Pulling Money-Market Funds Into Proper Regulation

By Jane Bryant Quinn
Sunday, August 2, 2009

I'm among the last people standing who think that Paul Volcker is right about money-market mutual funds. They pose a systemic risk to the financial system and need a radical fix.

That's not going to happen, at least not now. The Securities and Exchange Commission proposes to tighten the regulations governing money funds, but only by a little bit. The new rules won't force much of a change in the way that money funds operate.

The danger posed by these funds was exposed last September, when Lehman Brothers failed and the $62.5 billion Reserve Primary Fund got stuck with its commercial paper. Money funds are expected to maintain their net asset value, or NAV, at $1 a share to keep their customers' savings safe.

Reserve Primary's net asset value dropped to 97 cents -- known in the industry as "breaking the buck." That set off a run, not only on the Reserve Primary but also on the other funds that invest in commercial paper. Billions of dollars fled into Treasury funds, and the commercial-paper market froze. To prevent a meltdown in corporate finance, the government had to ride to the rescue with temporary federal insurance and a backup lending facility.

Enter the Group of Thirty, a private organization that studies international finance issues and risks. In January it issued proposals for reform, after a study that Volcker led.

The G-30 nailed the weaknesses in money-market funds, describing them as institutions with "no capital, no supervision and no safety net," yet offering checking-account and cash-management services like those of regulated commercial banks.

Higher Interest Rates

There's a difference here: Banks have to hold reserves against demand deposits and pay for Federal Deposit Insurance Corp. protection. Money funds offer similar transaction accounts without being burdened by these costs. That's why they usually offer higher interest rates than banks.

In most cases, money-fund sponsors have come to their funds' rescue if any question arose about the $1 value of their shares. Peter Crane, president and founder of Crane Data in Westboro, Mass., says as many as one-third of the funds will have needed support by the time this global financial squeeze abates.

But you cannot be sure that sponsors will always be willing or able to bail out shareholders, says Jack Winters of Hingham, Mass., an expert who worked in the industry from 1976 to 2008 and commented on the SEC proposals.

"Dealers supported auction-rate securities for 25 years until their financial situation precluded it," he says.

SEC Proposals

Under the new regulations proposed by the SEC, money funds will be required to invest in shorter-term securities, stick to the highest quality, hold a modest amount of liquid capital to satisfy sudden withdrawal demands, and post their holdings on their Web site once a month. All of that pretty much follows the industry's own suggestions, as outlined in a March report issued by the Investment Company Institute, the mutual fund trade association in Washington.

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