New Money Market Rules – What’s ‘Safe’ Now?

The SEC shakes up the money market world in hopes of avoiding another 2008-esque crisis

   
New Money Market Rules – What’s ‘Safe’ Now?

During the peak of the financial crisis, investors were stunned with the news that the valuation of their money market funds — considered by many as a cash equivalent — were breaking below the $1 level for the first time in their history.

Prior to this event, the $1 mark was a staunch line in the sand that gave money market funds the aura of completely secure investments — ones that enjoyed minimal increases based on money market rates with no potential downside risks. But once money market funds started “breaking the buck” in 2008, investors fled.

Ever since then — under pressure from the Treasury Department and the Financial Stability Oversight Council — the Securities and Exchange Commission has been debating regulatory reform for money market funds. That came to a head in July when, by a 3-2 vote, the SEC adopted new regulations that would force money market funds that invest in riskier fixed-income products to have “floating” prices (not fixed at that $1 price), as well as report daily changes to the value of their funds.

This change likely will resonate throughout the industry, as everyone who owns one of these funds will have to think about how this will affect their accounts.

The new rules separate funds into two distinct groups:

  • Retail money market funds will be allowed to keep the $1 minimum valuation, and likely enjoy an influx of new capital as many investors flock to completely secure securities.
  • Prime institutional funds will need to report a daily net asset value, and could see outflows as investors weigh how these new regulatory hurdles affect these funds.

Issues that you will need to think about include the liquidity of the riskier funds, as well as the potential losses you could face as other investors switch to funds not subject to daily reporting.

Measuring Liquidity

You can think of liquidity as the amount of money you will lose if everyone tries to sell a specific security all at one time. Although this is unlikely, each security has a risk, and funds that are forced to report a daily changing net asset value will need to place a value on every security they own. To achieve a price for each security, a fund will also need to describe its valuation methodology.

The most efficient way to value a security is to find the price that other investors are willing to buy and sell that security. A second, less-reliable way is a model-driven valuation, which is based on assumptions that could be incorrect.

For example, prior to the financial crisis, model-driven valuations for collateralized mortgage obligation securities assumed that home prices would climb by 5% a year without ever experiencing a decline. In hindsight, this assumption seems ridiculous, because as we know now, banks that owned mortgage-backed securities that were valued based on a model experienced enormous losses.

Prime institutional money market funds will be subject to scrutiny over their valuation methods, which could require them to create a reserve account to cover potential losses. The concept is similar to creating a margin account, except instead of posting initial margin to a stock broker, the portfolio manager creates a reserve account that insulates a portfolio manager from large slippage created by riskier financial products. Those reserves should protect investors from adverse market events, but still, the fact that the prices can “float” from the $1 mark still could have many investors shying away.

Bottom Line

As a side note, one potential benefit from this regulation is that many investors could migrate to U.S. Treasury bills, which are considered one of the least risky assets. That increasing demand could initially counter the Federal Reserve’s attempts to raise interest rates, as the supply of U.S. government 1-month debt securities outstanding is the smallest since 1952 and just 11.5% of the $12.1 trillion Treasury market, according to Barclays. And in turn, low interest rates could help keep mortgage rates down, and help promote U.S. growth.

As far as money market funds themselves go …

The SEC will implement the new rules over a period of two years in an effort to avoid a large exodus from prime institutional funds.

Regardless, this segment of the market likely will shrink as investors who need a minimum net asset value of $1 to feel secure find a new home


Article printed from InvestorPlace Media, http://investorplace.com/2014/08/money-market-funds-liquidity/.

©2014 InvestorPlace Media, LLC

Comments are currently unavailable. Please check back soon.