money market mutual fund industry
by the SEC is needed. Altering the structure and nature of money market
mutual funds would take away a vital short-term cash management tool
for companies throughout the country.
Thank you.
______
PREPARED STATEMENT OF DAVID S. SCHARFSTEIN
Edmund Cogswell Converse Professor of Finance and Banking, Harvard
Business School
June 21, 2012
Chairman Johnson, Ranking Member Shelby, and Members of the
Committee, thank you for the opportunity to appear here today to offer
my perspectives on money market mutual fund reform. My name is David
Scharfstein, and I am the Edmund Cogswell Converse Professor of Finance
and Banking at Harvard Business School. I am also a member of the Squam
Lake Group, which is comprised of 13 financial economists who offer
guidance on the reform of financial regulation. Our group has issued a
policy brief that advocates the introduction of capital buffers for
money market funds. I would like to provide a rationale for our
recommendations, but my statement, though aided by feedback from
members of the Squam Lake Group, is not being made on its behalf or any
other organizations with which I am affiliated.
Introduction
Observers of the first 35 years of money market fund (MMF) history
might have concluded that MMFs are a relatively safe investment and
cash management tool with no significant implications for financial
system stability. But the events surrounding the financial crisis of
2007-2009 suggest otherwise. When the Primary Reserve Fund ``broke the
buck'' after the failure of Lehman Brothers, it precipitated large
redemptions from prime MMFs, mainly by institutional investors who were
concerned that large MMF exposures to stressed financial firms would
lead to losses. This ``run'' on prime MMFs added to stresses on the
financial system at the peak of the financial crisis because large
banks depend on MMFs for short-term funding. Faced with large
withdrawals, MMFs were unable to invest in the commercial paper (CP),
repurchase agreements (repo) and certificates of deposit (CDs) issued
by large banks, broker-dealers, and finance companies. To stop the run,
stabilize the money markets, and ease the funding difficulties of large
financial institutions, the U.S. Treasury had little choice but to
temporarily guarantee MMF balances.
While extreme, the events of 2008 point to fundamental risks that
prime money market funds pose for the financial system. The main points
that I want to make are as follows:
1. Prime MMFs have evolved into a critical source of short-term,
wholesale funding for large, global banks. They are now a much
less important funding source for nonfinancial firms.
2. Prime MMF portfolios embed financial system risk because they are
short-term claims on large, global banks. Moreover, during
periods of stress to the financial system, some MMFs have
actively taken on systemic risk by investing in higher-
yielding, risky securities in an effort to grow their assets
under management.
3. The structure of MMF funding embeds financial system risk because
MMF shareholders can pull their funds on demand, and have done
so en masse when risk is amplified. This in turn creates
systemic funding difficulties for large banks that rely on MMFs
for their funding.
4. The SEC's 2010 reforms are a potentially useful first step in
enhancing money market fund stability, but more reforms are
needed to reduce risk in the financial system. Requiring
capital buffers large enough to meaningfully reduce portfolio
and run risk is a desirable next step in MMF reform.
Money Market Funds and Systemic Risk
A. MMFs as an Important Funding Source for Large, Global Banks
Total MMF assets are almost $2.6 trillion. Of this amount, $1.4
trillion are in prime funds, down from a peak of over $2 trillion in
August 2008. Approximately $900 billion of prime MMF assets are in
institutional funds, and the remainder are in retail funds.
Importantly, prime MMF portfolios are mainly invested in money-market
instruments issued by large, global banks--for the most part in CP,
repo, and CDs. Exhibit 1 lists the largest nongovernment issuers of
money market instruments held by prime MMFs. \1\ These top 50 issuers
account for 93 percent of prime MMF assets that are not backed by the
Government. And 93 percent of these are claims on large global banks,
most of which (78 percent) are foreign banks. The rest are mostly
claims on financial firms, including the finance arms of large
corporations. There are only 2 nonfinancial firms in the top 50
issuers. Altogether, only about 3 percent of prime MMF assets are
invested in paper issued by nonfinancial firms. A combination of
dramatic growth of financial CP, and declining nonfinancial CP issuance
since its peak in 2000, has meant that MMFs have small exposures to
nonfinancial issuers. \2\
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\1\ I am grateful to Peter Crane of Crane Data for providing these
data.
