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Unofficial Transcript: Roundtable on Money Market Funds and Systemic RiskMay 10, 2011Participants :
Chairman Mary L. Schapiro Session 1Chairman Schapiro: Good afternoon. I understand Chairman Volcker is on his way in, but I think we’ll go ahead and get started. I’m pleased to open today’s roundtable discussion on money market funds and systemic risk. And I’m particularly pleased to be joined by representatives from the Financial Stability Oversight Council, as well as my fellow SEC Commissioners. This multi-regulator presence reflects the broad level of focus and attention that money market funds garner and highlights their importance in the overall financial landscape. Money market funds catapulted into the public consciousness in September of 2008 in the midst of the market crisis. It was then the Reserve Primary Fund broke the buck and we subsequently witnessed a run on institutional prime money market funds. Regulators and investors alike were once again reminded of the tremendous significance of the role of money market funds in the financial system. During the week of September 15, 2008, investors withdrew approximately $310 billion from prime money market funds with the heaviest redemptions coming from institutional funds. This represented 15 percent of those funds’ assets. The run was halted by the announcement of the Treasury Money Market Fund Guarantee Program, which temporarily guaranteed money market fund account balances as of September 19, 2008. In addition, government facilities were put in place to provide liquidity to the commercial paper market in which prime money market funds invest. The SEC and other federal financial regulators worked closely and collaboratively on these programs, and we’ve worked closely and collaboratively since in order to wind down the programs and focus on regulatory reforms to mitigate the systemic risk posed by money market funds. The most significant of those regulatory changes to date include the SEC’s reforms to our money market fund regulations. Through this effort, we tightened credit quality standards, shortened weighted average maturities and, for the first time, imposed a liquidity requirement on money market funds. Those reforms, which we adopted in February 2010, have been in effect now for more than a year -- for nearly a year. In addition, we adopted new reporting requirements that provide for a comprehensive and searchable database of money market fund portfolio information. This database enables us to monitor trends in money market funds’ holdings and risk profiles. Complementing these developments, we have provided investors access to money market funds’ shadow NAV information. This information is publicly reported on a monthly basis with a 60-day lag. The public shadow NAV information is expected, in part, to help sensitize investors to the fact that money market fund shares are interests in pools of investments that fluctuate in value, although those fluctuations generally are small. Despite all of this, more needs to be done to better protect money market funds and the broader financial system from the destabilizing risk that can result from a broad money market fund run. I think everyone agrees that our country should never again be in the position of having to choose between providing support to private market participants, including money market funds, or risking a breakdown of the broader financial system. To further the public dialogue on this important issue, the President’s Working Group on Financial Markets issued a Report on Money Market Fund Reform Options. The SEC requested public comment on the options identified in the report and we received about 80 comment letters. The letters, which were thoughtful and substantive, reflected a variety of views. The issues surrounding money market funds are significant. And the variety of perspectives that exist regarding how best to moderate their run risk requires the kind of in-depth dialogue that can only occur by getting some of the best minds in one room to engage in a free exchange of ideas. That is why I am so thankful that our esteemed panelists have given of their time and been willing to travel across the country, and even across the Atlantic, to join us this afternoon. I look forward to a robust dialogue and a healthy exchange of ideas, and the perspectives of a broad range of current regulators as well as former regulators. Panelists include Paul Volcker and John Hawke, who represent a respected long-term perspective; as well as Paul Tucker, Bank of England Deputy Governor, who provides an important international focus. Thank you to the current and former regulators and to all of our panelists for your participation today. And finally, I would be remiss if I did not acknowledge Chairman Sheila Bair, who yesterday announced her official departure from the FDIC in July. Chairman Bair has been an extraordinary public servant, who has worked tirelessly to reduce risks in the financial system, and I will greatly miss working with her. And I’m now going to turn it over to Eileen Rominger, Director of our Division of Investment Management, and Bob Plaze, Associate Director, who will serve as moderators for today’s discussion. Eileen P. Rominger: Thank you, Chairman Schapiro. Good afternoon. I’d like to welcome everyone to the roundtable today. Before we begin the introductions, I’d like to briefly explain how we plan to lead the discussion today. We will have two sessions with a 15-minute break in between. During the sessions, Bob and I will ask a series of questions. We’ll pose some of the questions to the group as a whole, and other questions we will direct to specific panelists to start the discussion, but all panelists are welcome to join in and respond to those questions or to ask questions of their own, time permitting. We do have a lot of material to cover today, so may I ask you to be brief in your comments, and please be understanding when we need to move things along a bit. Now I would like to ask the panelists to introduce themselves, starting on my left. Daniel K. Tarullo: Dan Tarullo from the Federal Reserve. Luis A. Aguilar: Luis Aguilar, Commissioner here at the Securities and Exchange Commission. René M. Stulz: René Stulz from the Fisher College of Business at The Ohio State University. Paul Tucker: Paul Tucker from the Bank of England, and I’m very grateful to Chairman Schapiro for inviting me to be here today. Chairman Schapiro: Thank you for being here. It’s a huge effort, I know. David Certner: David Certner with AARP. Paul A. Volcker: Paul Volcker, once in a while with the Federal Reserve. It says so here. [laughter] Chairman Schapiro: That’s right. Mary Schapiro, Securities and Exchange Commission. Sheila C. Bair: Sheila Bair, FDIC. Travis Barker: Travis Barker, the Institutional Money Market Funds Association. Lance Pan: Lance Pan, Capital Advisors Group. Troy Paredes: Troy Paredes, Securities and Exchange Commission. Deborah Matz: Debbie Matz, National Credit Union Administration. Brian Reid: Brian Reid, the Investment Company Institute. Kathleen Casey: Kathy Casey, Securities and Exchange Commission. Jeffrey A. Goldstein: Jeffrey Goldstein, U.S. Treasury Department. Gary Gensler: Gary Gensler, CFTC. Seth P. Bernstein: Seth Bernstein, JP Morgan. Robert P. Brown: Robert Brown, Fidelity Investments. Bill Stouten: Bill Stouten, Thrivent Financial. Mario L. Ugoletti: Mario Ugoletti, Federal Housing Finance Agency. Carol A. DeNale: Carol DeNale, CVS Caremark. John D. Hawke, Jr: Jerry Hawke, Arnold & Porter, representing Federated Funds. Erik R. Sirri: Erik Sirri from Babson College. Elisse B. Walter: Elisse Walter from the SEC. Kathryn L. Hewitt: Kathryn Hewitt, Harford County, Maryland, representing the Government Finance Officers Association of the United States and Canada. Robert E. Plaze: Bob Plaze with the SEC. Eileen P. Rominger: And Eileen Rominger, representing the Investment Management Division at the SEC. Thank you. Let’s begin. The first part of our conversation concerns the potential for money market funds to pose a systemic risk to broader financial markets. The President’s Working Group Report concluded that money market funds are susceptible to runs because shareholders have an incentive to redeem their shares before others do, if they have a perception that the fund might suffer a loss. The report suggested that several features of money market funds contribute to this incentive. First, a stable net asset value fosters expectations of safety and has attracted highly risk averse investors. Second, funds are subject to interest rate and credit risk but can only absorb very small losses before breaking the buck. Third, a stable net asset value rewards first movers, who will get out at $1 and concentrates losses among remaining shareholders. And fourth, sponsor support fosters a perception that fund prices will not vary, but that support may not be available in a crisis. Do panelists agree with this assessment? Brian Reid: I think there’s one aspect of it -- of the markets in which money funds operate -- that’s important to also factor in. And that is that money markets themselves can go through periods, very long periods of time, where there is very little stress in them. And then during some kind of -- either a default event or other types of events where the markets go through a period in which investors pull back and issuers have a hard time rolling their paper. This began really even before money market funds were a factor in the market. You think of Penn Central. You can think of Franklin National. And so I think one of the additional factors here that would be very important as part of the discussion is to think about the money markets themselves -- there are periods of illiquidity that they can experience -- and the challenges of trading and transacting in those markets during those periods of stress. Robert E. Plaze: Mr. Stouten, the Thrivent comment letter addressed these issues in a sort of different way. You focused on a different feature. Bill Stouten: Yeah, a little different perspective. I do agree with the assessment. I think the primary factor that makes money funds vulnerable to runs is the marketing of the stable NAV. And I think the record of money market funds and maintaining the stable NAV has largely been the result of periodic voluntary sponsor support. I think sophisticated investors that understand this and doubt the willingness or ability of the sponsor to make that support know that they need to pull their money out before a declining asset is sold. I think that's the basic premise. Because the stable NAV money market funds use amortized cost accounting, the impact on the yield in NAV is only realized when the asset is sold. So the investor, the sophisticated investor, has an incentive to pull the money out beforehand. The manager of the fund also has an incentive to hang onto a declining asset because of the stable NAV, because if they hang onto the asset hopefully it matures or perhaps the credit improves before they have to sell it. The longer they hang onto it, the more shareholders become aware of the situation and are ready to pull the trigger before they do. And I think that both of those opposing incentives create runs on money market funds. Robert E. Plaze: One other thing you spoke to, and I think, Brian, you've spoken to it also, is the reliance in the short-term markets on liquidity by dealers whose balance sheets may be substantially less than those of the money market funds from -- who are thinking liquidity. Brian Reid: Yeah, I think that's, again, part of this overall market structure issue that we have discussed in the past. I think also one of the factors to keep in mind -- empirical pieces of evidence -- is that in many ways the investors in money market funds did not behave all that differently than investors in other types of similar funds over the course of that 2007/2008 financial crisis. In fact, we began to see problems arising first in Europe in some floating NAV funds that were there -- these were nonregistered funds -- and then moved. And so in many ways it was more of a reflection or a mirror of the overall investor concern and reluctance to continue to operate in these markets, again, starting first with the asset-backed commercial paper market. So I think that these periods of stress that the markets come under or that overwhelm the markets, is an important factor. And in many ways the money funds were, in the U.S., probably the most obvious example of it because the flows were the most transparent. Eileen P. Rominger: Yes, sir. John D. Hawke, Jr: I think it's important when you talk about money funds being susceptible to runs that we look at the history of money funds. Money funds have been extraordinarily successful since they were first brought onto the scene. And with the exception, albeit a significant one in 2008, it's hard to point to a situation in which there was a run on a money fund, albeit it's true that sponsors may well have stepped up to prevent that. It's also important to note that runs on money market funds such as they might be are vastly different from runs on commercial banks. This is not the Jimmy Stewart situation where people are lined up at a teller's window trying to get money, only to have it explained to them that their money is tied up in mortgages that are very illiquid. The funds of money markets are -- the investments that money markets have are very short-term. With the exception of very temporary liquidity discounts where there's significant market disruption, their assets are money good. I think it paints a misleading picture to say that money market -- to say flatly that money market funds are susceptible to runs. Lance Pan: I think all the comments are excellent, and I think everybody realizes that money market assets are different from other investment vehicles. I would like to add that money fund investors do view money funds as liquidity vehicles, not as investment vehicles. What I mean by that is they will take zero loss, and they're loss averse as opposed to risk averse. So to the extent that they own that risk, at a certain point they started to own that risk, then the run would start to develop. It's not that throughout the history of money market funds we did not have asset deterioration. We did. But I think over the last 30 or 40 years, people have relied on the perception that even though there is risk in money market funds, that risk is owned somehow implicitly by the fund sponsors. So once they perceive that they are not able to get that additional assurance, I believe that was one probable cause of the run. Robert P. Brown: Eileen? Eileen P. Rominger: Yes. Robert P. Brown: I just want to go back to the last run that I remember, which was September of '08. And I think investors left because there was no transparency. Treasurers and CFOs are not paid for the extra three or four basis points that they'll earn in a money fund. They're paid for principal preservation and liquidity. The SEC, through the regulations that were implemented in May of 2010, now provides for full transparency on a monthly basis of fund shareholdings as well as the market value NAV. Our fund, Cash Reserves, the largest retail fund in the money fund industry, experienced a two percent decline in net assets over the 10-day period prior to the Treasury guarantee. I would not describe that as a significant run. In fact, I would describe it as great, you know, resiliency within the fund. What we did experience was a large outflow in our institutional funds. And as people have noted here, sophisticated investors didn't waste time or didn't want to learn about what was in the fund. And, in fact, we saw a 40 percent reduction in our large institutional prime fund over a seven-day period. Although those assets were sold -- some at below par -- all of those assets matured over a three to four-week period at par. So we were a forced seller of those assets because of the lack of transparency. The SEC has adopted rules that now provide clear transparency to the sophisticated or institutional shareholders. On top of that, the fund industry is much more well prepared to deal with future moves from institutional investors by the liquidity requirements that were put in place. Eileen P. Rominger: Sure, yes, of course. Daniel K. Tarullo: Could I ask you a follow-up question on that? So you began, I thought, with the correct observation that treasurers and CFOs had a very limited incentive to look at the underlying instruments behind the money market fund for the three or four extra basis points. Even if there's a lot of disclosure required, how does their incentive change? Robert P. Brown: Their incentive does not change. Daniel K. Tarullo: Okay. So in all likelihood, if a crisis hits, the CF -- the investor -- the institutional investor is not going to have a very good sense of the relative problems with the assets that are underlying the fund. Robert P. Brown: That -- absolutely fair point. It's my expectation, though, that the CFO and treasurers are reviewing their portfolios on a monthly basis and there are some advisers out there that disclose shareholdings on an annual -- on a daily basis. So I think it was a -- the surprise factor, if you will, in terms -- or the uncertainty. So we believe that the transparency goes a long way towards educating the CFO and treasurers about what the funds actually do own. And in addition to that, we believe that the funds are now better prepared to withstand runs with respect to any uncertainty. Eileen P. Rominger: Mr. Goldstein. Jeffrey A. Goldstein: Does the observation you make imply that as we think about reforms we should look at this through a retail investor lens, differentiated from an institutional investor lens? Robert P. Brown: We would be willing to work with the regulators and the industry on helping to define that definition, yes. Robert E. Plaze: Well, I think that's relevant. Our experience here at the SEC is that during the period 2007, institutional investors were actually demanding transparency of their funds, and we saw more and more funds putting their portfolios on the website, making them available. And our sense was in 2008, what was happening was that fund investors were able to look through a portfolio and see exactly the exposures. And so day-to-day, when there was a headline in the Wall Street Journal, folks were looking in and seeing whether there was exposure to a particular name or company. So in some ways transparency cuts both ways. Eileen P. Rominger: