Thursday, March 26, 2009

Money Market Fund Regulation

There is some talk of an overhaul of the regulatory scheme for our financial system. Quite frankly, that's wholly unnecessary, and I suspect it will turn out to be counterproductive. As I will discuss in future posts, the government is primarily responsible for the unfolding economic disaster -- both because its interference in the housing market inflated the bubble and because it has failed to inject sufficient money into the private sector in a timely manner to mitigate the bubble's collapse.

The near meltdown of money market funds after Lehman's bankruptcy last September did underscore a vulnerability in this area of the market. There is only one change that is needed, however, an obvious one that addresses one of my long-term pet peeves.

Money market funds should not be allowed to fix their NAV per share at $1. The NAV per share should accurately reflect the market value of the portfolio. It's insane that it has been otherwise for as long as money funds have been existence. I suppose it is a vestige of a time when mathematicians hadn't worked out long division to more than 3 decimal places.

Using a market value NAV is important for two reasons:

First, not using a fair NAV for redemptions and purchases allows arbitrageurs to take advantage of existing shareholders. To see this, consider a sudden drop in the short-term interest rate of 200bps (this has actually happened twice in the past year). An arbitrageur can invest the next day at $1/share and earn the legacy interest rate for several weeks or months (i.e. a rate 200bps higher than the prevailing rate) at the expense of existing shareholders, who will earn less interest than they would have. The reverse works as well. An invested arbitrageur can redeem at $1/share if short-term interest rates were to rise suddenly. The arbitrageur takes his money out and earns the higher prevailing rate, once again at the expense of shareholders who will earn the lower legacy interest rate (and even less than they would have thanks to the arbitrageur).

Second, and more importantly, runs on money market funds are less likely to get started and less likely to grow. The NAV problem is one of the reasons runs start. The smartest investors see the underlying assets going down in value and take their money out while the NAV is still $1/share and the getting is good. Once a run begins, however, the fair NAV method helps to nip it in the bud. The manager of the fund starts selling assets to meet the redemption requests. This lowers the price of the assets, leading to a lower NAV per share and a higher implied fund yield. By the basic law of supply and demand, a lower price discourages current investors from redeeming and encourages new investors to purchase shares. Stability.

Unfortunately, I doubt that the Feds are going to figure this out.

1 comment:

David said...

Cool post. I never understood the whole $1-NAV thing until now. Thanks.