Money-market mutual funds would be forced to create capital buffers equaling 1 percent to 3 percent of assets to protect against losses under a plan now favored by staff at the U.S. Securities and Exchange Commission, according to three people briefed on the regulator's deliberations.
Top SEC officials, seeking to make money funds safer, prefer the plan over another capital buffer idea crafted by Fidelity Investments and calls to eliminate the funds' stable share price, said the people, who asked not to be identified because they weren't authorized to speak publicly. The concept is based on recommendations submitted to the agency in January by university economists known as the Squam Lake Group.
“Some variant of the Squam Lake proposal would be a significant improvement that would reduce the risk that money market funds pose systemic problems in the future,” Eric Rosengren, president of the Federal Reserve Bank of Boston and a frequent critic of the risk posed by money funds, said yesterday in an e-mailed statement.
Regulators and fund executives have wrestled for almost three years over how to prevent a recurrence of the run on money market funds that followed the September 2008 collapse of the $62.5 billion Reserve Primary Fund. The industry has fought a proposal to strip funds of their stable share price, saying it would kill the product that manages $2.64 trillion for companies and households, and represents the largest collective purchaser of short-term corporate debt in the U.S.
Squam Lake Proposal
The SEC's staff remains undecided on several details of the plan, including exactly how big the buffer should be, two of the people said. If the plan is endorsed by agency staff, SEC commissioners will have to approve it and may still consider rival proposals, the people said.
Florence Harmon, a spokeswoman for the SEC, declined to comment.
The so-called Squam Lake proposal would require funds to establish a segregated account holding cash or liquid assets such as U.S. Treasuries. The money would be used to bail out a fund if it suffered investment losses.
Any fund failing to maintain the required buffer would be forced to announce that failure and convert to a floating share price within 60 days, according to the proposal.
Under the plan, funds would sell bonds, or subordinated shares, to raise money for the buffer from a separate group of investors. Those investors would lose money if the buffer were tapped to cover investment losses.
The fund would pay bond investors interest, reducing the return to fund shareholders. Shareholders would benefit from the insurance provided by the buffer.
A key question is how much bond investors would demand in return for taking on the fund's investment risk.
“We don't think it would be difficult to attract investors or that the premium would be very significant,” René M. Stulz, an economist at Ohio State University's Fisher College of Business and a Squam Lake Group member, said yesterday in a telephone interview. “We're really talking about an extremely low probability risk.”
The SEC could release a proposed rule and ask for public comment as early as October, two of the people familiar with the process said.
Gus Sauter, chief investment officer at Valley Forge, Pennsylvania-based Vanguard Group Inc., said he would need to study the Squam Lake plan in greater detail before saying whether his firm would support it.
“We certainly haven't gotten to the point where we're satisfied enough to say any particular plan is the right way to go,” Sauter said in a telephone interview yesterday.
Under the idea floated by Boston-based Fidelity in May and backed by Wells Fargo & Co. (WFC) and Charles Schwab Corp. (SCHW), funds would build buffers gradually over a number of years by withholding returns. The money, which wouldn't be segregated from the fund, would be capped at 0.5 percent of assets to prevent the fund price from rising above a stable $1 share price.
“We are reviewing the details of the Squam Lake proposal and are exploring several questions related to it, as well as several variants of the concept,” Adam Banker, a Fidelity spokesman, said yesterday in an e-mailed statement.
Banker said the firm looked forward to “continued dialogue” with regulators and others in the industry.
Sauter said the Squam Lake plan had advantages and disadvantages compared with the Fidelity proposal. “Certainly it's more expensive, and so would create some drag on performance,” he said.
Floating Share Price
A government panel, charged with gauging systemic risks under last year's Dodd-Frank financial overhaul law, directed the SEC on July 26 to focus on three potential regulatory reforms for money funds. In its annual report, the Financial Stability Oversight Council, known as FSOC and headed by Federal Reserve Chairman Ben S. Bernanke, singled out proposals for a floating share price, capital buffers and steps that would deter fund investors from redeeming shares.
FSOC's members also include SEC Chairman Mary Schapiro and Treasury Secretary Timothy Geithner.
The Investment Company Institute's money-fund working group has scheduled a meeting with regulators for the second week in August, two of the people said.
“The ICI remains open to ideas to strengthen money market funds further, including ways to enhance liquidity and minimize the risks of a fund breaking a dollar,” Ianthe Zabel, a spokeswoman for the Washington-based trade group, said yesterday in an e-mailed statement.
ICI members have repeatedly warned that customers, especially institutional investors, would abandon money funds if they lost their stable share price.
Funds maintain a steady $1 share price by recording holdings at their expected value at maturity and by rounding to the nearest 1 cent. That means the fund can ignore small fluctuations in the market price of holdings and suffer a loss of less than half a cent without breaking the buck.
Groups including the FSOC and the Squam Lake economists have said the stable share price also can induce investor runs. Small losses grow as a proportion of a fund's assets as investors withdraw, giving shareholders an incentive to redeem shares before others, they say. Advocates for a floating share price include former Fed Chairman Paul Volcker and Sheila Bair, former chairman of the Federal Deposit Insurance Corp.