\2\ As of the first quarter 2012, there was only $127 billion of
domestic nonfinancial CP outstanding, down from its peak of over $300
billion in 2000. Commercial paper is also a much smaller share of the
liabilities of nonfinancial firms--now just 1.6 percent as compared to
its peak of 6.5 percent in 2000.
---------------------------------------------------------------------------
Given that prime MMFs mostly invest in money market instruments
issued by financial firms, it is not surprising that they provide a
sizable share of the short-term, wholesale funding of large financial
institutions. A rough estimate is that prime MMFs provide about 25
percent of this funding. \3\
---------------------------------------------------------------------------
\3\ Here I am defining short-term wholesale funding as uninsured
domestic deposits + primary dealer repo + financial CP.
---------------------------------------------------------------------------
Thus, prime MMFs essentially collect funds from individuals and
firms to provide financing to large banks, which in turn use the
proceeds to buy securities and make loans. This process essentially
adds a step in the chain of credit intermediation. The benefit of
adding this step is that it provides MMF investors with a diversified
pool of deposit-like instruments with the convenience of a single
deposit-like account. But the cost is that it adds risk to the
financial system. Risk is increased because MMFs allow investors to
redeem their shares on demand, thereby increasing the likelihood of a
run on MMFs and the banks they fund during periods of stress to the
financial system. Risk may also be increased because MMFs have
incentives to chase yield (and risk) in an effort to attract more
assets. And investors may be willing move assets to a riskier fund
because they can exit the fund on demand. MMFs and their investors do
not take into account the full societal costs of the risks they take
because they do not bear all the costs and because the Government has
proven willing to support money markets and MMFs during times of
financial system stress. Indeed, most of the Government interventions
during the financial crisis were directed at supporting the money
markets and money market funds. (See Exhibit 2 for a list of these
interventions.) Regulation of MMFs is needed to reduce excessive run
risk and portfolio risk.
B. Systemic Portfolio Risk
In a recent speech, Eric Rosengren, President and CEO of the
Federal Reserve Bank of Boston, noted that there is considerable credit
risk in the portfolios of prime MMFs as measured by credit default swap
(CDS) spreads. \4\ He reported that as of September 30, 2011, 23
percent of holdings were backed by a firm with a CDS spread between 200
and 300 basis points, about 10 percent by a firm with a CDS spread
between 300 and 400 basis points, and almost 5 percent were backed by a
firm with a CDS spread in excess of 400 basis points. For reference, as
of September 30, 2011, the average investment grade corporate bond had
a CDS spread of roughly 145 basis points. \5\ Thus, as of September
2011, a meaningful fraction of the securities in prime MMFs were issued
by firms with CDS spreads well in excess those of the safest investment
grade companies.
---------------------------------------------------------------------------
\4\ See, ``Money Market Mutual Funds and Financial Stability'',
speech by Eric Rosengren at Federal Reserve Bank of Atlanta 2012
Financial Markets Conference, Stone Mountain, Georgia, April 11, 2012.
http://www.bos.frb.org/news/speeches/rosengren/2012/041112/041112.pdf
\5\ In particular, the CDX.IG CDS index, which includes 125
investment grade corporate bonds, had a 5-year CDS spread of 144 basis
points on September 30, 2011. By contrast, the CDX.HY CDS index, which
includes 100 high yield bonds, had a 5-year CDS spread of 829 bps. Note
that these CDS spreads are for bonds with a longer maturity and, in
some cases, lower seniority than the money market instruments held in
MMF portfolios, and thus will tend to be riskier. Nevertheless, the
point is that MMFs can have significant exposures to risky banks.
