Remarks at the 2012 Mutual Funds and Investment Management Conference
Commissioner Elisse B. Walter
U.S. Securities and Exchange Commission
March 19, 2012
Thank you very much Karrie [McMillan], for that kind introduction. It’s wonderful to be here with you. This conference is consistently one at which serious and important topics are discussed by experts with a variety of viewpoints, and from a look at the program, this year’s conference is no exception.
Today, I will speak to you about a topic that is near and dear to your hearts, and to mine — that is money market funds. The significance of these funds, and the regulatory approach to them, cannot be overstated.
Yes, I too just felt the oxygen leave the room.
For some reason, lately this topic seems to be making all of us lose our heads. If you don’t know what I’m talking about, please rise and head down the corridor, past the bagels and orange juice, to the next ballroom; perhaps your conference is in there.
For those of you who are in the right place, I hope that you will take a deep breath and then engage or re-engage in the discussion on these issues, both during this conference and after.
Simply put: the regulatory process is better with you as a part of it.
I have always appreciated the views and involvement of the industry, and believe that your engagement is essential to reaching optimal answers to the important questions posed in securities regulation.
The topic of money market funds, in particular, is just too important to let the dialogue play out through a public volley of slogans.
I’ll say at the outset that I’m not here to talk about my position on the need for any further reform. In fact, I don’t even have a draft release to consider. And, I understand that the staff plans to set forth a number of options. Before formulating a definitive position, my plan is to continue to discuss these critical questions with the staff, my fellow commissioners, the Chairman, members of the public, and those of you who are interested in that dialogue. I’d like to focus on you today.
In fact, I’d like to ask for your help in returning to the productive process in which we had been engaged. I believe that all of us would be better served if we took a moment to step back and re-gain our perspective by reviewing the history of money market funds, placing the issues in context. Of course, please keep in mind that my remarks today represent only my own views.i
History of Money Market Funds
There were many important events that occurred in the 1970s, and like most decades, there were both high and low points. I’ll leave it to you to decide which is which, but I’ll highlight just a few.
For example, the 1970s saw significant progress in the role of women in society. This included the rise of a significant number of women into politically prominent positions across the world — including Margaret Thatcher.
The 1970s also brought important developments in science and technology. For example, this period is known as the birth of modern computing, with the development of the microprocessor and rudimentary personal computers.
Although bell-bottoms and turtle necks remained popular, they later gave way to three-piece suits, perhaps thanks to the flawless performance of John Travolta in Saturday Night Fever. Sideburns were in for men, while for their part women plugged in curling irons to create their own versions of Farrah Fawcett’s feathered hair.
Despite these fashion-forward developments — and returning to the serious side of things — in the United States and most other industrialized countries, times were tough, due at least in part to the oil crises of 1973 and 1979. With this came “stagflation.” The average annual inflation rate climbed to 13.3%, and by the end of 1980 the prime rate hit 21.5% — the highest in history.
By just looking at her bank account, however, my Aunt Millie would have been hard pressed to see evidence of that. Market rates of return at that time were available only to institutional investors and wealthy individuals. Regulation Q had capped the interest rates that banks could pay on demand deposits, prompting Aunt Millie and other retail investors to seek out other places for their money. Stepping in to meet this demand were money market funds.
Beginning with the Reserve Fund in 1971, the money market fund sector at first grew slowly. Three years later there were still relatively few funds, with net assets under management of approximately $800 million. By 1975, however, there were 42 registered funds, with assets exceeding $3.7 billion.
In the mid-1970s, the Commission’s Division of Investment Management commenced a preliminary review to determine whether money market funds presented any significant regulatory questions. The Division observed that although some funds were using market valuation for their portfolio securities, others were using “amortized cost” valuation.
Since mutual funds sell and redeem shares on a continuous basis, there was concern that amortized cost might cause the portfolio to be over or undervalued, leading both new and redeeming investors to pay or be paid too much or too little. These effects could be particularly acute under certain circumstances, such as rapid and dramatic changes in interest rates.
