Beyond Breaking the Buck - How to Retool Money Funds? - NYTimes.com

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By DIANA B. HENRIQUES

AFTER a fever of panic raced through the nation’s money market mutual funds in September 2008, the industry and its regulators promised quick action on new rules that would restore health and confidence to that $3.6 trillion market.

Investors are still waiting for new rules — and the industry is warning that some proposals for a regulatory cure may do more damage than the original disease.

The loudest debates have been over a proposal that would force money funds to allow their share prices to fluctuate.

For decades, investors have come to expect money fund prices to remain fixed at $1 a share — and with good reason. Although fund sponsors have repeatedly warned that they do not guarantee that price, they have also repeatedly bailed out any fund that seemed in danger of “breaking the buck” — reporting a share price below a dollar. As a result, most investors consider money funds almost as safe as bank accounts.

A floating share price “would ultimately destroy the industry” by undermining that confidence, predicted Michael R. Rosella, who specializes in investment management law at Paul Hastings in New York.

“Folks use their money funds as checking accounts — and without certainty about their principal value, they can’t do that,” Mr. Rosella said.

Almost none of more than 150 letters filed with the Securities and Exchange Commission supported the idea of a floating share price, although the White House nevertheless wants regulators to take a look at it. Still, that lopsided debate has obscured other regulatory proposals that could have sweeping and unpredictable consequences for the industry and its investors.

These proposals would create two categories of money funds, one for institutional investors and one for retail customers, and establish liquidity requirements that would inevitably allow retail funds to offer higher yields.

Other ideas under consideration would require funds to upgrade their software to handle share prices below $1, acquire some kind of private insurance to protect them from a run during a panic, and honor giant-sized redemption requests by distributing actual securities, rather than cash.

Critics of these proposals say they do not address what went so spectacularly wrong in September last year, when the giant Reserve Primary fund — forced to abruptly write down its Lehman Brothers notes after Lehman’s bankruptcy — broke the buck in an avalanche of disorderly redemptions and touched off a run that spread across the already uneasy money fund industry.

A temporary government guarantee program calmed the panic within a few days, but that program expired last month, and Reserve Primary fund investors are still waiting for the last of their frozen assets. Under a plan proposed by the S.E.C. and awaiting court approval, they could get as much as 99 cents back for each dollar invested. But the plan is opposed by many institutional investors, and additional litigation could delay the process.

Obviously, one lesson that could be drawn from that drama is that Reserve Primary could have broken the buck without setting off a panic if money fund shares had routinely fluctuated above and below $1.

But a floating share price would eliminate the threat of a run on money funds by eliminating money funds, said Mercer Bullard, founder of an advocacy group called Fund Democracy, and Barbara Roper, director of investor protection at the Consumer Federation of America, in a joint letter to the commission.

Once the perceived safety of a stable price is gone, investors will simply search for yield, said James J. Angel, a securities law professor at Georgetown University. And that could “push more investors into short-term bond funds with higher risks.”

Another lesson from the run on the Reserve funds was that institutional investors, with their warp-speed timing and “hot money” habits, can turn a problem into a panic in a big hurry.

INSTITUTIONAL investors were latecomers to the money fund market — there were no statistics kept on their role until 1996 — but they made up for lost time. They currently comprise 67.2 percent of total money fund assets, up from 32.6 percent in 1996.

They were the first to race for the doors at Reserve, and their billion-dollar demands accelerated the pace at which things went haywire. That pattern was repeated across the marketplace.

From this experience, the S.E.C. has concluded that money funds primarily serving institutional investors should be required to maintain a much bigger cash cushion than funds serving less-twitchy retail investors. It has proposed that fund boards sort themselves into one category or the other, with bigger cash cushions — and, therefore, lower yields — for the institutional funds.

Paul Schott Stevens, president of the Investment Company Institute, the fund industry trade group, thinks that this is a really, really bad idea.

Two big things could go wrong, Mr. Stevens said. Fearful of being second-guessed by regulators, every fund could err on the side of caution and label itself an institutional fund, leaving retail investors nowhere else to go. Or institutional investors could try to sneak into retail funds to capture those higher yields, leaving retail customers no safer than they are now.

“The real issue is not who the customers are, but how they behave,” he said. Leaving it to fund managers to make that assessment and adjust their cash levels accordingly would provide greater safety, he added.

But regulators worry that his approach would burden retail investors with lower yields than they would need to accept if the cash needs of the hot-money guys were not factored into the equation — or, alternatively, allow funds to keep enough cash for retail redemption habits but too little for institutions.

Another lesson is that a money fund’s computer systems should be able to calculate share prices of less than $1, even if the fund never intends to break the buck. Those at the Reserve fund complex could not, and that greatly delayed the unwinding of those funds.

Regulators, obviously a little testy about this, point out that money funds should already have that software in place because there is no legal guarantee that they will never need it. But the industry argues that retrofitting every fund complex would increase fund costs while adding little benefit.

The idea of a private-sector source of insurance that fund sponsors could tap in a crisis was specifically raised by the White House, which has directed the President’s Working Group on Financial Markets to study the concept. Indeed, some large fund companies are quietly exploring the notion on their own, although Mr. Stevens declined to comment on that effort.

The S.E.C. proposals, however, are silent on that option — which strikes some critics as strange, because liquidity insurance is the one thing that might reliably have prevented the Reserve run.

But the approach raises a number of questions: Can money funds afford the expense? Would the cost further erode yields? And would it perversely encourage reckless fund managers — the familiar “moral hazard” issue?

PAYING off large redemption orders with securities rather than cash is already an option, but one that money funds almost never use. The S.E.C. is studying the wisdom of requiring such in-kind redemptions, while industry critics say the current arrangement works fine.

If there’s one undisputed lesson that regulators and the industry have drawn from the Reserve fund saga, it is that money funds need a better tool kit to deal with systemic panic like the one that followed Lehman’s bankruptcy.

The S.E.C. has proposed rules to allow funds to suspend redemptions more easily, but several critics argue that these proposals do not go far enough to protect the rights of investors caught in a forced liquidation, citing the difficulties that Reserve Primary investors have faced in getting the last of their money.

Given how controversial these proposals are, it is perhaps a blessing that there’s no sign they will be acted on quickly. The industry is still waiting for the report of the president’s working group, which was supposed to report on Sept. 15 but has postponed until Dec. 1 to allow it time to review the S.E.C. proposals more fully.

There are some signs that the market is weathering this continued uncertainty. While the assets in money funds have dropped since last March, trends suggest that investors are reacting more to rock-bottom interest rates than to safety concerns.

But privately, regulators are clearly still worried that the industry and its investors are missing the larger picture. The goal of these new rules, they say, is not only to protect money fund investors from another economic debacle, but also to protect the economy from another money fund debacle.

If doing that makes money funds less attractive to fund sponsors and investors, that seems to be a risk some regulators are ready to take.

Fair enough, said Mr. Rosella, the fund industry lawyer. “But if you’re going to kill money funds, do it directly,” he said. “Don’t kill them accidentally.”