How safe is your money market? (2008-01-07)

How safe is your money market?

(2008-01-07) by David John Marotta

The first U.S. money market fund was created by Bruce Bent in 1970. The Reserve Fund, as it was called, offered investors a way to preserve their cash liquidity and still earn a small rate of return. Today 22% of all mutual fund assets are invested in nearly 900 money market funds.

Money market funds are a type of mutual fund that usually sells and redeems their shares for $1. The value to the consumer is the interest earnings plus the stability of getting their principal back. Unlike other mutual funds, money market funds are restricted to investing only in the highest quality debt with average maturities less than 90 days.

While money market funds typically are very stable, it's important to note that money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Money market funds seek to keep their share price at exactly $1.00, but this is not guaranteed. It is possible to lose money by investing in these funds.

Protecting the consumer, several rules govern those who offer money market funds. They must invest at least 95% of their assets in securities that get the highest credit rating. Money market funds cannot have more than 5% of the portfolio invested in debt from the same issuer, except for the federal government debt. They can invest in Asset Backed Commercial Paper (ABCP) which is backed by a pool of assets that can include credit card debt, car loans, regular mortgages and subprime mortgages. Money market funds can invest up to 5% of their assets in securities with the second highest rating, but cannot put more than 1% with any one issuer. When an issuer's credit rating drops from the best credit rating to the second best credit rating, a money market fund will be on alert to sell the position quickly in order to satisfy SEC rules.

Some money market funds have lent money to what are called structured investment vehicles (SIV). Since they promise to pay the money back within a short period of time, SIVs can qualify as legitimate money market investment. The SIVs then take the money and invest it in high-yielding risky investments such as subprime mortgage debt. The SIVs then repay their debt by bundling and selling this mortgage debt and making their repayment deadline. They make money by collecting much more in interest and the sale of the loans than the cost of borrowing the money in the first place.

The difficulty is that it has become much more difficult for SIVs to sell their subprime mortgages. When there is a rise of foreclosures and defaults, companies devalue the bundle of mortgages which increases the likelihood of SIVs being unable to repay their loans from the money market funds. The ratings on some of this commercial paper have dropped with the increasing defaults on subprime mortgages.

Because of the rules that govern money market funds and their diversification requirements, the credit risk problems of subprime defaults are limited. A good manager should be diversified enough to weather these storms without showing losses in the money market.

Money market funds have several purposes in an investment portfolio.

They provide a liquid stable place to park free cash. They provide a place to keep money for rebalancing your portfolio in case of a market run up or a market correction. And they provide a place to collect interest and dividend payments.

Money market funds can also serve as an investment class by itself. In the decade of the 1970's with its rampant inflation, money market was the investment category with the highest returns at the end of the decade.

When interest rates are falling, longer term bonds with higher fixed interest rates will appreciate in value. But if interest rates are rising, these same long term bonds will lose the most value. In a period of rising interest rates, your money market investments will adjust quickly and simply pay a higher rate of interest.

Some money market fund investors are worried about losing their money. If a money market fund holds bad debt, the money market fund's value could drop below $1.00 and "break the buck". A money market fund has broken the buck when you go to get your money out of your account, and they return less than you put in.

So far, only one money market fund "broke the buck." They paid their investors only $0.96 per share. Although only one fund has dropped below a dollar, there have been a number of cases where the banks have bailed out their money market fund by pumping in more capital in order to show a positive return.

Any brokerage firm that showed a loss on a money market fund would ruin their reputation and their future business. Brokers would rather spend a fraction of their marketing budget supplementing their returns than face the public relations nightmare of their money market losing money.

It is not impossible that a money market fund would lose money, but if it did, it would probably take down the company running it as well. As a result, I would expect the company running the fund to take the hit themselves and supplement the fund's return if it were at all possible. Large companies with highly visible reputations and expensive marketing budgets are the most likely to bail out a money market rather than break the buck.

Money market investments are clearly not the safest place to hide all your savings, but they are a reasonable and strategic place to allocate a portion of them in a well balanced and actively managed portfolio.

from http://www.emarotta.com/article.php?ID=264