The SEC approved some new rule changes for money-market funds this week. One of them requires a floating net asset value (NAV) rather than a fixed $1.00 par value - this is a welcome addition to a new post-crisis reality. However, the other proposed change, which would allow money managers to suspend redemptions by investors, or charge them fees to redeem during volatile periods, is a travesty.
Why any changes to this asset class took six years after the dawn of the world's worst financial crisis since the Depression, and were completely missed during the Dodd-Frank rule-construction period, is quite a head-scratcher. Until, at least, you ponder the power of financial industry lobbyists - then the delay becomes understandable.
The perfect ingredients of a real crisis and "run" are first, the incorrect recording and marking of risk on the balance sheets of investors, corporate debt issuers, or money managers; and second, a canyon gap between perception and reality. The money-market industry possesses these ingredients and the Federal Reserve knows it.
The Fed's behind-the-scenes motions belie its many public comments that it's not too worried about "bubbles." But the all-powerful lobbyists shouldn't bow their heads in defeat entirely - they managed to walk away with a consolation prize: Charles Schwab (NYSE:SCHW - News) paid its lobbyists well and they managed to insert a gift: Money-market funds sold to individuals (as opposed to institutions) will be exempt. For Federated Investors, which receives 40 percent of its income from money-market funds primarily sold to institutions - not so much.
Usually the portfolio in a money-market fund doesn't move at all in price, due to it's very short duration. That's until a shock event hits one of the entities in the portfolio, which was the case of the Lehman Brothers default. Investors then all the sudden realize they don't own "cash," and instead own risky corporate debt, which in the case of Lehman, opened up Monday morning Sept. 15, 2008 at a bid-offer of 10 cents to 12 cents on the dollar. Suddenly "cash" just lost 90 cents on the dollar. Yup. That's when the proverbial crap hit the fan, and the clothes came off the emperor. Investors started shooting first and asking questions later and liquidated all their money-market funds and transferred them into 30- day T-bills. That's how a "run" begins. The tide goes out and you realize who's been swimming naked. And boy, is the money-market industry naked! And we are talking about an asset class with a notional value of $2.6 trillion currently.
Roughly 35 percent 40 percent of all investment-company assets are comprised of money-market funds, with 80 percent of corporations using money-market funds to manage their cash balances , and 20 percent of household cash balances comprised of money-market funds ( source: SEC report, June 24 2009).
Incorrect recording of risk
The incorrect recording of risk in money-market funds lies in the implicit promise of the portfolio manager to never "break the buck," i.e. compensate investors for any losses below $1.00 par value resulting from any underlying defaults. There are numerous examples of money managers shielding investors from any losses in money market funds and thus eating the losses themselves. They were able to do this because they had the capital to do so and felt it was worse for business if they didn't. The most famous case from 2008 is the Reserve Fund, which didn't have the capital to do so and essentially collapsed and passed along the losses to investors. The problem here is that if it is the intention of the manager to shield investors from losses, what that manager is essentially doing is writing default protection, or CDSs, at par on the underlying portfolio of securities, and essentially insuring the portfolio. But this risk is never recorded on the manager's balance sheet, and never quantified for its shareholders. This is one giant AIG problem: AIG wrote default protection and clipped billions of basis points but held no collateral against the trades nor disclosed the risk properly to shareholders. AIG was AAA-rated of course, and didn't have to. Of course...
A firm like Federated, for example, would argue it doesn't have to. Why? Because there is NO LEGAL OBLIGATION OR PROSPECTUS LANGUAGE REQUIRING THEM TO "NOT BREAK THE BUCK," OR INSURE INVESTOR LOSSES IN FUNDS. So why should they account for that? If they did insure losses, they did it out of good business practice and had plenty of capital to do so, unlike the Reserve Fund. Yet the lack of any legal requirement precludes the need to account for it on Federated's balance sheet.
