THE SEC AND MONEY FUNDS: “WHY NOT USE YOUR MENTALITY—STEP UP, WAKE UP TO REALITY?”

6/6/13

Once upon a time, yours truly was the head of the fixed income department of a money management arm of a large money center bank.   As head of fixed income, I had responsibility for all fixed income (bond, in common, but not precise, parlance) assets with maturities greater than one year, so my area of responsibility did not include money market funds.  However, back in the early ‘90s, the money market funds encountered some, er, difficulty, as did several larger money market funds at the time.   When the funds “broke the buck,” i.e., their net asset values (“NAV”s) fell below the perceptually guaranteed $1.00 per share, and the bank holding company had to bail out the money funds, the guy who oversaw the money fund operation was summarily fired and was replaced by the logical guy, yours truly.   Having only had limited experience with money funds, but being a decent manager, I left the technical details of ironing out our problems to a very good operational money fund guy who had had no part in the funds’ demise.  I oversaw his work, but left it in his very competent hands.   We worked through the problems and it was far tougher on the operations guy than it was on yours truly, largely because he had been around when the problems arose and the problems were far deeper, though, again, did not involve him, than those encountered by other money funds that were breaking the buck at the time.  The ending was happy; the funds were restored to health, the bank holding company came out even, the business was restored, and yours truly got a lot more credit than he deserved.   But the guy whom I effectively put, or left, in charge of unwinding these things also did quite well as a consequence, though not as well as he should have.

I tell that story, as vaguely as I can, because it establishes both my interest in and bona fides for discussing the Security and Exchange Commission’s (“SEC”’s) latest machinations in the money fund industry.

The SEC yesterday approved a proposal requiring prime money market funds, which are money funds that cater primarily to institutional investors and that don’t restrict their purchases to government paper, to float their share prices, i.e., to not stick to a fixed $1.00 share price.  The new rule is the latest, though probably not the final, product of the machinations of the SEC, at the prodding of Congress, the Fed, and the Administration, to address the systemic risk that lurks like a time bomb in the $2.6 trillion money fund industry.   When the financial system encountered its problems in 2008-’09, money funds were one of the centers of the difficulty; when the Primary Reserve Fund, a prime money market fund, broke the buck, the fear was that the entire industry would face a run almost straight out of “It’s a Wonderful Life.”  The federal government ultimately guaranteed money fund assets, as it does bank deposits, until the danger passed…temporarily.  The SEC was charged with addressing the underlying issue of the safety of the money fund industry and to institute measures that would prevent, or at least avoid, money fund runs.

Three major approaches were proposed:

• Requiring money fund share prices float rather than be held at $1.00.
• Requiring money funds to hold capital, like banks, that would provide a buffer for shareholders.
• Imposing redemption restrictions on money fund shareholders, either temporarily in times of difficulty or all the time.

The mutual fund industry didn’t like any of these proposals for obvious reasons, screamed and yelled, kicked and screamed, and put their considerable lobbying power to work.  The industry succeeded in delaying any of the proposed restrictions, until yesterday.   But the pressure remains for further safeguards in the industry.  The SEC, kindred agencies, the Congress, and the Fed remain very interested in this issue, so work will continue on something that will be trumpeted as an ultimate solution until either another problem, or another solution in search of a problem, arises.

The ideal solution to those of us who feel that markets work would be to make clear to money fund shareholders and potential shareholders that money market funds are not bank accounts but are, as their name indicates, mutual funds and that, as such, their values are subject to fluctuation.  And if they get in trouble, it looks like YOU, Mr. Shareholder, not the taxpayers, have a problem.  The government will not rescue errant money funds.  So caveat emptor.   If you want absolute safety, put your money in a bank and be mindful of the FDIC insurance limits. 

The above market based solution will not be implemented, however, because there is no way the government will not bail out the industry, and the shareholders, if trouble arises again; $2.6 trillion perched at vital intersections of the financial system will not be allowed to fail.  Thus the above three alternatives.