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Importantly, because MMFs own a pool of claims on large financial
institutions, this credit risk also includes considerable financial
system risk. If the financial system is under stress, as it was in the
2 years surrounding the failure of Lehman Brothers in September 2008,
it manifests itself in short-term funding difficulties, and an increase
in the risk of money market instruments.
Moreover, during the financial crisis of 2007-2009, and the more
recent eurozone sovereign debt crisis, some MMFs actually sought to
increase risk and yield in an attempt to attract investors and grow
assets under management in a low interest-rate environment. In
particular, during the summer of 2007, interest rates on asset-backed
commercial paper (ABCP) rose dramatically in response to concerns about
the quality of subprime loans that served as collateral for these
conduits. Some MMFs responded to this spike in market risk by actually
increasing portfolio risk, taking on higher-yielding instruments like
ABCP in an effort to boost returns and attract new investors. Indeed,
institutional investors proved to be very responsive to higher yields,
moving assets to MMFs that had increased yields and risk. Exhibit 3,
based on data used in a 2012 study by Marcin Kacperczyk and Philipp
Schnabl, shows that MMFs offering the highest yields were able to grow
their assets by close to 60 percent from August 2007-August 2008, while
those that did not increase yields by very much saw little or no asset
growth. \6\
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\6\ See, Marcin Kacperczyk and Philipp Schnabl, ``How Safe Are
Money Market Funds?'' Working Paper, Stern School of Business, New York
University, April 2012. I am grateful to Philipp Schnabl for preparing
Exhibit 3.
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Prime institutional funds responded in similar fashion to the
eurozone sovereign debt crisis. As concerns rose about the exposure of
eurozone banks to struggling eurozone countries (such as Greece,
Portugal, Spain, and Italy), yields on instruments issued by these
banks increased. This created an opportunity for MMFs to increase
yields and attract assets, albeit with an increase in risk. Indeed, a
recent study by Sergey Chernenko and Adi Sunderam finds that some funds
loaded up on the riskier, higher-yielding securities of eurozone banks
and in the process were able to grow assets. \7\
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\7\ Sergey Chernenko and Adi Sunderam, ``The Quiet Run of 2011:
Money Market Funds and the European Debt Crisis'', Working Paper,
Harvard Business School, March 2012.
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Two important points emerge from these studies. First, some MMFs
view it as in their interest to chase risk in an attempt to increase
yields and grow assets even though such risk-taking could threaten the
viability of the fund, trigger runs at the fund and other ones (as
later happened with the Reserve Primary Fund), and ultimately threaten
the stability of the broader financial system. Second, institutional
investors can be extremely yield sensitive and risk tolerant; they
appear willing to move large sums to increase returns by 10 or 20 basis
points. In part, this may be because they get some measure of
protection from the option to redeem their shares on demand. But when
they protect themselves in this way, they exacerbate the stress on MMFs
and they threaten the ability of MMFs to fund the activities of the
banking sector.
C. Systemic Funding Risk
As just noted, the funding structure of MMFs creates risks for the
broader financial system. Because MMF shares are demandable claims--
they allow investors to redeem their shares on a daily basis--investors
can pull their funds from MMFs at the slightest hint of trouble.
Funding risks are also amplified by the fact that MMFs are allowed to
maintain a stable $1 NAV per share using amortized cost accounting and
rounding. This enables investors to redeem their shares at a $1 share
price even if the marked-to-market value is less than $1 per share. The
stable NAV feature creates incentives for investors to beat other
investors out the door before the fund breaks the buck and is no longer
allowed to redeem shares at the $1 share price.
