Is Mary Schapiro losing the war on money funds?

Christopher Donahue, chief executive officer of Federated Investors Inc. (FII), is sticking up for the family business when he defends money-market funds. Donahue, whose family-controlled firm has three-fourths of its assets in the cash-like products, is the most outspoken opponent of an effort to impose new regulations on the $2.6 trillion industry. Donahue, who refers to the funds as “the eighth wonder of the world,” called one of the proposals “totally brain dead” in an interview. “How can I defend them with anything but passion,” Donahue, 63, said in the interview at Federated's Pittsburgh headquarters from his office overlooking the Allegheny River. “I've got passion for the beauty of money funds.” Donahue's lobbying campaign, aided by allies in the mutual-fund business and in Congress, may defeat a lineup of regulators pushing for change in the wake of a 2008 fund collapse that sent clients fleeing from the industry. Securities and Exchange Commission Chairman Mary Schapiro, who along with Treasury Secretary Timothy F. Geithner and former Federal Reserve Chairman Paul Volcker has championed rules to make funds safer, can count on only one backer as her five-member agency prepares to vote on the proposals as early as this month. The fact that Schapiro has yet to bring the matter to a showdown is telling, said John Hawke, a Washington lawyer who represents Federated. “The measure of Chris's success is that the chairman has been talking about this since early in the year and nothing has happened,” Hawke said in a telephone interview. 'Shortsighted' Industry Should Donahue prevail, the U.S. financial system will be more vulnerable to instability, Douglas W. Diamond, a finance professor at the University of Chicago Booth School of Business, said in a telephone interview. “The industry is being shortsighted about risk,” Diamond said. John Donahue, Christopher's father, started Federated in 1955 to sell mutual funds. The senior Donahue previously sold funds from other companies door-to-door in the Pittsburgh area. Christopher Donahue joined the company in 1972, a year after the first money-market fund was introduced. The product gave investors access to a liquid account that also earned a market rate of interest. By 1975, he was selling Federated money funds to bank trust departments in New Jersey and Georgia. Because the concept was so new, he didn't always get a warm reception. “I was thrown out of plenty of trust departments,” Donahue said. Asset Growth Federated's money-fund assets rose along with the industry's, the result of both organic growth and acquisitions. The firm ranked second in money-fund assets at the end of July, behind only Boston-based Fidelity Investments and New York-based JPMorgan Chase & Co. (JPM), according to research firm Crane Data LLC in Westborough, Massachusetts. Money-market assets in funds and separate accounts, at $265.5 billion, accounted for 75 percent of Federated's $355.9 billion in assets and 47 percent of revenue in the second quarter, the company reported in July. At Fidelity, money funds made up 27 percent of assets as of July 31. At JPMorgan, they were 35 percent as of June 30. Federated remains a family affair. Donahue's father, 88, is still the chairman, and his brother Thomas is the chief financial officer. John Donahue has 13 children and 84 grandchildren, and a handful of other relatives have worked at the company, Christopher Donahue said. The family owns a separate class of stock that allows it to maintain control. Shadow Banking The Federated sign on top of the firm's building is one of the most visible in the city skyline. Donahue, fit and trim, brought a marked-up, inches-thick copy of the 2010 Dodd-Frank Act to the interview. Dodd-Frank established, among other things, the Financial Stability Oversight Council, a multi- regulator panel that could impose restrictions on money funds should the SEC fail to pass Schapiro's proposal. Money-market mutual funds, which hold short-term debt and are used by clients for liquidity, are the biggest source of short-term credit in the U.S. They're part of the so-called shadow banking system, along with hedge funds and other institutions that provide cash globally and are not subject to banking regulation. The business has drawn scrutiny since the September 2008 collapse of the $62.5 billion Reserve Primary Fund, which held debt issued by Lehman Brothers Holdings Inc. Its shutdown a day after Lehman's bankruptcy triggered an industry run on funds eligible to buy corporate debt, helping to freeze global credit markets. Investor Run The run abated only after the U.S. Treasury guaranteed money-fund shareholders against losses on more than $3 trillion in securities for a year and the Fed began financing the purchase of fund holdings at face value to help them make redemptions. Congress has since prohibited the Treasury from acting in the same way. The SEC passed rule changes in 2010 designed to strengthen the funds. Schapiro has said more action is needed. Her proposal would force funds to abandon their fixed $1 share price or introduce withdrawal limits and capital buffers. Without the changes, money funds remain susceptible to runs, Schapiro told the Senate Committee on Banking, Housing and Urban Affairs in June. “It is essential we address this risk now rather than waiting until the middle of the next crisis,” she said. Schapiro has