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FACT: Money Market Funds Expose You To Risk

Due to many years of sunny days and good fortune, holders of money market mutual funds have had their senses dulled. Money market funds have been so dependable for the past few decades that most people consider them to be a type of “super checking account” that offers full and immediate liquidity yet still pays a decent rate of interest. Though these funds are offered through mutual fund companies and broker-dealers and sold only by prospectus, some people I’ve talked with assume their funds are somehow guaranteed against loss or even insured by the FDIC.

The fact is, money market funds are not guaranteed in any way and may carry a larger element of risk than most investors are aware of. This fact is becoming increasingly evident as systemic risks in world credit markets have increased relentlessly over the past year and a half. I began alerting clients, friends, and relatives to consider moving their investments into the safest types of money market funds (details below) more than a year ago as I watched tensions in the short-term credit markets beginning to build to what I considered “serious enough” levels to command careful monitoring.

So what are the risks? To answer this you must first get out the prospectus your broker sent you when you opened your account. You will plainly see that your fund’s OBJECTIVE is to maintain its share value at $1 but there is NO GUARANTEE that this objective can consistently be met. It will also state that you do risk a loss of principal. Since most people have primarily been focused on getting the highest yield, they typically opted to place their money in the type of fund that carried the most risk – the corporate and commercial paper money market fund. These particular markets are ground-zero for many of today’s most acute credit problems and conditions are worsening.

Money markets are places where very short term debt instruments – typically commercial paper, bank repurchase agreements, corporate notes and IOU’s, etc. – are traded back and forth between financial institutions. These are institutional markets that are accessible to the public only through professionally managed money market mutual funds. Over the past 30+ years, these funds have attracted hundreds of billions if not trillions of dollars of investment due to their long-standing reputation for ready liquidity, relative high yield and, in most cases, check-writing features.

So what bad things can happen to a money market fund investor? Several things. First, the $1 share price can drop without warning due to a default or a substantial decline in the value of the financial instruments owned by your fund. This has already occurred in several funds over the past 18 months but, until now, the funds’ managers have chosen to step in and support their share price with their firm’s own capital to avert a loss of confidence and a generalized panic that could severely damage the entire industry. Of course, there are limits to the ability of any fund manager to sustain a capital loss of this nature and investors cannot reasonably expect this type of remedy to always be there to back them up. Fund rescues are a face-saving favor, not an obligation or a duty. At some point, fund managers will be forced to tell irate investors to read their prospectuses.

When a money market fund’s share price drops below $1 (known as “breaking the buck”) your shares may only be redeemable for less than 100 cents per share. Here’s just one recent example of a fund that did this:

Reserve Primary Money Fund Falls Below $1 a Share

A second potential risk is that liquidity of an investor’s funds is available only when credit markets themselves remain liquid and trading is brisk between institutions. Due to rampant fear in today’s financial world, institutional credit markets are becoming more sluggish with some securities having no market at all. Therefore, the other risk investors face is it may begin taking longer and longer for redemptions to be transacted. Eventually, this could mean that your money market fund can no longer clear checks written on your funds in a timely manner. It is entirely possible that if credit markets get tight enough, funds may be illiquid for long periods of time. Here is a glimpse into the inner-workings of these markets:

Lending Among Banks Freezes

A logical follow-on to the above is that some people are likely to need immediate access to their money at any price. This could put further pressure on fund managers to sell into already distressed markets and drive down asset values even more, exacerbating the problems in the very markets that need both time and patience to work out their critical problems.

So what should investors do? Of course I cannot offer any advice in this blog but the best advice I’ve read is to invest your money in U.S. Treasury-only money market funds or to simply buy U.S. Treasury securities (bills, notes, bonds) directly with funds that can be tied up for longer periods. This defensive posture can be maintained for as long as it takes for credit markets to stabilize and return to normalcy. Don’t be surprised if this stabilization process takes many months or even many years. I would imagine that Treasury-only funds probably won’t experience the problems that many non-treasury funds could be facing. Treasury-only funds would be much more likely to continue offering ready-liquidity and there are no FDIC limits to be concerned about.

For firms and companies that have ongoing needs for large amounts of working capital to make payroll and to conduct business using bank checking accounts, I suggest keeping accounts at several different banks (as many as it takes) to keep account balances safely beneath the $100,000 FDIC insurance limit at any one bank. Try to select banks with stronger financial ratings. One place to find a strength rating on a bank is:

www.bankrate.com

Bear in mind that even the FDIC has limited funds available with their current level of reserves. The FDIC will need to access funds from the Federal Reserve Bank or direct from the U.S. Treasury if enough banks fail to deplete the current reserves. Insured bank deposits will almost certainly be repaid to depositors at some point but the question could become “when”. In a severe crisis, how long would it take for the FDIC to free up frozen bank assets? I write this only to underscore the importance of diversifying your larger balances between a variety of institutions, rather than winging it and feeling secure with just one or two.

In conclusion, investors must be reminded that money market mutual funds do not carry guarantees. While they have proven themselves to be dependable and safe in “normal times”, we are not experiencing normal times, we are living through a credit collapse. The current failures will ultimately cleanse the excesses that have emerged in our financial system and we will, again, live to see brighter days once the storm passes. The trick will be to keep what’s yours and not lose it to the collapse of the system. Keep your powder dry and live to play another day. Will Rogers once said “I’m not so much interested in the return ON my money as I am in the return OF my money”. Sage advice in his day as it is in ours.

Stay tuned and, by all means, don’t panic but keep your focus on safety over yield.

1 Comment on “FACT: Money Market Funds Expose You To Risk”

  1. #1 “FACT: Money Market Funds Expose You To Risk” - Updated 10-22-2008 – David Haas, Consultant
    on Oct 22nd, 2008 at 12:09 pm

    […] original posting “FACT: Money Market Funds Expose You To Risk” was made on 09-17-2008, literally days before a wave of other similar articles began to hit […]

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