Tuesday, September 4, 2012

Jeff Gordon of Columbia Law on Money Market Funds

Professor Jeff Gordon of Columbia Law School posted on a blog this morning about an issue we covered in yesterday's post, namely the failure to reform money market mutual funds (MMF). 

Here's an excerpt from his post:

"The core problem, which the SEC staff has identified, is that money funds hold risky assets but have no independent capacity to bear loss — no capital nor any other loss-absorbing layer. In times of systemic instability, money fund users will run, because being first in line to redeem may increase the chance of receiving 100 percent. A required “holdback” of a small percentage of deposited funds for a fixed period would reverse the run dynamics because it would mean that an investor’s best chance to avoid loss is from not running. That plus a small capital layer would add considerable stability to the money market fund industry.

Money market funds assemble diversified packages of short term credit claims, particularly short term claims issued by banks and other financial institutions. In their present fixed NAV form money funds can play a useful transactional role as a bank substitute, especially for large institutions with large cash balances that exceed the limits of deposit insurance guarantees. But stability of the financial system is a public good that cannot be sustained in the presence of pervasive free-riding. The present money fund structure is like a nuclear power plant atop an earthquake fault. The question of a disaster is not whether but when."
My take on this is different.  The SEC's effort, and perhaps rightly so, was to focus on improving MMF transparency beyond the current level of additional disclosures, and to increase their capacity to bear loss.  Additionally, a holdback in investor redemptions would have added an element of shareholder risk sharing, which partly addresses the 'free rider' problem.  Good ideas.

However, the bigger potential, systemic risk locus is in the repo market itself and in its mechanics.  In particular, I refer to the risks posed to the two clearing banks in the event of a large broker-dealer's inability to get short-term funding and the dealer's subsequent failure.

MMF are one class of cash investors. which are but one element of the repo market.  The broker-dealers perform a valuable service, but they too get a 'free ride' in the shadow banking system's repo market.  A freezing up of their short-term financing poses significant systemic risk, as opposed to shareholder risks at the MMF.

All of this "reaching for yield" is exacerbated in the continuing low-interest rate environment, which is not attributed as social cost of the unconventional monetary policy of the Fed. 

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