Which of the above “solutions” would be best?   Being a believer in markets, and a man who tries to look reality squarely in the face rather than pretend it isn’t in the room, I like the idea of extending to all money market funds the floating share price that the SEC mandated for prime funds.   The underlying share prices do indeed fluctuate, usually only by small fractions of a penny, but they do fluctuate and sometimes by more than half a penny, which would round to an NAV above or below a dollar.  So what?   Again, these are mutual funds, not bank accounts.  While the industry has gotten quite fat on the notion that money funds are the equivalent of bank accounts, that notion is wrong, though never discouraged, certainly not by the mutual fund industry.  Better to face reality and let the share price float. 

The result of a more general float will be either or a combination of

·        The better, safer funds will tighten things up and indeed keep their NAVs at $1.00, probably at the expense of some yield.

·        The more adventurous, or less well run, funds will allow their NAVs to float slightly and will either go out of business or attract investors who are willing to accept some share price fluctuation in exchange for more yield.

What would be so bad about that?

Barring an NAV float, the next best alternative would be to impose redemption restrictions on fund shareholders.   For example, fund holder would be able to redeem X% of their shares immediately, Y% of their funds with 7 days notice, and Z% of their funds with 30 days notice.   This would give fund managers the ability to manager the funds’ liquidity and meet redemptions without causing market turbulence.  It would also reinforce the notion that money funds are mutual funds rather than bank accounts.

The SEC is indeed proposing redemption restrictions for prime funds, but the SEC, in addition to limiting these restrictions to prime funds, would like to impose the restrictions temporarily and only during times of trouble.   This would be counterproductive, not avoiding runs but expediting runs as shareholders attempt to redeem shares before such restrictions are implemented.  Permanent restrictions would allow for orderly meeting of redemption demands while keeping things calm, or as calm as possible. 

Capital requirements are probably a non-starter, especially while we are still in the throes of Ben Bernanke’s War on the Elderly in which there is no yield to be had in short term investments in any case.   Fund families are waiving fees and losing money on money funds; requiring them to hold capital would exacerbate the situation, doubtless forcing people out of business in bad times and making yields uncompetitive in good times, defined in this case as times of high yields in short term instruments.   While some might justifiably argue “So what if the market winnows out weak performers, or a weak product, that can’t compete on level playing field with banks that must hold capital?”, the comparison to banks is not apples and oranges here and, in any case, the industry would never go along with such a rule.

The key point here is not that yours truly, who knows something about money funds, likes floating NAVs or redemption restrictions for such funds, certainly more than I like capital requirements.  The point is that ANYTHING the SEC or other powers that be does about money market funds MUST reinforce the distinction between such funds and bank depository accounts.  The reality is that money market funds, contrary to popular opinion, are not bank accounts and are not insured by the federal government, at least not when the defecatory product stays away from the wind motivation device.  Potential investors who think they are savers have to be made aware of that reality.  Withdrawal restrictions or a floating NAV would accomplish that goal.

JEROEN DIJSSELBLOEM’S COMMENTS ON CYPRUS: “THE DUTCHMAN’S NOT THE KIND OF MAN WHO KEEPS HIS THUMB JAMMED IN THE DAM THE WHOLE DAY THROUGH”

3/27/13

The new and youthful Dutch Finance Minister, Jeroen Dijsselbloem, who is also president of the Eurogroup of eurozone finance ministers, apparently has not spent enough time around the club he recently joined.  Why else would he enrage estimables in the European Central Bank, in the continent’s financial capitals, and even at home among the normally plain spoken Dutch, with his crazy assertions that the investors in an enterprise should actually bear the brunt of the risk of that enterprise’s failure?

