Group of Thirty Recommends Fundamental Transformation for Money Market Funds

A working group of international leaders from the public and private sectors has recommended that the fundamental nature of money market funds be transformed to create two different products: one that offers a stable net asset value (NAV) and is offered only by “special-purpose banks,” and another that does not use the amortized cost method (which money market funds currently use to stabilize NAV) and has a fluctuating NAV. The Working Group on Financial Reform, which issued the report, is a steering committee of the Group of Thirty – a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia, including several advisers to President Obama. The steering committee was led by Paul Volcker, former chairman of the Federal Reserve Board and chairman of the Economic Recovery Advisory Board under President Obama, and members of the Group of Thirty include Timothy Geithner, U.S. Treasury Secretary, and Lawrence Summers, a senior economic adviser to the Obama administration.

The recommendation is part of a series of 18 sweeping proposals that address a broad range of financial and economic issues, including the role of rating agencies, the regulation of structured products and the method of liquidating financial institutions.

The recommendation regarding money market funds draws a regulatory distinction between funds that offer services that are “most appropriately housed in regulated and supervised banks, particularly the right to withdraw funds on demand at par” and funds that offer services that “can reasonably be provided by mutual funds focused on short-term fixed-rate credit instruments.”

• Stable NAV Funds. Money market mutual funds wishing to continue to offer “bank-like services, such as transaction account services, withdrawals on demand at par, and assurances of maintaining a stable net asset value . . . at par,” would be required to reorganize as “special-purpose banks, with appropriate prudential regulation and supervision, government insurance, and access to central bank lender-of-last-resort facilities.” (These funds are referred to in this Alert as “stable NAV money market funds.”)

• Floating NAV Funds. Other institutions remaining as “money market mutual funds” (referred to in this Alert as “floating NAV money market funds”) would “only offer a conservative investment option with modest upside potential at relatively low risk.” These vehicles would be “clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV.” These money market mutual funds would not be permitted to use amortized cost pricing and instead would carry a fluctuating NAV rather than a value that is stabilized at $1.00 per share. The amortized cost method allows money market funds to seek to maintain a stable share value by permitting money market funds to value shares based on the acquisition cost of assets, as adjusted for amortization of premium or accretion of discount, without adjustment for fluctuations in value which may occur due to factors such as credit risk changes, interest rate fluctuations and changes in market liquidity. Rule 2a-7 – the rule that currently governs money market funds – permits use of the amortized cost method, rather than market valuations, for funds that satisfy the strict requirements of the Rule relating to quality, maturity and diversification.

• allow only “special-purpose banks” to offer stable NAV money market funds with transaction account services;

• effectively repeal the current regulatory permission to use amortized cost valuation for money market funds offered by non-“special-purpose banks;” and

• eliminate the right to withdraw funds at par value for non-bank money market funds.

• Transition. The recommendations do not address how the transformation of money market funds would be effected. Presumably, any transition would be structured so that money market funds need not solicit proxies to determine whether they can change their investment objectives. One way to move towards the transformation would be to eliminate from Rule 2a-7 the permission to use the amortized cost method. That change could be made after substantial lead time to permit shareholders to exit the fund. It is possible that the impending change could trigger increased shareholder redemptions, which could exert downward pressure on the value of fund holdings – an undesirable result. This result may be mitigated to some extent if the transition is made while the Treasury Guarantee Program for Money Market Funds is still in effect. That program, which supports share value for the amount of money market fund shares held on Sept. 19, 2008, is scheduled to expire on April 30, 2009, and may be extended until Sept. 18, 2009.

An additional issue is whether any special arrangements need to be made for shareholders who have less flexibility to exit a fund and chose an alternative investment (such as those investing through retirement plans or insurance products that offer limited alternatives).

• Economic Effect. Regulators will need to consider the potential effects of the recommendations on the economy generally. One important aspect of this analysis is whether the assets of the two types of money market funds, together, will – at least initially – be less than the assets in money market funds. If assets “leak” into other types of accounts during the transition, the market for commercial paper and other types of assets held in money market funds could be reduced, aggravating the current stall in the credit markets.

• Which Entities Could Offer Stable NAV Money Market Funds? It is not clear whether non-bank fund sponsors could meet the criteria to “reorganize” as special-purpose banks, as the basic structure of banks differs from that of non-bank sponsors in various fundamental respects. Banks collect earnings based on the spread between payments on deposits and income from loans, whereas non-bank fund sponsors collect earnings based on a percentage of assets under management, paid out of income from investments. One alternative approach might be to allow non-bank sponsors of stable NAV money market funds to retain their non-bank character, but subject these entities to reserve requirements or other bank-type regulation with regard to their money market fund products. The recommendations do not appear to envision that approach.