Ms. DeNale. Carol A. DeNale: Well, being a corporate treasurer, I can tell you that my department looks at every investment that we do in the money markets. We dive down into all the detail on it. And I think that one, yes, transparency helps, and I think the rules that went into effect that affected the WAM, and the amount held overnight, and in 30 days has relieved some of the pressure that you will see that -- from 2008. But I think treasury departments of large corporations are absolutely reviewing the funds that are held because, you're right, we don't want to lose principal, but it's also our responsibility -- I have very strict investment guidelines that I have to adhere to. And to invest blindly in a fund, it just does not happen in large corporations. We have to be reviewing underlying securities. Paul Tucker: So in the run up to the crisis, the money fund industry became part of the search for yield, buying ABCP where some of the underlyings were fairly illiquid. Is that something which the universe of corporate treasurers were encouraging the money funds to do? And similarly, over the last two to three years, where there's been a big flow of capital from the U.S. money funds into the European -- largely but not exclusively continental -- European banking industry, is that something which the corporate treasurer and municipal authority treasury universe have been focused on and encouraging? Carol A. DeNale: We haven't been encouraging it. I mean, I do not look to the money markets for yield. I'm looking at it for a place to put my investment funds for a certain period of time and withdraw them. Corporate treasurers use money market funds in two separate ways. I use it -- CVS Caremark uses it -- for two different things. One, I have a three and a half billion dollar commercial paper program. I look to them to purchase commercial paper. Approximately 40 percent of my outstanding CP at any given time is owned by a 2a-7 fund. That's an amazingly important part of our capital structure, and one that will not easily be replaced. In the other end of my -- we run some small companies that have investment portfolios. I'm not at all talking to the money market managers saying, "I want you to pick up yield." I'm looking at what their portfolio is in their product and determining, "Does this meet the requirements of my company that I can invest in?" Eileen P. Rominger: Mr. Pan. Lance Pan: My firm manages cash for about 250 corporate accounts. Every one is an individual entity. My experience has been that, prior to 2007, investors were voting with their feet. In other words, they were chasing some of the higher yielding funds. Not all investors, but a good representation of the market. Since 2007, investors are pickier. They're looking at the underlying holdings, and they're asking the question. So that observation absolutely is true. Going back to the questions about the money market funds making investments in ABCP or structured investment vehicles and such. We view that really, in money market funds, because of their own success, this is a large liquid pool of assets, and it naturally will attract the attention of some of the shadow banking products because it's easy to hold some of these less liquid securities in a very large money market fund, and it will also see money funds tend to move in certain waves. For example, when we experience problems with ABCP, we definitely saw the pickup in the holdings of European banks across all prime funds. When the problems with a Euro debt crisis started to bubble, then many of the funds would rotate out of those banks, into some of the Canadian or Australian banks, and then into repurchase agreements. Now we have lower yield in the repo market, and funds are rotating out of repo into some other asset classes. So that's another way of saying that we also need to address the correlation risk of the investments that large money funds make to reduce the systemic risk. Seth P. Bernstein: I think it would be -- Eileen P. Rominger: Mr. Bernstein. Seth P. Bernstein: I think it would be negligent of us to also ignore another fundamental change that the Commission imposed last year, because money funds historically could not stop redemptions, could not liquidate, and close and liquidate. While it is an extreme step, it's one that is now part of ours, and I'm sure others', liquidity planning process with regard to dealing with that credit event which drives a run. And we think that was a very significant change which wasn't available at the time. Robert E. Plaze: But ability of one bank to shut its doors doesn't necessarily mean the other banks won't be affected, does it? Seth P. Bernstein: No, it doesn't. And actually I think that is a strength because, in fact, had Reserve shut the door, it would have certainly reduced the pressure on secondary pricing throughout the market. And while liquidity was certainly not evident in any large size, that pressure I think would have abated significantly had they done so. Robert E. Plaze: Mr. Volcker. Paul A. Volcker: I may be commenting on something that comes later, but you asked the specific question, "Are they prone to a run?" Eileen P. Rominger: Yes. Paul A. Volcker: I think the answer is obviously yes, and incontestably. But the real test of what we're talking about is what happens in a time of crisis? Obviously in fair weather, nothing ever happens, and you don't have to worry. The question is we've got an institution here which is vulnerable to a crisis. We had a big crisis, it turned out to be terribly vulnerable. There was no backstop, no capital, no official assistance available. Most unusual measures were taken. You know, whoever thought that the Exchange Stabilization Fund, which I used to run, would be used to support domestic money market funds? I mean, that is an indication that something's the matter. And what happened to the commercial paper market upon which they were all dependent? They all use this great sophisticated local commercial paper, it wasn't worth a damn in the midst of a crisis. Now, I don't care how much a company's looked at it and was careful. You had a structural problem here of an organization that had no backstop, had no capital, had no official liquidity support. So it had to run from one extraordinary action to safeguard it to another, and you asked, "What is the public good that this institution is providing that makes it worthwhile to run a big risk, vulnerability to a crisis?" Eileen P. Rominger: Thank you. We'll definitely follow up on some of those points later in our conversation, as well as now. Mr. Pan, you used the term "shadow banking." Many would view money market funds as having played an important role in the growth of short-term markets. They have a role in allocating capital among short-term borrowers. They provide investors diversified access to these markets. Others, however, view money market funds as part of a shadow banking system, and they view them as perhaps primarily designed to circumvent banking laws. Which of these views is the right one? Robert E. Plaze: Or are they both? Eileen P. Rominger: Or both. Paul A. Volcker: All of the above. [laughter] I may be the oldest person around this table. Robert E. Plaze: And the tallest. Paul A. Volcker: I happened to be there at the birth of money market funds. It was pure regulatory arbitrage. Banks could not pay interest on demand deposits. So there was a gap in the market, which was filled by money market funds saying, "We'll pay you interest, and we'll provide a demand deposit." Now, you ask yourself whether that is -- the relevance of that at this point. It is a shadow bank. And do we need shadow banks, or are we making real banks? John D. Hawke, Jr: Let me just add that the prohibition against payment of interest on demand deposits had been around for many, many years before under Chairman Volcker. Interest rates were run up to close to 20 percent, and it was Reg. Q -- it was the Reg. Q ceiling on bank deposits that encouraged the creation of money market funds. Since that time, money market funds have been enormously successful. There are 30 million people who have money market investments. We're up to almost three trillion dollars in money market funds. Chairman Volcker asked, "What's the public good?" A lot of people out there think money market funds are very good for them, and they find them enormously useful for cash management, for liquidity, for diversification. And retail investors in money market funds put a high value on the transaction account feature of those funds. And while we, again, talk about money market funds being susceptible to runs, I think there's a great danger in looking at all sorts of mechanisms for reinventing or reengineering the money market fund business. And the danger is that there will be unintended consequences and that people who find money market funds extremely useful will be deprived of the benefits and the utility of those funds. The basic problem that the Reserve Fund issue caused was how you deal with emergency liquidity needs. And I think that ought to be the focus of any discussion about what, if anything, should be done with money market funds. How do you deal with those extraordinary situations where there's tremendous market disruption, not caused by money market funds, but as to which they are in a sense the victims? How do you deal with the demand for liquidity that comes when investors want to cash in? Eileen P. Rominger: Professor Sirri? Erik R. Sirri: Professor [unintelligible]. [laughter] So, you know, mutual funds generally are wonderful in many ways for investors. Money market funds particularly so. Among the things they do besides diversify is they provide absolutely infinite liquidity, or I should say they promise infinite liquidity to people. Now, I think your point, Chairman Volcker, was that they don’t always deliver on that promise. But I would make clear that they're all -- that the idea of guaranteed liabilities is the trade of all financial intermediaries. A life insurance company has a policy it promises to pay if you die. If the life insurance company is bankrupt, it can’t make good on that, so we have various things that we put in place to make sure that the life insurance company does make good. The real question here, I think, is: "How do you make good on the guarantees that are explicit in a money fund?" The guarantees right now are managed by 2a-7. The SEC set the rules of the road for money funds on how guarantees get managed. It sets the pricing rules; it sets who gets out when; it sets all those terms. There are various people who fill a role of guarantor. Advisers will step in as guarantors. This happens under a process under the SEC. And at times the federal government has stepped in. But it seems to me that we’ve seen money market funds have issues for years. 2007 wasn’t the -- 2008 wasn’t the first time guarantees needed to be enhanced. Like Moody’s put out a report that said, in 144 instances before 2008, money funds were guaranteed by their sponsors. So that a guarantee is called upon, it seems to me, is not unique. What we really have to figure out, it seems to me, is how you pay for it and who’s actually going to be the guarantor. Eileen P. Rominger: Yes, Mr. Tucker. Paul Tucker: Just building on that, I mean, John Hawke’s obviously right that there are millions of people in this nation and around the world who benefit and like money funds, but that isn’t the public policy issue. Those are the private benefits of this structure. The issue is that because they are susceptible to runs, and because they are so impregnated and vital to the sinews of our financial markets, that when things go wrong, the costs of that spill over to everybody beyond the financial contract. And in terms of Professor Sirri's comment, so who guaranteed the liquidity in those circumstances? Well, the only type of institution that can guarantee the liquidity did: the central bank, effectively. And once the state -- in this case through the central bank -- steps in and says, "We will underpin the liquidity guarantee that you give,” but because of the social costs of it being otherwise, then the state is also entitled to say, “And what are the rules of the game for providing that liquidity guarantee?" Now, this issue has arisen because there are rules of the game in precisely the other form of finance when this arises, banking, and there have not been rules of the road for addressing this particular externality. And so in that sense the debate is not about "What are the -- are there millions of people that like having money market mutual funds?" Of course, there are. The question is how do you build a regime that offsets -- either takes away the implicit liquidity guarantee or makes explicit the liquidity guarantee without having different rules of the road for money market funds on the one hand, from banks on the other hand? That’s what this debate is surely ultimately about. John D. Hawke, Jr: Could I just respond briefly to that? When we talk about the guarantee, money market funds have not had credit quality problems, with the exception of the overinvestment in Lehman paper that the Reserve Fund made. That was very unusual for money market funds. And 2a-7 and what the rating agencies do, as well as what investors in money funds do with the use of the transparency that they have, credit problems in money market funds and the backstopping of funds for credit related problems should not be a great concern. The problem is one of liquidity, what happens when there are external disruptions in the marketplace and particularly institutional investors get concerned about their ability to redeem at par and they start running for the exit. How do you meet that unusual demand for liquidity, keeping in mind that the assets of the funds are what I call money good. We’re talking about assets that, if they have a depreciation in the marketplace, it’s only because of the liquidity crunch that they’re facing and not because there are fundamental credit problems. These are assets of very short maturity and very high quality. And it’s what I think the experience showed after Treasury came up with the insurance program and the Fed started funding the purchase of paper from the funds, that there were no losses. Treasury made a profit. The Federal Reserve made a profit on those facilities, and the problem worked itself out, and the prospect that there would have been losses on those securities was virtually nil. Daniel K. Tarullo: One second, though, Jerry. Well, how does the run start in your telling of the story? John D. Hawke, Jr: The run starts with -- well, first of all, there was tightening in the short-term credit markets even before the Reserve Fund broke the buck. But when Reserve announced that it was going to break the buck because of the Lehman holdings -- Daniel K. Tarullo: Questions about the creditworthiness of the underlying instruments, right? John D. Hawke, Jr: No. Well, that was why Reserve broke the buck. But the institutional investors left other funds that didn’t have Lehman paper because they were worried about their ability to get out before anything else happened. And, you know, when the Reserve Fund wrote the Lehman paper down to zero, it reduced the net asset value to 97 cents. I mean this was not the end of the world when that happened, but institutional investors wanted to get out. And the overhang of their redemption requests was what caused the liquidity crunch. It was a situation in which the tremendous demand for redemptions caused the depreciation in the market price of the assets that were being liquidated, and those assets, had they been held to maturity which, you know, was 30 to 40 days probably, would have paid out at par. This was not a situation where the assets of the funds were tied up in long-term illiquid assets. So the question is: How do you fashion an emergency liquidity facility that can deal with that really short-term problem? Daniel K. Tarullo: So let me see if I understand what you’re telling us. So questions about the underlying creditworthiness of the issuers of the CP that lay behind the money market funds, as a result of the Lehman problem, created a run on some of the money market funds as firms tried to get their liquidity out, which would then in turn potentially force the funds to sell some of the underlying assets in order to garner the liquidity necessary to pay the redemption demands, which presumably, in turn, would push down the value of those assets including those that are still held by other money market funds, isn’t that kind of the -- John D. Hawke, Jr: Yeah, the -- Daniel K. Tarullo: -- thin line between a liquidity and a solvency problem? John D. Hawke, Jr: Well, it pushed down the temporary value of those assets, but those assets were money good assets. They were government securities. They were high quality commercial paper with short maturities. And as the experience showed, they paid out at par. These were not situations like the Lehman paper itself where there was a fundamental credit problem with the paper. René M. Stulz: Can I just -- Eileen P. Rominger: Professor Stulz. René M. Stulz: I think there’s a problem with the argument, which is the following: on September 17, nobody knew who would be money good 30 or 60 days later. So what we saw then is $200 billion leaving prime money funds -- that wasn’t government money -- and, as a result, wreaking havoc with the CP market, with the repo market, and with the funding of the European banks. Eileen P. Rominger: Mr. Brown. Robert P. Brown: I'd just like to pose a question back to many of the regulators. Is the suggestion here that the money fund industry should adopt bank-like regulation, and if so, is that for direct access to the Fed's discount window so in the time of a liquidity crisis we have that access? Eileen P. Rominger: We will be addressing that probably a little bit more -- Robert P. Brown: Can I interrupt? Okay. Eileen P. Rominger: [affirmative] Robert P. Brown: Chairman Volcker has spoken loudly about the need for bank-like regulation, and I’m just trying to understand what does that provide the money fund industry? I’ll preface it, or go behind it, but just to say that we have studied our market value NAVs over the past 20 years, and we would consider a significant deviation from the amortized cost NAV to the market value NAV of 10 basis points. I think the integrity of rule 2a-7 speaks loudly with those numbers. We’ve looked back over the past 20 years during various credit cycles and interest rate cycles, and we would consider a move