A fight is breaking out between the money-market mutual fund industry and federal regulators. Whatever the outcome, investors will question whether they can continue to rely on money funds as a safe place to keep cash readily accessible.
The Securities and Exchange Commission staff is drafting proposals that chairwoman Mary Schapiro says are needed to safeguard the industry and the investing public in the event of another financial crisis. It’s an attempt to fix weaknesses exposed when a large money-market fund collapsed in 2008, creating a scare that led the government to temporarily guarantee money fund assets so investors could be assured they’d be protected from losses.
Although the SEC strengthened its rules two years ago by further restricting how money funds operate, Schapiro says more needs to be done. There’s still a risk, she says, that money funds won’t be able to withstand a potential spike in investor withdrawals from another shock like the Lehman Brothers bankruptcy, the event that triggered the Reserve Primary Fund’s failure.
The industry largely agreed with the rules adopted a couple of years ago. Since then, money funds have held up to a host of threats, from the debt crisis in Europe to last summer’s downgrade of the federal government’s credit rating and near-zero short-term interest rates that have left investors earning practically nothing.
Now, months after Schapiro outlined more potential safeguards, the industry is objecting loudly. Industry leaders say the moves would undercut the key rationales for investing in money funds, rather than keeping cash in a bank.
Further details about the SEC’s deliberations emerged last week, leading the Investment Company Institute to warn of broad economic harm. The ICI’s chief executive, Paul Schott Stevens, warned of a “regulatory hat trick’’ that could “harm investors, damage financing for businesses and state and local governments, and jeopardize a still-fragile economic recovery.’’
Stevens’s warning may be extreme, but it’s true that money-market funds are a linchpin of the economy. They hold $2.7 trillion and their investments represent more than one-third of the commercial paper market - the short-term IOUs that companies sell to meet cash-flow needs, such as payroll. They also invest in more than one-half of the short-term municipal debt on the market, which state and local governments rely on to finance roads and building projects. Individual investors, corporate treasurers, and professional money managers rely on money funds to limit losses when stocks plunge.
So there’s plenty at stake in a regulatory debate, beyond the impact on individual investors. Schapiro has stressed the importance of not letting money fund vulnerabilities linger.
A formal proposal from the SEC is expected to be submitted for public comment in the early spring, and likely won’t be finalized until late this year, according to people familiar with the process who spoke on condition of anonymity because the SEC hasn’t yet put forward a plan publicly.
Options include tweaking the requirement that money funds hold at least $1 in assets for each dollar put in, so investors are protected - though not guaranteed - against losses. But that requirement has come under scrutiny after the Reserve Primary Fund “broke the buck.’’ Managers were unable to give investors making withdrawals a dollar back for each dollar they had invested, due to a Lehman Brothers investment that became worthless.
Schapiro says some investors treat the dollar-for-dollar requirement “as an all-or-nothing proposition - and run at the first sign of trouble.’’
One option is giving managers leeway for temporary fluctuations, or a “float,’’ around the dollar-for-dollar level. Investors might have to absorb modest losses when markets are under stress. The industry opposes a float, saying the dollar-for-dollar expectation is what attracts safety-minded investors to money funds in the first place.
As an alternative the SEC may require money funds to maintain bank-style capital cushions to ensure that they always have adequate cash to return money on demand.
Such rules might eventually prevent another fund from collapsing, but they also make money funds less appealing in the short-term.
Things are so bad that Federated Investors CEO J. Christopher Donahue questions whether money funds can survive if the industry is forced to choose between a float or withdrawal restrictions.
On a recent conference call with financial analysts, he compared it to a condemned man’s choice of dying “by hanging or by bullet.’’
To ensure investors are at least earning marginal returns, Federated and its rivals have been waiving investment fees and eating the costs of running money funds. Federated, for example, waived nearly $202 million last year. The companies can shoulder such burdens because they’re diversified, and aren’t relying exclusively on money fund operations to stay afloat. So the regulatory debate comes at a time when the industry is already under intense pressure.
Whether Schapiro can get a required majority of the five-member commission to approve meaningful changes is in doubt, because some members have expressed reservations.
Robert Lee, a Keefe Bruyette & Woods analyst, said in a note to clients this week that it could be next year before any rules are finalized, even without litigation that he expects the industry to file.
“Ultimately,’’ Lee says, “we think the proposals will be watered down.’’