As the redemptions piled up, the analyst sat stunned.

This is so much worse than anticipated, he thought to himself. Nobody expected this level of out-flows.What’s going on?

#-ad_banner-#Now, he knew the fund was prepared. In fact, an e-mail from the previous day indicated the company expected upwards of $1.5 billion in redemptions.

By 8:37AM, the company watched as more than $5.2 billion flew out the door… But that was only the tip of the iceberg.

You see, the company saw more than $40 billion in redemptions in about 24-hours. The bleeding stopped only when the fund’s bank stopped wiring cash later that morning.

So what happened?

The day was September 16, 2008. It was one day after Lehman Brothers declared bankruptcy. But it would be best remembered for being the day that a giant money market fund was brought to its knees.

On this day, the nation’s oldest money market fund failed to keep its net asset value (NAV) at $1. It was the first time in history that a retail MMF failed to hold its NAV, and the market freaked out…

Why is this important now?

The lack of cash brought the nation to a halt in 2008. It spawned the failures of Lehman Brothers and Bear Stearns. 

And it scared regulators. And scared regulators beget more regulation.

That’s one of the reasons that new rules for money market accounts went into effect last week.  

What’s Changed, And How Will It Affect Your Portfolio? 
The SEC now groups investors into one of two classes: retail (individuals) or institutional (large institutions). Institutions can no longer invest in retail MMFs. 

Also, the SEC distinguishes between government MMFs and non-government MMFs. 

Let’s look at government MMFs for retail and institutional investors.

Investors buy shares in government MMFs to hold money for short periods. These funds hold cash, Treasury bills, and government repurchase agreements (repos). Government MMFs must invest 99.5% of assets in cash or government securities to be a qualified fund. They are a safe place to park money.

What has changed is that government MMFs may impose redemption fees or redemption gates to their funds. This allows the MMFs to charge a 2% redemption fee or to suspend all redemptions if liquid assets fall below 30% of total assets. Suspensions are limited to 10 business days in any 90-day period.

Additionally, these funds can impose a 1% redemption fee if liquid assets fall below 10% at the end of any business day — unless the board determines the fee is not in the shareholders’ best interest. 

Remember, these provisions are optional. It’s unlikely any government MMF would adopt such rules.  

That isn’t the case with retail non-government MMFs…

Retail non-government MMFs hold cash, T-Bills, and commercial paper. They now require redemption fees and gates. No longer is the decision to impose the rules on shareholders left to the board. This means that investors could lose money (through fees) or experience delays in redeeming shares.

But these rules pale in comparison to those for institutional non-government MMFs. 

Rules For Institutional Non-Government MMFs
Institutional non-government MMFs (also called prime funds) hold cash, short-term government securities, tax-exempt securities, repos, and commercial paper. These funds now have the same redemption fees and gate requirements as retail non-government MMFs. But they also have a floating NAV.

This is a major change and means MMFs must “mark to market” daily to calculate their net asset value. Investors will see the NAV in these funds trade at, above, or below $1.

These fluctuations in the NAV will be very small. The rules require MMFs to calculate the NAV to four decimal places. This means an investor might see a NAV of $1.0001 or $0.9999. 

The SEC hopes the floating NAV will provide greater transparency for investors. 

What’s the Takeaway?
Retail and institutional government MMF investors are safe. 

Retail non-government MMF investors are subject to losses or redemption delays when volatility is high. They should immediately move to a government fund if losses and delays represent too much risk.

Institutional non-government investors have an easier decision… 

These investors should immediately transfer their funds to government MMFs. 

Here’s why…

Institutional MMFs have seen nearly $700 billion in outflows to safer government funds. The prime market will see another $500 billion move by December 31. That’s almost half the market’s previous value before the rules changed.  

This is a dangerous development. You see, the prime market greases the wheels of commerce. By drying up this market, the SEC has all but guaranteed a future credit crunch and a market that is more susceptible to risk — not less.  

Prime market funds will not be able to hold their NAVs to $1 in the next credit crunch. With global debt to GDP ratios around 313%, central banks have no ability to backstop future losses as they did in 2008.

And the losses could be catastrophic. And that’s why institutional investors must move into much safer government funds without delay.

Risks To Consider: In an effort to reduce redemptions, prime fund managers may make changes designed to increase yields. This could once again make them attractive investments, even with the risk introduced by the new regulations. 

Action To Take: Reduce risk to your portfolio by getting out of prime funds now. If you’re not sure if you have a prime fund, you can contact your fund via phone or through the fund’s website. By default, any investor not using a social security number for the account is an institutional investor. This includes small business accounts, defined benefit plans, and endowments.

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