““Liquidity” belongs in quotes in this context because no one knows which securities will enjoy a liquid market come the next financial crisis. A significant contributor to the 2008 financial panic was regulators’ insistence that financial firms follow the judgments of government-anointed credit-ratings agencies…

…Highly-rated mortgage-backed securities were officially sound as a pound, yet turned out not to be. The government also systematically misled investors into thinking money-market mutual funds were as safe as bank deposits by blessing the reporting of fixed net asset values, as if the prices of the underlying securities never fluctuated. Now the SEC plans to repeat these catastrophic mistakes by creating a new liquidity regime that is bound to fool some investors into thinking there are no liquidity risks in funds.”, The Wall Street Journal Editorial Board, February 4, 2016

Opinion

Mutual Funds Are Risky

A new liquidity rule may exacerbate the next financial panic.

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The Securities and Exchange Commission headquarters in Washington, D.C. on Oct. 1, 2013. PHOTO: JOSHUA ROBERTS/BLOOMBERG NEWS

We invest in mutual funds like millions of others, and thank goodness markets still allow the risk without which there can be no reward. Whether a mutual fund holds stocks, bonds or something more exotic, it is an investment product, not a bank account. But financial regulators are again trying to conjure the illusion of safety around this industry.

The Securities and Exchange Commission is crafting a final rule to impose new “liquidity” standards for the investments held by open-end funds, including mutual funds and exchange-traded funds. The idea is to make sure that funds have plenty of assets on hand that they can easily sell if they need cash to meet customer redemption requests. More specifically, regulators are demanding that funds report which of their assets can be sold quickly without materially affecting their price.

“Liquidity” belongs in quotes in this context because no one knows which securities will enjoy a liquid market come the next financial crisis. A significant contributor to the 2008 financial panic was regulators’ insistence that financial firms follow the judgments of government-anointed credit-ratings agencies. Highly-rated mortgage-backed securities were officially sound as a pound, yet turned out not to be.

The government also systematically misled investors into thinking money-market mutual funds were as safe as bank deposits by blessing the reporting of fixed net asset values, as if the prices of the underlying securities never fluctuated.

Now the SEC plans to repeat these catastrophic mistakes by creating a new liquidity regime that is bound to fool some investors into thinking there are no liquidity risks in funds. The agency has long provided general “guidelines” on this subject but is about to get much more prescriptive. And while the agency is not planning to dictate which securities a fund must buy—at least not yet—its proposed rules could be nearly as destructive.

The SEC will require funds to classify each asset into one of “six liquidity categories that would be convertible to cash within a certain number of days: one business day; 2-3 business days; 4-7 calendar days; 8-15 calendar days; 16-30 calendar days; and more than 30 calendar days.”

As with previous SEC regulatory train wrecks, this will present a misleading picture of mathematical precision and certainty for what is really a series of guesses about how markets will behave in the future. The system will also create new risks. As funds start categorizing their assets, there may be pressure to conform so as not to be viewed as the outlier without ample liquidity. And so the agency may end up herding everyone into the same popular assets, as they did before the last crisis.

Perhaps most dangerous, the SEC also proposes to formally enact a current agency guideline that is intended to make funds safer but could inflame a panic. The agency aims to prohibit a fund from investing more than 15% of its money in “illiquid assets,” meaning anything that can’t be sold within seven days for roughly the value assigned to it by the fund.

This is intended to protect fund investors, but by preventing funds from buying anything that would nudge them above the 15% level, it could prevent flexibility at moments when markets and investors most need it. In a falling market, more and more assets could land in the “illiquid” category and become untouchable to mutual funds, even if fund managers spot bargains that their investors should own. A market rout could accelerate as regulation prevents falling assets from finding buyers.

There are other potential problems. How can a fund precisely track a volatile stock index if it is pressured to hold things other than the stocks in the index to meet a liquidity standard? Will it employ more derivatives to try to offset the regulatory distortion?

Investments carry risks, including liquidity risks. Misleading people into thinking risk can be controlled by regulation would be another SEC disservice to investors. The agency should instead rescind its existing guidelines and urge fund clients to beware.

 

Posted on February 9, 2016, in Postings. Bookmark the permalink. Leave a comment.

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