Sunday, 25 September 2016

The new Money Market Mutual Fund rules.

A recent Brookings Institution article by Robert Pozen entitled “US money market reforms: the gain isn't worth the pain…” criticises the new rules for MMMFs.

First some background. MMMFs are institutions which seem to be more popular in the US than elsewhere, and they accept deposits and invest only in relatively safe bonds: bonds issued by blue chip corporations, cities, the US government etc. Before the crisis which started in 2007/8 MMMFs promised depositors they’d return $X to depositors for every $X deposited. And that is very much the promise that ordinary banks make to depositors.

Now there’s a glaring anomaly in that promise, or perhaps “fraud” would be a better word: the promise effectively means saying depositors’ money is totally safe. But the mere fact that the money is loaned out means the money is quite clearly NOT totally safe. As Adam Levitin (professor of banking law) put it in the first sentence of the abstract of his paper “Safe Banking”, “Banking is based on two fundamentally irreconcilable functions: safekeeping of deposits and relending of deposits. Safekeeping is meant to be a risk-free function, but using deposits to fund loans inevitably poses risk to deposits, thereby undermining the safekeeping function.”

In short, the basic promise made by MMMFs prior to the new rules was a “have your cake and eat it” promise: you allegedly get the advantage of total safety, while reaping the advantage of taking a risk. That’s just plain, simple fraud. It’s a Ponzi scheme, sort of.

Now if you remove that “too good to be true” offer, then clearly interest rates will rise, which is basically what Pozen complains about. But what he doesn’t mention is that whenever interest rates change, the losses by one lot of people are exactly matched by gains for another lot. E.g. when interest rates rise, the above mentioned cities and corporations pay more interest, but against that, savers (pensioners in particular) will gain. So on the face of it, it’s a wash: there is no overall gain or loss. Well not quite.

It all depends on what the OPTIMUM rate of interest is, and I suggest the optimum rate is the rate that prevails in a free market: in particular, what might be called an “honest free market”. That’s a market where “have your cake and eat it” and “too good to be true” promises are outlawed.


Another problem with the “too good to be true” offer made by banks and MMMFs is that it encourages runs in times of trouble.

That is, as long as everything seems to be OK, depositors can have their cake and eat it: they’re guaranteed their money back at the same time as undertaking the risk involved in lending. But as soon as trouble looms, well you might as well get out before the bank closes its doors, or the MMMF announces it has to break the buck.

Those sort of runs are disruptive: the 2007/8 crisis was to a significant extent a run on shadow banks.

In contrast, if depositors’ stakes in an MMMF vary with the value of the underlying assets / loans, then as soon as it looks like those assets have fallen in value by Y%, the value of the latter stakes fall by about Y% as well. So there’s no point in running.

When BP made a nasty mess in the Gulf a few years ago, it was immediately obvious BP would have to pay billions by way of fines and compensation to fishermen and others adversely affected. But there wasn’t a run on BP shares because the shares were marked down before anyone had a chance to run, apart maybe from a few insiders actually working near the relevant BP rig in the Gulf who had information about the disaster an hour or two before others.

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