WASHINGTON -- The Securities and Exchange Commission voted yesterday to propose a rule that would require diversification of holdings by tax-exempt money market funds that invest in bonds from more than one state.

But the commission opted not to require funds that invest only in the bonds of a single state to diversify. Instead, the agency proposed that such funds be permitted to invest in only the highest-quality bonds in a state and that they disclose to investors the increased risk of investing in a fund that concentrates in one geographic area.

The proposals are part of a package of amendments designed to tighten the agency's Rule 2a-7, which sets standards for the quality and diversity of bonds held by tax-exempt money market funds. The commission approved tighter standards for taxable money market funds in 1991, but said it needed more time to study the unique problems of tax-exempts before making proposals in that arena.

Yesterday's proposal, which was approved on a 4-to-o vote by the panel, will be reprinted shortly in the Federal Register. Public comment will be accepted for 90 days.

The SEC rule would limit "nationwide" funds to investing no more than 5% of assets in a single issuer. But it would not impose the same requirement on "single-state funds," because such funds "face tight supplies of high-quality securities in many states," the agency staff said in an information sheet circulated after yesterday's public meeting.

"Requiring single-state funds to be diversified could make it impossible for many of these funds to meet their investment objectives," the information sheet says.

During yesterday's meeting, SEC chairman Arthur Levitt Jr. asked whether the rule would "call for much restructuring" by the industry.

"No one can tell for sure," responded Barry Barbash, director of the agency's investment management division. "I think there will be some restructuring but it will [be less] restructuring than the last go-round in 1991."

"Will we see a diminution in the yield?" Levitt asked.

"The 1991 amendments resulted in some diminution of yield," Barbash said. "Federal Reserve Board economists suggested that it wasn't that great. It was about 20 basis points."

The agency's proposed rule would bar national funds from investing more than 5% of assets in "second tier" conduit bonds, those that have the second-highest marks from a rating agency. And national funds could invest no more than 1% of their assets in the second tier conduits of a single issuer.

The commission estimated yesterday that money market funds invest over two-thirds of their assets in securities subject to "puts," which are features that allow bondholders to be repaid on demand. The proposed amendments would require that puts be rated by at least one rating agency. And they would limit funds to investing no more than 10% of assets in securities subject to puts from a single put provider.

"If a fund invests more than 5% of assets in a single put provider, the puts must be rated in the first rating agency rating category," the agency said in its summary of the proposed rule. "A fund that invests more than 40% of assets in securities subject to puts would be required to disclose in its prospectus that the credit quality of the portfolio is linked closely to the credit quality of banks."

The agency expressed concern that bonds subject to puts are often in a fund's portfolio for extended periods of time. The amendments would require that the credit risks of the bonds be continuously reviewed.

And in a proposal sought by commissioner Richard Roberts, funds would have to get credit information about the securities underlying puts when there is a deterioration in the credit quality of the put or when the put is scheduled to expire. If the information is not available, the fund would have to drop the bond, the summary statement said.

In July 1991, Mutual Benefit Life Insurance Co. was seized by the New Jersey Insurance Commission. Some of the tax-exempt funds that held securities backed by the insurer would have had to price shares below $1, known as "breaking the dollar," if the funds' advisers had not bought the securities at par from the funds.

The agency warned that because of the shortage in the supply of high-quality tax-exempt bonds, an increasing number of funds are investing in derivatives and asset-backed securities with complex structures. "To address the concern that funds may not be able to evaluate these structures, the amendments would require that [these securities] be rated by a rating agency," the agency said.

Levitt, Roberts, and commissioner Mary Schapiro expressed concern that the rule is placing a greater premium on the rulings of rating agencies than ever before. "I think we should think about what goes into those ratings and how consistent they are and how reliable they are," Levitt said.

Schapiro said the decision by the SEC staff against applying the 5% diversity test to single-state funds "was exactly the right call." But she suggested that such funds might have supply problems because of the staff's decision to propose a "first tier only" requirement for the funds in lieu of a 5% concentration limit that national funds would have to meet.

"We don't believe so," responded Robert Plaze, assistant director for investment management at the SEC. "Currently, only about 8% of single-state fund portfolios, on average based on our sample, [invest[ in second-tier securities. Some of that can be remedied by obtaining high-rated guarantors for those securities."

Barbash predicted that the new rules should not lead to "that much pain and suffering" for funds adjusting to the standards. He said a recent study by two Federal Reserve board economists suggested that the agency's 1991 rule for taxable funds has reduced credit risks of funds "at a very small cost to the investor [in terms of] yield."

"I know the industry has been concerned with the supply situation," Roberts said, referring to industry concerns that the supply of credit-quality tax-exempt paper would be inadequate to meet the rule.

"Personally, I am more concerned about the credit quality of tax-exempt money market funds, their safety and soundness, rather than their supply problem," he said.

"It is my understanding that all tax-exempt funds do not have to be money market funds. So, if it's not an area [of the country] where a single-state tax-exempt money market fund is available, a single-state tax-exempt fund could be available," Roberts said. "In some respects, I would view the supply argument as a little deceptive."

Roberts said that there is a tax case in Ohio that may have severe ramifications for state funds. "But I can't say we know all the ins and outs," he said. He was referring to a lawsuit charging that Ohio is violating the U.S. Constitution by taxing income on out-of-state municipal bonds.

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