SEC's 698-Page Plan to Prevent Bank Runs Boils Down to 2 Words

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SEC Chairman Mary Jo White testifies before the House Financial Services Committee on Capitol Hill in Washington, District of Columbia, U.S., on Thursday, May 16, 2013. Photographer: Pete Marovich/Bloomberg
Pete Marovich/BloombergSEC Chairman Mary Jo White.
In 2008, the impossible happened. Investors lost money on something they thought they could never lose money on.

One of the oldest and most respected money market mutual funds, Reserve Primary Fund, announced that due to losses incurred on its investments (in Lehman Brothers debt) in the midst of the financial crisis, the fund lost money -- investors were down (down! in a money market fund!) 3 percent.

This was the first time such losses had been recorded -- by any such fund -- since 1994. And it's been nearly five years since the Reserve Primary Fund money market fund "broke the buck," repricing shares downward that bank depositors had thought securely attached to a $1-to-one-share ratio.

Five years later, the Securities and Exchange Commission is proposing to do something to make sure that losses in these "safe investments" don't happen again.

What's the Deal with the Timing of All This?

Why is the SEC so worried about bucks breaking, and why has it taken them so long to do something about it if they're so worried?

Good questions. Let's explain.

First, the SEC hates the idea of "breaking the buck" because last time it happened, it darn near broke the economy, too. When Reserve Primary told people who thought they had, say, $100,000 stashed safely in a money market mutual fund that in reality they now had only $97,000 -- they freaked.

Now at this point it's worth clarifying: A money market mutual fund is not a money market bank account like the ones you can open for yourself at a bank in lieu of a plain-vanilla checking account. Money market bank accounts are offered solely at banks, and are FDIC-insured against loss of principal. Money market mutual funds, in contrast, are managed by mutual fund companies, and are usually tied to other mutual fund accounts you own, or to brokerage accounts.

Individual depositors use money market bank accounts. But the SEC regulates only money market mutual funds, which both individuals and institutional investors use.

Freak Out!

This distinction didn't make much difference back when the buck got broke in 2008, however.
When Reserve Primary admitted that its shares had become worth less than $1 apiece, the news produced an honest-to-goodness run on the bank, as institutional investors withdrew $300 million in funds -- 14 percent of Reserve Primary's assets at the time -- before they could lose any more money.

Worse, seeing one money market mutual fund breaking the buck got investors in other money market mutual funds -- and even ordinary depositors using money market bank accounts -- scared that it might happen to them, too. More money got withdrawn, and more liquidity left the financial system.

Uh-oh...

Uh-oh is right. We all remember what happened next. Bankruptcies and bailouts. Companies unable to access their cash. Foreclosures. Job losses. Obviously, this is something we'd rather not have happen again.

Hence the SEC is proposing one of two things:

First, the SEC might order money market mutual funds to get rid of the 1-to-1 ratio entirely, and have cash invested in these funds "float" with the value of the fund's investments -- just like the value of an ordinary mutual fund's shares float, up one day, and down the next.

The second thing they're proposing is to permit money market mutual funds to put the brakes on withdrawals in the event the buck "breaks" again. A fund whose money is running low might, for example, be permitted to charge investors a 2 percent fee to withdraw their money -- discouraging redemptions and slowing down any potential bank run. Or the fund might come right out and suspend redemptions (temporarily), preventing a run that way.

The first option would not apply to retail-oriented money market funds that individuals patronize. Neither option would apply to money market mutual funds that invest exclusively in U.S. government bonds -- only to funds investing in more exotic securities, such as Lehman Brothers debt.

Now as for why it's taken the SEC so long to propose these regulations, the reason is that thinking up a fix is no easy task. Indeed, Reuters summarized the SEC's proposed rules change in a few short paragraphs -- but the actual report recommending and explaining the changes stretches to 698 pages. (No joke. Read it yourself if you doubt.)

I Don't Want to Read That!

And you don't have to. Fact is, we can basically boil down these 698 pages to a two-word summary for mom-and-pop bank depositors: "Don't panic."

Fact is, the SEC's proposals don't affect individual bank depositors at all, and if that's all you've got, you've got nothing to worry about. Going forward, the dollars in your money market bank account will still be worth what you think they're worth. You can still withdraw your money when and in whatever amount you like. And the 2 percent withdrawal fee? Doesn't apply to you.

The only time the SEC's rules might affect you will be if you own shares in a money market mutual fund itself.

Motley Fool contributor Rich Smith has fond memories of the day his money market mutual fund was paying 5 percent interest.


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