CreditSights: The Week In Credit
On the surface, the regulatory probe of numerous mutual fund activities that is currently taking place lacks some of the spice that peppered the recent Wall Street research investigations with their memorable e-mail disclosures and the corporate governance crisis with its focus on the spending habits of some notable corporate big wigs. But if the headlines are somewhat less gossipy, they are just as indicative of the failure of self-regulation as the tainted opinions of the financial literati and the personal profligacy of the industrial glitterati were. Unfortunately, with regulators working at a fever pace to respond, debate exists about exactly what constitutes an appropriate response.
The large number of firms indulging in misconduct and the fact that New York Attorney General Eliot Spitzer appears to be on the war path and out for blood are just two reasons to expect that there will be no industry-wide settlement to bring a quick resolution, like in the research scandal. This is driving fears that the reputational damage to the industry will impede the efficient flow of capital in the investment markets as investors seek alternatives to mutual funds. At this point, investors have shown no inclination to abandon the mutual fund investment process despite the negative headlines of the last two months. Hence, it currently appears likely that the long-term implications will be felt more from the perspective of winners and losers in the industry than a wholesale threat to the role that the mutual funds fulfill.
What could take an interesting twist, however, is the price that the regulators exact for the misconduct that has been uncovered. The industry's fee structure has become the crusade of Spitzer. He is on record as saying that he will not settle with a firm found to have indulged in misconduct unless it agrees to improve its fee structure for mutual funds, as these are of greater relevance to investors than the comparative amounts affected by such practices as late trading and market timing. The Securities and Exchange Commission sees its role in terms of protecting investors from violations of securities regulations. Spitzer is more inclined to use the leverage inherent in the failure of industry self-regulation to lower money management costs.
The determination to cast a regulatory arm into the pricing process in the mutual fund industry may be laudable as it shows an intention to marry a regulatory response to wrongdoing by creating a benefit for those harmed, but it has a corollary of interfering with the free market determination of prices that is generally considered to be optimal. In that environment, those individuals who acted illegally will suffer criminal or civil action and likely be disbarred from the industry. The firms that failed to effectively police adherence to the securities regulations (or their fund prospectuses) will incur business harm via fines and reputational loss, driving up their cost base and making it more difficult for them to compete. Increased industry-wide regulation will work to prevent future abuses, but also likely increase the industry cost base, favoring the most efficient firms. Such changes would not be expected to occur at a breakneck pace but the trend in lower margins would continue, as would the Darwinian survival process.
As the headlines are still unfolding it is too soon to suggest that there will be no more fund dissolutions or criminal penalties. Investors currently seem to be of a mindset to consider these in a company-specific manner, rather than indulging in a response to the industry as a whole. But if the penance that the mutual fund industry must pay for its most recent misdemeanors is to be exacted in its fee structure, then the broader effect on the industry will be an acceleration of the competitive process. This would lead to a faster pace of consolidation as the low hanging fruit finally falls from the tree. Just who is considered low hanging fruit however, could well change as the drama continues to unfold.
Analysis by CreditSights, Inc., an independent online credit research platform. Call (212) 340-3888 or visit www.CreditSights.com for more information.
