Money Funds and Free Lunch

While the world focuses on rescuing the large banks, there are other major institutional changes afoot. Money Market Funds, part of the "shadow banking system", are facing an existential crisis, and for good reason: money funds take term or credit exposure but offer zero volatility and daily liquidity to their investors.  In theory, this would require capital, just like a commercial bank, but  the SEC 2a-7 guidelines provide investment criteria that have served to support the fixed $1.00 net asset value ("NAV") until last fall's crisis. To some degree, stable money fund NAVs are a fiction, allowed by special accounting treatment ("amortized cost accounting") for funds that meet 2a-7 guidelines.

The zero-capital stable value money fund construct requires stable short-term credit markets and a high degree of institutional confidence. Neither existed in the fall of 2008. As we stared into the abyss last October, high quality short-term paper traded at discounts that would have broken any money fund. Hence the plethora of Federal Reserve programs shoring up the commercial paper markets and the commercial banks.

The group of 30 has made recommendations on reforming the money fund system, essentially splitting out money funds that would have floating net asset values and creating a system of super-stable funds that would be allowed to keep the $1 NAV.  To some extent, this has already happened. Funds that don't currently follow 2a-7, such as securities lending reinvestment pools (which have, along with SIVs, torpedoed State Street's remaining tangible equity), and funds that have already broken the buck (such as the Reserve Primary Fund) are already trading at NAVs below $1. 

But observers are right to say the reforms will kill the money fund industry, unless parallel changes are made to the tax code. Imagine the complications on one's tax return of all the minute gains and losses on a floating NAV money fund?  They would amount to almost nothing in dollars, but several pages of capital gains information.

Some sort of tax reporting relief for de minimus price fluctuations would allow the money fund industry to continue in a much more transparent and realistic short-term investment landscape.