Monday, June 14, 2010

Do I really have to read this?

Yes!!! Readers of this blog know that I have been writing for almost two years that I thought the Federal Reserve Open Market Committee would keep short-term interest rates low for more than an extended period. I felt that the Fed would not move before the third quarter of 2011. That forecast was before the problems in Europe. Now I think the extended period could run into 2013. This was the easy part to read, now comes the hard part.
The Securities and Exchange Commission, (SEC) instituted changes in how Money Market Mutual Funds have to invest their money on behalf of shareholders. For almost 18 months investors in money market mutual funds have been earning close to zero interest. I know that investors have not been earning interest but most people are not aware that managers have actually lost money. One example of the magnitude of the loss is Charles Schwab and Co. They reported that they lost revenue and paid expenses to operate their funds in excess of $125 million in the first quarter 2010 alone.

I also know that investors and managers alike have been hoping that the Fed would start raising interest rates, producing positive results or at least stop the bleeding. The SEC was concerned about the risk some money market mutual funds were taking in 2008 in order to get the highest possible yield. The specific catalyst was the bankruptcy of Lehman Brothers and the losses in the Reserve Money Market Fund.

The group of rules that govern the operation of money market mutual funds is 2a7. The SEC adopted new rules that I believe will put the long-term viability of money market funds in serious question. The new rules are 122 pages and I’m not going to ask you to read them but I will give you some of the highlights and what you need to do about the changes,

Duration, or how far out can they invest my money?

Money market mutual funds used to be able to invest up to a year. Under the new rules they can go out only about 60 days, Why is this important? When the Fed starts raising interest rates the rate of interest money funds can pay will be restricted and perhaps not be competitive to alternatives.

Credit Quality, or how much risk can they take with your money?

Some funds in the past reached for yield to attract money and as I said above the Reserve Fund had to shutdown because of investments that were worthless. The Reserve Fund has not priced their Primary Money Fund since September 16, 2008.  The new rules state that a single investment of lower quality can only be one half of one percent, The rules also state the maximum percentage a fund can own in higher risk securities is 3%. No more reaching for yield by fund managers.

Liquidity, how much do they need to keep on hand to satisfy redemption's? Get me my money.

The fund must be able to meet redemption's of one third of the funds assets within 7 days. This provision means that about 30% of all assets will have to invest in the highest quality in order to assure they can meet redemption's. The higher the quality the investment then generally the lower the return it will pay.

Expand the number Credit Rating Agencies used to assess risk, get some help,

Fund managers and their outside directors will have to review the credit rating agencies they use to help them to evaluate the credit risk they are taking with your money. The SEC is concerned that the credibility of the credit rating agency is in question and they feel that they want managers to get a second opinion on what the risk is that is being taken with your money.

Changes to come. 

The clock is ticking on who will be the first manager to close their fund and return the money. Once the first one closes look for a cascade of funds closing. When management companies lose money for as long as they have these new changes from the SEC will give them the catalyst to close their funds. Managers will start blaming the Fed, blaming the SEC for the low returns on money funds. The reality is that is not the fund managers fault their funds are yielding zero and losing money, but it is their fault that they have tried to save an industry that is outdated and no longer productive to investors.

The longer you wait to find an alternative the more negative your returns will be. Remember that even in a low inflation environment earning zero produces negative real return.

I think new products are being developed to fill the void left by the changes and the viability of money market mutual funds. As they appear look for them here.

Dan Perkins

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