The collapse of Lehman Brothers led one of the largest US money market funds, Reserve Primary, to break the buck - its net asset value dropped below $1 for the first time on September 16 due to losses on holdings of Lehman commercial paper.
The fallout saw a frenzy of redemption requests from money-market investors, typically small retail investors with high risk aversion and short time horizons; this in turn harmed the commercial paper market on which many banks depended for funding. Another fund, Putnam Prime, was closed and liquidated on September 24 following fears that satisfying redemption requests would lead it too to break the buck.
To relieve pressure on the funds, the Federal Reserve stepped in, agreeing in October 2008 to make loans in order to fund the purchase of up to $540 billion in commercial paper and short-term certificates of deposit from money market funds. The funds had been switching to overnight and other very short term assets, creating a shortage of credit in the one week to 90-day term - however, the Money Market Investor Funding Facility had not lent out any money by April 29 this year, the most recent date for which data was available.
Another scheme, the Commercial Paper Funding Facility, bought commercial paper directly from issuers in order to maintain the supply of short-term credit to struggling banks in the absence of money-market funds; this had advanced $235.2 billion in loans by the end of April, the Fed said.
The new rules will further restrict the investments allowed to money market funds. They will be compelled to have a minimum percentage of assets held in cash or "securities that can be readily converted into cash"; the portfolio average maturity will be cut from 90 to 60 days; funds will not be allowed to invest in second-tier securities (those with short-term credit ratings of 2 rather than 1, which can currently make up 5% of the portfolio) and will have to undergo regular stress tests.
In addition, funds will have to post their net asset value publicly, and will be permitted to suspend redemption requests as part of an orderly liquidation process.
Presenting the proposals, SEC commissioner Troy Paredes said he personally had "significant reservations" about the ban on second-tier investments. "I am not aware of any evidence showing a causal link between second tier securities and the stresses money market funds came under last year. Indeed, the release itself does not suggest any such link," he said, adding he would welcome comments on how the ban might affect banks' ability to raise credit and the ability of the funds themselves to diversify their portfolios.