Since the crisis in 2008, regulators have paid extra attention U.S. financial markets. Sweeping changes like Dodd-Frank and the Department of Labor fiduciary ruling will change the way Americans save for retirement. While these two examples have received tremendous media coverage, others haven’t. SEC money market reform efforts have important implications, but seem to have flown under the radar. Here’s what you need to know:
Background
Money market funds are a type of mutual fund developed in the 70s, which invest in short term fixed income securities. Their objective is two-fold:
- Never lose money
- Provide a higher yield than interest bearing bank accounts
The money fund market is comprised of three types: government funds, tax exempt funds, and prime funds. As you can guess, each type describes what securities the fund may invest in.
Government money funds invest in government securities only, and as a result are thought to be the safest of the three types. Tax-exempt funds invest in municipal securities that are exempt from U.S. federal income tax, while prime funds may invest in both corporate and U.S. government debt. So, while government funds may be safer, prime funds normally offer a higher yield in exchange for slightly more risk.
Reserve Primary Fund
Many investors have historically viewed all three types of money market funds as safe alternatives to cash. This view changed during the financial crisis in 2008. At the time, the Reserve Primary Fund was the largest money market fund in America, with assets of over $55 billion.
Being a prime fund, the Reserve Primary invested in an array of corporate debt issues. And in 2008, its portfolio included sizable chunk of securities issued by Lehman Brothers – which wasn’t seen as an overly risky proposition at the time.
As you probably know, the Lehman Brothers investment did not turn out well. Lehman Brothers was in far more trouble than its management let on, and the company eventually went bankrupt and could not repay its debts. This meant the Reserve Primary Fund lost its entire investment in the debt securities, striking a blow to its portfolio value.
Breaking the Buck
The hit was large enough to cause the fund to lose money, as its net asset value fell from a stable $1.00 to $0.97 per share. Also known as “breaking the buck,” only three other money funds had lost money in the 37 year history of money market mutual funds.
The reaction from the fund’s investors was fierce, as the consensus opinion at the time viewed the Reserve Primary Fund as a safe alternative to cash. Investors ran for the exits and demanded millions in redemptions. The fund lost over 60% of its assets in a mere two days, compromising its ability to meet other redemption requests and further spreading market contagion.
To diffuse the situation, the U.S. Treasury Department stepped in and offered to insure money market funds much like the FDIC insures bank deposits. Investors in funds participating in the Treasury’s program would be guaranteed at least a $1.00 net asset value if their fund broke the buck. This support helped limit liquidation pressure, and helped stabilize money markets until the crisis subsided.
SEC Money Market Reform
Unsurprisingly, the government does not want to be in the business of insuring money market funds today. So, the SEC has responded with reforms to help avoid this situation in the future. In July of 2013 the SEC amended Rule 2a-7, which will be enacted in October of 2016 and change the market structure of money funds.
The amendment essentially bifurcates money funds into two broad categories: retail and institutional. The previous classifications of government, tax-exempt, and prime will still exist, meaning that each will be further partitioned into retail and institutional classes.
