The purpose of this post is to review a recently published monograph authored by former FASB Chair Dennis Beresford. To summarize, it supports the status quo for money market funds, and I want to explain why I think the reasoning and analysis leading to that conclusion is flawed, and hence potentially misleading.
With no disrespect intended, I'll be referring to my subject as Denny. And, without wishing to lay it on too thick, I want to state at the outset that I consider him to be a friend whom I greatly respect for both his intellect and integrity.
Speaking of which, Denny told me that he refused compensation from the monograph's publisher, the U.S. Chamber of Commerce, so as not to have to deal with anyone questioning his true motivations. I was not the least bit surprised to learn of his refusal to take nothing (except perhaps a couple dozen golf balls). However, it must be stated just the same that the Chamber is a conservative and large-scale lobbyist that raises millions in large chunks from anonymous donors, who themselves keep a low profile as the Chamber uses their millions to sway political elections and policy deliberations. To give you some idea as to the nature of the Chamber's 'support,' consider this from a New York Times investigation:
Prudential Financial sent in a $2 million donation last year as the U.S. Chamber of Commerce kicked off a national advertising campaign to weaken the historic rewrite of the nation's financial regulations.
I think it's safe to assume that if Denny's positions were not congruent with what some have referred to as the banking oligarchy, his monograph wouldn't have seen the light of day.
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To understand the nature of the policy issues, and my misgivings, let's start with a couple of basic questions – having nothing whatsoever to do with accounting:
If someone had invested $1 million in a mutual fund yesterday, could she withdraw the full $1 million today – even if the fund's investments have declined in value? (For the purpose of your answer, ignore any dividends earned.)
Interpretive Response – No, unless said mutual fund is a "money market fund" conducting its business in accordance with SEC Rule 2a-7 under the Investment Company Act of 1940. Paragraph (c) of the rule provides that, with certain qualifications, a "…money market fund shall limit its portfolio investments to those United States Dollar-Denominated securities that the fund's board of directors determines [emphasis supplied] present minimal credit risks …" and the average maturity of the investment portfolio should not exceed 60 days.
Should money market funds, unlike other mutual funds, be allowed to redeem shares at $1/share (i.e., a constant net asset value, or NAV), even if the net market value of the fund is less than $1 per share?
This is the crux of the matter. The current legal response to this question is 'yes,' provided it is 'safe' to do so. It may be safe today, and revisions in 2010 to Rule 2a-7 have tightened things up somewhat; but not everyone believes it will be safe for long. Denny, however, avers that adequate security measures are already in place. Notwithstanding, kindly refer to the part about the BOD's discretion in the interpretive response to Question #1, above.
In contrast to Denny, SEC Chair Mary Schapiro certainly doesn't think it's safe. She has gone out on a limb to make money market fund reform a centerpiece of her legacy, but thus far has been frustrated – reportedly to the point of tears – by special interests.
And Ms. Schapiro is not alone. Arthur Levitt, the longest serving SEC chair in history and by my estimation a moderate not given to hyperbole, had this to say to Bloomberg Radio about the current status of money market funds:
"There's clearly a need to do something about money-market funds. Everything else [other mutual funds] is marked to the market. This should be marked to the market in the interest of investors. The fact that Mary Schapiro couldn't get her three members of the commission to support this is really a national disgrace….
"We've had a number of instances where funds have broken the buck, and the funds have made up for it because they know that the whole faith and confidence in the fund market would be damaged. Today, the margin of error is narrower than it's ever been."
The sponsors of money-market funds simply don't want this regulation." [bold italics supplied]
As an aside, even if it is safe from a systemic perspective to maintain a constant NAV, does it do right by investors?
To answer that question, think about where the money comes from when the investor with the $1 million redeems her shares. If you happen to hold shares in the same fund, the difference between $1 and the market value per share has to come out of your pocket. And, what if she should invest her $1 million in another money market fund whose market value is greater than $1? If you're an investor in that fund as well, then more money comes out of your pocket.
On its face, a constant NAV is an open invitation to arbitrageurs. Yet maybe, as Denny argues, the provisions of Rule 2a-7 ensure that these windfall transfers of wealth are insignificant when spread out over all of the investors in a fund; but couldn't the same be said about insider trading? And, over time and with automated trading strategies (perhaps yet to be invented) this kind of thing could run into real money.
Given that marking to market probably entails fewer record keeping costs than maintaining a constant NAV, I don't see how this constant barrage of individually small rounding errors can be ignored.
How should a money market fund account for and report the value of its investments: at 'amortized cost' or at 'market value'?
The title of Denny's monograph, Amortized Cost is "Fair" for Money Market Funds, clearly indicates that this is the accounting question he is answering. For one thing, placing "fair" in quotes can only indicate that Denny is simply referencing an accounting term of art, and not broader questions of fairness as commonly understood. If his monograph were entitled, "Is Money Market Fund Accounting Fair to Investors?," without the quotes surrounding "fair," then very little of Denny's analysis could have been salvaged.
The bulk of the monograph is an interpretive response to an accounting question that is derived from the consideration of accounting concepts, precedents and even accounting materiality. However, the questions for policy makers regarding money market funds are perforce grounded in economic considerations, and not the form of the accounting. Those policy questions are the ones I have already posed in this post.
As Arthur Levitt implies in his criticism of the status quo, how one answers the economic questions determines the answers to the accounting questions – and not the other way around. Stated another way, the answer to an accounting question should depend on the purpose an accounting purports to serve. Regarding money market funds, I believe there is broad consensus as to the predominant purpose of an accounting: to serve merely as the basis for determining how much money will be distributed to investors when they redeem their shares. Once the basis for distributions is determined, the accounting question solves itself.
I believe that Denny realizes this. Even though he emphasizes the accounting aspects, he must eventually come around to considering the economics. But with all due respect, Denny's background as an accounting standard setter does not particularly qualify him to address the potential economic consequences of Rule 2a-7 as it is currently written. My biggest gripe is that from a couple of pages of cursory analysis, Denny is willing to confidently state that money market funds are subject to sufficiently prudent regulation under Rule 2a-7; but Mary Schapiro and Arthur Levitt, who have lived and thought about these issues for much longer, say differently. I think Denny has stuck his neck out too far.
It also doesn't help that when Denny attempts to ameliorate concerns over the limitations of amortized cost accounting, they are hedged in practically every case with qualifying language. Here are three examples from just a single page (9) [italics supplied]:
- "The … restrictions in SEC Rule 2a-7 ensure that the difference between market value and amortized cost generally is immaterial."
- "Further, money market fund investments are often held to maturity and any discount or premium in the purchase price is realized by the fund."
- "Gains and losses tend to be immaterial."
Take out those qualifiers (which I have highlighted with italics), and were are left with unsupportable generalizations. But leave them in, and we have very little to take away from the analysis except for this: amortized cost as a basis of accounting and for administering money market funds works fine – except for when it doesn't.