The SEC Punts (Again) on Financial Stability Reform

Posted by Jeffrey N. Gordon, Columbia Law School, on Tuesday September 4, 2012 at 9:09 am
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Editor’s Note: Jeffrey Gordon is the Richard Paul Richman Professor of Law and Co-Director of the Center for Law and Economics at Columbia Law School.

In an all-too-familiar pattern, the SEC has backed down in the face of industry pressure and dropped a key proposal to prevent a repetition of the 2008 financial crisis. Despite valiant efforts by Chair Mary Shapiro, a divided Commission has rejected further steps toward reform of money market funds, a $3 trillion dollar financial intermediary that was at ground zero of the financial crisis and that now presents a continuing threat to financial system stability.

A powerful industry group, mutual funds and some of their clients, have persuaded three SEC Commissioners to ignore the near implosion of the money market fund sector in 2008. Here are their names, for now is an accountability moment: Luis A. Aguilar, Daniel M. Gallagher, and Troy A. Parades.

At the onset of the financial crisis, the Lehman Brothers bankruptcy forced a large money market fund, Reserve Primary, which held a chunk of Lehman securities fund, to “break the buck,” meaning , to drop below the $1 fixed net asset value that makes a money fund a functional substitute for a bank transactional account. The prospect of receiving less than $1 for each dollar invested in turn triggered a massive run, $300 billion in a week, that was halted only by extraordinary government intervention. Treasury guaranteed all existing money fund deposits and the Federal Reserve provided emergency liquidity facilities and took on unprecedented credit risk. Congress rightly saw these actions as a bailout and specifically stripped Treasury of its guarantee power and limited the Fed as well.

In 2010 the SEC adopted measures that were thought to add some stability to money market funds, in particular, requiring the funds to hold more liquid assets and limiting the kinds of assets that can be held. These measures were understood as partial, to buy time for the regulators to investigate the money market fund stability problem more thoroughly.

This is what we have learned (or have been reminded of): that money market funds buy securities that are not risk-free. Indeed, some funds may “reach for yield” because many investors are attracted by higher yields and the sponsor’s profits typically increase as pool of managed assets grows larger. Nor is it hard to identify the funds that are “reaching.” The market is very efficient – higher yields mean higher risk. So in times of financial distress, the intensity of the investors’ “run” is significantly greater at the higher yielding, because riskier, funds.

We have also learned that the stability of the money fund industry depends upon implicit sponsor guarantees. Various analyses from Moody’s, the SEC, and the Boston Fed have agreed that sponsor support — the sponsor subsidizing the fund to protect net asset value – was all that prevented more than two dozen funds from breaking the buck during the crisis period that began in 2007.

The recent report of Treasury’s new Office of Financial Research underscores this continuing problem. Funds are seriously exposed to the credit risk of their portfolio assets. Treasury found that 105 funds are at risk of breaking the buck if any of their largest 20 issuers defaulted. Sponsor support is crucial.

Yet in a punishingly low interest rate environment, the industry has been consolidating to maximize scale economies, and reaching for yield to minimize losses from fee waivers — all without any testing of sponsor capacity to provide support and without any binding commitment to actually do it.

The core problem, which the SEC staff has identified, is that money funds hold risky assets but have no independent capacity to bear loss — no capital nor any other loss-absorbing layer. In times of systemic instability, money fund users will run, because being first in line to redeem may increase the chance of receiving 100 percent. A required “holdback” of a small percentage of deposited funds for a fixed period would reverse the run dynamics because it would mean that an investor’s best chance to avoid loss is from not running. That plus a small capital layer would add considerable stability to the money market fund industry.

Money market funds assemble diversified packages of short term credit claims, particularly short term claims issued by banks and other financial institutions. In their present fixed NAV form money funds can play a useful transactional role as a bank substitute, especially for large institutions with large cash balances that exceed the limits of deposit insurance guarantees. But stability of the financial system is a public good that cannot be sustained in the presence of pervasive free-riding. The present money fund structure is like a nuclear power plant atop an earthquake fault. The question of a disaster is not whether but when.

But Congress foresaw that a particular financial regulator might be stymied by industry forces and thus the Dodd-Frank legislation places ultimate responsibility in a “college” of regulators, the Financial Stability Oversight Council. The FSOC has two relevant powers: First, it can “issue recommendations” to the SEC to apply “heightened standards and safeguards” for an activity, like maintaining a money market fund, that it deemed to pose a systemic threat. Second, the Council can determine (by a two-thirds vote) to subject particular money market funds or fund complexes to Fed oversight, upon a determination that they “could pose a threat to the financial stability of the United States.”

The SEC having punted, the ball in now in the FSOC’s court. This is an accountability moment for other US financial regulators as well.

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