The Derivative Project

Congress, Here is Why SEC Chairman Shapiro is Correct on the Need for Money Market Reform

Congress, Here is Why SEC Chairman Shapiro is Correct on the Need for Money Market Reform

Due Diligence, by the Individual Investor, on Assets held in Money Market Funds is Impossible

SEC Chairman Mary Shapiro appeared before the Senate Banking Committee last week to argue the need for crucial money market reform.  Here is her Testimony on “Perspectives on Money Market Mutual Fund Reforms”.  The systemic risks, particularly with a fragile, global economy and uncertainty with the Euro are perhaps far great than in 2008.  To quote Chair Shapiro:

“Although the Commission took steps in 2010 to make money market funds more resilient, they still remain susceptible today to investor runs with potential systemic impacts on the financial system, as occurred during the financial crisis just four years ago. Unless money market fund regulation is reformed, taxpayers and markets will continue to be at risk that a money market fund can “break the buck” and transform a moderate financial shock into a destabilizing run. In such a scenario, policymakers would again be left with two unacceptable choices: a bailout or a crisis.”
Taxpayers Had to Back Money Funds During 2008-2009 Financial Crisis
Senate Banking Chair Tim Johnson (D-SD) stated at the Hearing on June 21:
“Market uncertainty during the financial crisis in 2008 destabilized the money market mutual fund industry, prompting the Treasury Department to temporarily guarantee funds’ holdings. That one-year guarantee prevented a potential systemic run on the money market mutual fund industry.
“In response, the SEC adopted significant new rules in 2010 designed to increase the funds’ resilience to economic shocks and to reduce the risks of runs. The key reforms required funds to shorten maturities of portfolio holdings, increase cash holdings, improve credit quality, and report their portfolio holdings on a monthly basis.
“The adoption of these rules has no doubt improved investor protection, but questions still remain about what risk the funds present to investors and the American economy, and whether more action needs to be taken to address that risk.”
SEC Chairman Shapiro is also pressing the SEC Commissioners to take a vote on money market reform. The Wall Street Journal, June 23, 2012 reported “Ms. Schapiro and some other top financial regulators see money funds as a continuing vulnerability in the U.S. financial system. Fund firms and other experts say the cash-like investments rarely run into serious trouble. “
What are the Issues for Individual Investors and Taxpayers?

In addition, to the troubling systemic risk posed by money market funds, that Ms. Shapiro calls attention to, it is also troubling the lack of disclosure by mutual fund companies on supposedly “safe” assets that are being dumped into money funds today.

Mutual fund companies have created the impression that money market mutual funds are just like any bank savings or checking account.  They advertise that misrepresentation and investors believe it.  That is fraudulent misrepresentation, a breach of securities laws. Of course, the wording is gray and they indicate these funds are not FDIC insured, but the impression given to investors, by the fund industry, is that money market funds are as safe as your checking account.
If an investor examines money market fund prospectuses, one will find structured investment vehicles, (SIV), such as Charles Schwab’s investment in Whistlejacket, which was held in their money market fund, that went bankrupt.  Money market funds hold asset backed commercial paper that are impossible for investors to determine what assets are held by the special purpose entity.
Historically, based on credit review and prudence in placing very safe assets in money market mutual funds, when they were first developed, these funds held highly rated commercial paper, banker’s acceptances and other highly rated short-term debt of American blue chip corporations and banks.  Those days are long gone.  Money market mutual funds have gone the way of the rest of Wall Street ‘s ongoing misrepresentations.  Money market funds compete to have the highest returns in an exceedingly low interest rate environment. Fund holdings are no longer just blue chip, short-term debt of names that individual investors can recognize. Many hold significantly risky assets, particularly now with the European banking crisis, where European banking debt is a key component of many money market funds.
Advertisements from a major broker dealer state:
“Money market funds are considered to be one of the most stable types of mutual fund investments available.”
However, it is clearly possible, even the Fund companies packaging the assets in today’s money market mutual funds cannot determine the quality of assets placed in some of the special purpose vehicles they are investing in.  These vehicles may be backed by quality banks, but when these assets go into bankruptcy, recouping losses is very uncertain, as the farmers have learned with M.F. Global.
The onus is on the individual investor to study the Prospectus of any money market fund to determine if it is an investment product that suits the investor.
The largest money market mutual fund is Fidelity Investments’ Cash Reserves (Nasdaq:FDRXX), with assets exceeding US$110 billion.  The Derivative Project looked at Fidelity’s Cash Reserve Money Market Mutual fund’s Holdings for month end, May 31, 2012.
The bulk of the fund’s investments are recognizable names, short-term prudent and safe holdings. However, there are many holdings that any individual investor is unable to determine if it is indeed blue chip and safe.  Here are some examples:
Fidelity Cash Reserves (FDRXX) holds:
  • Straight-A Funding LLC (the “Issuer’”).  Short-term government agency debt. ” It was established to provide a desperately-needed financing program for lenders that originated student loans through the Federal Family Education Loan Program (“Participating Originators”). The Issuer provides this funding by issuing short- term promissory notes (“Short Term Issuer Notes”)The Short Term Issuer Notes have an expected maturity date of no greater than 90 days after issuance and a legal final maturity date of 3 business days after the expected maturity date. “