A run is not just damaging to the MMF, but it could be damaging to
the broader financial system. A run at one MMF could precipitate runs
on other MMFs if, as one might expect, investors are concerned that the
factors that led to losses in one fund could affect other funds. In
this case, multiple funds will have difficulty rolling over the
securities in their portfolio, amplifying the funding stresses on
financial institutions, which can spill over into the real economy. It
is altogether possible that an otherwise healthy bank will face funding
difficulties because the failure of another bank leads to a run on the
MMF sector.
A systemic MMF run has occurred twice in the last 4 years. As shown
in Exhibit 4, the failure of Lehman Brothers in September 2008
precipitated a run on prime institutional MMFs, with assets falling by
29 percent within 2 weeks. There was no run on prime funds by retail
investors. The run would likely have been much more severe had Treasury
not stepped in and temporarily guaranteed MMF balances.
A similar, but slower-moving version of this story played out in
the second half of 2011, as prime institutional MMF investors became
concerned about the exposure of European banks to the sovereign debt of
struggling eurozone countries. Given the large presence of money market
instruments issued by eurozone banks in the portfolios of U.S. MMFs,
this led to significant redemptions from prime institutional MMFs from
June-December 2011, as shown in Exhibit 4. Again, the redemptions were
more pronounced among institutional investors than retail investors.
This is consistent with research showing that it is institutional
investors that are more prone to chase yield and risk, and then pull
their funds when their perspectives on risk change. \8\ MMF outflows
have added to the stresses on eurozone banks, particularly on their
ability to fund their dollar loans both here and abroad.
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\8\ Kacperczyk and Schnabl, op. cit.
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Regulatory Reform Alternatives and the Need for Capital Buffers
The broad goal of money market fund regulation should be to ensure
that portfolio risk and funding risk are within acceptable limits.
Regulation can take a variety of forms to achieve this objective.
Portfolio risk can be limited by placing restrictions on what MMFs can
hold in their portfolios, or by reducing the incentives of MMFs to take
excessive risk. Funding risk can be limited by reducing the ability of
shareholders to redeem their shares on demand, or by reducing their
incentives to do so.
A number of reform proposals are being considered, including
elimination of stable NAVs and capital buffers (possibly combined with
redemption restrictions). These reforms would be in addition to new
regulations adopted by the SEC in early 2010, which require MMFs to
hold more liquid, higher quality and shorter maturity assets, allow
MMFs to suspend redemptions under certain conditions, and require more
disclosure of MMF portfolio holdings and their value.
The MMF industry has argued that these reforms are sufficient to
ensure MMF safety. \9\ While these reforms may, in fact, be helpful in
reducing portfolio and funding risk, SEC Chairman Mary Shapiro is right
to point out that more needs to be done. \10\ While it is desirable to
have MMFs hold more liquid securities to buffer against large
redemptions, it is often difficult for regulators to identify assets
that will continue to be liquid during a liquidity crisis. Indeed, even
securities backed by high quality collateral became illiquid during the
financial crisis in 2008. \11\ Moreover, the requirement that MMFs hold
shorter maturity securities, while potentially enhancing the safety of
MMFs, may actually come in conflict with the objectives of other
regulatory initiatives to get banks to be less reliant on short-term,
wholesale funding. \12\
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\9\ See, for example, ``Response to Reported SEC Money Market
Funds Proposals'', Investment Company Institute, February 17, 2012.
\10\ SEC Chairman Schapiro is quoted as saying, ``While many say
our 2010 reforms did the trick--and no more reform is needed--I
disagree. The fact is that those reforms have not addressed the
structural flaws in the product. Investors still have incentives to run
from money market funds at the first sign of a problem.'' See, Sarah N.
Lynch, ``SEC Schapiro Renews Call for Money Fund Reforms'', Reuters,
March 15, 2012.
\11\ See, Morgan Ricks, ``Reforming the Short-Term Funding
Markets'', The Harvard John M. Olin Discussion Paper Series, No. 713,
May 2012.
