The new SEC rule on money market funds takes effect October 17, 2016. There is never a crisis that simply passes. Such events always lead to more regulation even when those creating the rules are clueless about what they are regulating. The 2007-2009 crisis did more that wipe out Lehman Brothers and Bear Stearns than anything else. The impact of the crisis led to a panic in money market funds. It was assumed that all money market funds were safe and that you would never get less than what you invested. That proved to be false in the midst of the Lehman failure.

The Reserve Primary Fund, which was the oldest US money market fund, fell during the crisis to 97 cents. You might say it was due to negative interest rates. However, it was perceived as a risk and not safety. True, the fund had some Lehman paper, but that was only a very small portion of the Reserve Fund’s assets. The collapse in confidence was the key. People feared banks and bank paper. When the market began shorting Goldman Sachs shares, its former CEO came to the rescue and banned the short selling of banks. Investors essentially stampeded out of the Reserve Fund in mass, for if Paulson was banning short selling on Goldman, then a collapse of the banking system was not so far-fetched. This triggered a run on money market funds, and when the oldest went, the contagion spread and threatened the liquidity of the entire financial system.

Big, smart money ran to equities. Many individuals ran into gold. The PE ratio on the S&P exceeded 100; at the peak of the dot.com bubble, it only reached 50:1. Money market funds became vulnerable for they invest short-term debt securities like commercial paper. Indeed, banks and big corporations rely on those funds for liquidity to fund immediate operations. Lehman failed for it could not redeem its overnight paper it borrowed against in the overnight repo market. They had just 24 hours to pay or fail, and they did the latter. This is why the government had to step in with bailouts to make sure the whole system didn’t collapse. It was liquidity that evaporated.