Risky money market fund bets may be illegal

(Fortune) -- Did mutual fund companies fall afoul of a key federal regulation by allowing their money market funds to buy securities issued by the shadowy debt funds that are now struggling?

Money market funds are often the safest investments offered by fund companies, but several large money market funds own securities that were issued by structured investment vehicles (SIVs), the large, offshore funds that have recently made it into the headlines because the U.S. Treasury, along with Citigroup (Charts, Fortune 500), Bank of America (Charts, Fortune 500) and JP Morgan Chase (Charts, Fortune 500), are working on a plan to shore up them up.

Typically, SIVs borrowed money by issuing short-term notes at a certain interest rate and then invested that money in longer-term securities that had higher interest rates, hoping to make money on the difference between interest rates. Many money market funds bought the notes that SIVs issued to raise the money to make their bet.

Securities regulations state that money market funds can only buy short-term, very safe securities. In particular, rule 2a-7, part of the Investment Company Act of 1940, says that money market funds can only hold securities that have "minimal credit risks."

The fact that the SIVs are in trouble suggests that SIV securities had more than "minimal credit risks." Of course, money market funds would have felt comfortable buying SIV securities because they had very high credit ratings, but the current SIV difficulties indicate that those top-notch ratings were in many cases undeserved.

Fortune reported last week that a Bank of America money market fund, the $67 billion Columbia Cash Reserves fund, held $640 million of securities issued by Cheyne Finance, a SIV that recently went into liquidation. Cheyne was originally rated AAA by Standard & Poor's and Moody's.

Other fund company's money market funds have also recently held SIV paper, including funds managed by JP Morgan, Fidelity and Federated, according to company filings.

The issue here is whether money market funds should ever have been invested in SIV paper at all.

Some fund management companies that have large money market funds have very small SIV-related holdings, like BlackRock (Charts) (under 0.5% of money market fund assets, according to a company spokesman) and Goldman Sachs (Charts, Fortune 500) and Vanguard, which have none, say company representatives.

In other words, certain money market funds chose to eschew SIV securities, which dispenses with the excuse that SIV exposure is an industry-wide phenomenon. Not everyone was into it.

If a fund company was doing its job, it would have asked itself very seriously whether the SIV notes deserved to be in a money market fund. Specifically, they'd go about enquiring whether SIV securities met the requirement of rule 2a-7 -- that they didn't present anything more than the minimal credit risks.

The argument for the defense of money market funds holding SIV paper goes something like the following. The SIVs that issue the notes are highly rated, well managed and have high quality balance sheets. Recently, they have been hit, almost unfairly, by an extraordinary panic in the credit markets that has led to a drop in demand for the notes the SIVs issue to fund themselves. And once the markets get back to normal, especially with the help of the Treasury, the SIVs will be fine.

Why isn't this approach convincing? Remember the key test is whether the securities present minimal credit risk. In this case, we have to ask whether the SIVs were actually strong enough to deserve the AAA rating, which usually only applies to entities with tiny amounts of credit risk. That rating on a SIV implies that the SIV has the strength to get through almost any crisis. The fact the SIVs stumbled so quickly shows that they weren't built with anywhere near enough capital or commitments of back-up funding.

Fund management companies should have looked beyond the rating and basically asked themselves: Does a SIV really have the same creditworthiness as U.S. Treasurys, also rated AAA? And they should also have noted how skewed the SIVs were to short-term funding, since that is a common mistake in investing.

The other defense argument is that the SIV notes are backed with assets, which means the holders won't take a big loss because they have a claim on those assets and the income they produce. This is true, and it is a source of comfort for any poor money market funds holding SIV paper that does go into a liquidation process.

But it'd be a stronger argument if the SIVs had actually made public what the assets are that back their paper. What if those assets were loans or securities that are themselves distressed or very hard to sell? If so, the holder of the SIV securities will end up getting back less than 100 cents on the dollar.

But if a money market fund were to recoup the value of its SIV securities by claiming the underlying assets, wouldn't that allow the fund company to say that the SIV securities had "minimal credit risks" after all? Are you crazy?

Money market funds are supposed to the safest fund investments of all. They're not supposed to get involved in liquidations. That sort of event is a nightmare for a money market fund. And indeed it will be a nightmare if it does turn out that fund management companies have failed to follow rule 2a-7.