received public backing from Boston Federal Reserve Bank President Eric Rosengren and New York Fed President William Dudley. Death Choice The Boston Fed this month released a report showing that at least 21 money-market funds got support from their sponsoring companies to prevent shares from falling below the fixed $1 price during the financial crisis. “The status quo is not acceptable,” Rosengren said in an April speech. “Reforms are necessary to protect the economy from financial instability in the future,” Dudley wrote in a Bloomberg View column Aug. 15. Donahue, on a conference call with investors in January, said the SEC proposals would destroy the industry and likened the two main ideas -- floating prices and capital buffers -- to a choice between dying “by hanging or by bullet.” He threatened legal action to block the rules from being implemented. In conference calls, congressional testimony and speeches, he has offered a narrative of the role money funds played in the 2008 crisis that differs from the one conveyed by regulators. The exodus the funds experienced was the result, not the cause, of the broader meltdown, he said. Lobbying Effort The run on money funds was the only one in the industry's 40-year history, according to Donahue. Shoring them up didn't cost the federal government any money, and the 2010 changes made the funds resilient enough to handle the stresses they are likely to face, he said. Donahue's conclusion -- that the SEC's ideas threaten the survival of the money-fund business -- has won support from other mutual-fund firms. Fidelity Investments, in a March letter to the SEC, said the proposed reforms “will ultimately destroy the money-market fund industry.” The 10 biggest money-fund managers and the Investment Company Institute, a Washington-based trade group, reported combined lobbying spending of $16 million in the first half of 2012 in disclosures that reference money funds, according to a review of documents by Bloomberg News. That compares with $16.7 million in all of 2010. Federated pitched in $230,000. Wooing Treasurers Donahue has wooed corporate treasurers and state officials, two constituencies that issue securities purchased by money funds. “I will speak to anyone who will listen,” he said in the interview. He has also found friends in Congress, including Pennsylvania Republican Senator Patrick Toomey. Toomey, at the June hearing, defended money funds with some of the same language Donahue has employed. Winning allies hasn't been difficult because money funds are popular, according to Donahue. “There is still $2.6 trillion in these funds even though there is no yield,” he said. “People love them.” Money funds yielded an average of 0.06 percent as of Aug. 15, according to Crane Data. Interest rates near a record-low have forced money fund providers to waive fees on some funds to prevent yields from turning negative, which has undermined profitability. Making Acquisitions Federated has risen 1.3 percent since the Federal Reserve lowered its target rate to a range of zero to 0.25 percent in December 2008, compared with the 26 percent average gain for the Standard & Poor's 20-member index of asset managers and custody banks. The firm has continued to make acquisitions during that time, including a pending deal announced in April to acquire $5 billion in money-fund assets from Cincinnati-based Fifth Third Bancorp. Donahue, at the June hearing, sparred with David Scharfstein, a finance professor at Harvard Business School and member of the Squam Lake Group of academics who have recommended steps to strengthen the U.S. financial system. When Scharfstein, in response to questioning, said money funds should have to raise capital equal to 2 percent to 3 percent of their assets, Donahue said, “The math doesn't work.” In the interview, he said of the suggestion, “It's totally brain dead. It would be too expensive.” On 'Fringe' Donahue is “on the fringe of the industry,” Scharfstein said in an interview. It's up to academics and regulators to challenge vested interests opposing change, according to Scharfstein. “We need a safer system,” he said. The SEC has yet to set a date to vote on Schapiro's proposals, John Nester, a spokesman, said in an e-mail. Schapiro has the support of Democrat Ellise B. Walter at the SEC, while Republican commissioners Troy A. Paredes and Daniel M. Gallagher have said they oppose the plan. Commissioner Luis A. Aguilar, who was reappointed last year by President Barack Obama, has signaled his opposition without saying whether he would kill it before inviting public comment. Donahue sees the latest tangle over money funds as part of a long-running war the industry has fought with the Fed and the SEC. “It was rather like they were standing outside the delivery room when these things were born trying to club them,” he said at an investor conference in June. 'POW Camp' Volcker, in a September 2011 speech, spoke in favor of tougher rules. “The time has clearly come to harness money-market funds,” he said. Volcker told the Financial Crisis Inquiry Commission in 2010 that most of the cash in money funds “should be with the banks” because they are more tightly regulated. Donahue told his staff to prepare for more confrontations, he said in the interview. “We are in a POW camp behind enemy lines, trying to survive,” Donahue said. “I assume the battle continues. We will defend money funds come what may.” --Bloomberg News--