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SEC's retreat leaves money funds vulnerable to a crisis

SEC's retreat leaves money funds vulnerable to a crisis

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If we don't learn from the financial crisis of 2008, George Santayana's famous dictum tells us we'll have to repeat it someday.

Unfortunately, the Securities and Exchange Commission just flunked a lesson from one of the crisis' scariest moments.

When investors pulled $300 billion out of money-market mutual funds in a single week, it was the modern equivalent of a run on the bank. One fund's losses on Lehman Brothers investments had shaken confidence in the multitrillion-dollar industry.

Because the funds are big buyers of commercial paper, a form of short-term financing that corporate America depends on to pay its bills, the run threatened to bring much of the economy to a screeching halt.

The threat was averted when the Treasury stepped in with an emergency guarantee. Later, a bailout-weary Congress decreed that such a step can never happen again.

SEC Chairwoman Mary Schapiro figured, then, that regulators should make money funds safer. She proposed a set of rule changes, but ran into opposition from the mutual fund industry.

Last week, unable to win enough votes on the five-member commission, Schapiro dropped her proposals. In the view of many people, including Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner, that leaves the funds vulnerable to another run.

“I'm sorry to see this outcome,” says Michael Alderson, a professor of finance at St. Louis University. “Our experience with these funds has demonstrated that they aren't equivalent to a savings account. … Maybe what will have to happen is that people will have to lose money in a money-market fund again before we can get reform.”

To understand today's debate, it helps to understand the history of the money-market mutual fund. These funds were created in the 1970s, when interest rates were rising but banks faced limits on how much they could pay on savings accounts.

By investing in commercial paper and short-term government securities, mutual fund companies offered savers higher rates. To make the funds as bank-like as possible, the companies set a fixed share price of $1.

This set up a fundamental contradiction that still exists. The funds take some credit risk, yet their fixed value of $1 implies that they're perfectly safe. Unlike banks, the funds also don't have capital requirements or deposit insurance.

Schapiro's proposal would have addressed this problem in one of two ways: Either allow the funds' share price to float, or require them to hold a capital cushion to absorb losses.

The fund industry didn't like either option. Capital would be costly, and the floating share price might spook investors.

Alderson, though, thinks investors could get used to a price that varied by a fraction of a cent per day. “If you allow it to vary right now when the change is likely to be tiny, people would be conditioned to it,” he said. “Then, a loss wouldn't be the cliff event that it otherwise is.”

If a floating price scares some investors, then maybe they shouldn't be using these funds in the first place. As we learned in 2008, the risk is real, even though it's hidden most of the time.

The Financial Stability Oversight Council, a sort of super-regulatory body that includes both Bernanke and Geithner, could still overrule the SEC and impose new regulations on money market funds. The fund companies won't like that, but history should teach us that it's the right thing to do.

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