How to restore trust in money market funds

June 29, 2009

If the idea of having precious cash tied up brings back dark memories of the sudden clamping down of billions of dollars of funds during the credit crisis, you’re not alone.

By some counts, the auction-rate securities mess has left hundreds of billions of dollars trapped in a short-term market that many had been told was as good as cash — just with better returns. That’s enough to keep any investor wary.

Even money market mutual funds, which few questioned as a risky place to park cash, became suspect after Lehman Brothers-related losses snapped the sacrosanct $1 net asset value for the Reserve Primary Fund and set off a $300 billion run on these investment vehicles. Investors in that fund are still fighting for their money back.

The Securities and Exchange Commission has laid out a proposal to tighten regulation on these mutual funds in an attempt to restore confidence in this $3.8 trillion market, where about a fifth of households stash their money. But the proposals themselves highlight what is still worrying about so-called cash-equivalent funds — they lack the simplicity and liquidity of the real thing.

For one, the SEC has proposed granting money market funds the authority to cease redemptions if a fund gets into serious trouble and needs to liquidate. This isn’t a bad idea since it would in theory stop the kind of panic that swept through the market and threatened to bring down the global financial industry. But it’s a reminder that even “safe” money that households and companies count on can still be trapped during periods of extreme stress.

Then there’s the make-up of the funds. The SEC proposes that funds allocate a certain amount of holdings into “liquid” assets — cash, U.S. Treasuries or securities that can be readily converted into cash within one day to a week. For retail money market funds, five percent of the portfolio would have to be ready to convert into cash in a day, and 15 percent within a week. For larger, institutional funds, the percentages would be 10 percent and 30 percent, respectively.

This is an improvement from the status quo, where there are no liquidity requirements. But the bulk of the portfolios can be invested in less liquid securities, presumably so money market funds can continue to give investors a bump in yield and themselves a working wage.

This is too much and should serve as a warning. And a warning label is certainly in order so investors are clear that sending money to a money market fund isn’t the same thing as allocating it to pure cash. This would help avert future heartache and sleepless nights, while also paving the way for greater transparency and trust in money market funds.

It’s important to get this right, so that investors are clear and confident about their “safe” investments as well as their risky ones — an essential step on the road to recovery.

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