Here’s a wonderful idea for a financial product: raise trillions of dollars from investors, invest in a variety of risky assets, and then lie to investors about what the shares of the fund are worth. Just to make this easy, claim that each share is worth $1, even if it’s really worth less. To support this fiction, redeem shares at $1. If prices fall and investors suspect that the shares are actually worth less than $1, they will race to withdraw their funds. The first to withdraw receive $1, the last receive whatever is left, perhaps nothing.
You can be forgiven for thinking that I’ve just described Bernie Madoff’s investment fund. In fact, I’ve described the operation of money market mutual funds in the U.S. (Note that these are mutual funds, not insured “money market accounts” offered by banks.) A year ago there was a run on these funds. Over the span of a week, investors withdrew almost $170 billion after the Reserve Fund “broke the buck”, i.e., announced that it’s shares were worth less than $1. This announcement caused investors to flee other funds because of a fear that those other funds would also break the buck. Investors wanted to exit at $1, before the buck-breaking. In the end, the Treasury staunched the outflows by temporarily insuring money market funds. This insurance expired last week.
There was a run because money market funds routinely lie about their value, which the SEC permits them to do. (If you are interested, the details are in Rule 2a-7; the quick summary is that funds can do “penny-rounding”, meaning that a fund worth $0.995 can report itself worth $1 as long as “The board of directors of the money market fund shall determine, in good faith, that it is in the best interests of the fund and its shareholders to maintain a stable net asset value per share or stable price per share … and that the board of directors believes that it fairly reflects the market-based net asset value per share”. Huh?)
As a result of the run last fall, the SEC is in the process of revising the rules for money market funds. In a rational world, money market funds would behave just like all other funds: every night they would report to investors their true net asset value, which might differ from $1. Investors would then be able to choose money market funds as they do stock funds, investing in a riskier fund if they wanted higher returns, accepting that the net asset value might fluctuate more. Just as stock fund investors have no incentive to run, money fund investors would have no incentive to run. In any event, money funds would have small price fluctuations if they invested in high quality, short duration assets.
Unfortunately, rather than simply requiring funds to tell the truth, the SEC is proposing new and more elaborate rules that will restrict the behavior of money market funds and possibly leave money market fund investors unable to withdraw in a crisis. The proposed rules would include
- New restrictions on the assets in which funds can invest. The assets must be “liquid” (of course we have seen that liquidity vanishes in a crisis), rated in the highest credit category (we have seen that ratings are not reliable ina crisis), and funds must hold a reserve in cash or T-bills
- The ability of the fund to suspend redemptions
- A “know your investor” requirement in which “funds would develop procedures to identify investors whose redemption requests may pose risks for funds.” (It would be exciting to be labeled a “flight risk”!)
- Funds must have the ability to redeem at other than $1 per share
The important thing to notice is that these rules mostly do nothing to prevent investors fleeing funds in a panic. The SEC will try to convince investors that money funds are safer than ever. However, if there is a crisis, investors will still try to exit before redemptions are suspended. The SEC is avoiding the simple alternative, with funds just telling the truth.
The SEC’s approach to money market funds is discouraging because it is emblematic of the approach to other financial reforms in the wake of the crisis. The administration has a unique opportunity to simplify and rationalize regulation. Instead they are crafting a Rube-Goldberg machine.
There is one unexpected twist if money funds were to routinely break the buck. Once funds report their true value, investors will buy and sell fund shares at a floating price, and would therefore be obligated to report as income any resulting capital gains (as with any other mutual fund). These gains would almost always be very small, and the money funds could surely calculate taxable income as a service for investors. But there would be reportable capital gains.
On the other hand, is it a surprise that you can simplify your tax calculations if you lie about your income?