Money market funds and risk in all the wrong places

By David Peartree The Daily Record Newswire Money market funds are not cash and they are not risk-free. The notion that you could lose money in a money market fund is foreign to many investors. The risks of money market funds are underappreciated. The current threat comes in the form of exposure to European banks and debt. For years, investors have used money market funds to fill much of the "cash" portion of their investment allocation. In more stable times, money market funds were a competitive alternative to CDs and bank deposits. They seemed to offer most of what investors wanted out of cash -- stability, safety, and easy access -- but at better yields. Other factors also contributed to growing impression that money market funds were no different than cash. Many brokerage firms and custodians have allowed investors to write checks against their money market accounts. Perhaps most importantly, money market funds have traditionally maintained a $1 per share value. The SEC allows money market funds to publish a stable $1 per share value, even if that does not exactly match the true value of the underlying investments, so long as the fund meets certain requirements addressing credit quality, diversification, liquidity and maturity limits. Publishing a stable share value creates the impression that the underlying assets do not fluctuate in value. But they do. Sometimes the published $1 per share value is fact, and sometimes it's fiction. When packaged with all of those attributes -- stable value, perceived safety, liquidity, and, until the last few years, decent yields, investors can hardly be blamed for viewing money market funds as a safe cash-equivalent. Money market funds, however, are not cash and they are not risk free. They are actually mutual funds that invest in very short term, high quality bonds and other debt issued by governments and corporations. The risk may be slight by comparison with stocks and even most bonds, but the risk cannot be dismissed. Primary risks include plain old investment risk, the risk that the investments drop in value, and liquidity risk, the risk of not being able to cash out if there is a rush of redemptions. Also, unlike bank deposits, they are not FDIC insured or guaranteed. Under enormous financial stresses during 2008, many money market funds struggled to keep their $1 per share value, but only one fund, Reserve Primary Fund, "broke the buck." A fund breaks the buck when its market value falls below $1 per share. Because the Reserve Primary Fund had exposure to Lehman Brothers, the collapse of Lehman caused the Reserve Primary Fund to break-the-buck and was one of the immediate causes of the ensuing market turmoil in the fall of 2008. The Reserve Primary Fund was only the second such fund in 40 years to break-the-buck. It may be rare, but the impact when it does happen can be dramatic. After the Reserve Primary Fund broke the buck, close to $400 million flowed out of money market funds in a matter of days. The federal government was concerned enough about the systemic impact of this that it felt compelled to guarantee certain money market funds, if only temporarily. After all, much of the short term financing for corporations and even governments comes from the money markets. Those guarantees lasted from September 2009 through September 2010. Congress applied enormous political pressure on the Obama administration to ensure that the guarantees were temporary. Interestingly, the direct impact on investors at the end of the day was limited. Investors in the Reserve Primary Fund were reported to have collected $.99 on the dollar. Financial reforms post-2008 included requirements that money market funds hold more cash, higher quality debt, and even shorter maturities. These reforms all mean lower potential yields. With interest rates already at virtual zero because of the Federal Reserve, many funds have found it impossible to make money, and many have been forced to waive their fees, consolidate, or close. According to the Investment Company Institute, the number of funds fell from 805 at the end of 2007 to 652 at the end of 2010, a drop of 19 percent. In 2007 many money market funds offered average 7-day yields close to 5 percent. Current yields are closer to 0.01 percent, a rounding error away from zero. Many funds have reached for higher yield by picking up exposure to European banks. These, in turn, have exposure to European sovereign debt, and therein is the concern. The point is not whether money market funds present a high level of risk. The point is that at current yields, investors are not being compensated for any risk. After all, the objective of money market funds is to realize a decent yield with a high degree of safety. If the yield is not there, all the emphasis should be on safety. Published: Tue, Dec 20, 2011