In 1975, the Commission proposed to prohibit the use of amortized cost. Many commenters on the proposal were opposed, asserting that investors desire a stable net asset value (NAV), and that the use of amortized cost enables money funds to offer investors liquidity and stability that surpasses that of the instruments they hold.
In 1977, however, the Commission issued an interpretation concerning amortized cost valuation, stating that it did not represent a “good faith” effort to determine “fair value” of portfolio securities, except those with remaining maturities of 60 days or less. The Commission reasoned that amortized cost failed to account for the impact of market factors on a security’s value after its purchase, and that the probability that amortized cost would not approximate “fair value” would be progressively greater for securities of increasingly longer maturities.
As a result of the interpretation, money funds feared they would not be able to offer investors a fixed NAV and stable yield. Several funds filed applications requesting exemptive orders to permit them to use amortized cost valuation, and after hearings on the issue, the Commission began granting relief in 1979.
The Commission did not take lightly the decision to allow amortized cost, however. This was a matter of great debate at the hearings, and the Commission relied on industry testimony that — short of extraordinarily adverse market conditions — the limitations on quality and maturity should enable a properly managed fund to maintain a stable price per share.
The question of whether to codify the exemptive relief was soon before the SEC. In 1982, the Commission proposed to do just that,and adopted rule 2a-7 a year later. Under the rule, as you know, money market funds are able to use either penny rounding or amortized cost to compute their share price. To reduce the likelihood of material deviations from market value, the rule contains risk-limiting conditions and procedural requirements for the board, including shadow pricing. If there is a difference of more than ½ of 1%, the fund’s board must consider what action should be taken, including whether to “break the buck.”
When the Commission adopted rule 2a-7, the nearly 300 registered money market funds held about $180 billion in assets, and played only a minor role in the short-term credit markets. Fast forwarding to the present day, more than 640 money market funds are registered with us, and assets under management are tipping $3 trillion. Overall, they now account for nearly 25% of all investment company assets.
And, they play a crucial role in the capital markets. Money market funds are by far the largest holders of commercial paper, providing a substantial amount of short-term funding to businesses. They also play an important role in other parts of the lending markets, such as repos, government bonds and municipal securities. Moreover, according to one recent survey, companies allocate nearly one-third of their short-term investments to money market funds.
These haven’t been the only changes. The money fund industry has morphed from retail to largely institutional, with institutions today holding nearly two-thirds of assets. The industry also is highly concentrated — with about 75% of all assets, and 80% of institutional assets — in the top ten complexes.
Historically the money market fund sector has had a strong record of stability. But, it has been dependent on fund managers stepping in from time-to-time to bail out funds by buying distressed securities. These bailouts occurred irregularly, and in a limited number, until 2007, when they became much more pervasive. Our staff estimates that, from August 2007 to December 2008, more than 100 funds in 18 complexes — or nearly 20% of the money market fund universe — received support from managers or their affiliates.
Losses in subprime mortgages adversely affected a significant number of funds that had invested in asset-backed commercial paper issued by Structured Investment Vehicles (SIVs). While the SIV problems and the resulting fall in prices of commercial paper threatened to force many money market funds to break the buck, they were ultimately able to escape the situation due to outside support. There were also large flows at the time into money market funds, as investors — principally institutional ones — fled what they perceived to be riskier investments.
The stress on money funds was only to increase, however. It culminated in September 2008, triggered by the bankruptcy of Lehman Brothers and exacerbated by the problems of AIG. I will not go into any great detail here since the facts are well known to you; suffice it to say that, beginning with the run on The Reserve Primary Fund, problems spread throughout the money market fund sector with heavy redemptions in institutional funds, particularly prime funds. More broadly, this contributed to a freeze in short-term lending and downward pressure on share prices. Many sponsors took extraordinary steps during this time to protect funds’ net assets and preserve shareholder liquidity by bailing out the funds.
Money market funds investing exclusively in U.S. government securities were flooded with new investments in a flight to quality, prompting the lowest Treasury yields in decades. We saw at least three Treasury funds close to new investors, funds waiving expenses to avoid negative yields, and some sponsors leaving the business altogether.
