A year ago, when opposition from the asset-management industry killed her plan to make money-market mutual funds safer, U.S. Securities and Exchange Commission Chairman Mary Schapiro looked to Timothy Geithner, then the Treasury Secretary, to tackle “one of the pieces of unfinished business from the financial crisis.”
It remains unfinished.
As Schapiro and Geithner prepared to leave government toward the end of 2012, the effort started anew to make the $2.6 trillion money-fund industry less likely to disrupt global financial markets. Norm Champ, a Harvard University-trained lawyer and the SEC's top regulator of mutual funds, canvassed the remaining four commissioners, seeking to find common ground on which new rules could be built after Schapiro failed to corral enough votes to push her plan forward.
“We had hit a stalemate,” Commissioner Elisse B. Walter said in an interview. “We started with a blank sheet of paper to figure out where we could all agree, using the knowledge we'd acquired over the prior two years.”
Champ and Walter succeeded in putting together a compromise acceptable to the other commissioners, no small feat given the divisiveness of the issue. In doing so, they scaled back Schapiro's controversial proposals to require all money funds to float their share prices or set aside capital to absorb losses.
Even so, companies including Fidelity Investments and Federated Investors Inc. oppose the more moderate proposal, saying it will damage the appeal of money funds and add significant costs. What's more, there's no consensus that the SEC's rules, unveiled in June for public comment, would prevent the kind of investor run that in 2008 woke up regulators to the threat money funds pose to the financial system.
“Nothing has fundamentally changed to address the structural weaknesses of money funds,” said Sheila Bair, former chairman of the Federal Deposit Insurance Corp. who now leads the Systemic Risk Council, a nonpartisan group whose members include former Federal Reserve Chairman Paul Volcker and former Treasury Secretary Paul O'Neill.
The SEC began working with the Fed and Treasury Department on ways to buttress money funds shortly after the $62.5 billion Reserve Primary Fund was brought down in 2008 by a loss on Lehman Brothers Holdings Inc. debt.
The fund's decision to re-price its shares below $1, known as breaking the buck, set off a panic among investors, who had assumed their principal would never be lost. They pulled $310 billion from money funds in a single week, almost exclusively from those that were big buyers of corporate debt, according to the SEC. That almost froze the $1.76 trillion market for commercial paper, a short-term IOU used by companies to pay everything from bills to salaries.
To halt the run, the Treasury Department guaranteed all money-fund shareholders against losses from default, putting the government on the hook for about $1.6 trillion in corporate and municipal debt, according to an estimate by research firm Crane Data LLC in Westborough, Massachusetts.
The crisis showed that money funds were vulnerable to runs that could damage broader credit markets. Fifteen months later, the SEC imposed new rules, with the industry's support. The rules improved portfolio liquidity, required higher-rated assets, shortened the average maturity of fund holdings and forced more disclosure of fund holdings.
“They were way less controversial and we could get them done reasonably quickly,” Schapiro said in an interview. “We were bolstering the resiliency of money-market funds, but we were not solving for the underlying structural problem. That was going to take more time.”
Schapiro unveiled her second set of reforms -- which would have stripped funds of their fixed share price or required capital buffers against losses -- in November 2011. Several commissioners, whose votes she needed to approve new rules, publicly expressed doubts from the start.
Industry lobbyists met with SEC commissioners and began pressing their arguments -- that regulators needed to study the impact of the 2010 reforms, and that Schapiro's ideas would impose bank-style regulation on an investment product.
The 10 biggest money-fund providers and the Investment Company Institute, the industry's trade group, reported combined lobbying spending of about $63 million from the beginning of 2011 through the first quarter of 2013 in disclosures that reference money-market mutual funds, according to a review of documents by Bloomberg News. They found the most receptive audience with commissioners Daniel M. Gallagher and Troy A. Paredes, two Republicans, and Luis A. Aguilar, a Democrat.
The industry considered Aguilar, a former general counsel at money-management firm Invesco Ltd., as a possible swing vote to block Schapiro's proposal, according to a lobbyist who asked not to be named because the meetings were private. Both Aguilar and Gallagher complained that Schapiro's team wouldn't consider their input on the plan, including Aguilar's call for a study of the impact of the 2010 rule changes. Gallagher accused Schapiro of ceding too much control to the Federal Reserve and Treasury.
