Squam Lake Group on Money Market Fund Regulation

Christopher Condon and Robert Schmidt of Bloomberg report that:

Money-market mutual funds would be forced to create capital buffers equaling 1 percent to 3 percent of assets to protect against losses under a plan now favored by staff at the U.S. Securities and Exchange Commission, according to three people briefed on the regulator’s deliberations.

Top SEC officials, seeking to make money funds safer, prefer the plan over another capital buffer idea crafted by Fidelity Investments and calls to eliminate the funds’ stable share price, said the people, who asked not to be identified because they weren’t authorized to speak publicly. The concept is based on recommendations submitted to the agency in January by university economists known as the Squam Lake Group.

Readers will remember the Squam Lake proposal on contingent capital, which I didn’t like, but was a whole lot better than OSFI’s idiotic approach.

I reported in May that the SEC was grinding ahead on MMF regulation; readers will remember that I have a long-standing interest in the topic.

The Squam Lake Proposal for MMF regulation points out:

In the past, without the prospect of government guarantees, whenever money market funds threatened to break the buck, it had been common for their managers to bail them out in order to preserve the franchise values of their fund management businesses. Between August 2007 and December 31, 2009, at least 36 U.S. and 26 European money market funds received support from their sponsor or parent [footnote] because of losses incurred on their holdings of distressed or defaulted assets, as well as the costs of meeting the redemption demands of investors through sales of assets. Going forward, if sponsors believe that their funds will receive government support, their incentive to bail out their own funds may be substantially reduced, particularly given the squeeze on profitability associated with exceptionally low money-market interest rates.

Footnote: See “Sponsor Report to Key Money Market Funds,” by Henry Shilling, Moody’s Investor Service, !ugust 9, 2010; The forms of support included capital contributions, purchases of distressed securities at par, letters of credit, capital support agreements, and letters of indemnity or performance guarantees.

They propose a capital buffer:

Thus, as an alternative to floating NAV, a second broad approach, which we focus on below, preserves the stable NAV structure but enhances its safety by requiring sponsors to establish contractually secure buffers that could absorb at least moderate investment losses to their money market fund investors. This is akin to a capital requirement for stable-N!V funds; The President’s Working Group Report (2010) describes various alternatives, including some forms of liquidity facility or insurance that are consistent in spirit with this approach, but it does not make a specific recommendation. [footnote]

Footnote: See “Report of the President’s Working Group on Financial Markets: Money Market Fund Reform Options,” October 2010, [published by the Treasury] which suggests that money market funds continue to pose systemic risk. Among the alternative policies described in the President’s Working Group Report are: conversion of all funds to floating NAV; a private or public insurance scheme for stable-NAV funds; a rule by which large redemptions would be paid in kind (that is, with a portfolio of assets held by the fund); a two-tier system of both floating-NAV and stable-NAV funds under which stable-NAV funds would be required to have some support mechanism; a two-tier system under which stable-NAV funds are only available to retail investors; a rule forcing stable-NAV funds to convert to special purpose banks, holding capital and having access to lender of last resort facilities, and for which depositors would have some insurance coverage.

The Squam Lake group proposes:

The manager of a stable-NAV money market fund must provide dedicated liquid financial resources that, in combination with those represented by the assets of the fund class investors, are sufficient to achieve a net buffer of “X” per dollar of net asset value. These additional resources are to be drawn upon as needed to support fund redemptions at one dollar per share until the fund converts to a floating-NAV or until the buffer resources are exhausted. That is, at the end of each business day, the combined resources available to fund investors represented by the sum of dedicated additional sources and the previous day’s marked-to-market per-share value of the fund’s assets must exceed 1+X per share held as of the end of the current day. The fund must convert to a floating-NAV fund within a regulatory transition period, such as 60 days, in the event that the fund manager falls out of compliance with this buffer requirement.

They do not formally recommend a buffer size (that is, the value of X in the proposal) but indicate that 3% is a good place to start discussion:

When setting the size “X” of a required buffer, regulators may wish to consider the amounts by which money market funds have broken the buck in the past, or the amounts per share that fund sponsors have contributed in order to prevent them from breaking the buck. In the two-day period following Lehman’s bankruptcy, the Reserve Primary Fund reported a minimum share price of 97 cents.9 Had redemptions not been halted by the Reserve Fund’s sponsors, a fire sale of additional assets could have caused significant additional losses. A buffer of at least $0.03 per share would therefore have been necessary to prevent the Reserve Fund from breaking the buck.

Another consideration in determining the size of a buffer requirement is the concentration of fund assets among the debt instruments of a small number of borrowers. As of June 2010, for example, the top 5 exposures of U.S. prime money market fund assets, were all to European banks, with each of the 5 banks representing an exposure of at least 2.5% of aggregate fund assets.

Frankly, I think this is unnecessarily complex and specialized. Money market funds are, essentially, banks. They should be regulated as banks.

Update, 2011-8-3: The Fidelity plan is a little different:

Given that tepid response, the SEC is discussing other ideas such as those suggested by Fidelity Investments, which opposed the notion of a liquidity bank in its comment letters to the President’s Working Group.

Under the Fidelity proposal, money market funds would create a capital reserve or an “NAV buffer” by charging investors more over a period of time, said Norman Lind, head of trading for the taxable- and municipal-money-market desks at Fidelity Management and Research Co., the investment adviser for Fidelity’s family of mutual funds.

The SEC would work with fund boards to determine a range that a fund should keep for capital reserve, he said during a panel discussion.

“Let’s say you retain five basis points per year and you accrue that over time,” Mr. Lind said. “The idea is that once you have a buffer in place … you stop charging that fee.”

Unlike the ICI’s proposal, Fidelity thinks that its idea is simple to implement and doesn’t require regulatory changes, Mr. Lind said.

I don’t get it, frankly. Who owns the buffer?

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