$900 Billion in Capital Is About to Move

By: Money_Morning

Michael E. Lewitt writes: Six years after the financial crisis, the SEC finally concluded a four-year battle with financial industry lobbyists to toughen regulations governing money market funds.

Readers may remember that a run at the $62.5 billion Reserve Primary Fund during the 2008 financial crisis brought the multi-trillion money market industry to a standstill.

And it required federal intervention to prevent a market collapse...

The reason: the Reserve Primary Fund was forced to "break the buck" (that is, lower its price to below the $1.00-per-share industry standard for its type of money market funds) due to heavy exposure to plummeting Lehman Brothers debt securities.

Here's why the new regulations are about to cause a colossal market cash shift...

The Regulations That Will Change This Giant Market Permanently

The rules, approved by a tight (but unusually bi-partisan) 3-2 vote on July 23, require the riskiest funds, the so-called prime money funds to use floating prices for their shares. These funds cater to institutional and high-net-worth investors, and buy securities such as commercial paper issued by banks.

That is, instead of trading at a stable price of $1.00-per-share (meaning that $1.00 invested in a fund can always be redeemed for $1.00) prime funds will have to mark their shares to market based on fluctuations in the value of their underlying securities.

This is a radical break with industry norms that have employed fixed-rate pricing that ignored fluctuations in the prices of the underlying prices of their holdings.

As I mentioned, the Reserve Primary Fund was battered in 2008 by big holdings of Lehman Brothers commercial paper that was not being marked-to-market. If that situation were to occur today under the new rules, a fund would have to mark down its shares to below $1.00. For the most conservative investment imaginable, one often equated to a bank deposit in terms of safety, this would be a confidence-shattering event, just as it was in 2008.

The new rules also include measures to ease the tax reporting burden on fund investors. The U.S. Treasury Department and Internal Revenue Service agreed to require investors to account for gains and losses only once a year, at year-end, instead of tracking prices at which they buy or sell. The IRS also waived its "wash-sale" rule, which could have penalized investors who trade frequently in these funds.

In a nutshell, a massive "safe" money sector just got a lot less predictable...

This Shift Will Ripple Through Investment Markets

One consequence of the rule change is that as much as $900 billion of the $2.6 trillion of assets invested in these funds may now move out of them and into bank accounts, according to the Financial Times.

The reason is that certain types of fiduciaries have zero tolerance for any type of principal loss in these types of holdings. The rule was the subject of intense lobbying by the usual suspects. The U.S. Chamber of Commerce warned that the new rule would destroy the appeal of prime funds, which many corporations use to manage cash.

Boeing Co., for example, has warned that it would move the $2 billion to $3 billion of cash it invests in prime funds because of the risk of principal loss. Instead, it may move that money into funds investing in short-term government securities as an alternative; those funds will continue to be allowed to use fixed-rate pricing of their shares.

The SEC also added a rule that would allow the boards of directors of money funds to temporarily suspend withdrawals or impose fees when a fund faces trouble meeting redemptions.

These restrictions on withdrawals are known as "gates" and are widespread in the world of hedge funds, which often invest in securities that become illiquid in a crisis.

During the financial crisis, many hedge funds were either forced to put up "gates" since they were unable to sell many of their investments or chose to put up gates since they did not want to sell their assets at crisis-level prices. "Gates" can work in favor of investors in the long-run in terms of maximizing the value of their investments, but in the short-run they deprive them of access to liquidity and tend to make them very unhappy.

The ability of a fund of any kind to impose "gates" can also have the unintended consequence of causing investors to redeem preemptively, creating a contagion effect that can ultimately harm them.

These rule changes will alter the landscape of the money market industry and, by extension, the investing of nearly $1 trillion.

Both the firms providing these funds and the investors who use them will adjust, but it's likely that prime money funds will shrink and money will move into bank accounts and other investments that protect principal without "gates."

Source : http://moneymorning.com/2014/07/28/900-billion-in-capital-is-about-to-move/

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