On September 19, just three days after The Primary Fund’s announcement that it would break the buck, the Treasury and Federal Reserve Board announced an unprecedented market intervention to stabilize the markets. These programs successfully stemmed the tide, with all but two money market funds participating in the guarantee program.
The severe problems experienced by money market funds during this time period and the resulting impact on the financial system prompted the Commission and other regulators to explore how to prevent future harm.
The Group of 30, led by Paul Volcker, issued a report in January 2009 recommending that stable value money market funds should be regulated as banks, and that other funds should have floating NAVs. In June 2009, the Treasury published a report recommending financial regulatory reform, concluding that the vulnerability of money market funds to breaking a buck, and the susceptibility of runs on prime funds, remained a significant source of systemic risk. The report recommended that the President’s Working Group (PWG) assess whether more fundamental changes, such as a floating NAV or private liquidity facilities, are necessary.
Drawing from the March 2009 Report of the ICI’s Money Market Fund Working Group, in the summer of 2009 the Commission proposed amendments to its money market fund rules. The amendments were designed to make funds more resilient to certain short-term market risks, and to provide greater protections for investors in a fund that is unable to maintain a stable NAV.
The amendments, adopted in early 2010, strengthened the risk-limiting provisions of rule 2a-7 by requiring money market funds to maintain a portion of their portfolios in highly liquid investments, reduce their exposure to long-term debt, and limit their investments to only the highest quality portfolio securities. The amendments also required the monthly reporting of portfolio holdings, and allowed the suspension of redemptions if a fund "broke the buck," to allow for the orderly liquidation of fund assets.
The Commission’s release made clear that the proposals were intended to be the first step in addressing the issues, and requested comment on other more far-reaching and transformative changes, including floating NAV and in-kind redemptions. In response, the industry strongly objected to changes that would affect stable NAV, but other commenters pointed to recent history in support of more substantial changes.
In the fall of 2010, the PWG issued its Working Group Report on Money Market Funds Reform and the Commission published a request for comments on the options discussed in the report. The report identified the run on money market funds as one of several key events during the financial crisis that underscored the vulnerability of the financial system to systemic risk. It stated that the events of 2008 distorted incentives and pricing, and increased systemic risk.
Although expressing support for the Commission’s recent rule changes regarding money market funds, stating that they reduce the likelihood of runs, the report also concluded that money market funds should be required to internalize fully the costs of liquidity and other risks associated with their operations. The report detailed a number of options for the Financial Stability Oversight Council (FSOC) to consider.
To date, we have received more than 100 comments on the PWG report. These comments were quite useful, but we felt that a forum would further the dialogue. So last May, the Commission held a roundtable discussion on money market funds and systemic risk. At the roundtable, various stakeholders exchanged views on the potential effectiveness of certain options, including those in the PWG report. Members of the FSOC, other regulators, sponsors of money market funds, short-term debt issuers, investors, and academics all participated in the discussion.
Following the roundtable, discussions among all interested parties continued, and they worked together to reach possible solutions. The discussions were quite productive — with an eye to meeting policy goals in a balanced way — and as they progressed, the number of viable approaches narrowed.
Late last year, however, the industry brought its dialogue with the Commission to an abrupt end. It has since moved to the media — with a flurry of statements in the press. That deeply disappoints me, and the Chairman, and the Commission’s staff.
Re-opening a Constructive Dialogue
With apologies to members of the “fourth estate,” I would like encourage you to move away from media statements and instead move back to building upon the discussion of the past two years. Let’s continue a process of “constructive engagement,” instead of one of “unconstructive disengagement.” I would certainly like that, and know I’m not alone in this way of thinking.
Regardless of how you or I may feel about money market fund reform — past, present, or future — we can’t just say that an issue doesn’t exist. We need to remember that money market funds have changed over time. We need to remember the events of the last financial crisis and the relationship of money funds to systemic risk. And we need to remember that we must anticipate the future. Money market funds today present important questions implicating critical policy goals, related to not only investor protection but also, as I stated, to systemic risk.
