Sorting Out the Collapse of Reforms for Money Market Funds

Four years after the fall of Lehman Brothers, and with a presidential campaign in full swing, everyone can surely agree on one thing: we shouldn't risk another financial crisis.

But after four years of studies, hearings and round tables, the late last month abandoned efforts to impose new regulations on money market funds intended to prevent another panic like the one that occurred in 2008 and eliminate the need for a taxpayer bailout of the multitrillion-dollar funds.

The S.E.C.'s proposed reforms had the backing of the White House, Treasury officials, the Federal Reserve, the Bank of England, a council of academic experts, The Wall Street Journal's conservative editorial page, the former Fed chairman Paul Volcker, former Treasury Secretary Henry M. Paulson Jr. - just about every disinterested party who weighed in on the issue.

So it's no wonder many S.E.C. staff members were shocked when three of the five S.E.C. commissioners - two Republicans and one Democrat - indicated they wouldn't support the proposals. It was a rare case of a Democratic commissioner breaking ranks with the agency's chairwoman, , an Obama appointee who is a political independent.

“I'm not the crusading type,” a frustrated Ms. Schapiro told me. “This isn't based on conjecture. We know what can go wrong. We saw what happened with the Reserve Fund in 2008. There was a broad run on money market funds; credit markets froze. People didn't have access to their money, which was extraordinary. We're trying to prevent that. And if you're opposed to government bailouts, you have to support these reforms.”

So what accounts for the collapse?

Though Republicans in Congress have generally sided with the industry, and the reforms emerged from a Democratic administration, several people I spoke to said it was a mistake to view the outcome through the prism of partisan politics. “It's not Republicans versus Democrats,” a person involved in formulating the proposals told me. “It's the mutual fund industry and its allies versus the American taxpayer.”

For many in the mutual fund industry, 2008 seems both a distant memory and the equivalent of a 100-year flood, something unlikely to be repeated. But just four years ago, on Sept. 16, 2008, shortly after Lehman Brothers collapsed, the Reserve Fund, the nation's oldest money market fund, “broke the buck” and set off a run on the global money fund industry.

Money market funds - convenient, higher-yielding and supposedly ultrasafe alternatives to deposits at banks - are a mainstay of the mutual fund industry, offered by all the major fund families. They typically invest in short-term, low-risk assets (like United States Treasuries and highly rated ), and with the blessing of regulators, each day they report a stable net asset value of $1 a share. That's convenient for tax purposes (there are never any reportable gains or losses), and it promotes the idea that these funds are risk-free because the reported value never fluctuates.

In reality, this has always been an illusion, or what Ms. Schapiro calls a “fiction.” Even short-term assets may fluctuate as interest rates change, even if the moves are very small. And they can also fluctuate because of credit risks. That's what happened to the Reserve Fund: it owned $785 million in Lehman Brothers' commercial paper. When the value of Lehman Brothers debt collapsed, there was no way the Reserve Fund could claim that its shares were worth $1, even using generous rounding and averaging tactics to mask shifts in value. When the Reserve Fund admitted its shares weren't worth $1, investors panicked and began a run on the fund. Reserve froze its assets and no one could get their money out, even though the actual net asset value was only a few cents less than $1.

The run quickly spread to other money market funds. Funds were frantically trying to unload commercial paper and other assets to raise cash. Major corporations that rely on commercial paper to cover day-to-day operations found themselves unable to issue new securities as the market teetered on collapse. Secretary Paulson fielded phone calls from chief executives alarmed that they might be unable to meet their payrolls. The run on the Reserve Fund and other money market funds took the financial crisis straight from Wall Street to Main Street.

I remember that week vividly because I relied on a money market fund for cash. When I needed some, I went to an A.T.M. and tapped in my access code. I didn't even have a conventional bank account and prided myself on my modern approach - until I woke up the morning after the Reserve announcement to face the prospect that I might not have access to any of my money. In the many years I'd been relying on my money market account, such a calamity had never crossed my mind. Those old-fashioned government-insured bank accounts suddenly looked appealing.