Tuesday, May 26, 2009

The Debts of the Spenders: SEC Promotes Regulatory Arbitrage W/Proposed Money Market Changes

When will they learn. After breaking the buck ( a reference to the Reserve Primary Fund which sank below its $1 NAV, net asset value, after exposure to Lehman Brothers paper. The $1 rule is a threshold of regulatory capital and applies to US money market funds ) last fall, money market funds fell into a deep slide and led to the formation of an unprecedented dollar rally. The result was an environment of forced liquidation where funds were forced to sell anything and everything to raise cash on a short term basis to meet redemption demands.

However, the SEC is now proposing that the $1 NAV Rule, or more formally known as Rule 2A-7 of the Investment Company Act of 1940 (I hate talking in legalese but have to revert to form occasionally), is nothing more than a symbolic formality, a relic of older times. You know, like Glass Steagall.

The removal of Rule 2A-7 can lead to potentially . . . dramatic changes as it seems like a blatant endorsement of more "financial innovation"; e.g. risk taking. If approved, expect a resurgence into inflationary bubble building assets like commercial real estate, hotels, and other high beta assets.

In June, the SEC will consider radical changes to Rule 2a-7, including the elimination of the stable $1 NAV, limiting a fund's size relative to its respective market, requiring minimum cash reserves such as 10% of the fund's total assets, and requiring money funds to have insurance guarantees similar to the Federal Deposit Insurance Corporation's bank guarantee.

But without a $1 NAV, industry leaders fear that trillions of dollars of assets could leave the mutual fund industry for other sectors that are perhaps less suited to handle such traffic.
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