Gap between perception and reality
And this is where crisis ingredient No. 2 comes into play: the gap between perception and reality. There is an investor PERCEPTION that their money-market fund is insured by the manager due to the "break-the-buck" concept. In fact, there is absolutely no legal requirement or guarantee that money managers must "never break the buck" or shield investors from losses. The situation is analogous to the Agency Mortgage Bond market of pre-2008. Everyone knew there was an implicit guarantee of a par put from the U.S. federal government, but it appeared nowhere explicitly or legally in the prospectus. Not until Vladimir Putin made a phone call to then-Treasury Secretary Hank Paulson in late 2008 and demanded an explicit public statement of a guarantee or Putin would dump all his agencies, did the Feds actually step forward and engrave the guarantee in stone.
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So who really holds the risk of a default in the underlying portfolio? It's one big game of "hide the salami." Investors hold the bag in the end, while money managers fool them into forgetting that, by dangling this fixed $1.00 mark along with the "wink-wink" nod that the manager will insure the portfolio against losses. Both features are false premises used to fool investors into thinking this is "cash"
First, these underlying securities contain corporate credit risk-of-default like any other corporate bond. Second, there's no legally guaranteed "par put" to the manager, like there is in agency mortgages now to the U.S. government. The money-manager industry knows that by allowing these funds to have a floating NAV, they allow the investor to take a bite from the apple of the tree of knowledge, and thus bring radical change to an industry which will never be the same again.
Good! It SHOULDN'T be the same again.
So the Federal Reserve has been rightly concerned about a repeat run similar to 2008 and the SEC has responded logically. Imposing a floating NAV and thus exposing investors to losses in the money-market portfolio (which they always were exposed to but didn't know it) is the right move.
But the proposed rules fall far short and end up penalizing the true victim and only real innocent entity in this game of "three-card monte" - the investor. One of the other key rule changes is to allow managers to limit investors' ability to redeem the funds, or charge them extra fees for redemption, in periods of excessive volatility. That begs the question: How do you call something a "money market," thus giving it the metaphorical equivalent of cash, and limit investors' ability to treat it as such? And how do you impose fees, like 0.25 percent, on something that doesn't even annually yield the amount of the fee? Why would we penalize investors for the completely rational thought process of selling securities during risky volatile times?
The other way these proposed rules fall short is in what type of funds they cover. The proposed rule changes apply only to PRIME funds, which contain corporate debt, and not tax-free municipal funds. Second, they cover only funds sold to INSTITUTIONAL clients, not individuals.
So apparently the SEC doesn't think there is an inherent "run" risk involving the collapse of tax-free municipal money market funds? Despite the fact that the largest muni-bond issuer of them all, Puerto Rico, whose muni paper is in about 80 percent of the muni-market fund portfolios out there, is facing worse credit metrics than Detroit, or perhaps even Argentina, and is on the brink of largest default/restructuring ever? I can't think of a bond sector more ripe for a "run" than that.
Money-market funds sold to INDIVIDUALS remain exempt from the rules. For that, we can thank Walt Bettinger of Charles Schwab, who famously wrote an op-ed in November of 2012 accusing institutional clients of causing the money-market run in 2008, and thus, the only investors who should be subject to the new rules. Of course institutional investors started the run, Walt. They were the only people who had a clue what was going on and what type of real risk they had stuffed up where the moon don't shine. Professional, educated members of the finance Industry tend to move more quickly than the public sheep. The fact is, individuals were in the dark on what they owned; after all, it's CASH, right? They remain in the dark today, and this rule exemption in the new SEC proposal does nothing to fix that perception gap.
So what can an investor do and what advice would I give them as a financial advisor? Stay out of money market funds! The few extra basis points of yield aren't worth it. You own NO legal guaranteed par put or portfolio-manager insurance from losses. Keep your cash in short term T-bills. Yes, there is very little interest. We live in a ZIRP-world, and that's how it goes unfortunately. Or, put your short term money in FDIC- guaranteed bank CDs. The yield differential isn't worth taking the capital-loss risk inherent in money-market funds, and the FDIC is the only real insurance around. If the FDIC can't honor its agreement, then we'll be living in a Snake Plissken world and it won't matter anyway.
Commentary by James Sanford, a portfolio manager for Sag Harbor Advisors (www.sagharboradvisors.com). He has also worked with Credit Suisse Securities, JP Morgan Securities and Gleacher & Co.
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