I don’t think that we can simply say that enough has been done — that the Commission’s latest rules have addressed all of the problems. We need to continue to discuss that; debate it; try to come to a meeting of the minds or, at the very least, truly informed disagreement.
On the broader issue of whether reform is necessary, let’s look at both sides. On the one hand, money market funds have had a successful history. And, in 2010, the Commission took steps to make money market funds more resilient. This included not only enhancing the risk-limiting conditions, but also taking other steps such as permitting fund boards to halt redemptions immediately if the fund breaks the buck, and requiring the public disclosure of the “shadow” price.
On the other hand, we all just went through a significant and far-reaching economic crisis. It severely affected money market funds, more than 100 of which received capital support from their sponsors. Without a well-funded sponsor, one broke the buck. The resulting massive run by institutional investors — $300 billion in three days — worsened problems in the broader markets.
Ultimately, the federal government stepped in with programs specific to money market funds — putting taxpayer money at risk to shore up a private industry. But the federal government no longer has the same authority to stop a run on money funds. That, in part, is why regulators must consider the structural features of these funds that make them prone to runs.
I feel strongly that we simply cannot say that this type of crisis won’t happen again. If there is one thing we should have learned from past financial crises, it is that the next one — and there will be a next one — will be both the same and different from the last. We cannot entirely anticipate what will happen in the future and we need to plan for what we view as the inconceivable, as well as the likely and unlikely.
I understand that there is risk in moving ahead with additional reforms — especially in a time of low yields. However, there is also significant risk in not acting. Balancing the upsides and downsides to reach hard decisions is what our job — both yours and mine — as stewards of the mutual fund industry is all about. The current environment, however, is not, in my view, conducive to reaching the best decisions. Please join with the Commission and change that, as there is no shortage of things to discuss. As Dr. Bob Nelson has said: “Communicate, communicate, and then communicate some more.”
To illustrate the types of issues on which we could use your input, I will just mention a few of the options open to regulators (in no particular order). I do so not to endorse any of them, but to illustrate the breadth and complexity of the issues.
For example, there has been discussion of establishing an NAV buffer to absorb losses, in order to allow a stable NAV. Although this could be an explicit substitute for the current implicit buffer of 50 basis points, concerns have been expressed about the cost and source of the funding.
Also, the option of floating NAV is on the table. Some have said that it could address the investor misperception that the value of money market fund shares does not fluctuate, and should dampen the incentive that shareholders have to institute a run on money market funds. Conversely, there are concerns that it could undercut the ability of corporate and municipal treasurers to use money funds as a short-term financing device, and that it correspondingly could undercut the vitality of commercial paper.
There has also been discussion about a liquidity or redemption fee to help offset costs. But there are questions about how to structure it equitably, and whether a holdback would create liquidity management issues for shareholders.
A two-tier system is another idea. One variation could be to allow retail investors to choose between floating and stable NAV funds, while institutional investors in certain funds would be limited to a floating NAV. While this might focus on those funds that were at the heart of the issue in the 2008 run, there have been significant questions about how to draw the line in a practical way.
There are further options still, but as I’m running low on time, a simple list includes mandatory redemptions in kind; insurance; private emergency liquidity facilities; funds as special purpose banks; enhanced restraints on unregulated substitutes; revisiting and enhancing the parameters adjusted in our 2010 rules; and, added investor transparency.
In conclusion, I ask you to use this conference as an opportunity to think again about the way forward. Engage with me and my colleagues to work toward a solution — perhaps one that is not your ideal, but one that aims to best serve our nation’s investors — in money market funds and the broader marketplace. Let’s not forget that the only reason we are all here together today is because of investors.
I would be happy to discuss these issues with you. Although I am heading back to Washington shortly, my counsel Christian Broadbent will be here for the conference and would be happy to hear your thoughts and to arrange a future time when we can speak about these critical questions. Thank you.
i The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publications or statements by any of its employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission, other Commissioners, or the staff.