Schapiro's effort collapsed in late August 2012 when Aguilar, Gallagher and Paredes told her they would vote against it, a rare move to block a proposal from being issued. Aguilar said the staff's proposal was too narrow and should analyze “the cash management industry as a whole and the effects of the 2010 amendments.”
Money-market mutual funds first appeared in 1971 as a higher-earning substitute for bank deposits, whose interest rates were capped by the Federal Reserve. Thousands of households and businesses use them as a safe place to park cash, though unlike bank accounts they're not federally insured.
For investors, the appeal of money funds stems from their stable pricing of $1 a share, implying that the value of the principal won't decline.
Only two money funds have ever dropped below $1. The $35 million Community Bankers U.S. Government Mutual Fund was too small to cause wider fallout when it blew up in 1994. The Reserve Primary Fund proved to be a bigger deal in September 2008.
Unsure of the safety of other funds and the stability of other large banks, companies and large institutions across the world responded to Reserve Primary's troubles by stampeding out of scores of money funds, known as prime funds, that held commercial paper. One large sovereign wealth fund pulled more than $10 billion from BlackRock Inc. in a single withdrawal, according to an employee of the money manager who asked not to be named because the information wasn't public.
Money-market funds are the largest collective buyer of U.S. commercial paper, and their sudden withdrawal caused the market to seize up. Companies with outstanding paper faced possible insolvency because they couldn't roll maturing debt into new issues.
After the crisis, Schapiro aimed to prevent another seizure in the commercial paper market more than she sought to protect investors in any one money fund. That mission gained urgency after Congress stripped the Treasury and Fed of their abilities to bail out money funds.
“This core part of our financial system is now operating without a net,” Schapiro told the Senate Banking Committee on June 21, 2012.
When Schapiro left the SEC in mid-December, after four years of steering the agency's response to the financial crisis, the seeds of a new effort were already planted.
Aguilar, Gallagher and Paredes had taken heat from former regulators such as Arthur Levitt, who led the SEC during the 1990s and labeled the failure to propose new rules for money funds a “national disgrace.”
Geithner had called on the Financial Stability Oversight Council, a creature of the 2010 Dodd-Frank law, to recommend new money-fund rules. FSOC was created by Congress to fill regulatory gaps and monitor the kind of threats that contributed to the financial crisis. In late November, the FSOC issued a proposal consistent with the ideas favored by Schapiro and her staff.
With FSOC looking over their shoulder, SEC commissioners were united in wanting to show the agency could get the job done, Walter said.
“The interest of FSOC changes the dynamic, brings in another force,” Walter said. “Everyone at the SEC agreed, no matter what their view was on the merits, that it was preferable that action on this issue should be taken by us.”
Aguilar, Gallagher and Paredes also had gotten something they wanted: in late November, the SEC issued a study on the 2008 run and the role of current rules. The report made it clear that investors ran from prime funds and parked cash in funds that bought U.S. government debt, whose assets grew by $409 billion between early September and early October 2008, according to SEC data. It also showed that retail investors hadn't contributed much to the run.
After the study was issued on Nov. 30, Aguilar said he would consider additional regulation.
Some fund companies were already pushing the commission to exempt retail funds from new rules, laying the grounds for a compromise. On Nov. 22, Charles Schwab Corp. Chief Executive Officer Walter Bettinger wrote in the Wall Street Journal that imposing a floating share price on prime funds used by institutions “is the right thing to do to bring the debate to closure.” Retail funds should be allowed to keep the fixed $1 share price, he wrote.
Bettinger's article, along with the SEC staff study, became an important factor because it signaled a compromise acceptable to key people in the industry, according to a person familiar with the SEC's deliberations, who asked who asked not to be named because negotiations over the rule were private. A retail exemption was also favored by some commissioners, including Walter.
When Walter stepped into the chairman's job in December, she began by holding individual meetings with each commissioner, a type of walk-the-halls diplomacy that Schapiro rarely practiced. Gallagher and Paredes gave her a list of must-do issues, which included a new proposal for money funds, according to two people familiar with the matter.
From the start, Walter expected she would have to find a way to bridge diverging views on the commission. Gallagher and Paredes were united against the idea for a capital buffer, though they were open to changing the fixed-share price.
The Republican commissioners also liked an idea favored by the Investment Company Institute. ICI wanted to give money funds the ability to put down “gates,” or suspend withdrawals, when a fund was under stress, and to impose fees on redemptions, which would help rebuild a fund's liquidity.
