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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.

None of these rules would prevent or mitigate a run if investors lost confidence in money funds again. The government would have to step back in.

Money Is Safe?

As the G-30 sees it, money funds that want to offer bank-like services, such as checking accounts and withdrawals at $1 a share, should reorganize as a type of bank, with appropriate supervision and government insurance. Funds that don't want to operate that way should not maintain the implicit promise that investors' money is always safe. Instead, their share values should be allowed to rise and fall like those of any other mutual fund. They could manage their portfolios to stick closely to $1 a share.

The industry unanimously shouted "no."

"Money-market funds as we know them simply disappear," says Paul Schott Stevens, president of the Investment Company Institute. Investors seeking guaranteed safety and soundness would migrate back to banks or the new bank-like funds. The remaining funds would become less attractive because of their fluctuating price.

To Volcker, bringing investor money back to the banks would be just fine.

"Why let another business develop without the responsibilities of a bank and that ends up making banks weaker, when banks are the ones we want to protect?" he said in an interview last week.

Hot-Money Dangers

Retail money funds, conservatively invested, aren't as vulnerable to runs as institutional funds and may be safe in their present form. The danger lies with the hot-money institutions that can pull billions of dollars out of a fund in a millisecond. Of course, big investors could also start a run on money funds that fluctuate too much in price. But they would be less likely to sell if they'd lose money on the trade, Winters says.

The SEC didn't propose a floating NAV. It merely asked for comments on the idea.

"It's off the table," Crane says. "The crisis is over. The need for radical surgery has lost its impetus."

That is, until the next time. Will money funds be the only institutions "too big to fail" to escape the costs?

Jane Bryant Quinn, author of "Smart and Simple Financial Strategies for Busy People," is a Bloomberg News columnist.

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