Mr. Dijsselbloem had the temerity to suggest that shareholders, bondholders, and uninsured depositors should actually (egad!) take losses when banks fail, as was the case in Cyprus.  While he was careful, perhaps too careful, to say that Cyprus is “no blueprint” for future bank bailouts, he did say that the Cyprus bailout “fit into the new approach toward bank rescues that is gradually evolving.”  (See my posts on the Cyprus situation, 3/20/13’s CYPRUS AND THE “RIDDLE, WRAPPED IN A MYSTERY, INSIDE AN ENIGMA” and 3/18/13’s THE CYPRUS DEPOSIT “TAX”:  “DON’T CRY FOR ME (NICOSIA)!”  Note that the plan Mr. Dijsselbloem speaks rather highly of bears little resemblance to the disastrous plan on which I commented on 3/18.)   For making this outrageous statement, Mr. Dijsselbloem is being castigated for “causing unrest” and “creating uncertainty.”   No one mentioned “sticking up for taxpayers” or “averting moral hazard.”   But such considerations apparently have no part in the calculus of new age finance.

That Mr. Dijsselbloem is being vilified throughout Europe (and doubtless from some quarters over here) for stating that those who take risk should be expected to bear risk shows how goofy modern day, new age finance has become.  The treatment he is receiving also indicates why the world got into so much financial trouble a few years ago and why we are doomed to encounter more such trouble…unless we stop listening to the world’s financial Merlins and regain some measure of common sense.

CYPRUS AND THE “RIDDLE, WRAPPED IN A MYSTERY, INSIDE AN ENIGMA”

3/20/13

My already seminal 3/18/13 piece, THE CYPRUS DEPOSIT “TAX”:  “DON’T CRY FOR ME (NICOSIA)!” covered my larger thoughts on the situation in Cyprus.   But the situation is rapidly evolving and new thoughts spring up more quickly than revisions and rejections of proposals for salvaging the balmy money laundromat in the eastern Mediterranean.

The key to saving Cyprus may be Russia, the citizens of which have about $30 billion deposited in Cypriot banks, or about one third of all bank deposits in Cyprus.  Russia could easily bail out tiny Cyprus, the economy of which is about one quarter of the size of all bank deposits there and a tiny fraction of the GDP of Russia.   Russia could easily extend and increase its current 2.5 billion euro bailout loan to Cyprus and thus save the day, probably in return for some financial, but also some largely geopolitical, concessions from Cyprus.  The question is whether Russia has the will to bail out Cyprus.  That question centers around whether Russia wants to bail out the gangsters and other felonious finaglers who have money deposited in Cyprus.  

One school of thought contends that the Russian government surely doesn’t want to save people who have put their money in Cyprus to avoid Russian taxes.   While that would make sense on its face, Russian politics is perhaps murkier now than it was back in the ‘30s when Churchill said that Russia was “a riddle, wrapped in a mystery, inside an enigma.”  We can’t assume that the Putin government, despite its bravado, is on some crusade to destroy the oligarchs and the thugs who control much of its wealth; indeed, sometime the oligarchs, thugs, and politicians in Russia are indistinguishable.   As one who has spent most of his life in and around Chicago, which has long had a similar system of government, one could easily see at least elements of the Putin government using public resources to rescue its friends who live and prosper in the shadows.

It’s already quite clear that the powers that be in Cyprus are quite concerned with mollifying the dirty money that has made that island off the underbelly of Turkey something of a world financial center.   Note that the plan to tax deposits greater than 200,000 euros as the onerous rate of 15%, the plan on the table when I wrote my 3/18 piece, was quickly scrapped in favor of a plan that would keep that rate at 9.9%, thus skewing more of the burden away from the dirty money and toward the average Cypriot saver.   And one does not have to be as cynical as your truly to think that yesterday’s parliamentary rejection of the whole deposit tax scheme did not bear the fingerprints of the “international investors” who doubtless have some pull in the Cypriot parliament. 

We already know the Cypriots, understandably, have some interest in protecting the dirty money that has made their country the Mediterranean’s foremost money laundromat, a status that has mightily contributed to whatever prosperity the island enjoys.  The question is whether the Putin government has an interest in protecting its citizens who use Cyprus to avoid Russian taxes.   Don’t assume it doesn’t.