The real rating on this debt, “Agency Paper”, is impossible for the individual investor to determine or what would actually happen in the event of default and bankruptcy.  Is this Agency debt backed by the full faith and credit of the U.S. government?  Perhaps it is, but it is impossible for the individual investor to determine that.

  • Windmill Funding Corp, Windmill is a multiseller, ABCP conduit program established in 1993 by RBS. The conduit is structured as a special purpose, bankruptcy-remote, Delaware corporation. Its sole purpose is to issue 4(2) ABCP and use the proceeds to purchase and finance securitized receivables pools, loans, future revenue transactions and other financial assets. Windmill issues CP with a maximum tenor of 397 days.

Moody’s announced credit downgrades this week.  Windmill Funding is on the attached list in this link and was downgraded to P2.

Here is Moody’s Press Release from June 22 “Approximately USD 37 billion of Commercial Paper affected
New York, June 22, 2012 — Moody’s Investors Service has downgraded to Prime-2 (sf) the ratings of 7 US asset-backed commercial paper (ABCP) programs and to Prime-2 the ratings of 4 US letter of credit (LOC) backed ABCP programs. This announcement follows Moody’s decision to downgrade the ratings of several US and European banks, as announced on 21 June 2012. This rating action concludes the rating review initiated on February 16, 2012. For full details, please refer to the webpage containing all of Moody’s related announcements: www.moodys.com/eusovereign.
In the case of Windmill Funding, it is impossible for the individual investor to determine what assets are actually held in the “special purpose, bankruptcy remote securitized pools”.
If these assets fail, within Fidelity’s Cash Reserve fund, the individual investor loses. The issue with money market funds today is they have become a repository for “junk” and asset-backed securities where their credit quality is indeterminable.  This was not the case when the money fund industry was initially created.
What is the Mutual Fund’s Industry Response?

The mutual fund industry has advocated against this reform, as describe in this April 9, 2012 Forbes article, “Fidelity, Federated Lead Charge Against Money Fund Reform.”

“The stakes for the $3 trillion money market fund industry could hardly be higher, since its success rests largely on investors’ assumption that the funds are as safe as bank accounts. Reforms that would undermine that assumption “would be detrimental to Federated’s money market fund business and could materially and adversely affect Federated’s operations,” Federated Investors argued in its 2011 10-K. Federated gets more than 40% of its revenues from its money market business.
William Birdthistle, professor at Chicago-Kent College of Law, believes money market sponsors such as Federated are right to worry that regulatory changes designed to demonstrate to investors that money market funds are not risk free could spell the end of the business.”

What is the Solution?

“The SEC may be powerless to stand in the way of changes, however, since the big push for reforms comes from the Federal Reserve, according to Ed Mills, government policy analyst at FBR Capital Markets. Nonetheless, Mills isn’t sure new rules will be as destructive to the industry as some fear.”
“Among changes suggested by Mills include increasing capital requirements only against some of the riskier holdings of money market funds.”
The problem for individual investors is that asset-backed securities held in money market mutual funds have no transparency.  The 2008-2009 financial crisis has shown it is up to the individual investor to safeguard your assets and do your own due diligence.  Know exactly what you are investing your hard-earned savings in.  It is your responsibility.  If you are harmed and file a claim with FINRA for losses, you had the opportunity to read the Prospectus to see what you were investing in.  Any losses are your fault.  However, the situation with today’s money market mutual funds is for the individual investor, it is impossible to determine what assets the fund holds.
The compromise:
  • Money market mutual funds must no longer continue to advertise their funds as being as safe as FDIC insured bank deposits.  That fact must be clearly disclosed to any investor.
  • Mandate that money market mutual funds increase capital requirements against the riskier holdings.
  • Mandate that money market mutual funds can no longer hold asset-backed securities, unless there is a direct link to the actual asset held in the special purposed entity, which may be an impossible task, given their structure.
  • Define the nature of government agency debt.  Disclose the rating and indicate if it carries the full faith and credit of the U.S. government.