\12\ In particular, the Tri-Party Repo Task Force established by
Federal Reserve Bank of New York has recommended that dealers should
shift to longer-term repo funding. See also ``Basel III: International
Framework for Liquidity Risk Measurement, Standards and Monitoring,''
Bank for International Settlements, December 2010, for a description of
international regulatory initiatives to reduce bank dependence on
short-term funding.
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Additional reforms are also needed because a number of the tools
that the Government used to support money markets and stabilize MMFs
are now more restricted or unavailable. In particular, the Emergency
Economic Stabilization Act of 2008, the legislation that created the
Troubled Asset Relief Program, outlaws the use of Treasury's Exchange
Stabilization Fund to guarantee MMF shares as it did in September 2008.
And programs that the Federal Reserve and FDIC introduced to stabilize
money markets during the crisis would now require either executive
branch or Congressional approval. \13\ Some might argue that without
these emergency supports, moral hazard will be reduced and, as a
result, MMFs and their shareholders will take less risk. But the
response of MMFs and their shareholders to the eurozone sovereign debt
crisis suggests otherwise.
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\13\ Ricks, op. cit.
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The two main types of reform proposals are (i) replacement of the
stable NAV structure with a floating NAV structure; (ii) various forms
of capital buffers. The capital buffer proposals include: requirements
that sponsors put their own capital at risk; creation of two
shareholder classes, one subordinate to the other; and redemption
holdbacks that are put at risk when shareholders redeem their shares.
Floating NAV Proposal
As noted, above stable NAVs exacerbate run incentives when MMFs get
in trouble because early redemptions are made at the $1 share price
even if the market-value NAV is less than $1. There are a number of
ways in which a floating NAV structure would help promote MMF
stability. First, it would reduce the benefits of early redemptions
from a stressed fund since redemptions would occur at market values
rather than an inflated $1 NAV. Second, it would likely make clear to
investors that MMFs are risky investment vehicles and it would provide
a more transparent view of the risk. This could help to dampen the sort
of yield-chasing behavior we have recently observed, followed by the
runs that occur during a crisis. Thus, the floating NAV proposal, while
mainly acting to reduce funding risk, could also help to reduce
portfolio risk.
The MMF industry has strongly opposed floating NAVs, arguing that
investors derive significant operating, accounting, and tax management
benefits from the ability to transact at a fixed price. \14\ While
there may be benefits of such a pricing structure, it is unclear how
much of the institutional demand for MMFs derives from such a
structure. After all, many large institutional investors manage their
own pool of money market instruments, which of course fluctuate in
value. It is possible that a good deal of MMF demand comes from the
higher yields they have historically been able to offer, combined with
the potential benefits of being able to diversify across money market
instruments. These benefits would continue to exist in a floating NAV
structure.
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\14\ See, ``Report of the Money Market Working Group'', Investment
Company Institute, March 17, 2009.
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Another concern is that floating NAVs might not be sufficient to
stop runs in times of stress. Advocates of floating NAVs believe that
the fixed NAV structure is the attribute of MMFs that significantly
exacerbates run incentives. An alternative view is that runs derive
from a change in investor perception of risk combined with their
ability to redeem shares on demand regardless of whether the redemption
occurs at $1 or slightly less. Indeed, given the illiquidity of
securities in MMF portfolios, mass selling of those securities could
drive down their price. The prospect of fire sales also gives MMF
shareholders incentives to exit early and could precipitate a run. One
MMF industry study has pointed out that floating-NAV instruments, such
as ``ultra-short'' bond funds and certain French floating-NAV money
market funds were not immune from substantial sudden redemptions during
the financial crisis. \15\ If so, then some form of a capital buffer
could be a more effective run-prevention mechanism.
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\15\ Ibid.
