How to Create a Time Bomb

SLAM!
Duuh duuh duuh,
Duuh duuh duuh,
Let the boys be boys!

- Onyx

Last week the SEC adopted new rules designed to strengthen the money market fund world (or "2a-7 world" if you want to get technical), which are targeted at increasing liquidity, credit quality and transparency (See the details here). Without going into too much detail, the new rules will effectively limit investment options for these funds, including the development of a concentration of funds to be invested in the very short term.

About 48 hours later it was announced the Reserve Primary Fund — the only one of these types of investment vehicles to "break the buck" during the crisis — completed its final distribution to shareholders some 16 months after locking up. Investors not only lost principal during this period (almost two cents on the dollar) but also lost any potential interest or, more importantly, ability to use the funds. This experience even forced some investors into bankruptcy — all for a vehicle that was supposed to be "good as gold."

Quite interesting timing if you ask me.

At its core, I am happy the SEC is making some changes, especially directed toward increased liquidity of these funds, but I'm also fearful of the unintended consequences of such changes.

Anytime government bureaucrats dive deep into the world of finance, there are surely mistakes and misunderstandings to be had. The question is whether the added "protection" provided by regulatory changes outweighs losses incurred due to investor efforts to circumvent or exploit the new rules.

In this case, I am concerned that a dramatic and sustained increase in demand for debt maturing less than 30 days will recreate a bubble-and-burst scenario quite similar to the mortgage bubble just experienced. This outsized demand will create a "step" in funding costs from 30 days to 31 days (and longer). When the economy gets rolling again, anyone issuing, say, 90- to 360-day debt will need to seriously consider issuing 30-day debt and taking on refunding risk each month.

On the margin that doesn't sound so bad, but imagine a broad scale of borrowers crowding into the 30-day theater and the spark of fear that will surely come at some point in the future.

The goal of these rule changes is to prevent "runs" on individual funds or the fund industry as a whole. It's possible these rules are setting the stage for exactly the type of runs they are trying to prevent. If, for example, a large issuer of this paper is unable to refinance at the 30-day mark, losses in the fund industry will be massive and broadly spread.

It would be better to let the "boys be boys" and put the onus on investment decision-making back where it belongs — with those who have money. Clearly, investors have the best motivation to guard their wealth either through the use of a registered investment advisor or by educating themselves and trusting themselves to navigate Wall Street.

But, instead, we are headed toward a society that does not want individuals or corporations to take on risk. It seems that we've already crossed over into the looking glass and are determined to "bail out" most bad investment decisions as long as they are on a grand scale supposedly causing "systemic risk."

Key Developments

The housing market continues to face challenges as existing home sales plunged 16.7 percent and new home sales fell 7.6 percent in December. On the flip side, the FHFA house price index rose 0.7 percent in November, its largest monthly gain in four years. Taken together along with recent month's data, the housing market continues to show signs of bounding along the bottom.

Durable goods orders increased 0.3 percent in December, reversing the 0.4 percent decline experienced in November. Year-over-year, the decline decreased from 6.9 percent in November to just 3.1 percent in December. Look for this number to turn slightly positive in the coming months, but don't expect solid gains until consumers can find their feet.

GDP increased a whopping 5.7 percent as there was less inventory liquidation during the quarter. Stripping away these effects, the economy still grew 2.2 percent, matching the third quarter's efforts. It is difficult to analyze how government spending and credit programs affect these numbers in order to get a true "private sector" growth rate, but given the tepid market reaction to these figures, one could guess the government is driving growth today.