between the market value NAV or the amortized cost NAV of 10 basis points -- that’s what we have experienced, and we would consider that significant. We would say, given the fact that we’re talking about a half a cent with respect to the theoretical breaking of the buck, you’re down to 10 basis points. We think that represents a true definition of the integrity of rule 2a-7. But I would be curious to understand what bank-like regulation would actually bring to the money fund industry. Sheila C. Bair: I guess I think the regulators get to ask the questions, but I -- Robert P. Brown: Yeah. Sheila C. Bair: You know, I guess we haven’t really talked much about moral hazard, and the fact that it did go wrong, and the government did have to come in, and we don’t provide deposit insurance just when things go bad and banks need it. There is extreme moral hazard involved with that. So government has long recognized in the aftermath of the market crash that the banking people who would desire bank-like products, they want that stable NAV, they will run. If they think they have a risk-free investment, as soon as they think they don’t have it, they will run. And that’s why we have deposit insurance. That’s why we have banks who offer deposits; they have to have deposit insurance, and they have to pay for it in good times and in bad. So we got into a situation where money market mutual funds have had this stable NAV; I believe it is a fiction. The investments clearly are not risk-free, and just because your term is short does not mean that the investment is risk-free. And so it was broken. It was a model that was broken, and we saw that during the crisis, and the government had to step in. And now, it seems to me, we have a moral hazard issue. And perhaps money market mutual fund investors now think -- well, if something goes wrong again, if they make a stupid investment, if they over lever in commercial paper markets in Europe or whatever, that the government's going to step in again. And how are we going to fix that? And I understand from your business perspective, maybe the status quo is just fine. I mean, maybe you have the best of both worlds right now. But that’s not really what regulators should be worrying about. Regulators should be worrying about moral hazard, and frankly, I think, skewing allocation of investment dollars to highly short-term investments. You know, it seems to me that retail customers who want money market mutual funds kind of want a bank account. That’s how they want to use it. And it sounds to me like a lot of institutional investors are really asking the money market mutual funds to intermediate for them investments that they are unwilling to make directly in commercial paper because of the different accounting treatment. They use a money market mutual fund to mediate so they can keep a stable NAV. But the investments behind that are higher risk. They are not risk-free investments. But that is skewing investment dollars into highly short-term funding that is unstable during a crisis. So that’s the public policy issue we really have to deal with. And I’m glad the industry is here, and I want to hear your views, but that’s what we have to deal with. And it’s not just your business model and what you need to do to keep your investors happy. There’s a broader public policy issue that I think we need to deal with. Eileen P. Rominger: Brian? Brian Reid: Yeah, I think that’s a very good question. The question in my mind is let’s state what the public policy issues are. So one of them that is on the table clearly is that of the systemic risk caused when investors quickly pulled out of money funds and at the same time were pulling back from the short-term markets generally. So my point that I made very early on in the conversation here was that in many ways what we observed very clearly with money market funds -- because the flows are published on a daily basis by third parties out there -- what we were observing there was what was happening more broadly in the money markets themselves. And I think the real challenge before us is that there’s a very clear stated demand out there on the part of investors for a non-bank product that creates a pooled investment in short-term assets. In fact, the existence of that, even though the fund industry sometimes likes to say that money funds were the first pool for this, it’s actually not. Banks had created these types of pools called "short-term investment funds" before money market funds even existed. They were there for their trust clients, for instance. Local government investment funds existed prior to money funds as well. So there’s a very large base of demand for this product, and it’s important to keep in mind that the banks can’t satisfy this because an undiversified exposure to a single bank is considered to be far riskier because of that undiversified exposure. And so the money is ultimately going to want to flow to these pooled products that offer short-term cash investment and that can provide the types of access to the money markets, into those short-term investment instruments that are out there and have long been out there prior to even money funds being created. And I think that’s where the part of the public policy conundrum is. We can squeeze on this part of the short-term market, but where will the money go then? And I really don't believe it'll go to the banks because we’ve only seen about 150 billion go into demand deposits over the last year and a half. And -- Sheila C. Bair: Funds have shrunk a lot already. Where is that money going? Brian Reid: Some of it has gone, on the part of institutional investors, back into alternate products. Again, it’s difficult to monitor that because there’s no official reporting. Some of that goes into separate accounts where individual firms are operating their own cash pools. Some of that has gone longer out on the yield curve for retail investors into short-term bond funds. And a portion of that has gone into banks. I mean, we’ve seen that for years where interest rate spreads between bank deposits and money funds narrow, we see money temporarily go into banks. But for the large institutional investor, which I think is what everyone is concerned about here, that money does not naturally go back to the banking system because that uninsured, undiversified exposure to a single bank is sort of unacceptable as part of a fiduciary standard for the large corporate investor. Travis Barker: If I may, we see this a little in the offshore space. Outside of the U.S., money market funds are fundamentally an institutional phenomenon. They evolved in the absence of Regulation Q, so it wasn’t a kind of regulatory arbitrage-type rationale because there was no Regulation Q outside of the U.S. They largely invest their money, at least 50 percent actually, in certificates of deposit, time deposits. It’s not about circumventing the banking system. It goes back into the banking system. Fundamentally they exist for precisely the reason that Brian described, which is they’re there to provide institutional investors with greater diversification than they could otherwise achieve. And if you step back and think about it from a systemic risk regulator’s point of view, that’s a good thing because a world without money market funds in theory would be a world where, presumably, institutional investors were trying to manage credit risk, not through diversification but presumably through concentration in banks that they would think would be too big otherwise to fail. It’s not clear to me that a world without money market funds would be better or that institutional investors would act in a way that would create fewer systemic risks than is currently the case. Now, that’s not to say that the points about public policy aren’t very important points, and we need to figure out ways of affecting money market funds so that those shareholders can’t avoid paying for the risks that they’re taking. But fundamentally the product exists for legitimate risk mitigation reasons. Eileen P. Rominger: Mr. Pan. Lance Pan: I just wanted to second the other two panelists. That point that you've made, that as we represent institutional investors, as we’ve seen the assets in the money funds world have dropped -- just to give you some numbers, the issuance of ABCP has dropped about 67 percent, and overall money fund assets have dropped off 30 percent, and today the yield level is less than a year ago -- yet the institutional prime fund assets today are higher than they were a year ago. So that tells me that institutional investors would very much like to have some substitute to bank deposits because all the right conditions are in position for basically institutional prime fund investors to go back to bank deposits, but they have not. So that speaks to the benefits of them -- the diversification benefit to them, and also they have to worry about their counterparty risk to some of the large international banks already. Sheila C. Bair: If the institutional investors want professional money market managers to manage these investments for them, you can do that with a floating NAV. But with a stable NAV, again, you have relatively higher risk assets behind those investments, yet you’re maintaining this fiction of a stable NAV, which implies risk free assets, and that’s not what you’re investing in. You know, invest it all in government securities if you want, it seems to me, honesty in the valuation. But I do think because you are managing this credit risk for them and allowing them to maintain a stable NAV, you are skewing resources in favor of short-term funding, which is destabilizing to the financial sector. There would be less short-term funding available, I think, if you didn’t have this, and I don’t know that that’s a bad thing. Travis Barker: If I may, though, very specifically on that. I don’t know if we're going to talk about this after the break as well, on the question of floating versus fixed NAVs. I mean, you know, we observe in some countries they have money market funds with floating NAVs. Others have money market funds with constant NAVs. Both of those funds appear to be susceptible to runs where investors lose confidence in the underlying asset class. So I entirely take the point that we need to find a way of making sure the investor pays for the risks that the investor is accepting. In particular, in order to mitigate the risk of a run, which has all these horrible systemic consequences, it's just not at all clear to me that the pricing mechanism of the fund, the floating versus fixed NAV, is the right fix. I think we need to look for something different. Eileen P. Rominger: Ms. Hewitt? Kathryn L. Hewitt: I wanted to step back a minute to speak again to being an institutional investor, a corporate treasurer, and speaking to what Mr. Reid said about the diversification that money market funds offer to the investor. It's very important to our membership -- they’re governments of all sizes -- that we have access to investments that are diversified. And just putting our money in the bank and getting an interest rate on it in a bank deposit concentrates risk for us significantly. Many times the local banks aren't even particularly highly rated banks even though they may be certainly FDIC insured. We need to have corporate cash management practices. We encourage looking at money market funds as one of our alternative investments and not our only investment, but by getting into a money market fund, we're hiring expertise to analyze the investment portfolio for us. Most of us don't have the time, the energy, or the resources at our fingertips to analyze the credit quality of every security ourselves. So we're in essence, by going into a pooled fund, hiring that expertise for us. We're paying something for that, yes, but it gives us diversification, it gives us immediate cash management needs where we can move money into and out of it, and it satisfies much of our operating cash investment opportunities. Eileen P. Rominger: Yes, Chairman Matz. Deborah Matz: The discussion has centered around the institutional investor, but about a third of the investments are from individuals who seem to think that there is no risk involved and think of money market fund investments as comparable to having money in bank deposits. And so from a public policy perspective, there's a question as to whether there should be a two-tier system, and whether there should be some additional protections for individual investors who probably don't understand the risk involved. Eileen P. Rominger: Mr. Pan? Lance Pan: Just a very quick comment. In my mind, there really is not much distinction between institutional investors and retail investors. The reason I said that, you know, if you think back to September, 2008, the U.S. Treasury had instituted the guarantees for money market funds on September 19. That's three days after the Reserve broke the buck. What I'm trying to say is the psychology of an institutional investor is very much the same as that of a retail investor, which is loss aversion. Retail investors simply didn't have enough time to act. If they did have the month end, and looked at their balance sheet, or looked at their statements, they might have acted together. So I think, at the end of the day, really we needed to look to the transparency of the holdings to really give them the assurance that there is not a reason to run. Going back to my earlier point that their state of confidence is really not necessarily in the holdings of the money market funds. There are a lot of sophisticated investors that do look to the holdings, but some of the responses that we've gotten from the investors (by the way, my firm does not manage money market funds) -- what we've heard from the investors is that, "Yes, we recognize there might be a risk in a portfolio, we wanted to be interested in that, but at the end of the day, if we don't own that risk, then we are comfortable staying in that fund, which means if the fund sponsor is capable of making whole any problems, then we can still stay in that fund, we just keep watching it.” So from an institutional versus retail perspective, I think really there should not be separate treatment there because of -- you know, all that's different is the order of magnitude, and really it does not change the nature of loss aversion of the money fund investor. Eileen P. Rominger: Chairman Gensler? Gary Gensler: Thanks, Eileen. May I make three points? I tend to agree with Ms. Hewitt that corporate treasurers -- and having for some number of years been on boards of public companies -- we're always looking for diversified ways to put some cash that wasn't yet being there for investment. But one thing comes along with the money market funds, which is the stable value, or if I can say as an old market guy, it's a "free put." You can put back an instrument and get 100 cents on the dollar. And it's that free put that I think causes some structural challenges. Secondly, and the SEC did a terrific briefing for some of us on the FSOC, and I think I can say it publicly, but I was struck by how much this industry has changed over the years, how much of the funds are actually flowing through prime money market funds to European banks. It's like European banks have figured out this is dollar deposits that they can get, and God forbid, maybe with the Federal Reserve standing behind it. But, and there's just a tremendous amount of the asset, so it's almost like doubling down on the risks that if the European banking centers had problems, you'd want to pull your money out at par. We don't want the Federal Reserve standing behind it, but Jerry Hawke might want them there, I don't know. And so that's that. The industry does support U.S. commercial paper, but the majority of the money, I think this was correct, is funding European and Asian banks' dollar deposits. Third point is just something that we learned at the CFTC. It was before I was there, but when the Reserve Fund broke the buck, and on September 19, futures commission merchants that we oversee -- that's something equivalent to a broker-dealer -- had about six billion dollars in the Reserve Fund, and they couldn't get the money. In fact, they didn't get some of it ever, but it was four different payments from October to the following April. So that six billion was frozen. It wasn't even a question of value; it was just frozen. And the staff at the CFTC had to think, "Well, this was customer money frozen; it was supposed to support transactions in the futures market.” So there are a lot of knock-on effects in the middle of a crisis. I know that wasn't the center of the crisis, but it was something that our staff is very worried about even today about money market funds, and how it happens in a crisis. It's all about the crisis. Every other day is fine, just the crisis. Chairman Schapiro: I just want to follow up on a point that Gary made because I think we do understand the corporate and the local government's desire for diversification and professional management. I guess I'd like to understand how important the stable NAV is to that because it's almost as though this is playing out as we have two choices: one is banks and the other is money market funds exactly as they're currently structured. And I don't think -- and I know we'll get into some of the other options -- but it seems to me that it's a little bit of a false choice we're making if we're presenting the issues as only really between those two. And so I wondered how important the stable NAV really is to your two organizations. Kathryn L. Hewitt: To us it's extremely important to have a stable NAV. We face our taxpayers. That's the money we're investing, our taxpayers' dollars. And it's very important to us to be able to put a dollar in and get a dollar out. We are not paid to make an extra couple of basis points. It's more important to us to have safety of principal. We do want to have basically a market rate of return, yes. Putting it under the mattress isn't really doing our taxpayers any good either. So we're trying to balance having investments that we categorize as being our operating cash investments, that we are going to get par back for, and we may do that by buying some money market funds, we may buy some other term investments for 30 days, 60 days, 90 days, that will pay us par at maturity plus interest. We may also use bank deposits for part of our money. We use a mixture of investments, but this is one important piece of our investments, and that stable NAV is extremely important. If we don't have it, if we have a fluctuating