SEC Doesn't Go Far Enough with Money-Market Reforms, Argues Professor Jeffrey Gordon


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New York, Sept. 22, 2009 – Proposed reforms by the Securities and Exchange Commission to strengthen money-market funds do not go far enough and could even increase the risk of investing in those funds, according to a leading securities law expert at Columbia Law School.
Jeffrey N. Gordon, Alfred W. Bressler Professor of Law and Co-Director of the Center for Law and Economic Studies, told the SEC in a letter that volatility in the $3.8 trillion invested in money-market funds (MMFs) could be better managed if funds for retail and institutional investors were treated differently.
“…I think the SEC has failed to grapple with the fundamental problems with MMFs that last fall’s financial crisis revealed and, in the main, its proposals will exacerbate systemic fragility, not reduce it,” Gordon wrote.
A year after Wall Street was rocked by the collapse of Lehman Brothers, another shockwave hit the financial markets last Sept. 17 when Reserve Primary, a money-market mutual fund, saw its share price fall below its fixed net asset value (NAV) of $1. That meant investors saw their principal shrink, which had never happened before in any money-market fund open to the public.
This so-called “breaking the buck” panicked investors, and some $300 billion flowed out of these funds, once viewed as a safe haven, forcing the Treasury Department to create a temporary program to guarantee money in those funds. That program ended on Friday.
The SEC has sought comment on proposed reforms released in June that, among other things, would force money-market funds to have part of their portfolios made up of highly liquid investments, be restricted to owning only the highest-quality securities and reduce their exposure to long-term debt.
However, Gordon labeled the proposals “quite modest.” Instead, he advocates a division between MMFs sold to retail investors and institutional MMFs sold to corporations, governments, and pension funds. The former would be covered by deposit insurance to ensure a fixed NAV. The latter, he said, should “give up the promise” of a fixed NAV and reduce the risk of a run on withdrawals since there would be no “buck” to be broken.  Why this approach?
One reason, according to Gordon, is that MMFs are required by the SEC to purchase only short-term instruments, such as commercial paper, to maintain their net asset value.
Along with other rules that favor short-term financing, that leaves corporate issuers vulnerable when financial markets are roiled, as they were a year ago, and lending dries up.  As MMFs retreat to safer investments like Treasury bills, firms that rely heavily on short-term finance, such as investment banks, face an immediate liquidity crisis. 
Many problems, Gordon said, are tied to the rules that support the MMFs’ assurances of a fixed $1 NAV. Because of that, Gordon wants money-market funds for institutions to be freed from rules on the composition of their portfolios, when they mature and how highly they are rated, as the SEC has proposed.
Instead, Gordon would allow funds to determine their own investment rules, which they would have to fully disclose, along with what is in their portfolio. That can leave funds less vulnerable to sudden gyrations in the financial markets and avoid a stampede of redemptions if a crisis emerged, he said.
“The result of these … reforms should be to reduce systemic risk,” Gordon wrote.
Lowering risk is also the goal of a proposal by Gordon to require MMFs to have deposit insurance as a condition for having a fixed NAV, instead of relying on the implicit US government guarantee that manifested itself last fall.  This, he said, would allow funds and banks – which are required to have such insurance – to compete more fairly.
Money-market funds were created in the 1970s as a way around government-imposed ceilings on bank interest rates. Gordon said they have since turned into a “non-bank bank” and favors having the SEC examine their “continuing value.”
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