Four years after the fall of Lehman Brothers, and with a presidential campaign in full swing, everyone can surely agree on one thing: We shouldn't risk another financial crisis.
But after four years of studies, hearings and round tables, the Securities and Exchange Commission (SEC) abandoned efforts to impose new regulations on money market funds intended to prevent another panic like the one that occurred in 2008 and eliminate the need for a taxpayer bailout of the multitrillion-dollar funds.
The SEC's proposed reforms had the backing of the White House, Treasury officials, the Federal Reserve, the Bank of England, a council of academic experts, The Wall Street Journal's conservative editorial page, former Fed Chairman Paul Volcker, former Treasury Secretary Henry M. Paulson Jr. — just about every disinterested party who weighed in on the issue. So it's no wonder many SEC staff members were shocked when three of the five SEC commissioners — two Republicans and one Democrat – indicated they wouldn't support the proposals. It was a rare case of a Democratic commissioner breaking ranks with the agency's chairwoman, Mary L. Schapiro, an Obama appointee who is a political independent.
"I'm not the crusading type," a frustrated Schapiro told me. "This isn't based on conjecture. We know what can go wrong. We saw what happened with the Reserve Fund in 2008. There was a broad run on money market funds; credit markets froze. People didn't have access to their money, which was extraordinary. We're trying to prevent that. And if you're opposed to government bailouts, you have to support these reforms."
So what accounts for the collapse?
Though Republicans in Congress have generally sided with the mutual fund industry, and the reforms emerged from a Democratic administration, several people I spoke to said it was a mistake to view the outcome through the prism of partisan politics. "It's not Republicans versus Democrats," a person involved in formulating the proposals told me.
"It's the mutual fund industry and its allies versus the American taxpayer." For many in the mutual fund industry, 2008 seems both a distant memory and the equivalent of a 100-year flood, something unlikely to be repeated. But just four years ago, on September 16, 2008, shortly after Lehman Brothers collapsed, the Reserve Fund, the nation's oldest money market fund, "broke the buck" and set off a run on the global money fund industry.
Money market funds — convenient, higher-yielding and supposedly ultrasafe alternatives to deposits at banks — are a mainstay of the mutual fund industry, offered by all the major fund families. They typically invest in short-term, low-risk assets (like US Treasurys and highly rated commercial paper), and with the blessing of regulators, each day they report a stable net asset value of $1 a share. That's convenient for tax purposes (there are never any reportable gains or losses), and it promotes the idea that these funds are risk-free because the reported value never fluctuates. In reality, this has always been an illusion, or what Schapiro calls a "fiction." Even short-term assets may fluctuate as interest rates change, even if the moves are very small. And they can also fluctuate because of credit risks. That's what happened to the Reserve Fund: It owned $785 million in Lehman Brothers' commercial paper.
When the value of Lehman Brothers debt collapsed, there was no way the Reserve Fund could claim that its shares were worth $1, even using generous rounding and averaging tactics to mask shifts in value. When the Reserve Fund admitted its shares weren't worth $1, investors panicked and began a run on the fund. Reserve froze its assets and no one could get their money out, even though the actual net asset value was only a few cents less than $1.
The run quickly spread to other money market funds. Funds were frantically trying to unload commercial paper and other assets to raise cash. Major corporations that rely on commercial paper to cover day-to-day operations found themselves unable to issue new securities as the market teetered on collapse. Paulson fielded phone calls from chief executives alarmed that they might be unable to meet their payrolls. The run on the Reserve Fund and other money market funds took the financial crisis straight from Wall Street to Main Street.
I remember that week vividly because I relied on a money market fund for cash. When I needed some, I went to an ATM and tapped in my access code. I didn't even have a conventional bank account and prided myself on my modern approach — until I woke up the morning after the Reserve announcement to face the prospect that I might not have access to any of my money. In the many years I'd been relying on my money market account, such a calamity had never crossed my mind. Those old-fashioned government-insured bank accounts suddenly looked appealing.
The situation was saved by Treasury and Federal Reserve officials who concluded that money fund assets would be backed in their entirety by the full faith and credit of the United States. The move stopped the run in its tracks. The commercial paper market came back to life, borrowing costs eased, and ATMs kept dispensing money to people like me. Though largely unsung at the time, it was an important step that staved off a global financial collapse.
It also made US taxpayers liable for more than $3 trillion, the total assets held by money market funds at the time. It dwarfed the size of the subsequent TARP bailout, which was $750 billion. And even though policymakers across the political spectrum vowed that such a thing could never happen again, the failure of the SEC's draft proposals last month means that U.S. taxpayers could again be liable for trillions of dollars in assets.
To prevent this, the SEC proposed two major reforms. The first was to report money market fund values the way every other fund does, which is the actual net asset value, or NAV, not something rounded to $1. The idea is that investors would become accustomed to and comfortable with slight changes in values. The net asset values of many short-term bond funds fluctuate modestly, and there aren't any panics or runs just because their value declines a penny or two.
The second was to require fund sponsors, if they wanted to maintain the stable $1 value, to start holding cash reserves.
The mutual fund industry rallied against the proposals and lobbied fiercely to defeat them.
The industry's self-interest is obvious: The proposals impose costs and additional regulations. More fundamentally, why wouldn't the industry and money market fund customers love the status quo? They get all the benefits of an implied government guarantee while taxpayers assume all the risk. Several people compared the situation to the way the mortgage industry fiercely supported Fannie Mae and Freddie Mac before the financial crisis made the government responsible for them.
But is it only naked self-interest that explains the industry's opposition? I spoke to John S. Woerth, a spokesman for Vanguard, which is the largest mutual fund company and, as a nonprofit company, can usually be relied upon to act in the best interests of its customers. Vanguard has strongly opposed the SEC's reform efforts.
"We believe the proposals, if implemented, would end money market funds," Woerth told me. "Our clients want a stable NAV. They write checks, pay their bill from these accounts. Would every one of these now be a taxable transaction based on gains and losses? That's untenable."
As for the capital requirement, "It would be onerous and raise costs, which would have to be passed onto our clients." He noted that Vanguard's Prime money market fund this week was yielding just 0.4 percent and additional costs would bring it close to zero. He noted that many fund companies were already waiving expenses to keep the funds' yields above zero, and said that additional costs were not sustainable.
Vanguard has also argued that the 2008 crisis set off by the Reserve Fund was a liquidity crisis, and that reforms adopted in 2010 address that issue. The SEC counters that its job isn't to ensure the survival of money market funds, but to protect Americans from another Reserve-type crisis, which remains possible unless there are further changes.
Even John C. Bogle, Vanguard's 83-year-old founder and former chairman, broke ranks with the company and offered support for the SEC's proposed reforms.
In a recent interview, he told the Associated Press that the stable $1 value is an "illusion" and that money market funds pose "one of the major risks in the mutual fund industry."
Source:James B. Stewart /The New York Times News