one, for instance, my government won't be in it, okay, not with our regular operating cash. We might be in a money market fund with some money we've identified, that we can take a little more risk in, that's reserve funds perhaps. But with our daily operating cash that we have to pay our bills with, that, we need to have stability for. Chairman Schapiro: But also a market rate of return, and that's where I think you can't have both, in a sense. Kathryn L. Hewitt: Well, what I mean by a market rate of return is something reasonable in the marketplace. If interest rates are five percent, we shouldn't be earning one percent on our money. If interest rates are five percent, is it okay to be earning four and a half? Yeah, that's probably reasonable. We need the safety, the stability of the $1 NAV. Chairman Schapiro: Yeah. Eileen P. Rominger: Ms. DeNale? Carol A DeNale: Yeah, I'd like to add onto that. I think what's missing here from a corporate treasurer perspective is, I am not running an investment house. I will not invest in a floating NAV product. I do not have the capacity. None of my systems, not the treasury systems or the accounting systems, have the ability to mark to market on a daily basis. We will not do it. We will pull out of money market funds, and I think that is the consensus of the treasurers that I have talked to in different meetings that I've been in, in group panels. This is not a product that corporate America, day in and day out, who's running a CP program and has small investments that they can make on a daily basis, can get behind. I run a portfolio for other of our companies, and we do not just invest in money markets. We invest in CP and, you know, a whole host of different products, but the money market is just an avenue for diversification. I do not expect to be picking up different -- yield through my money market. I'm looking at it as a diversification product for my portfolio. We have strict investment guidelines. I can have so much. I have to be within a certain amount of days. I can't invest more than a certain dollar amount in any one product. This is purely a diversification, but corporate treasurers who are not in financial institutions, so not in insurance companies, not at a bank, et cetera, we are not running investment companies. We are not geared to mark to market on a daily basis. Bill Stouten: So how would you replace that asset in your mix then if it wasn't there? Carol A DeNale: You know, I'm not sure. I have a hard time looking to -- I would not be investing in banks. I think that it would be very small investment deposits in banks. I don't think there's -- you know, the ratings of some of the banks would make me nervous, also; they're not guaranteed. I'm not going to put a $20 million investment in some banks. There's no guarantee that I'll get that money back. I see no differential in putting $20 million -- it's not a guaranteed product -- $20 million in a bank overnight, and some Euro dollars -- there is no guarantee on that. And there were runs on banks during the 2008 credit crisis. You know, we operate 7,200 stores. I moved funds from banks. I ceased my stores’ depositing in banks because I wasn't sure that bank was going to be there over the weekend. And let's just remember, corporate accounts were not guaranteed dollar for dollar on that. There was a run on banks also. We moved from a lot of different banks and ceased depositing. So I think to say that money market funds had a run on them and other products didn't is not true. And also I think we should go back to looking at why the Reserve Fund failed. We need to go back to how did S&P and Moody's rate Lehman brothers as an A1P1? I mean, that's a fundamental question that's not being addressed. Lehman Brothers was rated as an A1P1 commercial paper instrument, and yet they weren't. It went bankrupt. The next set of series, I think we're all forgetting, that week Morgan Stanley and Goldman Sachs were about to fail. That also created a run on various institutions. This wasn't just the Reserve Fund that created the run. I mean, I was in New York that week. Morgan Stanley and Goldman were about to fail. AIG had to be bailed out by the government. People were investing in banks at zero percent. They were paying banks to take their money. To say that the run was created by the Reserve Fund breaking the buck is a very naïve, narrow-minded focus on this. Bill Stouten: So -- Eileen P. Rominger: Mr. Stouten. Bill Stouten: Yeah, just a quick comment, I do believe that money market funds can continue to play the role that they play without offering a stable NAV. You know, as Mr. Brown mentioned, the NAV actually doesn't fluctuate if you go back historically, and I think investors will eventually realize that. And somebody else mentioned that money market funds are a diversified investment, and institutions need that. They'll continue to be that. So, while they may complain, investors, shareholders may not like not having a stable NAV, but there aren't a lot of real good alternatives. Now, some money may move out of money market funds, but a declining asset base in the money market industry is not necessarily destabilizing, and in fact, that's what the money market industry was designed to do, to provide liquidity. So if assets move out of the money market industry, to some degree, I don't see that as a problem. In fact, I see that as actually making the industry more healthy. As an investor in the short-term markets for a period of time, I've seen when the markets were liquid and illiquid. And if you go back to 2006, 2007, and even in this environment, I really believe that there is actually too much in assets -- too much money in the industry chasing too little supply. That compresses credit spreads. And money funds have the assets. They still need to make the investments, and oftentimes they make investments that they wouldn't otherwise make. If the industry assets declined, money market funds could be more selective and make better investments. So I actually think that some decline is actually healthy, especially in this environment. Eileen P. Rominger: I think we'll take one more and -- or two more -- and then break, if that's all right. Mr. Pan, your hand was up, before. Lance Pan: Thank you. Again, I'm speaking for about 250 of our clients. Each one will get a separate account statement at the end of the month. Speaking of the problems with that variable NAV is that money funds are used as sweep vehicles, so at the end of a month, every account will have to account for all the transactions that are flowing through that account, and it will be transacted at something other than a dollar. They have to keep the tax lots of every transaction that occurred, and also they'll have to make amendments in their investment guidelines. And just about every institutional investor has to abide by those guidelines, which is basically saying -- those money funds would have to be of a minimum size, will have to have minimum ratings, and have to have a $1 NAV. So to go back and change all that, and have to keep accounting of different tax lots, and also remember that many of the investors are agents who are having an agency problem. If they do an excellent job in a, even in a stable NAV world, they may get a pat on the back. If they don't do a good job, and if they end up losing money for their corporations, the consequences would be far greater. So I think that basically says, if we were to go to flexible NAV, if we wanted to re-intermediate assets back in the banking system, variable NAV might be an effective way of doing that. Otherwise, I don't see any benefit. Eileen P. Rominger: One more, and then we'll break. Mr. Bernstein. Seth P. Bernstein: It is certainly true that extraordinary amounts of liquidity in the front end of the market were invested in a variety of assets that they shouldn't have been invested in. I think it's a leap, however, to therefore say it's because money funds were too large, that that happened. It was a global phenomenon. It was a global phenomenon that has existed on and off for decades. There have been wholesale funded financial institutions for my entire life. The auto leasing, the auto finance companies were always wholesale funded. The structured investment vehicles are a relatively new phenomena. But remember, from a corporate investment perspective, a lot of people took more comfort in investing in individual credit mistakenly than they did in corporate credit, just given the wholesale decline in U.S. credit quality that had been proceeding for the prior 20 years. And finally with respect to being a transmission vehicle for U.S. savers to dollar deposits for European or Asian banks, which is absolutely a significant phenomenon, I'd make the observation to you that given the limited choices of truly creditworthy U.S. financial institutions, a number of investors thought that core Europe presented a much better opportunity and diversification factor than sitting back in the United States. Gary Gensler: Be a heck of a perverse outcome if our taxpayers have to stand behind European and Asian financial institutions through the transmission of U.S. money market funds, though, right? Seth P. Bernstein: Well, I think we already have. Gary Gensler: Perverse. Seth P. Bernstein: Perverse, but I think that’s exactly what happened, not through the money funds, but through the crisis. John D. Hawke, Jr.: Right. Eileen, could I make one comment on -- Paul Tucker: Everybody, can I just make this point? Almost everybody’s taxpayers have stood behind everybody else’s -- [laughter] Gary Gensler: Fair -- Paul Tucker: -- in their -- Gary Gensler: Fair point, fair point, Paul. Paul Tucker: -- and the U.S. taxpayers have certainly stood behind the international operations of U.S. firms, and European taxpayers have stood behind the U.S. operations of international firms. And we are so bound into each other. I completely agree with what Gary said, these portfolios were not something that was just to do with U.S. domestic financial intermediation, it was part of international financial intermediation. And it’s not obvious that that was understood here. John D. Hawke, Jr: Just one quick -- Eileen P. Rominger: Mr. Hawke, and then we'll break for 10 minutes. John D. Hawke, Jr: Just one quick comment on this. There’s a kind of a jingoistic element to my friend Gary’s point here about investing in foreign banks. These are not small European banks that are obscure and as to which there’s no transparency. Most of the offshore banks that money funds are investing in are global banks. Seventy-five percent of what’s invested in these global banks is invested through the U.S. offices -- U.S. branches or offices of those banks. Only 25 percent is issued by non-U.S. affiliates. And they have a transparency that is every bit the equal of U.S. institutions, the subject of the Basel rules the same way as U.S. institutions are. So to try to paint a scary picture that money funds are investing in some unknown foreign banks I think is a bit misleading. Eileen P. Rominger: With this, let’s take a break now for 10 minutes, and then we will reconvene. Thank you very much. [brief recess] Session 2Robert E. Plaze: Welcome back. Thank you very much. I want to tell you -- the last session, I think, covered everything those of us who are planning this had hoped to cover and a little bit more. [laughter] This is the session where we're going to start talking about what policy options are available to policy makers at this point. And that conversation is important, because embedded in various options we have available to us are different views of money market funds, the role they play, and the changes that might be acceptable, not acceptable, and the nature of the systemic risk. And I think you'll find, if this works as planned, that some of the things we talked about in the first panel will work themselves into the various options. The first one, for example, being -- and the one that's most talked about is -- whether one ought to introduce a floating rate NAV for money market funds. That is, to allow it to float the way other types of mutual funds do and whether that would address systemic issues. Or whether we ought to perhaps convert them into banks and how that might work, a full panoply of bank regulation. And what might that accomplish? But first let's talk about the floating rate NAV. One way of addressing systemic risk that we identified in the President's Working Group Report is to require all money market funds to float like any other. But if they wanted to retain a stable NAV, to treat them like banks. The question I have for the group -- first, I'm going to ask Mr. Tucker, because I think you've spoken eloquently about this. Would a floating NAV reduce the money market funds' susceptibility to runs? And how would you expect investors' behavior to change? Paul Tucker: Well, thank you very much, and let me thank Chairman Schapiro again for inviting me. We in the Bank of England care greatly about this issue. It's an international issue. Capital flows seamlessly across borders, as Gary said. The U.S. money fund industry is heavily invested in the European banking system. Were there to be, God help us, renewed problems in the European banking system, I don't doubt that that could cause an entrenchment of the provision of liquidity by U.S. money funds to Europe, which would no doubt exacerbate difficulties in Europe, and that would eventually flow back to the larger banks in the U.S. We are all -- this is a highly interconnected world. The second thing I would say is this was always one of the known fault lines of the international financial system. Chairman Volcker has probably been the most prominent exponent of this view. But this view was widely held in official circles -- that there was a brittleness in U.S. domestic finance and in consequence, international finance, due to the break-the-buck problem. And although it only crystallized in a really nasty form in the autumn of 2008, there were a number of points during the unfolding of the crisis from the late summer of 2007 onwards, in which officials in this country and around the world were very focused on taking immediate measures to provide liquidity to the markets, in part because of pressures on some money market funds. And as Governor Tarullo said earlier, this is because nothing is risk-free in today's world, and any world, in fact. And therefore, money funds -- apologies to Jerry Hawke -- they do invest in risky instruments. And the evidence for that is plainest in the extraordinary degree of support that was provided from bank sponsors and non-bank sponsors to money funds over the year or so before the period. These are significant amounts of money, and these are contingent exposures which no bank currently has to hold capital against. We'll come back to that. And what is going on here, I think, because this industry has existed for a long time -- and as Jerry Hawke has said, it's provided very useful services -- is we somehow find ourselves on both sides of the Atlantic in an environment where people want safety, and liquidity, and return, and it is impossible to deliver that. Banks are not guaranteed. Retail deposits with banks are guaranteed. We have discovered during the crisis that some very large banks and complex banks are difficult to close without support, and Sheila at the FDIC, and my institution, and the FSB -- Dan -- we will fix that over the coming years. So this isn't something where we are just picking on the money fund industry. There are big changes having to be made to the banking industry as well. And if banks aren't guaranteed -- and they can't be -- then it's a very strange place to say that -‑ I understand where Ms. DeNale and Ms. Hewitt come from -- that somehow your investment in a money fund should be guaranteed. But that would be the only wholesale investment that was guaranteed, and the only body that can do that in your country is the federal government. So you're effectively asking for some kind of subsidy to be transferred from the federal government to municipal, state levels of government or from the federal government to the corporate sector. And this is a distorting thing. So, what difference would it make to move to variable NAV money funds? The big difference it would make, I think, would be in the psychology of the investor base, because they would no longer think of these investments as completely safe. That is not to say that they would not think of them still as highly liquid and pretty safe. I mean, government bonds fall into that category. The price of government bonds shifts around and, as Jerry said, the shift in even some of the money funds that lost most was only from 100 cents on the dollar to maybe mid 90s. This is not a catastrophic loss. This is something which I think that investors in money funds could get used to. Would it affect the shape of the industry over time? Yes it would. Can I predict precisely how that would occur? Thank God I can't, because we believe in capitalism and free markets. But it would take away the implicit state support. And in a way, the appeal I would make to you, coming from London to the industry, is you shouldn't want to be in the position where you're relying on implicit state support for the structure of your industry, given the quality of liquidity service that you can provide. And the appeal that I would make to policy makers here is that you should be bold, as you plainly are, about two things: first of all, the implicit subsidy, and secondly, about the possibility that in a world where, in straining to maintain a stable net asset value, money funds invest in very short-term instruments, that American finance and global finance may end up with too much short-term debt in consequence, which probably makes the whole of our economy slightly more fragile than needs be. So precisely because of what Jerry said, that there are low risk instruments that would fluctuate relatively little, this could, I think, still be a home for liquid savings. But it can only be safe if it is underpinned by the American taxpayer and taxpayers of other countries. And that just doesn't seem to be the best way of allocating capital or incentivizing the managers of finance. Thank you very much. Robert E. Plaze: We -- Erik, you were going to -- Erik R. Sirri: Yeah. I think I agree very much with what Mr. Tucker said, but I'd like to begin with something Chairman Schapiro said last time, in our last half of this session. You were asking questions about market rates. And what I took your comment