WASHINGTON - SEC chairman Arthur Levitt Jr. wants to tighten standards for bond and other mutual funds in the wake of the first collapse of a money market fund triggered by derivatives.
Testifying before a House panel yesterday, Levitt proposed reducing the limits on non-money market fund holdings of illiquid assets and called for funds to provide more information to investors and the Securities and Exchange Commission about their derivatives activities.
Levitt told members of the House Energy and Commerce Committee's subcommittee on telecommunications and finance that the need for these regulatory and legislative initiatives is highlighted by the collapse of the Community Bankers U.S. Government Money Market Fund.
The fund, which is owned by a group of community banks, began redeeming its shares for less than $1 on Monday after the value of its derivatives holdings plummeted.
The fund, according to Levitt and other SEC officials, held about $83 million in assets, $35 million of which were structured notes issued by government-sponsored enterprises that were designed to achieve higher returns than the federal funds rate. The value of the notes fell when interest rates rose. The funds' 112 shareholders, almost all of which are banks, are expected to get about $0.94 for every dollar invested once holdings are liquidated, Levitt said.
The SEC is investigating whether the fund's derivatives holdings violated SEC guidelines or rules, he said.
Levitt said that while the money-market fund's demise "harms no individual investor, it serves as an alert, as a warning of the steps that have to be taken" to protect individual investors who are unaware that mutual funds may be engaging in risky derivatives activities.
Mutual funds' use of derivatives is limited at the current time. A recent industry survey found that the total market value of all derivatives held by participating funds was about $7.5 billion, or 0.78% of total net assets. Fixed-income funds, however, accounted for 84% of the total market value of all derivatives holdings reported in the survey.
Mutual funds and money market funds are big investors in the municipal bond market. Mutual funds were the second largest investor group for municipal bonds, behind individual investors, and held about $221 billion of bonds at the end of March, according to the Federal Reserve Board's Flow of Funds Accounts.
Money market funds, the fourth largest investor group in the municipal market, held $114.9 billion of bonds, the Fed said.
Levitt told committee members that the SEC has an obligation to protect individual investors who increasingly have taken their money out of certificates of deposit and moved it into mutual funds.
While derivatives are used by many mutual funds to increase returns and reduce risks, they can also increase risks and produce significant losses, he said.
Outlining the steps he plans to take to improve the SEC's oversight of mutual funds' use of derivatives, Levitt said he has asked the SEC staff to draft a rule that would reduce the limit, to 10% from 15%, on the amount of illiquid assets that can be held by a non-money market fund. A 10% limit is already in place for money market funds.
The lower limit will help ensure funds maintain liquid portfolios to meet Investment Company Act requirements that say they must stand ready to redeem shares daily and must pay for those redeemed shares within seven days.
In addition, Levitt said the SEC is considering requiring mutual funds to disclose in their prospectuses some general measure of risk that will help alert investors to risky derivatives activities.
The SEC, he said, will issue a release early next year seeking public comment on whether funds should be required to disclose some form of "standardized, quantitative risk measure" and what that measure should be.
The SEC is also reexamining securities law limits on a mutual fund's use of leverage because the risk/return profile of a fund can be affected significantly by derivatives that introduce leverage, he said.
The commission plans to issue a release seeking public comment on what regulatory and legislative measures are needed to address this issue, he said.
Further, Levitt said, the SEC will seek legislation to clarify and expand its recordkeeping, reporting, and inspections authority to better monitor funds, derivatives activities.
The SEC wants to be able to require funds to keep certain records electronically and to provide them to the SEC upon request, he said. But the Investment Company Act currently imposes some limitations on the SEC in this regard, he said.
Rep. Edward Markey, D-Mass., the subcommittee chairman who, along with Rep. Jack Fields, R-Tex., had asked the SEC to study mutual funds, use of derivatives, seemed pleased with Levitt's proposals and report.
Markey asked Levitt, however, if the SEC should consider extending its 2a-7 rules to short-term funds. The rules are designed to limit money market funds to investing in short-term, high-quality securities that have a low level of volatility.
Levitt said he would be reluctant to take such a step because that would raise the question of how far the SEC should go in extending it to other funds. Levitt said he would rather school investors about the distinction between money market funds and short-term funds and crack down on any abuses that occur.