PrefBlog

The Investment Company Institute has announced:

that its Board of Governors has received a report from the Money Market Working Group and has unanimously endorsed the Group’s recommendations concerning new regulatory and oversight standards for money market funds.

John J. Brennan, Chairman of the Money Market Working Group and Chairman of The Vanguard Group, reported to the Board: “The recommendations respond directly to weaknesses in current money market fund regulation, identify additional reforms that will improve the safety and oversight of money market funds, and will position responsible government agencies to oversee the orderly functioning of the money market more effectively.”

The report itself is a miracle of the salesman’s art. Essentially, they propose to eliminate credit risk by regulation:

We also believe that credit ratings, while far from perfect, provide an important floor that constrains money market funds from taking undue risks to increase yield. We therefore recommend that the SEC retain ratings as a starting point for credit analysis.

Finally, we recommend that money market funds designate a minimum of three credit rating agencies that they will monitor for purposes of determining whether a portfolio security may be eligible for purchase. We anticipate that credit rating agencies will compete with one another to achieve this designation, and that this competition will enhance the quality of their analysis and ratings in this market.

I will certainly concede that a lot of the Commercial Paper vs. T-Bill premium is due to liquidity effects. But that does not mean that there is no credit risk.

There is always credit risk. Even beyond market forces, there is always the potential for fraud. Credit Rating Agencies can not, will not and should not be forced to pretend they can determine lack of fraud. Even auditors can’t do that, if the rot exists at a high enough level in a sufficiently complex company. Jesus Christ Himself could give an AAA rating to a security and have it default – remember, he screwed up on Judas.

Portfolio maturity. The maximum weighted average maturity (WAM) of fund portfolios currently permitted by SEC rule may have been too long at some times to accommodate extraordinary market conditions. In response to this observation, most money market funds voluntarily shortened their WAMs, which provided additional protection against interest rate risk. The Working Group believes that the WAM should be shortened from 90 days to 75 days for all such funds. The Working Group also recommends the adoption of a new WAM calculation (referred to in this Report as a “spread WAM”). Unlike the traditional WAM measure that allows funds to use the interest rate reset dates of variable- and floating-rate securities as a measure of their maturity, the new spread WAM requires funds also to calculate a WAM using only a security’s stated (or legal) final maturity date or the date on which the fund may demand payment of principal and interest. This new spread WAM could not exceed 120 days.

I wasn’t aware that US MMFs were permitted to use reset dates in lieu of maturity; the working group’s response demonstrates the intellectual bankruptcy of the typical salesman. We’ve been through two years of the most hellacious credit crunch in memory and people are still referring to pretend-maturities as if they mean something? It’s ludicrous.

Fixed Income is all about credit. The Money Market sector of Fixed Income is all about credit credit credit credit credit. If a portfolio manager – who finds himself virtually ignored in this trash – decides he is no longer comfortable with the credit quality of an issuer he holds, he always has the option of letting it run off the books … unless he was silly enough to buy a 100-year floating-rate note with a quarterly reset. (Such notes have been seen in putative Money Market Funds, by the way. Strange but true.)

I’m not going to get into any big arguments about whether 75 days is better than 90 days. My feeling is that it’s a cosmetic change … but it’s a relatively arbitrary number anyway, so I’m not fussy about it. But the limit on “Spread WAM” should be exactly equal to the limit on WAM.

We recommend that money market funds and other institutional investors in the money market provide the appropriate government body with nonpublic data designed to assist that body in fulfilling its important mission of overseeing the markets as a whole. We pledge to work with appropriate federal officials to implement such a regime for nonpublic reporting and monitoring.

I have quite enough problems already with Regulation FD, thank you very much! The idea that important credit information is to be reviewed not by me, but by a snivel servant clerk with a two-year college certificate in boxtickingology gives me absolutely zero comfort. If it needs to be known, it needs to be public.

The Volcker proposals for MMF reform have been reported on PrefBlog and are addressed in section 8 of the report.

commentators suggest that this would reduce systemic risk by addressing some of the difficulties that money market funds encountered in 2008, as they tried to provide both liquidity and a stable NAV.

The Working Group strongly disagrees. Fundamentally changing the nature of money market funds (and in the process eviscerating a product that has been so successful for both investors and the U.S. money market) goes too far and will create new risks. As discussed below, there are substantial legal, operational, and practical hurdles to redirecting retail and institutional demand from a fixed to a floating NAV product. Indeed, because of the very real and well-ingrained institutional and legal motivations driving the demand for a stable NAV product, investors will continue to seek such a product.

One reason why the product is so successful for the industry is because the stable NAV encourages the unsophisticated to think of an MMF like a bank deposit. It ain’t. There ain’t no capital and there ain’t no federal insurance neither. If a floating NAV forces investors to think about this, so much the better.

These examples demonstrate that despite having floating NAVs, fixed-income funds can experience significant outflows if their investors are highly risk-adverse. The reason is that during periods of financial distress, markets for fixed income securities can become illiquid while the risk-averse investors in these funds are seeking to redeem their shares. As a result, investors’ demands for redemptions can outstrip the ability of fixed income funds—even those with floating NAVs—to meet such redemptions because assets cannot be quickly sold in an illiquid market.

Seems to me, then, that as a matter of prudence a MMF should have a significant allocation in goverments. I have no objection to allowing MMFs to hypothecate some securities, either to the commercial banking system or to the Central Bank (the latter applying a penalty rate) for the week or two that it will take them to mature.

The cost of requiring advisers to hold capital to any meaningful degree ultimately would be borne by fund shareholders or their advisers. To the extent that shareholders bear the costs, they would incur higher fund fees and lower returns. If advisers bear the costs, they may elect to exit the money market fund business and use their expertise to manage large private pools of capital that could serve as money market fund substitutes, or even create offshore subsidiaries to manage U.S. investors’ money, potentially increasing systemic risk.

This totally evades the issue. The fund industry has been getting a free ride due to public perceptions of rock-solid MMFs that have very little basis in fact. This crisis was caused by widespread perception that risk avoidance was free. If it is made plain that risk avoidance is, in fact, not free – that’s a step forward.