THE CYPRUS DEPOSIT “TAX”: “DON’T CRY FOR ME (NICOSIA)!”

3/18/13

Cyprus’s looming decision to effectively confiscate part of every bank account in the country as a means of partially financing a bailout of the Cypriot banking system is the big financial news story today, and deservedly so.  Whether I can say anything spectacularly original about the story I don’t know, but perhaps I can add some fresh insight.

Like legions of others, I am appalled that, should this proposal pass (As of this writing, the vote in the Cypriot parliament has been postponed until Tuesday and the banks will remain closed until Thursday.), the new law will run roughshod over centuries of corporate law and established business practice.   While the senior debt of the banks will remain unscathed, depositors, who are at least pari passu (equal in terms of liquidation payouts…not a literal Latin translation) with and probably at least structurally senior to the senior debt, will take hits ranging from, at this writing, 3% to 15% depending on how much money they have in the bank.  Deposit insurance will make no difference; as of this writing, insured and uninsured depositors will pay the same “tax.” This defies both law and practice and certainly rattles the confidence not only of insured depositors but also of investors.  The ramifications for the reliability of deposit insurance are obvious.  In addition, bondholders and potential bondholders, and not only in Cyprus or even only in Europe, have to be asking something like “If the government can override law and established practice to benefit me, why can’t it do the same thing to hurt me?”   This does not create an environment that is conducive to prudent risk taking.  

On the other hand, one might easily, and justifiably, retort that the bondholders’ rights were ignored in the bankruptcies of General Motors and Chrysler.   Many of us bemoaned the abuse of the law in those cases and predicted dire consequences for the bond markets and the investment environment in general.   So far, though, we have seen no effects.  It’s as if no one cares.   But remember that people, and especially the current generation of financial, political, media, and business leaders, have a hard time dealing with the long run.   Their sense of history is lacking and their memories, and attention spans, are short.

Sure, there are extenuating circumstances here.   Cypriot banks are unusually heavily funded by deposits, so there aren’t many senior bondholders to go after.   (But there are plenty of uninsured deposits; uninsured deposits exceed insured deposits in the Cypriot banking system and, as the Wall Street Journal pointed out in today’s (Monday, 3/18’s) editorial on the subject, it looks like relatively modest “tax” on uninsured deposits could raise the 6 billion or so euros expected of depositors in the bailout deal.)   Cypriot banks are havens for money laundering and other nefarious financial finagling, and any deposit tax will thus hit, say, Russian gangsters much harder than the Cypriot in the street.  And, after all, Cyprus is too small to set much of a precedent. There were also extenuating circumstances in the GM and Chrysler bailouts, though.   But the law is the law and is not to be brushed aside due to extenuating circumstances.   Politicians, and others who would like to take your money, can always come up with extenuating circumstances.

There are many who are assuring us that there will be no runs on European banks because the European Central Bank (“ECB”) has at its disposal an assortment of tools, including its aggressive use of Long Term Refinancing Operations (“LTROs”) to keep the banks solvent and/or liquid.  But such mechanisms would be useful in this situation only in an indirect way, if at all.   In this case, a run would not have its genesis in a fear that depositors’ money will disappear; a run would emerge from the fear that a portion of seemingly insured deposits will be seized in the form a one time deposit “tax,” as in Cyprus.   Instead of “I’d better get my money out before it’s all gone,” the fear would be “I’d better get my money out before the government takes (some) percent of it.”   The motivation would be different, but the result would be the same.  At that point, such mechanisms as the LTROs would be brought in to stem the chaos, but the chaos would have wrought its damage, and possibly would continue.

U.S. markets don’t seem to much care about Cyprus; they closed today (Monday, 3/18/13),the first trading day after news of the planned deposit tax leaked, down only modestly after a tougher night in Asia and a wild ride here.  But, again, memories and attention spans are short among the people who seem to matter in today’s world, as is the sense of history of those same people to whom we, perhaps foolishly, entrust so much.