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Capital Buffers
The Squam Lake Group, of which I am a member, has proposed capital
buffers as a mechanism for promoting more stable MMFs. \16\ The policy
brief outlines a number of possible ways that capital buffers could be
structured and suggests that individual MMFs be given some flexibility
in choosing the precise form of the buffer. For example, some sponsors
may prefer to set aside their own capital, while others may prefer to
issue a subordinated, loss-absorbing share class. While some choice may
be desirable, it will be necessary to restrict the menu of options so
that investors can readily assess the degree of capital support.
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\16\ ``Reforming Money Market Funds: A Proposal by the Squam Lake
Group'', January 14, 2011.
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With a capital buffer, first losses are incurred by capital
providers, either fund sponsors or subordinated share classes. This
reduces the incentive of MMF investors to run because they can be more
confident that their investment is protected. A capital buffer could
also act to reduce portfolio risk. If the sponsor provides the capital,
the sponsor would presumably have greater incentives than it does now
to avoid losses. Even if capital is provided by a subordinated share
class, sponsors would have incentives to reduce portfolio risk to limit
the cost of this capital and increase yields on the senior share
classes.
Although capital buffers may seem like a significant departure from
the current regime, MMF sponsors have often provided capital support
when necessary. As documented recently by Eric Rosengren, fund sponsors
provided capital support in 56 instances from 2007-2010. In nine cases,
support exceeded 1 percent of net asset value. \17\ However, capital
requirements are preferable to ad hoc capital support because with
capital requirements investors will know that there is layer of capital
support to protect them; if capital support is ad hoc, investors will
run in the face of uncertainty about whether support will be
forthcoming.
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\17\ Rosengren, op. cit.
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There is also active debate about what the right level of capital
should be. Industry advocates suggest relatively low levels of capital
given historical loss rates. However, it is important to set capital
levels comfortably above historical loss rates and prior levels of ad
hoc capital support so that investors are confident that their funds
are safe and have no incentive to run. In addition, historical loss
during the crisis of 2007-2009 occurred against the backdrop of
extraordinary Government support of the money markets and money market
funds. Without such support, which may not be forthcoming to the same
degree in the next crisis, loss rates could well be higher than the
historical crisis average. For these reasons, capital buffers would
need to be set meaningfully in excess of historical loss rates and ad
hoc capital support levels.
Finally, the MMF industry has generally opposed capital buffers,
arguing that they are costly and would make MMF sponsorship
unprofitable. While there are costs of a capital buffer, the costs
should not be particularly high if, as industry opponents argue, MMFs
are relatively safe. \18\ Moreover, as discussed above Moreover,
capital is also costly to banks, and yet there is widespread agreement
that they should hold capital. Like banks, MMFs are systemically
significant financial intermediaries and as such should have capital
buffers to promote a more stable financial system.
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\18\ For example, suppose there was a capital buffer that required
sponsors to set aside 2 percent of NAV in Treasuries. Sponsors would
have to pay a liquidity premium for holding Treasuries. This liquidity
premium is on the order of 1 percent. With a 2 percent buffer, this
cost amounts to just 2 basis points. The potentially greater cost comes
from the possibility that the sponsor loses the capital as compared to
a situation where the sponsor just walks away from the fund. If the
risk is low, this cost should be minimal. Note also that many sponsors
choose to support their funds when they risk breaking the buck, so
relative to such noncontractual support the cost of the buffer is even
lower.
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Thank you for the opportunity to present my views on money market
fund reform. I look forward to answering any questions you may have.
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Additional Material Supplied for the Record
PREPARED STATEMENT SUBMITTED BY THE FINANCIAL SERVICES INSTITUTE
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LETTER SUBMITTED BY MICHELE M. JALBERT, EXECUTIVE DIRECTOR--POLICY AND
STRATEGY, THE NEW ENGLAND COUNCIL
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PREPARED STATEMENT SUBMITTED BY JEFFREY N. GORDON, RICHARD PAUL RICHMAN
PROFESSOR OF LAW AND CO-DIRECTOR, CENTER FOR LAW AND ECONOMIC STUDIES,
COLUMBIA LAW SCHOOL
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