Last week, word emerged that the Securities and Exchange Commission (SEC) Chair Mary Schapiro lacked the votes to advance her proposal to reform the $2.5 trillion money market mutual fund (MMMF) industry. This is tragic news because money market mutual funds are a key source of systemic risk at the core of what has come to be known as the “shadow banking” industry.
The financial crisis has been used to justify sweeping legislative and regulatory reforms in areas that had nothing to do with the crisis. What Congress or regulators have not yet done is address the two aspects of financial intermediation that were actually proven to be destabilizing to the broader economy: too-big-to-fail institutions and non-banks’ vulnerability to “bank runs.”
The “shadow banking” system consists of a network of institutions that perform banking functions outside of the traditional banking system. Since shadow banks perform banking functions, they are susceptible to the same crisis of confidence that trigger bank runs and liquidity crises. At the same time, since shadow banks exist outside of the traditional banking system, they lack the regulations, deposit insurance, and lender-of-last resort facilities of traditional banks. In many ways, this is the worst of both worlds: all of the risk of banks with none of the safety net.
At its core, banking is about accepting or issuing money-like liabilities (customer deposits) to buy risky assets (loans to businesses and households). But, there is a tension here. Household transaction balances that are supposed to be as good as cash and can be redeemed at any time are used to fund loans for commercial developments that take years to complete. No bank, no matter how sterling the quality of its loan portfolio, could meet redemption requests en masse because its assets are less liquid than its liabilities.
The issuance of money-like liabilities is also at the core of shadow banking. Indeed, without some mechanism to attract “deposits,” shadow banks wouldn’t perform the banking functions that make them vulnerable to crisis. Money market mutual funds (MMMFs) are the key channel through which the shadow banking system raises deposit-like overnight funding in lieu of a banking license.
Money market mutual funds (MMMFs) suffer from a basic mismatch between what they own and what they owe. According to the most recent statistics, only $474 billion of the $2.5 trillion of assets held by MMMFs (19%) consist of Treasury securities. The rest involve some degree of credit risk. (Even if we assume – and add to this total –the $360 billion in savings account deposits are held in banks and fully guaranteed by the Federal Deposit Insurance Corporation (FDIC), the total credit-risk-free holdings of MMMFs account for less than one-third of their total assets.)
Yet, the MMMFs issue fully-redeemable “shares” to the public whose value is fixed at $1. These “shares” are fixed in value to create the appearance among “investors” that these shares are effectively deposits or just as good as cash. But because the MMMFs own risky assets like foreign bonds and commercial paper that cannot themselves be redeemed at par, the “moneyness” of MMMF shares is a sort of intellectual fiction. By creating the impression that their shares are as good as cash, MMMFs profit from a perspective arbitrage where risk-free liabilities are somehow funded with risky assets.
This credit mismatch finally caught up to MMMFs in 2008. The Reserve Fund “broke the buck” – i.e. the net asset value fell below the fixed rate of $1 per share due to losses on Lehman commercial paper – causing a panic in the sector. In addition, at least 47 other MMMFs received at least $3.2 billion in bailouts from affiliated bank parents. Some of these funds undoubtedly were TARP-financed.
More significantly, the federal government took two steps to bailout the industry directly. First, the Treasury created a program that effectively guaranteed $2.4 trillion of MMMF liabilities. Secondly, the Fed created the “Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility,” that indirectly channeled $150 billion in bailout funds to MMMFs through banks over the course of 10 days.
The experience of 2008 taught us two very important lessons. First, in a stressed situation, the mismatch between what MMMFs own and owe predictably results in disaster. Investors in MMMFs seek to redeem their shares en masse in the same manner that depositors “run” on a bank they believe to be insolvent. The incentive to “run” stems from the fact that those who get there first get one hundred cents on the dollar, while those who redeem shares at a later date get less, or nothing at all. There is no incentive to wait; any hint of problematic assets should be enough to cause investors to demand immediate repayment. Second, the government has no choice but to bail out these funds in crisis situation. MMMFs provide critical short-term financing to businesses and financial institutions. According to the Fed, MMMFs held 45% of all commercial paper outstanding. A sudden stop in the supply of short-term credit creates liquidity crises and the potential for mass defaults.
The importance of MMMFs as a source of short-term financing creates an interesting question: why don’t investors in MMMFs invest in commercial paper and other short-term loans directly? The MMMFs don’t provide financing themselves; they are simply intermediaries that raise short-term funds to make predominately short-term investments. The most likely answer is that investors in MMMFs are not seeking short-term investments, but rather deposits. MMMFs are viewed as a place to store money, not invest it. Their existence depends, in part, on their perception as a riskless repository for households’ excess liquidity.
Since this perspective arbitrage is at the core of what makes MMMFs attractive, the industry had no use for S.E.C. Chair Schapiro’s simple proposal to require MMMFs to either: (1) hold capital and impose a redemption limit on investors; or (2) allow the net asset value to fluctuate instead of being fixed at $1 per share. Holding capital would make MMMFs unprofitable in the current rate environment (unless they imposed negative interest rates). Redemption limits and floating NAVs would reduce the perceived “moneyness” of MMMF liabilities, which again is their key attraction. So a majority of SEC Commissioners decided that they would prefer a status quo that guarantees, in the fullness of time, either destabilizing “runs” or huge bailouts.
There was a time before the crisis reached full intensity that self-styled conservatives opposed fair value accounting on the grounds that it was a senseless government regulation. This was quite astonishing. So-called defenders of markets and the importance of price signals were saying, essentially, that market prices were either wrong or had no economic value.
The same problem is evident today. A sensible reform plan is viewed as regulatory overreach despite the fact that the MMMF industry is organized around the government-sponsored charade that a portfolio of modestly volatile assets always has a per-share value of $1.
MMMF reform should have been a bipartisan opportunity for policymakers to demonstrate that they’ve learned from the crisis, and that there is a difference between being pro-market and pro-business.