It is not clear who would own the special-purpose banks. Presumably the sponsors, not the depositors, would own the entity. Current law places limits on ownership of a controlling interest in a bank. The ownership structure will need to be fleshed out.

• Timing. The timing of implementation of the recommendations is not known. If uncertainty about the future of money market funds continues, money market fund sponsors under current Rule 2a-7 who are evaluating the risks and rewards of providing these funds may choose to exit the business rather than to wait for, and convert to, a new regulatory scheme. Further, fund sponsors may be reluctant to launch money market funds or similar products until the regulatory framework emerges.

One consideration regarding timing is that shareholders have flocked to money market funds in recent weeks, in the face of greater perceived risks of other investments. It is possible that changing the nature of the money market funds at this time would cause further uncertainty in the markets.

• Appeal of Floating NAV Money Market Fund. A major unknown is the level of appeal that a floating NAV money market fund would have for investors, as compared to a stable NAV money market fund. It is possible that the floating NAV money market fund would gain acceptance. Although the floating NAV money market fund could not use the amortized cost method under Rule 2a-7, possibly it might continue to comply with the maturity, diversification and quality requirements of the Rule. As such, it might provide a relatively stable investment compared to other currently available non-money market floating NAV funds, and investors might accept it.

On the other hand, it is possible that shareholders may demand greater transparency as to the market value of a fund share than currently is generally available for a money market fund operating under Rule 2a-7. Currently, shareholders generally do not have access to the market value of a money market fund share, and share value is rounded to the nearest penny. The floating NAV money market fund would disseminate daily the market value of a share, and shareholders may want the value rounded to the tenth of the penny or further decimal place. Under the recommendations, the floating NAV money market funds would not be permitted to offer even an implicit assurance of stable value. To achieve this goal, it will be necessary to carefully consider any information disseminated regarding share value.

• Ability to Write Checks. It appears that the recommendations would forbid the floating NAV money market funds from offering check writing without assuring that account balance would remain at par. Check writing may be an important feature to shareholders considering the floating NAV money market fund.

• Ratings. The report recommends that compensation to rating agencies for ratings be structured to align incentives of the agencies and their clients and to permit users of ratings to hold rating agencies accountable for the quality of their ratings. Under this approach, rating agencies might be compensated by the users of ratings, such as money market funds, rather than by issuers, to avoid potential conflicts of interest. The report also recommends that risk ratings be made more robust, to reflect the risk of potential valuation losses arising not just from default probabilities, but also from the full range of potential risk factors, including liquidity and price volatility. These reforms could enhance the usefulness and reliability of ratings that money market funds use. However, it is unclear whether rating agencies will be able to provide ratings that reliably reflect the expanded risk factors. Also, these enhancements might increase costs to money market funds for using ratings.

• Structured Products. The report recommends that securitized and other structured products be held to regulatory, disclosure and transparency standards at least comparable to those applied to public securities markets. The report also recommends that regulators require regulated financial institutions to retain a meaningful portion of the credit risk they are packaging into securitized and other structured credit products. These reforms could help avoid a repeat of the problems that plagued money market funds that had invested in structured investment vehicles (known as SIVs), which posed unexpected credit risk due to mortgage-related exposure during 2007.

• Liquidation. The report recommends that regulators have authority to require orderly closing of regulated banking organizations and other “systematically significant regulated financial institutions,” which are identified by their size, leverage and scale of interconnectedness with other financial institutions and by the systemic infrastructure they provide. Legislation should establish a process for managing the resolution of failed non-depository financial institutions comparable to the process for depository institutions. The SEC has taken a step towards rationalizing the liquidation process for money market funds by promulgating interim final temporary Rule 22e-3T. This Rule permits money market funds to suspend redemptions during liquidations under the Treasury Temporary Guarantee Program for Money Market Funds. The Investment Company Institute (ICI) has commented that this permission should extend to any money market fund liquidation, not only liquidations under the Treasury Temporary Guarantee Program. A rationalized approach to liquidation might help preserve shareholder value and reduce the type of dislocation that has prevailed during the liquidation of The Reserve Fund since it broke the dollar in September 2008.

The report notes that the recommendations are intended to address recent problems faced by money market funds, which “underscored the dangers of institutions with no capital, no supervision, and no safety net . . .” The report does not reference the industry efforts and regulatory initiatives that have, to date, resulted in money market funds’ weathering the recent financial crisis with isolated instances of loss to shareholders—though at significant cost to some fund sponsors. Presumably, money market fund industry participants, including the ICI, will weigh in on the recommendations.

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