Walter also worked with a new director of investment management, the SEC division developing the rule. Champ, who joined the SEC in January 2010 from hedge-fund manager Chilton Investment Co., was less enamored of capital buffer, according to two people familiar with the matter who asked not to be named.
Champ worked side-by-side with Craig Lewis, the SEC's chief economist, whose division had produced the study showing how investors fled prime funds and rushed into those that held U.S. Treasury debt.
By late December, Champ had produced a two-page summary that didn't include a capital buffer or other costlier reforms championed by the Federal Reserve and systemic-risk regulators.
“Norm Champ brought an openness and willingness to engage in dialogue that was missing,” Aguilar said in an interview. “He was instrumental in turning the tide toward a constructive process.”
Champ and his staff were looking for a way to carve out retail money funds, but there wasn't an existing rule that distinguished them from institutional products. Investment companies themselves had different categorization methods.
The breakthrough came when the United Services Automobile Association, an investment adviser that caters to military members and veterans, proposed identifying retail funds as ones that limit a shareholder's redemptions to $250,000 a day. Funds that set the limit would be able to keep the stable $1 share price. The SEC embraced the concept and adjusted the threshold to $1 million a day.
“That was sort of a eureka moment, like 'here is a really good idea,'” Walter said.
Walter was replaced in April by Mary Jo White, who was favored by the White House to reestablish the regulator's reputation as a tough sheriff of Wall Street. By then, the proposal's main ingredients were already decided.
White didn't ask for substantive changes, according to two people familiar with the matter.
In an interview, Schapiro questioned the decision to exempt funds that invest in government debt. Schapiro now works for Promontory Financial Group LLC, which has done work for Bloomberg LP, the parent company of Bloomberg News.
“There is no investment product that is risk-free,” Schapiro said. “While the run was on a prime fund, my preferred approach would be to fix the structural weaknesses of a stable share price for all money-market funds.”
Other critics say the proposal is weak because it didn't include the capital buffer, which had been advocated by Robert E. Plaze, the SEC's longtime expert on money funds, and some at the Federal Reserve. Plaze retired from the agency in August.
Forcing money funds to hold capital against losses wasn't popular with some securities regulators, who thought it would impose costly, bank-like rules on an investment product.
Walter shared that concern, although she didn't say so publicly, as the commission struggled with the rule in early 2012. Her doubts were supported by SEC economists, whose work showed that many prime funds couldn't raise capital without reducing the returns they promise to investors or reducing their holdings of commercial debt.
“The capital buffer was very different because it was adding a feature that doesn't exist in this space,” she said. “Frankly, I had always worried, and then when I heard from the economists, I was more worried that capital buffers would really be too expensive to work.”
Federal Reserve Chairman Ben S. Bernanke said in June that, by including a floating share price in its proposal, the SEC was “moving in the right direction, and I'm hopeful that what comes out will be something that's sufficient to meet the very important need of stabilizing the money-market funds.”
The Treasury Department, whose secretary chairs FSOC, shares that view, according to a person familiar with the matter who asked not to be named. Treasury officials believe the SEC's plan is largely consistent with FSOC's recommendations issued in November, the person said.
“The Fed and Treasury will declare victory if there is either a floating NAV or a redemption limit,” Jaret Seiberg, senior policy analyst at Guggenheim Securities LLC's Washington Research Group, said in a phone interview. “If the SEC can't get this across the finish line, FSOC will wade back in.”
The Investment Company Institute and many fund companies still oppose a floating-share price for institutional prime funds. Boston-based Fidelity Investments wants the SEC, at a minimum, to exempt funds that buy municipal debt from the proposal, said Nancy Prior, head of money funds at Fidelity.
Plaze, who became a law partner at Stroock & Stroock & Lavan LLP, has criticized the agency's decision to include ICI's proposal for redemption gates. In an interview, Plaze said investors might flee a struggling fund if they thought it was preparing to suspend withdrawals.
“The way the SEC structured the gates would be destabilizing,” Plaze said in an interview. Plaze also said the floating-share price should be imposed on retail funds as well.
Looking back, Plaze said, the agency might have achieved a stronger rule had it moved forward with fuller reforms in 2010. The crisis was fresher in the minds of investors, regulators and taxpayers at that time.
“Every time there is a crisis, there is an immediate effort with missionary zeal to fix it,” Plaze said. “The problem, of course, is we didn't know what to do. We just didn't.”