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Money Market Funds are in the Fight of Their Lives

Money market funds aren't exactly the safe-haven investments they're cracked up to be.

In September 2008, when Lehman Brothers failed, money market investors fled funds in droves, exposing investors and capital markets across the globe to huge systemic risks.

Now, to better safeguard investors and prevent the commercial paper market from shutting down in future crises, SEC chairwoman Mary Schapiro is proposing to re-make the money market mutual fund industry in the image of banks.

The SEC staff is recommending money market funds set aside capital reserves, as banks are required to do, and fund sponsors issue stock or debt to bolster their positions as a "source of strength," as bank holding companies are expected to do.

Also, the staff recommended restricting redemptions under certain circumstances and potentially requiring funds to collect upfront fees to further cushion themselves in times of trouble.

Industry leaders immediately attacked the plan as an assault on their business. They're threatening to sue the SEC.

The battle ahead isn't just about changing an industry.

It is about reshaping modern finance, the future power of regulators, and the real world implications of moral hazard.

Money Market Funds Explained

Money market funds are mutual funds. Investors who buy shares are pro-rata owners of the underlying investments that funds hold.

Money market mutual funds are restricted by SEC rules under the Investment Company Act of 1940 to purchasing only the highest-rated debt of issuing companies. They also invest in government securities and repurchase agreements.

The duration of the debt instruments they hold cannot exceed 13 months and the average weighted maturity of their portfolios has to be 60 days or less. Additionally, funds can't hold more than 5% of one issuer, except for governments or repurchase agreements.

The first U.S. money market mutual fund, The Reserve Fund, was established in 1971 to directly compete with banks for investor deposits. At that time "Regulation Q" prohibited commercial banks from paying interest on checking accounts.

Money market funds quickly drew in investors looking to earn interest on cash positions.

By September 2008, the size of the oldest money fund in the U.S., the Reserve Primary Fund, was $64.8 billion. Total industry assets were $3.8 trillion.

Anatomy of a Money Market Fund Panic

On Sept. 15, 2008 Lehman Brothers filed for bankruptcy and everything changed.

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