David R. Henderson  

Break the Buck!

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Regulators are completing a controversial proposal to shore up the $2.7 trillion money-market fund industry, more than three years after the collapse of Lehman Brothers Holdings Inc. sparked a panic that threatened the savings of millions of investors and forced the federal government to intervene.
This is the lead paragraph from a Wall Street Journal article today, "U.S. Sets Money-Market Plan," by Andrew Ackerman and Kirsten Grind. It's about some proposed regulations for money-market funds.

First, note their use of the word "forced." That panic didn't force the federal government to do anything. The feds chose to intervene. But by using the word "forced," the reporters make it sound as if the regulators are trying to avoid ever being "forced" into something again.

Second, the panic arose because, in 2008, the money market funds were trying to hold on to a $1 per share value and it looked as if they might not be able to. So many people, including me, quickly took their founds out at the $1 per share value to avoid a small haircut. But shares in money market funds are not, repeat, are not like checking accounts or savings accounts. The people who own the funds have no legal obligation to give $1 when you redeem. If earnings fall enough, they might be able to afford only 99 cents or 98 cents or 97 cents. This is called "breaking the buck."

Had the feds not intervened by shoring up the money-market funds, some of the money-market funds would probably have had to cut to a number like 98 or 97 cents. That would have stopped most of the panicked withdrawals. And many people would have learned, or been reminded of, the difference between a checking account and a money-market fund.

Instead, the SEC proposes to stick with moral hazard and add the further regulation that government-caused moral hazard often leads to.

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CATEGORIES: Finance , Regulation

COMMENTS (7 to date)
Daniel Klein writes:

Good that you bring attention to "forced."

But I would say that word serves chiefly to tell readers that "we" are not to challenge the justifiability of said intervention. The implication of "forced" is either that it was justified or that it wasn't even a willful action, in which case the idea of justification does not apply.

David R. Henderson writes:

@Daniel Klein,
You said it better than I did. That’s what I was trying to get at, but you nailed it.

DougT writes:

This comes under the category of "closing the barn door now that the horse has gone." I'm no longer in the industry, but I used to run several 2a7 funds. It's clear what happened: Reserve Primary broke the buck because they didn't have a corporate sugar-daddy to bail it out, as did Bank of America, Morgan Stanley, State Street, Fidelity, and many other fund families.

Corporate parents stand ready to bail out their errant offspring, although they have no legal obligation to do so. They do it because of the reputational risk of giving a haircut to your biggest investors in a supposedly safe fund. This time it was credit risk; in 1994 it was interest rate risk that forced Bank of America to bail out its Pacific Horizon money market fund.

There used to be market discipline: edgy funds would buy sketchy securities, and investors who bought those funds got higher yields and slept less, knowing that your credit put depended upon the good graces of the corporate parent's management. Unsponsored funds like Reserve Primary ran a tighter shop, but investors knew there was no backstop.

But in the race for yield, standards were bent and the system started to break down. When the Fed stepped in, a full-fledged credit crunch was under way, as investors shifted hundreds of billions from prime funds to treasury funds. The Fed stepped in: first they sold *mandatory* insurance to the funds. Even T-Bill funds had to buy the Fed's insurance. Then they bought Commercial Paper directly from the issuers.

The next liquidity crunch won't come from the same source. These rules will do nothing but reduce the number of funds (to zero?). Money fund assets are shrinking, not because of 2008, but because they don't yield anything. If an asset is guaranteed to have a negative real yield, the size of that asset in the economy will shrink. Adding costs via the regulatory burden will only accelerate the process.

carol writes:

so, re basics, it was the 'commercial paper' that was a bit dodgy, yes?

ColoComment writes:

I believe the feds over-reacted to the Reserve MMF situation in 2008, and are over-reacting today with this proposed rulemaking. I have had a sweep MMF account with Vanguard Funds for a few decades now. Granted, one (only one!) MMF broke the buck in 2008, and some panic ensued, but I left all in place with high confidence in that institution. What the U.S government did or did not do was irrelevant to my decision. If you invest with a reputable fund family, you should be ok, as they have the deeper pockets to ride out difficulties. MMFs run on very slim expense margins, and now, in this ~0% environment, many MMFs are waiving expenses to keep their investors in positive return territory. Adding more cost to run MMFs is going to put them out of business.

Money market funds work, and work well, and are responsive to market demands. The fund families themselves are highly aware of what they need to do to safeguard the trillions of dollars invested with them; the government proposals are only going to handicap their efforts.

JeffM writes:

I respectfully disagree slightly with DougT.

He is of course correct that negative real returns or even expected negative real returns cause shifts in the flow of funds, as they should. Unless he expects real returns to be negative forever, this does not imply the elimination of entire industries. He also is correct that regulation imposes costs, sometimes heavy costs. Where he loses me is his apparent objection to the real costs of regulation if as a matter of practice the state is going to guarantee the implicit promise of no loss of principal made by money market mutual funds. (If I have misread him, I apologize for an unnecessary post.)

I understand the argument against the provision of backstops by the state to protect the users of certain financial services. I admittedly do not fully agree with that argument, but I absolutely admit that it is forceful, cogent, and sincere.

What I do not understand is the argument that such backstops should be provided without a price imposed on the beneficiaries. If we take deposit insurance as an example, the price paid comes in three forms: insurance premiums, reasonable prudential regulations, and other regulatory burdens. Those costs are typically passed on to the consumers who benefit from the insurance. Ultimately, of course, the taxpayer is on the hook if those premiums and prudential regulations turn out to have been insufficient (eg FSLIC). Whether taxpayers have benefited on a net basis from preventing bank runs more than it has cost them in taxes gets into the swamp of interpersonal comparisons of utility, but, by and large, deposit insurance has been self-funding. Over the approximately 75 years of federal deposit insurance, the real cost to the federal government of deposit insurance has been very slight (but not of course zero).

If in practice the state is going to guarantee investments in money market funds, then the state should be regulating the guaranteed entities and charging, directly or indirectly, the beneficiaries for the guarantee. Otherwise, as the main article states, we generate significant moral hazard. The real question (for me at least) comes down to what entities (if any) should be backstopped by the state, who should be the beneficiaries of the backstop, and how do we charge the beneficiaries enough to minimize the risk that the taxpayers will end up paying significant amounts for the backstop.

To put it a different way, the problem with Freddie and Fannie is not that they were regulated. The problems were that there was little or no justification for protecting those who were protected and virtually no meaningful regulation of private entities whose liabilities were guaranteed (implicitly but actually) by the state. Not only was there massive moral hazard, there was minuscule justification for what effectively was a huge subsidy to home builders, mortgage lenders, and investment bankers.

To get back on topic, either the state should make clear that under no circumstances will it rescue a money market fund (and stick to that declaration), or the state should regulate and charge for its guarantee. Given that federally guaranteed alternatives to money market mutual funds are readily available, I for one see no reason whatsoever for the guarantee, the regulation, or a charge.

Norman Pfyster writes:

I think you are wrong about the effect of breaking the buck on withdrawals. There is a distinction between NAV and "transaction NAV," which is the redemption price. Withdrawals can be processed at $1/unit even if NAV is below $1 (or above, for that matter); you end up with a tontine effect where the last person(s) bear all the loss. Thus, there is an incentive to withdraw early before the redemption price falls below $1/unit, which causes the run on the fund.

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