The Beginning of the End of Money Market Funds

Say goodbye to money market funds, and hello to more volatility, whether in money market funds, or their substitutes.  As with all of the financial crisis, it would have been better if the Fed and Treasury had not intervened.  Most money market funds would have survived.  The market panicked less than the regulators did.

But now we have the capitulation of Luis Aguilar, perhaps giving in to the pressures of the banks that hate competition from the money market funds.  Who is more powerful? Banks.  Where are there more systemic losses?  Banks.

Money market funds are not the problem.  If there is a crisis, let them fail.  The losses will be ~2% of principal; banks will do far worse.

Publishing the net asset value of Money Market Funds will destabilize them; rising NAVs will attract more money, and falling NAVs will lead to a run on the MM funds.   It is a recipe for disaster.

Far better is my proposal, which is an excellent compromise.

To those analyzing policy for money market funds at the SEC:

Greetings. My name is David Merkel, and I run Aleph Investments, LLC, a Maryland RIA. I manage stock and bond portfolios for upper middle class people, and for small institutions. I am a Chartered Financial Analyst, and in the past, I was a life actuary, where I developed stable value products for pension plans.

It is much harder to assure a stable share price with longer dated assets, but I was able to do so via a variety of strategies. Doing the same thing for money market funds is simple.

Before I continue, I want to make clear that I have no economic interest in money market funds, aside from being an investor in them. At present, the SEC is proposing a variety of changes to money market funds that practically render them uneconomic. No wonder the companies managing the MM funds oppose that.

But the companies managing the MM funds are unrealistic as well, they don’t see any reason for change. I have a proposal that splits the difference, and is trivial to carry out.

My proposal says this: Funds calculate their internal NAV, but do not disclose it to the public. They only disclose it in the rare case where the NAV drops below 0.995, and it would “break the buck.”

When a fund “breaks the buck,” it announces a credit event. It tells shareholders that they have lost money, and to protect the interests of all shareholders, all shareholders will suffer a small capital loss.

Whatever the fairly calculated NAV is when a capital loss is announced, the new NAV would be 1.0025, and the number of shares reduced to the level that supports that NAV. If the value of the assets has been accurately calculated, and there are withdrawals, the premium to NAV should rise, not fall, for the remaining shareholders.
As an example, imagine a fund makes bad decisions, and the internal NAV calculation reveals an NAV of 0.9825. The fund would announce a credit event, and roughly 2% of all units would be lost, and the new internal NAV would be 1.0025. Those leaving the next day would only strengthen the fund.

Few will like the concept of a credit event in money market funds. That said, the idea would have many salutary effects on money market funds:

  1. It would eliminate runs on the funds.
  2. It would get people used to the idea that there is some risk in money market funds, though limited.
  3. It would eliminate the need for the government to intervene and insure money market funds.
  4. It would allow some money market funds to take more risk, and offer more return. There would be less need to constrain maturity and credit quality of the investments in the MMFs so tightly.
  5. The cost would be minimal, most of the time losses would be 1-2%, which would be paid for through interest in less than a year.

My proposal is better because it treats money market funds like ETFs — they are pass-through vehicles, and as such, do not need capital buffers.

And, my proposal is better, because it recognizes that credit events should be rare but acceptable aspects of how money market funds work. Think about it: particularly when short term interest rates are so low, there is no way for interest to cover even the slightest discrepancies versus NAV.

Under my way of doing things, let there be stable net asset values, freedom in investment guidelines, but the possibility of credit events. The present set of restrictions in investing does no one any good, because the problem is not length of maturity or credit quality, but issuer concentration.

But let money market fundholders analyze the tradeoff between yield and risk. Guess what? Short-term bond fund holders have to do the same thing.

But why are we going after money market funds? When they fail, the cost is pennies on the dollar, and it rarely happens. Why not go after banks? They fail far more frequently, with much larger losses. I say let money market funds fail, and do not increase regulations on them. Rather, let them be like ETFs, and let them be constrained by the prudence of the free markets. What? You can have investment without the possibility of loss? Ridiculous.

Regulate the banks tightly, but let money market funds go free, but advertise that losses are more than possible.
I strongly urge that you adopt my proposal. The money market funds will not like it, but they can live with it. The SEC may not like it entirely, but it accomplishes all of goals that you care about. This is a compromise proposal where everyone can win.

Sincerely,

David J. Merkel, CFA, MA

To my readers, I only ask one thing — do you have contacts at Fidelity, Vanguard, Federated, ICI, etc., who care about this?  I wa able to put my proposal before the SEC through Commissioner Luis Aguilar.  I talked with two senior attorneys at the SEC in August.

But I am a political nobody.  I may have a bright idea, and many have told me that, but I need an entity with political clout to absorb my idea, and use it.  I don’t care if I get credit; I just want to do something good to minimize regulation, but deliver bad results to those who choose bad managers.

All that said, if the SEC acts as it is indicating, they will destroy money market funds, and we will all be the poorer for it.

4 Comments

  • Greg says:

    David — can you explain why we ?need? to fix the money market regulations in the first place?

    As best I can tell, the intention of the crooks in Washington is to paper over the cost of the FDIC insurance scheme (and it is a scheme). If the bank regulators were doing their jobs (***cough!!!***), we don’t need deposit insurance. Since the regulators are mostly watching porn, and the last two (appointed / aka unelected) treasury secretaries have unilaterally decided to bail out every bank at the expense of future generations — again, we don’t need deposit insurance.

    A lot of FDIC bureaucrats should lose their jobs — saving the taxpayer a lot of salary and pension costs.

    The desire of bureaucrats to have really big fiefdoms is the only reason I can see why this money market reform is being pushed.

    It doesn’t benefit the customer — most of whom already understand that MMF are not necesarily money good. Some contain short term investment grade debt, others (mostly out of business now anyway) contained a lot of garbage.

    If one’s money market account pays above market interest rates — it means the fund is taking more risk. We all learned there is no free lunch back in kindergarten.

    We don’t need a bunch of useless bureaucrats to “protect” us — even if we assume they are trying / not busy watching porn.

    This whole thing seems like a red herring to distract the public from reforms that are truly needed — like eliminating redundant (and ineffective) bureaucracies that we cannot afford.

    Who is going to pay for all this nonsense if “we” keep it? Certainly not the people currently in power that are calling for it.

  • cig says:

    Why not simply retire the current framework, and convert all money market funds to the ETF structure?

    Having a whole regulatory framework dedicated to notional effects that are of concern only to the deeply innumerate is a waste of everybody’s time, including the innumerate themselves, who miss a chance to become less ignorant.

    • A MMF is a book value fund. People need a stable unit of account, otherwise the accounting gets messy, particularly for corporations. My proposal recognizes the occasional need for adjustments to NAV due to capital losses.

      • cig says:

        OK, I guess I see what you mean, but could not that be done using a plain bond structure, with a short fixed term (days/weeks/months) and automatic reinvestment if need be for convenience. Then NAV adjustments are handled by (partial) default on the rollover date. Hasn’t the world got enough redundant financial instruments as it is?