to mean is that money market funds that are investing in risky securities -- by which I mean anything that is not short-term full faith and credit -- investors in those funds are taking risks, yet the investors are stating, as I understand it, that they can't bear any losses in those funds. And it seems to me the only thing in which we don't bear all potential for a loss, either liquidity, credit, or market, is a very short-term full faith and credit instrument. After that, you're going to bear a loss. So, it seems to me, you can't have both. You can't be free of an external guarantee and invest in risky instruments without the possibility of a loss. If you really want that, then I can just -- this is where I agree with Mr. Tucker, you need to bring in some other entity to guarantee -- as you pointed out, you need essentially the government. If you were going to have that, your query was whether that's a good thing or not, because of the distortive effects. Paul Tucker: [inaudible] Erik R. Sirri: Right. No, and I certainly understood that. But I think there is an open question about whether or not -- it seems that a lot of what we're talking about here is how you're going to provide a guarantee if you want to -- how are you going to fund that, how you can make it credible if you want to have a stable NAV product. You're going to talk about capital, and that's a standard way to fund a guarantee. You could also have a third-party guarantor -- whether privately funded or government funded. You would have to charge for it in the same way that you charge for deposit insurance for it to be non-distortive. But I think those are all mechanisms that are available if that's something you choose. I just make the last point with regard to the floating NAV. I agree with what Mr. Tucker said, and I think that would help with some of the issues about runs, but I don't think that would cure it, at least in my mind. Something with a floating NAV is still absolutely susceptible to a run. Robert E. Plaze: Go ahead. Kathryn L. Hewitt: As a public fund investor, I'm well aware that a money market mutual fund is not guaranteed. I'm aware that I'm investing in an investment product, and that is not a guaranteed return or a guaranteed $1 net asset value. But I do rely on the fact that the investment management company who is running the fund is managing it for 2a-7 guidelines. And that those guidelines make it more stable, and they manage to keep it at the $1, with a slight fluctuation above or below that's permitted within those guidelines. That's what I'm relying on -- that that investment company is going to manage to the rules that exist. Now, sometimes there are problems in the market. And then we saw the breaking of the buck. But I've always known, from the time I went into a money market fund, that could happen. But it's not the everyday occurrence. And a floating NAV fund, it's the everyday occurrence, because there's no longer that rule that you work towards that $1. It can go up, it can go down a little. And so, every day you have that risk, on a daily basis. Robert E. Plaze: Mr. Hawke. John D. Hawke, Jr.: I think we're using the term “guarantee” or “backstop” in two different senses. And nobody is suggesting at all that there ought to be some sort of governmental backstop or guarantee for money market funds that suffer credit losses. Nobody would suggest that the Reserve Fund, in the best of all possible worlds, should have been bailed out because of its improvident overinvestment in Lehman paper. And when it wrote the Lehman paper off, it took a three cent hit on its NAV. And I'm sure there have been other situations where the constant NAV was threatened by credit problems, where the sponsor stepped in and made the fund whole to avoid that. To the extent that funds are threatened with breaking the buck because of credit problems, I don't think anybody would argue that there ought to be a governmental backstop for that. The problem that was revealed by the Reserve Fund issue was quite different. It was a short-term emergency liquidity problem where people, for one reason or another, many of which were irrational, or at least uninformed, wanted to get out of the fund because they didn't know what was coming, that the marketplace was in turmoil. People didn't know whether Merrill Lynch and Morgan Stanley were going to survive the weekend. And there was a great deal of concern about whether other funds would have problems, even though there was no indication that other funds were suffering the same kinds of credit deterioration that the Reserve Fund was suffering. The problem was that when institutional investors started running for the door, assets that were perfectly good -- maybe not totally riskless, but assets that were perfectly good -- were faced with a discount in the market simply because of the overhang of a very large volume of requests for redemption. That's the problem that needs to be addressed: How do you deal with the pressures, the emergency liquidity pressures, that are created in that situation? The government's response was very creative. The Treasury Guarantee Program, which guaranteed only existing investors and not future investors, and the Fed program for funding banks that would purchase assets at amortized cost from money funds and secure their loans from the Fed -- non-recourse loans -- with those assets, were very creative devices. The Fed did what it's supposed to do. It provided liquidity. And those -- Male Speaker: [inaudible] those the money market funds? Paul Tucker: It is meant to provide liquidity to monetary institutions, to banks [inaudible] -- John D. Hawke, Jr.: It provided liquidity to banks, but for the purpose -- Paul Tucker: -- if we decide that money funds are entitled to liquidity from the central banking world, then surely they must become banks. I don't know, I defer -- John D. Hawke, Jr.: Well, one of the proposals that's on the table is for a privately funded liquidity bank that would become a member of the Federal Reserve System. It would be capitalized and funded by the industry itself. Others can speak to that. Simply because the Fed is there to provide the liquidity doesn't mean that everybody who gets liquidity from the Fed needs to be regulated as a bank. I mean, holding out the banking system as the model for regulation -- and I say this as a former regulator -- is a little perverse. I mean, the number of failures and the amount that's been lost in banks just in the last few years vastly outpaces the experience over the last 40 years in money market mutual funds. So, bank regulation doesn't seem, to me, as the -- necessarily as the optimum. But -- Robert E. Plaze: What I'm trying to capture is the notion -- is if we went to a floating NAV, would people -- would investors behave differently? One has to acknowledge -- what we've acknowledged, right at the beginning of the meeting -- that one of the things a stable NAV does is it gives an advantage to first movers who will get out at a dollar as opposed to the later movers. And the people who were in the Reserve Fund and redeemed before it broke $1, got their dollar, and other people were stuck in liquidation for a year or more. And the question is, if we went to a floating NAV, would people behave differently? Would there not be -- John D. Hawke, Jr.: Wouldn't you have the same thing with the floating NAV? I mean, at the first sign of the kind of asset quality problems that would cause the NAV to decline, people would run for the doors. And you'd still have the liquidity problem. Robert E. Plaze: Mr. Certner. David Certner: Well, I just want to bring up the point of view of the retail investor, because, you know, I think for them, a floating NAV, I don't think would work at all. They're in these products because of the stability, and the liquidity, and obviously, the modest additional rates of return they can get. But these products are sold to them, really, as models of stability, where they're guaranteed not to lose any money. So I think changing to a floating NAV just wouldn't work for the individual retail customer. And I think there's been some acknowledgement here that that's not really the threat here. These were not the people who are early redeemers or running out the door. So there's a minimal threat, at least in the retail side, for being a run, because these are not people who are acting with the knowledge of the sophisticated institutional investor. So, I don't know if there should be a difference but clearly, from the retail side, it would seem that floating the NAV would not work and not be in their best interest. Robert E. Plaze: If they believe it's guaranteed and that dollar contributes to that belief -- but it's not guaranteed, do you feel they're being misled? David Certner: Well, I think there may be some misleading, and we may discuss a little bit more about better ways to secure or guarantee that money. I think that's a fair discussion. But I think the way these products are, in effect, marketed in a way people have come to believe in, and I think the history has shown that that belief is relatively correct at this point, that that money is basically guaranteed. Robert E. Plaze: So, in some ways, changing the floating NAV would be to change a belief system. And there are other ways to support the belief system by -- David Certner: And if you were going to change that, I think it would probably take quite a while to explain that to people and for people to actually understand that there was a change. Robert E. Plaze: Professor Stulz. René M. Stulz: I just wanted to go back to what Ms. Hewitt said. She was concerned about volatility if we went to a floating NAV, but in terms of the true economic value of the shares, nothing would change. It would be exactly where we are now. The difference would be that we wouldn't have the accounting fiction of having a stable NAV. And so, we wouldn't have the accounting benefits that Ms. DeNale was talking about. But I think we have to be careful when we talk about the safety of the financial system, not to trade it out versus accounting convenience. Maybe something could be done about the accounting rules. Robert E. Plaze: Well -- Oh, I'm sorry. Mr. Brown has been trying to -- oh. Oh, Mr. Volcker. Okay. Apparently people do not want to stop on this topic. Mr. Volcker, first. Paul A. Volcker: Let me just make a couple of general comments that were inspired by what Mr. Tucker said and what others had said. We kind of forgot. There was a period, to the best of my knowledge, there was certainly speculation about it, that the Federal Reserve didn't want to use money very rapidly in the summer of 2007, if I remember correctly, because they were afraid it would drive the money market funds out of business and lead to a run. Now, that's a pretty severe indictment that they had to affect monetary policy because they were worried about the systemic fragility of the money market fund. Number two, I assure you that if Merrill Lynch had failed and Morgan Stanley had failed, so would a lot of other firms have failed, and money market funds would be failing right and left. It wasn't just one fund that was subject to one investment bank. The others were saved, obviously. But I just -- noting there's some systemic problems here, to the best of my knowledge, though right in the middle of all this crisis, there was not much of a run on commercial banks. In fact, at one point, there seemed to be a run into commercial banks, because people thought that was the safest place to put their money, all things considered. Presumably because they were protected by the U.S. government. Now, I forget what county you're from, Ms. Hewitt, but you might have wanted to run into the commercial banks for fear that something would happen to the money market funds, in that severe situation so that your councilmen would feel safe. But let me come back to the basic question. The simplest thing to do, I think we could all agree, is to stop the payment of par. I mean, that's simple reform. Mary can write one. Chairman Schapiro: One sentence. Paul A. Volcker: One sentence. In fact, I'll write it for you. Chairman Schapiro: Thank you. [laughter] Paul A. Volcker: Now, what would the consequences of that be? And I find it quite difficult to be impressed by an argument that says, “You know, we'll put money in CDs,” and “We'll put money in commercial paper,” “We're going to take a risk, but this other piece of money we have -- no, it can't go down by $0.02 a day or that will upset somebody.” I mean, you must be valuing all your investments, which are going up and down, unless they're all in money market funds, but you said they're all not in money market funds. So, I think you would market with -- some people would believe, obviously. They go to banks, or they should go. But I would suspect, if you did nothing but eliminate the par value, you would have all these mutual fund industry people continue to have very short-term safe money market instruments that they'll advertise. It's all going to mature in two weeks, or maybe 30 days, or whatever, and that's going to be our guideline. So, rest easy, you can't change but any significant amount compared to the generous interest we're paying. It just seems -- it strikes me you can argue this either way, but I can go back and argue the next thing, let's regulate them. But this is pretty simple. It avoids a lot of unnecessary regulation. Could you have a huge crisis that even you would get a run on, because you're getting a run on everything? Yeah, maybe, but I think you have not had the most sensitive money lending in the money market funds. Then you're better off than you are now, because you have more of it in the banks. They're all protected. Chairman Schapiro: I wonder if maybe some of the industry people could address a follow-on question for me, which is, if you didn't have the stable NAV, wouldn't you perhaps have actual competition to create a floating NAV fund that really was the highest possible quality, that met the standards of 2a-7, but actually created a competitive environment in a race to the top sort of approach rather than necessarily having money leave and go to unregulated entities, or offshore, or whatever -- and whether the floating NAV might not encourage people to work really, really hard to have the fluctuation as tiny as possible or not at all, so it was truly valued at a dollar because the value, was in fact, a dollar. I'd love to hear if there are any thoughts about that. Robert Stouten: I would definitely agree with that concept. I believe that money market funds would compete to create the most conservative investment. Something else was mentioned at the break about, you know, floating NAV wouldn't prevent a run on money funds. And I just wanted to make a comment on that. I don't know if that's necessarily the goal. It should be to help money funds prepare for a run, and I think a floating NAV does that. It helps them get through the crisis and come out the other side. Sure, shareholders suffer a minor loss, but it also creates another incentive for the shareholder to hang on. As somebody mentioned earlier, the assets actually matured at par. So why would you rush to the door and sell it at $0.97 on the dollar when you can hang on and get par two weeks, three weeks, a month later? Travis Barker: I mean, if I can just return to this point about the impact on shareholders or on investors. As Paul articulated, the purpose of the floating NAV is to change the psychology of investors. It's like a sort of form of aversion therapy, that they see movements in the NAV in benign market conditions and then when the crisis comes, they're somewhat desensitized. And so, they're less likely to run. And I think we can sort of understand the logic of that. The problem is, I don't see any evidence for that in practice. And if you look, for example, at the German money market fund sector, which is a variable NAV sector, they had a run from their funds. And in fact, Bundesbank even offered a statement of support which effectively halted that run. So the question isn't whether or not -- sorry, it says the concern, rather, is that this particular mechanism doesn't actually address what for me, is the problem, which is the risk of a run and its consequent impacts on the broader financial system, in terms of the withdrawal of funding from banking institutions. The floating NAV doesn't actually address the issue. Now, there might be other reasons that you support a floating NAV. For example, the shareholder equity point, which is the first out the door point, which incidentally, isn't the reason that people redeemed. They redeemed, as I think Ms. DeNale made very clear, because they lost confidence in prime credit issuers. It was the asset class that they lost confidence in, rather than the pricing structure of the fund, which frankly, before 2008, was probably an esoteric point lost on most investors, I would suspect. So, the concern then is that this amendment, this kind of changing the pricing structure, doesn't actually achieve the outcome that, I think we’re all seeking to achieve, which is to make investors less likely to run in a crisis. Chairman Schapiro: Anyone else on that point? Brian Reid: Just one point. And I think, to follow up on Travis's point, I think there's a great deal of risk here, by changing a fundamental feature of the funds as well. So, we don't know for certain whether, by letting the NAV float, we would reduce the likelihood of a run or not. In fact, the historical evidence from abroad and even here suggests that it may not. I think it also increases the possibility, obviously, that the money does leave the industry and goes into a 3(c)(7) fund or some other sort of unregulated pool. And there, we will lose the transparency as well as the 2a-7 guidance that really puts structure around the money market funds. To me, there has to be some critical feature of money market funds that keeps investors there, holding $2.7 trillion right now. Now, you could argue that it's a put back to the adviser. But my argument is, then why not simply go out the yield curve into a short-term bond fund, pick up 100, 150 basis points, and if you think that you're in a crisis, and you really believe that there's a put here, you just rush back into the money fund. So clearly, there's something critical about the very features of a money market fund. And what I would encourage us to do -- as we think through this -- is to think about those critical features and whether changing them will actually reduce the risk of a run, or whether it simply just pushes the problem to a place where we can't observe or perhaps even take some of those restrictions off that 2a-7 provides. Eileen P. Rominger: I'd like to turn now to some other approaches to regulation. We've discussed, quite a bit, some features of a bank regulatory regime, directly or indirectly. Several commenters had advocated creating a private liquidity bank to mitigate liquidity risk in the money market fund industry and the potential contagion effects that this risk can create. Mr. Reid, while you have the microphone, perhaps you can briefly describe the liquidity bank, and I'd love for us to have some conversation around that idea. Brian Reid: So the idea is -- the concept first was brought forth in the Treasury's White Paper in 2009. So, the industry got together to think about how you could possibly create some kind of facility that would be able to be a fulcrum in some sense, of providing liquidity when other market participants are unwilling buyers. And that, fundamentally, was the problem in 2008, in which for many of the member firms who came to us, and as we talked through the liquidity facility, said they could not, you know, get bids on paper that they were trying to put out there, to meet their redemptions. And so the concept here was to create some kind of offset. And this offset would be structured as a commercial bank. And this bank would build up capital over time. It would also issue time deposits and have on its balance sheet Treasury securities or agency securities, short-dated, that could be easily sold into the market, use those proceeds to buy up other types of paper that, for whatever reason, the markets had locked up on. Again, and in addition to its balance sheet, because it is a commercial bank, it would have access to the discount window as well. The recognition here is that this is fundamentally, at the times of market illiquidity, a market problem, not an industry problem. And yet, the challenge was put before us to think through, as a solution from the industry to find a way to address that when the investors generally are trying to all shift into Treasuries. And let's just be honest, I mean, that was occurring across the marketplace. It wasn't just money market funds. We saw huge inflows in the Treasury funds, but, you know the other 60 percent of the investors in the commercial paper market, there were no buyers standing there ready to buy the commercial paper. And so the concept here was to find a way to introduce some additional liquidity when market makers were unwilling or unable to commit the balance sheet to do that. We've been back and forth with the regulators to address particular concerns. The proposal is in our comment letter that the ICI submitted and it, again, is there to address very simply the illiquidity that occasionally occurs in the money markets. Eileen P. Rominger: Would the liquidity bank model work without access to the Fed window? Brian Reid: I think at the end of the day, because the current banks who are fundamentally market makers in the commercial paper and other markets have access to the discount window, they are using that access to be able to provide that liquidity. And interestingly, historically, if we think back to even before money market funds existed, when Penn Central collapsed -- it went bankrupt -- the Fed at that time allowed generous access to the discount window to provide the needed liquidity to the commercial paper issuers at that time that were unable to continue to issue into the marketplace. So ultimately, at the end of the day, you do need sort of an access point in which a commercial bank that is trying to make markets here and act as a market maker, has access to the discount window to provide that additional backstop. John D. Hawke, Jr.: I think that it's important to know that in the Penn Central situation, the Fed made liquidity available through banks -- through member banks, the same way that they did with the liquidity facility in 2008. It was channeled through member banks. It wasn't made directly to the institution that needed the liquidity, even though the Federal Reserve Bank gave the Fed the legal authority to make loans under unusual and exigent circumstances. Paul A. Volcker: There weren't any money markets -- I happened to be there. Penn Central. I was in the middle of it. They lent money to the banks that held the commercial paper -- John D. Hawke, Jr.: Yeah. Paul A. Volcker: -- so that the banks could buy the commercial paper. John D. Hawke, Jr.: Right. Paul A. Volcker: There were no money market funds. John D. Hawke, Jr.: No, that's what I said. Brian Reid: [inaudible] John D. Hawke, Jr.: My point was that they didn't make -- the Fed didn't make loans directly to the issuers of commercial paper. They made the loans to the banks to buy commercial paper -- which is the same thing they did in 2008. Eileen P. Rominger: Mr. Tucker. Paul Tucker: [inaudible] John D. Hawke, Jr.: The banks bought the commercial paper. Paul Tucker: The Federal Reserve bought the commercial paper! John D. Hawke, Jr.: The Federal Reserve made loans to the banks for money market funds. The Fed made loans to banks on the collateral of assets that the banks purchased from the money market funds. Brian Reid: Again, just so we keep in context the model that at least we put forth -- again, addressing the question of the White Paper of the Treasury. It is a commercial bank that would go to the discount window and use commercial paper and other types of assets as collateral to borrow. But it is not a direct loan to the money markets -- to the money market funds themselves. It's using a commercial bank model. Eileen P. Rominger: Mr. Tucker. Paul Tucker: This is, I think, a question. So -- and I'm certainly not expecting any member of the FSOC, least of all Dan -- sorry, Governor Tarullo, to respond to this. As I understand it, this is a bank whose sole purpose is to stand between the Federal Reserve and the money market mutual fund industry. If I think about that as a central banker, I think, “So, I'm lending to the money market mutual fund industry.” What do I think about the regulation of the money market mutual fund industry? How do I either get some influence, de facto or de jure, over the regulatory agency setting the rules of the game for the money market mutual fund industry? Or alternatively, do I want to become a kind of co-regulator of the money market mutual fund industry? I'm not advocating any of this. I'm just describing what happens when you write a liquidity line to a whole industry. And the other thought I think I would have is, “Oh my goodness,” although strike out the rhetoric, “If the money market mutual fund industry can do this, what's to stop other parts of our economy doing this and tapping into the special ability of the central bank to create liquidity because our liabilities are money and the ultimate settlement asset -- payment asset in the economy?” Now, I'm saying that, not -- I mean, this is a question in the following form: not to say, “and therefore, what you've said is a terrible idea.” It's not for me to view that one way or another. It's almost to bring out the enormity of the idea that you have floated. It's not quite existential for central banks. It doesn't go to the -- but it's kind of a first derivative of that, if I can be forgiven that, in that it's posing very big questions indeed, about who should have direct access and to the nature of the monetary economy. Brian Reid: I would agree, it poses very big questions. The question that we were trying to address in the concept here, as we put this forth, was to think about what is it that the central bank can do to provide liquidity, overall, to the markets during periods of market stress. We do know that historically, even before money market funds were a glimmer in somebody's eye, that we have these periodic market stresses within the commercial paper market, within the repo market, the money markets generally. In the United States, the money markets total about $12 trillion. Throw in Treasury's and agencies’ short-term debt in there. Obviously, that -- probably those markets, because the Fed can directly buy into those, are not faced with the same liquidity problems. But historically, the United States has had the money markets that have had these periods of low liquidity, and the banks have stepped in, sometimes through relaxing access through the discount window, through creating, this last time, these special facilities. This was an attempt by the industry to say, “Okay, without asking for some special dispensation through some facilities such as the AMLF or whatever, is there a way for the industry to come together to commit the capital to create this type of facility?” Now, if the broader question really is one about global -- a global systemic risk, and how is the U.S. central bank or any other central bank given tools to address this in the future, when we know the money markets are not going to completely go away, but will periodically experience a stressful situation that's going to cause borrowers to be unable to roll paper? Maybe that's a broader question to bring together the various regulators to think about that issue. But I think it is a systemic issue and one that certainly has been on the table here. Daniel K. Tarullo: Can I -- I just wanted to follow up on Governor Tucker's half-observation, half-question and ask you, Brian, what your reaction is to his comment that the Fed, in this case -- or any central bank in any country -- in response to a proposal like this would probably be wise to look beyond what's essentially a monoline institution to the industry that it's effectively providing liquidity for and to make a judgment about the regulation of and the stability of that industry. Is that something you agree with? Brian Reid: I mean, obviously, it's coming from the regulators. That would be a risk that we'd have to factor in. The question is, if we're talking about systemic risk then -- and apart from how to address that systemic risk down the road -- there will be another event in the future where money markets have a liquidity problem. And if we want to think through that issue, I think that's an important issue to think about now, as opposed to during a crisis. Daniel K. Tarullo: No, but I guess -- Brian Reid: And so, to that issue. If the concern from the regulators is that this is providing monoline access to the discount window for a particular industry, then maybe this is really a much broader question that you bring market participants together for, a group of participants within the money markets generally, both issuers and investors. Daniel K. Tarullo: But -- Eileen P. Rominger: Chairman Gensler. Gary Gensler: I -- Paul Tucker: Can I just have one sentence -- sorry, Gary -- -- I mean, being the lender of last resort to banks isn't the most comfortable thing in human life either. And it's why we require banks to hold capital on liquidity. And do we always do that brilliantly? No, of course not. But it is why -- the social contract with banking of deposit insurance, access to the central bank is precisely what is carried with it, regulation of the balance sheet, in terms of surplus capital and surplus liquidity. And so, I think you have to think that the conduit is just a conduit, because the risk is on the other side of the conduit. And I just think you have to think that through. I'm sorry. Gary Gensler: No, no. I think that -- I was just trying to help out Brian from the ICI. I think the specific question -- is the ICI proposal that you’re basically saying the Federal Reserve should regulate your industry? Because that's what Governor Tucker is saying. Is it just a conduit that is standing thinly between your industry and the discount window, which you wish to access? Brian Reid: So, the direct answer is “no.” It was looking to regulate the particular bank that had access to the discount window. Clearly, again, it was trying to address one of the issues that was put forth, in terms of the concerns -- of the systemic concerns -- that came out of the experience in 2007 and 2008. If the issue is more broadly framed about liquidity in the money markets, how do policy makers address those concerns in the future? Because those situations will arise again in the future. Maybe that is a broader question. We put forth a proposal coming from the fund industry because the President's Working Group Report had raised it there, and it was raised in the Treasury Paper, directed specifically at the money fund industry. But I would argue that this is a problem of liquidity that transcends the fund industry, but really to the markets as a whole. Eileen P. Rominger: Mr. Goldstein. Jeffrey A. Goldstein: I guess another way of looking at the question, although a narrow one, is how do you scale the size of this facility? I mean, you've described in your proposal getting to $50 to $55 billion in 10 years and you know, how do you know, under some stress scenario, that that's even close to enough? Brian Reid: Again, I think that's a very good question. One of the ones -- I think in our discussions we have suggested that we put forth a funding model. Again, coming from an industry that holds about 40 percent of the commercial paper, even though this is a general commercial paper market problem. That in the current rate environment, three basis points would basically wipe out all the existing return that's in money funds that are out there. But that, if this was viewed as a way to think about trying to provide a long-term solution to the periodic liquidity problems within a market, this industry at least put an idea on the table that tried to address that. Whether or not the capacity is there, whether it's sufficient for 40 percent of the market to try to create a facility that could try to address that, those, I think, all are important and very good questions, including the ones of, well, what does it mean for the Federal Reserve in terms of their regulatory oversight? Again, trying to think through -- at the end of the day, liquidity support to the markets has been a last ditch effort that the central bank has occasionally stepped into and felt compelled to provide, and is there a way to provide some sort of capital to that, going forward, where this isn't on the taxpayers' balance sheet. Eileen P. Rominger: We'll take one more on this, and then we'll move on. John D. Hawke, Jr.: I just want to make two quick points. One, the liquidity bank, of course, would be a bank, albeit a monoline, that is fully regulated and supervised by the regulators. And second, any advances that the Fed made to that bank, and would make those advances on terms that it specified, would be fully collateralized by assets that were purchased by the bank from money market funds. And the experience in 2008, when the Fed facility was set up, was that there were no losses at all on the assets that were pledged. And there's no reason to think that assets that would be pledged by the liquidity bank would be treated any differently. They would be the kinds of assets that money market funds invest in, and subject to whatever qualifications the Fed might impose. Sheila C. Bair: I just want to -- as someone who was there in 2008, I think the Fed, and the FDIC, and the Treasury did a lot of things we didn't want to do. So to say that it happened in 2008 and it was the right thing to do, I think, is not the right response. And I think, you know, I appreciate the good thinking that goes into this, but I think the better approach would be to try to reduce or eliminate the systemic risk, as opposed to just kind of acknowledge it, institutionalize it, and provide some-- what it really is is institutionalizing a bailout facility. I think if you want the money market mutual fund -- the shadow sector -- to become part of the banking system, then it needs to have all the tradeoffs that the banking system has, if they're going to have the kind of liquidity backstops and other benefits. But, you know, I think it needs to be one way or the other, because this kind of hybrid approach really gives you -- it really does, to me -- it sounds like it kind of institutionalized the unpleasant bailouts that had to occur during the crisis in a way that would exacerbate moral hazard, which would make the systemic risk more pronounced, not lessened. So, I would hope, you know, that we would go to the other direction. Robert E. Plaze: Well, we have other proposals on the table also. That one focused on dealing with the issues as a liquidity issue. I think Brian well put that -- to attempt to inject private capital that could be used to achieve -- to create liquidity, albeit with the help of the source of liquidity. Other proposals have suggested that we build up a form of capital in the money market fund that could withstand a credit event. Of course, in 2008, the run that occurred was preceded by a credit event. And the other events money market funds have had, have almost always, although not exclusively, been credit events. One of the interesting ones has been urged and is being promoted by Fidelity, to create a reserve within the fund. Could you, Mr. Brown, could you explain how that reserve would work, and how it could address potential systemic risk posed by money market funds? Robert P. Brown: Absolutely, I do want to -- I had raised my hand, but that was -- Robert E. Plaze: Okay. Robert P. Brown: -- appropriately deferred to Mr. Volcker. But just to respond -- Fidelity does not support variable NAVs. We totally recognize that there's a public policy issue with respect to the implicit -- at least the implicit impression that the government would be there to step in. And we don't think it's a credit issue. Money funds -- since 1983 -- have been using amortized cost accounting. The range there is a half a cent. And so, it's not an obscure, aggressive accounting. It's not as if the fund's market value NAV is at $0.90. We're moving back up to par. We really believe that the issue is liquidity, in terms of responding to a potential run, and we believe that the SEC has done a lot to answer that. I'll get into my proposal in a second. But with respect to -- so the round table participants understand -- the 30 percent liquidity that has been created, essentially from a purely construction perspective, requires essentially a fund to hold approximately 50 percent of the securities in 30 day liquidity. And just for background, I'd just like to share with you, our largest fund, our Cash Reserve Fund, currently holds 48 percent in 30 day liquidity, with a bulk of that in seven days. That was not present prior to September 2008. Our institutional fund holds 62 percent in 30 day liquidity. If the government believes that liquidity is the issue -- and it will help stop a run -- we believe that we're mandating higher liquidity requirements for general purpose funds, which is already being done. On one day, if you did a 10 percent higher allocation for a general purpose fund, you would raise approximately $165 billion. If you just stripped that out and used it for institutional general purpose funds, in one day you would raise $110 billion of additional liquidity for the system. In addition, my colleague, Mr. Bernstein, has noted that the board now has the ability to stop redemptions. We believe that a run on the fund is a result of inefficient liquidity. We believe that the SEC has done a tremendous job in building liquidity up. With respect to our buffer, our buffer was designed with respect to responding to the President's Working Group view that shareholders should internalize the cost of liquidity. It addresses all five areas of the President’s Working Group's Report that focuses on the incentive to redeem before other shareholders. The first one is it's responsive to the future with respect to maturity, transformation, and with limited liquidity resources. The buffer allows an investment manager or adviser to deal with selling securities below par, an environment that occurred in September 2008 that was challenging. This buffer allows for that. Second, it reduces the focus on the $1 NAV as the market value NAV will be consistently above par. Third, the buffer will ensure that the funds are able to handle credit and interest rate idiosyncratic risk. Fourth, it removes the discretionary nature of capital that would sit outside the fund. The fund would own the buffer. It would be mandated by the SEC. It would be regulated by the SEC, and it would be overseen by the Board of Trustees. Finally, the buffer sits well with the money market investors' low risk tolerance, with respect to understanding that they are actually paying for it, and it gets back to some of the criticism about the free put. Investors would actually be giving up part of their yield, essentially paying slightly more than $1 for something that registers as a dollar. So we believe that this is a -- answers all of the -- or at least addresses all the President's Working Group's concerns about the incentive to redeem prior to an existing shareholder. Also, the buffer is counter-cyclical with respect to redemptions. In a normal operating environment, as institutional or retail shareholders leave a fund, the buffer actually builds up because you have the buffer the same size, but the shareholder base is actually lower. And in extreme market volatility -- we have modeled this buffer both back in September of 2008, with our institutional fund, which had a fairly severe move in its market value NAV. The buffer actually would have generated -- it would have broken the buck on the upside during this time period. We recently submitted -- last week, we submitted a letter on our buffer that actually had an optical demonstration of redemptions up to 60 percent over a 10 day period, and the market value NAV of that buffer was still above par. And we believe it is the appropriate response to answering some of the criticism on the fictional accounting with the free put. The shareholders paying are the direct beneficiaries of it. It helps, and enables, and strengthens, and it makes the appropriate response for the remaining shareholders in the fund. They are not damaged by shareholders leaving the fund, so I'm happy to take questions on it. Robert E. Plaze: Let me ask you one. As you both pointed out, if the assets of the fund go down as a result of redemptions, the size of the buffer, as a percentage of the fund actually goes up. What happens when the size of the fund goes up quickly? We saw in the case of the Reserve Fund -- the 12 months before it broke a dollar, the Reserve Fund increased its assets by 113 percent. Robert P. Brown: Did you just say, what happens when the buffer goes up or when the buffer -- ? Robert E. Plaze: No, what happens when the size of the fund assets goes up -- the fund manager accepts greater risk, higher yield in order to increase their assets. How does -- what happens? Robert P. Brown: And I'm not sure I agree with the manager accepting higher risk. Robert E. Plaze: Yeah, I'm not either, I tell you. [speaking simultaneously] We have some agreement here around the table. But have you thought about that, I'm saying, that is that buffer -- because it's accrued out of shareholder income, it grows slowly over time. Robert P. Brown: You would have to hold back more income to get the buffer in line with whatever the industry agreed was the minimal level. Robert E. Plaze: To catch up. Robert P. Brown: Yes. Robert E. Plaze: Mr. Volcker. Paul A. Volcker: I'm sorry to be intrusive, but I have to run so I just want to make a point here about any of these systems that involve outside liquidity support. I made a recommendation along this line myself. I just decided that it's more simple just to do the net asset value change because you couldn't, in effect, make money market mutual funds a special kind of bank that's subject to capital requirements, and the Federal Reserve or some regulator is going to have something to say about that and liquidity requirements. You already, to some degree, are subject to those. And in return, you get, presumably, access to the central bank. I think you're going to end up with more regulation than you bargained for if you go in that direction. There will always be a temptation to fuss around, and I think particularly that the money market mutual fund is already a special kind of bank. It may really want to be a real bank. Maybe that's a good thing. They're sort of already being regulated by the Federal Reserve anyway, and have capital requirements and access to the Federal Reserve. Why do I buy commercial paper? I just, you know, make the commercial paper myself. I'll lend to the companies, make a good deal. Why don't I open up a credit card fund? Why don't I do a lot of other things? Why limit myself? The one thing, if you go in that direction, it'd be okay. But you're going to be, in effect, a bank holding company. You're going to be subject to all the restrictions of a bank holding company. So what else can that holding company do in a non-banking area, in a non-financial area? You can't have General Electric doing their stuff. They're a company. You can't have a lot of other companies. You can't have a CVS, if they want to do it, can't do it. They are a commercial company. So I think you can go that way. As I said, I proposed it at one point to a lot of other people [unintelligible] to me. But I would think pretty hard about a tradeoff for something simple, about no maintenance of par value without much regulation or opening up the floodgates of regulation. You know, a little bit attractive, that if you had how many thousand money market funds there are? How many are there? Chairman Schapiro: [inaudible] Paul A. Volcker: What? Chairman Schapiro: 650. Paul A. Volcker: 650? This country could use 650 more banks. We just lost about 1,000 during the crisis. [laughter] It might be a good deal, eh? I'm sorry. I've got to run. [laughter] Female Speaker: [inaudible] Sheila C. Bair: So Robert, I'm just curious -- would this be a constraint on growth, in respect to your question about maintaining the buffers as the fund assets increase? Would that be somewhat of a constraint on the growth of the fund? Would the -- Robert P. Brown: No. It would impact the net yield, because you would have to hold back, you know, the yield. So if rates are at one percent and your management fee is at 20 percent, you would hold back five percent. And once you build up the buffer to the appropriate level that the industry agreed on, that the SEC regulated, should you fall outside the range, you would turn the hold back on. And that would be fully disclosed and transparent to shareholders; they would know what they were paying for. Robert E. Plaze: For the record, that's not usually how we set limits. Daniel K. Tarullo: How would we set a buffer in this type of environment? I mean, with rates where they are and --? Robert P. Brown: Clearly, the current rate environment for any proposal -- whether it's a liquidity facility or a buffer proposal -- is challenging. But like all regulation that we've seen implemented recently, the implementation period is over a period of years. And that's what we would expect. Robert E. Plaze: One would argue that there's tail risk in money market funds. Events occur that are not currently reflected in the cost structure of money market funds or the yield. So to the extent that some would argue that money market funds are too large because they've attracted too much money, because the yield doesn't fully reflect those costs; to some extent, this addresses that concern also, doesn't it? Mr. Goldstein? Jeffrey A. Goldstein: I’d ask the same question here as I was asking with respect to the liquidity facility, and that is, what's the algorithm? What's the conceptual framework for setting the target? Forget about the transition period, forget about the ability to pay in various market rate environments. How do you determine the end state? Robert P. Brown: Great question. So, unfortunately, we start with GAAP accounting. So, we know that if you exceed par by .0050, you break the buck on the upside. That was our threshold to start. But then we used our quantitative research to go back and back test the model. As I indicated earlier in this roundtable, we have looked at our NAVs over the past 10 to 20 years, and the actual fluctuation in the market value NAV is somewhere around 10 basis points, including when the government raised rates 300 basis points. So, a significant move in a market value NAV would be, for us, Fidelity, in the 10 basis point range. And so, if you look at the overall buffer that we suggested in our first comment letter, of a range between 25 basis points to 40 basis points for a general purpose fund, we're essentially four times what we would consider a significant move outside of September of 2008. We believe, and we back tested it, we've done our redemption analysis, which we included in our second letter, that shows, over a 10 day period, you could sustain 60 percent redemptions and still price your fund at market value above par. Robert E. Plaze: But the amount of your buffer is constrained by GAAP -- the 50 basis points -- Robert P. Brown: Yes. Robert E. Plaze: -- forgiveness on either side. So that's what drives it, rather than looking at a sort of a macroeconomic need to -- Robert P. Brown: No. No, no, no. We -- it's not a fair point, Bob. Robert E. Plaze: Okay. Robert P. Brown: We were fortunate that -- Robert E. Plaze: Okay. Robert P. Brown: -- that over the past, you know, 20 years, that, you know, it goes to the strength of rule 2a-7 and integrity of it. Jeffrey A. Goldstein: But if you go back to the actual experience of sponsor support, the numbers are in fact -- in extreme cases -- well in excess of those numbers. Robert P. Brown: The buffer is not sized for a five percent position that has an ultimate recovery value of zero. We still believe that is up to the Board of Trustees to address those idiosyncratic credit risks, which the industry has done very well, as noted over 145 times in the life of the industry. That environment and that scenario still exists. What the buffer does is smooth out the difference between the amortized cost and the market value cost. It protects shareholders who stay in a fund if there is a run or a flight, and it really addresses the criticism of the free put. You know, shareholders are paying for the benefit of the stable NAV, and that will be transparent and they'll understand it and the market intelligence that we have, both from retail and institutional investors, is that they are willing to do it -- certainly not in this rate environment, but in a higher rate environment, they think it's a valuable option. Robert E. Plaze: Professor Sirri. Erik R. Sirri: I just had a question. I looked at your letter, and I had one question. As I understood it when you came up with your number, 60 percent, that you could withstand, you made an assumption that the assets that were sold could be purchased by the market, I think, with only a 50 basis point haircut. So, my question was, if there's an extreme event and people are selling paper, is there any data to support like maybe people have things to say about what happened before the September 19th facility was put in? If I was selling a block of paper would I really get 99.5 percent of amortized cost? Did we learn anything about that because I'm going to guess that, if you have a systemic event, the market for that paper dries up and that assumption of 99.5 is probably questionable. Robert P. Brown: A very good question. And what the model outlines is that the 60 percent redemptions are met by the fund, which is noted as currently carrying 40 percent of liquidity. So, the actual true redemptions in that scenario were 20 percent. As I've indicated earlier, our current institutional fund, our largest institutional fund is carrying 62 percent of 30 day liquidity, and we believe that that addresses some of the run factors. But with respect to the 20 percent, in terms of selling that in the marketplace, we believe, through our quantitative research, that that is an appropriate bid ask spread. If you assume a one-month security with a 50 basis point haircut, the actual return, the excess return is 600 basis points or six percent. We believe that's very powerful. As we noted earlier, our fund sold approximately 43 percent of its assets during that window, during that week in September, although those assets matured at par and that's a very, we think, a very attractive proposition. Erik R. Sirri: My question would be, when you sold them, did you get 99.5 or higher? Robert P. Brown: That we believe that the 50 basis point bid ask spread is appropriate based on our transactions that occurred during that week, yes. Robert E. Plaze: Mr. Tucker: Paul Tucker: Could I ask a question, not about the modeling but just this basically -- am I right in thinking that it's a bit like what we would call a mutual deposit take or a thrift here in that there's a surplus and, if ever the money fund were to be run down, the surplus would be paid out, distributed to the investors in the fund? It all ultimately is their property. Is that what this is? And so the question then would be, how would the de facto capital requirements for this compare with the capital requirements for a thrift, constituted as deposit, a bank, whatever you call them -- thrift banks here -- and whether there would be a big gap between the ones that have capital requirements and what you describe as the surplus requirements? And I ask that just because one of the things this country has done over so many decades is invented lots of different kinds of banks. I mean, there's the kind of things that exist in Utah, which are guaranteed by Sheila but not regulated by anybody. And so somebody regulated by this building kind of created really big ones, and is this -- I think just before -- you basically identified a capital requirement. And that, if I may say so, that obviously, goes in the direction of some of the issues that are being raised, and then I think the authorities have to think, "Well, how does that fit into the suite of types of banks that this country seems to like to--" Robert P. Brown: It is the buffer owned by the fund, and if the fund closed, it would be distributed to existing shareholders. But again, the buffer is there to smooth out the differences between amortized cost accounting and market value accounting. To your point with respect to modeling this against the Basel III type of regulations, we are, as Bob noted, we are constrained by the cap of breaking the buck on the upside. Theoretically you could see that GAAP accounting measure was modified. You could actually see that buffer potentially grow, but based on our existing modeling for idiosyncratic risk without looking at September of 2008, when we believe that has been answered through the liquidity requirements. Again, the integrity of rule 2a-7; you're operating in a margin where the risk is defined by half of a cent, a penny, half of a penny. That is a very tight band, and the industry has done a phenomenal job and the SEC has done a terrific job in the most recent reforms that they've put through. We believe the September of ’08 issue has been addressed through the liquidity requirements that money funds are required to have and also with the board's ability to stop redemptions. With respect to the capital requirements and modeling for idiosyncratic risk, these 145 issues that have been raised with respect to capital advisors, that addresses that and so we think it's a very powerful tool, but we are capped by current GAAP methodology. Robert E. Plaze: Let's move on to the next proposal. Professor Stulz, the letter from Squam Lake Group, which you are involved with, suggested capital requirements also for money market funds. The letter contemplates more permanent capital that would be provided by fund managers or third parties. Could you describe that? Ren é M. Stulz: Yes. We really have two solutions to the problem of runs. We have a very simple one, and we have a more complicated one. The simple one is to go to floating NAV. Okay, and we have 14 academics in our group. Half of us have been president of the American Finance Association. There's not a single one who doubts that that would significantly reduce the risk of runs. The other approach is to create a buffer. It's different from the Fidelity one. Now for us a buffer should have three characteristics. First, it should be a buffer that you can replenish quickly in the presence of losses. Now you can go back to full strength very quickly. Second, we want a fixed NAV fund to be converted to a floating NAV fund if the buffer is depleted. And third, once losses have been made, we would want the buffer to be replenished within a short period of time. That last feature is one that the Fidelity proposal can't have because you build over time from the shareholders. Our buffer would not come from the shareholders but would come from third parties or from the sponsors of the fund. We are not committed to a mechanism for the buffer, but we discussed four possible mechanisms. The first one is Federal Reserve deposits contractually committed to buffering the fund. The second is highly liquid government securities held in a segregated custody account that is contractually committed to buffer the fund. Third, insurance by parties that meets the fund regulator's standard for creditworthiness and liquidity. Fourth, an equity tranche claim on a pool of 2a-7 compliant assets whose senior claimant is the money market fund. The assets would be used to pay redemptions at the $1 NAV for the investors in the money market fund as long as this is feasible. I can elaborate on -- Robert E. Plaze: Of the different ways, one requires the sponsor of the fund to maintain capital. One of the issues there, and does it concern you, is that all money market fund sponsors may not have access to the same amount of capital and what implications might that have to the money market fund industry? Could it result in greater concentration? René M. Stulz: The industry is already fairly concentrated. I think the problem is that the ones that don't have the capital are also the ones that are more at risk of runs because people know that they couldn't support the fund. So, I think it cuts both ways. Robert E. Plaze: We have seen since 2008 greater concentration, and I guess that cuts both ways also. When you had problems in the 1990s, people would write checks for $10 or $20 million. Now it's in the hundreds of millions of dollars, and there's a point, of course, that the availability of those assets at times can be difficult. I'm interested in the fourth one which would be, you called it an equity tranche of capital, which suggests that the buffer, as Fidelity has characterized it, would be financed by the fund itself. Could you explain how that might work? René M. Stulz: Yes. The analogy may not be popular at this time, but we can think of securitization in the sense that with securitization you have a senior tranche and then you have a junior tranche. Here we would have the assets of the funds. We would have a senior tranche, which would be the money market fund, and then we would have a junior tranche, which would be -- which we call the equity tranche. One way to implement that concept is that the fund could issue notes at regular intervals in the amount necessary to create the buffer. For instance, they could have a six-month maturity. The notes could promise a fixed interest payment or could receive the income in the fund in excess of some amount. With fixed interest payments, the principal would be reduced if losses have to be paid. The notes could be issued through a bidding process or could be privately placed. If the assets are invested more safely, the note holders would require lower compensation for bearing the risk of losses. So, it would create incentives for the fund to be prudent. It would also be in the interest of the money market funds to be highly transparent so that they can sell the notes at higher prices. To have a sense of the numbers involved, suppose in a fund there's currently a total net asset value of $1 billion and that the buffer is required to be three percent. In this case, the principal amount of the notes issued would have to be at least $30 million so that the note holders could lose an amount equal to the buffer. Say that the probability of a loss equal to the buffer over six months is 0.05 percent. In this case, the note holders would be compensated for the actuarial value of the expected loss by an additional return of five basis points if the face amount of the notes is $30 million. The impact of five basis points paid to the note holders on the return to the money market fund investors would be miniscule since it would be a reduction of $15,000 of the return of the fund. The note holders might require -- you would expect them to require -- risk premium. But even if the risk premium is a multiple of the actuarial cost, it would still be very small in terms of the impact on the fund. Robert E. Plaze: So, a fund could actually lower expenses by reducing the risk of the portfolio it manages? René M. Stulz: Exactly. Robert E. Plaze: Any reactions? Robert P. Brown: I guess my first reaction is the complexity of the option that you've just proposed for retail and institutional shareholders to understand and the disclosure and transparency of that. And also would -- who would be the likely buyers of six-month notes, given the expected rate environment for the foreseeable future and given the opposing regulatory forces of Basel III, the Dodd-Frank bill and 2a-7, where you have issuers off the curve and money funds in the curve which is, generally, we think going to keep the front end zero to six months pretty flat. So, I'm not sure who the note buyers would be, and also I'm not sure how this responds to the President's Working Group request that the liquidity cost be borne by the shareholders and that the industry work toward an option that reduces the incentive to redeem before other shareholders. René M. Stulz: Okay, I mean, in terms of the complexity, ultimately what matters here is that the retail investor would know that there is a buffer of three percent or 1.5 percent -- certainly bigger than the one that you suggest, but they would know that. So, that by itself would be information that they could easily understand. So, now the precise mechanism in which it would be implemented I don't think would be of interest to retail investors. It might be of interest to institutional investors because they might want to participate. In terms of the regulatory forces, I find the point quite interesting because there seems to be a contradiction in the way of regulatory efforts. Now, on the one hand, for money market funds, the SEC wants them to be more liquid and have shorter maturities. On the other hand, the whole Basel III process wants banks to have longer maturity securities. So the question that Chairman Bair asked about how much of those short maturity securities should we have, I think is critical here. Now the regulator should resolve that and then figure out what is the optimal regulation for money market funds. How does it respond -- sorry -- [speaking simultaneously] René M. Stulz: Last point. How does it respond to the President's Commission? Now, ultimately, the shareholders will bear that cost. Now with the proposal, I mean, with the implementation I described, the return left for the money market fund investors would be what's left from the assets after the note holders have been paid their return assuming that there is no loss. Robert E. Plaze: Professor Pan -- Mr. Pan, do you have a reaction on? Lance Pan: Yeah, very quickly. I can represent some institutional shareholders. I like the idea of having a buffer. The question that needs to be resolved, I guess here, is who pays for that buffer? I think some of the -- at least from my perspective, institutional investors -- this is a way for us to think there's additional risk so I think we may be willing to bear some of that risk, but money fund investing also has information asymmetry, which means I do not get to see what the managers will do. All I see is the past. As a credit analyst, I would like to see the future -- what might happen. I think there needs to be skin in the game, which I would propose that a larger share of that buffer would either somehow come from the sponsor, if nothing else, but just to make sure that there's pain in the decision that goes badly. And so, at the end of the day, I do believe this is an option that's worth exploring. I just wanted to bring that into perspective. Robert E. Plaze: Mario? Mario L. Ugoletti: Yeah, just briefly. Is another way to think about this as sort of pre-funding the sponsor's commitment to capital in some sense, right? I mean, isn't that what… Robert E. Plaze: No, both buffers would in a sense do that. It's just two different ways of doing it. Mario L. Ugoletti: Two different ways to do it, but in sort of the one that we just talked about. If you're building a certain sized buffer, we’re talking about it as capital, but it's almost if you had some way to pre-fund that commitment and ensure that that pre-funding is there, whether that's through some insurance mechanism or through some other type of mechanism, that's kind of what we're getting at -- pre-funding the sponsor's commitment? Is that --? René M. Stulz: The buffer would achieve that outcome. I mean, the difference between the Fidelity one and the one that we recommend, is that, with us, it would be ready to go on day one. It would be fully funded on day one. Robert E. Plaze: Mr. Bernstein. Seth P. Bernstein: We find ourselves uncomfortable about the informal arrangements that have existed in the industry for some time because we believe it's both an issue of credit risk embedded in the portfolios, as well as the liquidity issues that arise in a run. And so, for us, they are intimately related and very hard to segregate from one another intelligently. And in our view, the proposal that Mr. Stulz has put forth has a lot of those merits associated with it. Where we differ, and we'd like to further explore and consider is, what is the right level of capital that goes in? We certainly would say that reasonable people can differ but, at the end of the day, looking at a confidence interval of 99.5 or in that kind of range, at least for the portfolios we're running today, based on the changes Mr. Brown has outlined, the SEC has implemented, brings us to a number that's significantly lower than three percent. Moreover, we do also absolutely embrace the notion of aligning the interests of the fund adviser to those of the investors themselves. I think that would reduce the overall level or potential risk of moral hazard in the investment portfolio design. But we do acknowledge that people have different resources. And what would be easier for us to put forth from the firm I represent would be very challenging for other firms to do. And so, while we would like to see it put up up front and change, in accordance with the size of the fund itself, we are open and think we should consider ways where you can share that over time, whether that's through increased fees that are borne by the investors themselves or some other way, perhaps even securitizing that stream if that was necessary in order to raise those funds from third parties. But we do think that the investment adviser should be there up front for that kind of commitment. Gary Gensler: Just a question maybe; have you thought through if this is an industry that, I don't know the exact returns, but institutional money market funds are maybe in the 20 basis points range and retail is higher in the 30s or something, but you put three dollars aside, 20 basis points -- I'm guessing the industry would still say they want to get a return just -- the return on capital issues that you’re doing. And number two is whose money is it? Could somebody try to take over a billion dollar fund to try to collect the $30 million that was sitting there? Sort of a raid on the fund but -- I'm sorry, I might be showing some of my earlier career. René M. Stulz: I mean, it would seem that some current rules would have to be changed to implement the proposal in the sense that we would expect at least part of that cost to be transferred to the investors in the fund. It's not clear that all would be but some would be, and with the precise implementation I discussed, actually all of it would come out of the return of the fund. So, we have thought some about that issue. Obviously, we could think more about it. In terms of whose money it is, obviously, it would be money that would be committed to the fund in a way that it cannot be removed from the fund and can only be used either when the fund is closed or when there are losses. I guess, for a takeover, a person that would still end up with the ability to try to take the fund over but the size of some of those funds would make it very difficult to take them over. Robert E. Plaze: Mr. Bernstein. Seth P. Bernstein: I just think that we should also think about the sizing of that layer of capital, if you will, to the ultimate liquidation or end state of that fund. If the board, which we think would be necessary, had the right, the unique right, to actually draw on that fund and, in our view, it would be a reserve account on the side rather than added to the NAV. Is it appropriate to consider that as part of a liquidation scenario and event: i.e., the board would be watching the NAV of the fund and, at some point, have the right to trigger its closing where they believe they'd have sufficient incremental reserves in that account necessary to make the differential between what they think is the net asset value at that moment in time and par. So, we would like to at least suggest to people as you consider that or we consider that as an industry, that it be tied to a liquidation event because I think it's terribly important to control the risk of that run. And I think the most interesting provision or one of the most interesting provisions from our perspective in the recent changes to 2a-7 was giving that board the right to shut the fund down in extremis because that does take those assets off the market at a critical time where that secondary liquidity is not there. Brian Reid: And to Mr. Bernstein's point, I mean, clearly, there's about $750 billion in Treasury agency funds right now which, presumably, given that the agencies are effectually on the government's balance sheet at this point is a net liquidation event not posing any credit risk. And so the question is too, if you had these various types of capital buffers, would they be adjusted for the type of funds and so the type of assets that were sitting inside of them? Seth P. Bernstein: In our view, it would relate to credit funds. We would look at government or agency funds as separate and not requiring that, although, of course, government funds, at least one government fund broke the buck on interest rates several years back. Robert P. Brown: Our buffer model would include holistically all funds but with different ranges. Robert E. Plaze: There are two ways I think to look at your proposal. I'd be interested to see which one you've done because I've made some assumptions that are incorrect. One way, as Mr. Bernstein suggested, is it would be available in the event of a liquidity event. The other way is it would simply be there and absorb losses for the fund, in which case there would be no such thing as amortized cost pricing for money market funds anymore. Which way do you conceive of it? René M. Stulz: So we have thought of it as being there in the event of losses. Now the accounting treatment is something that we believe accounting rules can be changed to make the resulting product still attractive. Robert E. Plaze: Let me just spin that for a second in people's reaction to this. Another way is to look at it is the daily -- to cut losses that differentiate the dollar from the shadow price. If you had a separate share class that could absorb those losses and reap those gains, the dollar net asset value that the investors redeem or sold each day would be a dollar. There’d be a dollar behind -- all the deviation would be absorbed by the subordinate class of shares. So, rule 2a-7 will look very different. René M. Stulz: I just wanted to say something about the size of the buffer. Now both Mr. Brown and Mr. Bernstein have talked about studies that they have done on the risks of their funds. I think it will be very interesting to have access to those studies. They might lead people to think of the size of the buffer differently. The way that we thought about it was how the Reserve Primary Fund, essentially, reported a minimum share price of 97 cents. When the sponsors supported funds, on average it was 1.62 percent of net assets. And then, as of June of last year, the top five exposures of the U.S. prime money market funds were all European banks and the lowest exposure was 2.5 percent -- I mean, to a single bank was 2.5 percent. So now they suggest that 1.5 to three percent seems to be a reasonable buffer but, obviously, we would be open to thinking about this in light of the studies that you have done. Eileen P. Rominger: Mr. Tucker. Paul Tucker: This line of thinking about, as Mr. Bernstein said, making manifest the implicit sponsor support gives rise to the following thought, which is if this country were to keep a stable NAV thing then -- and something like this does not happen -- then there is a question faced by bank supervisors about what to do about the implicit support, which is whether the banks themselves -- because not all sponsors of money market funds are banks, Fidelity isn't but some are-- but, in the case of bank-sponsored funds, why wouldn't banks be required to hold capital against the implicit risk or, indeed, to consolidate the money market mutual fund? And one of the things that's come up in Basel III is precisely that approach to certain types of SPVs, which is why there is a reputational risk and, in reality, the bank is going to have to stand behind it. Well, let's quit pretending and make the bank hold capital against that. And why doesn't that fault run here if stable NAV remains, but there isn't -- if sponsor support is not made explicit. And I say that because, at this point, the interests of bank-sponsored money market mutual funds, I suspect, start to diverge from the interests of non-bank sponsored money funds. And the authorities would have to think about the channels of systemic risk because the amounts of support that the banks provided were substantial in some cases, and banks and dealers I mean, and substantial for the institutions concerned, and that's a kind of nasty risk to have out there. Eileen P. Rominger: Mr. Pan. Lance Pan: I do want to second Governor Tucker very quickly. I'm an investor in bank bonds and many of our clients are uninsured depositors of banks, so this is an issue that we have to deal with. If I have to stand behind money market funds in receiving the deposits back in an insolvent situation, I will be concerned. Eileen P. Rominger: This might be a good point at which to thank our distinguished panelists for devoting so much time to this excellent conversation today: a very important topic. We really, really appreciate the time you've spent traveling to be here and preparing for it. We think the conversation will provide much perspective and insight. So, thank you very much. [End of unofficial transcript]
http://www.sec.gov/spotlight/mmf-risk/mmf-risk-transcript-051011.htm
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