Debunking money market fears

Recent reports say money market funds are now getting hit by the subprime mortgage meltdown. Don't panic, says Money Magazine's Walter Updegrave.

By Walter Updegrave, Money Magazine senior editor

NEW YORK (Money) -- Question: With all the woes in the subprime market and considering the reports that some money market funds hold money in securities that include subprime debt, should I be worried that my money market fund may "break the buck"? - Keith Lobel, Columbia, S.C.

Answer: The news wires have certainly been abuzz lately with reports of securities linked to subprime mortgages turning up in money market funds. And reading some of these reports can scare the bejeezus out of you, as many have a "the sky is falling" tone to them.

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Indeed, some of the coverage conjures up images of "The Blob," the 1958 sci-fi flick that featured that jelly-like mass that kept growing and growing, devouring everything in its path.

I don't want to dismiss concerns about the security of money market funds. Given the level of fear in the credit markets these days, it makes sense to be cautious. But you don't want to be paranoid. So to answer your question of how worried you should be, let's first step back and try to gain a little perspective.

To begin with, you should know there has been some misinformation floating around about this issue. Two weeks ago, a number of financial news outlets reported that an Illinois money manager told clients it wouldn't satisfy redemption requests for the $1.5 billion it manages in money funds.

The reports also referred to money market funds investing in subprime-related investments. But the account in question is a cash management account for commodity traders. It's not a true money market fund.

Prior to that report, two AXA funds that had been swept up in the turmoil of the subprime market were also referred to as money market funds, although they too were not true money market funds. So you've got to be careful when reading press reports about problems in money funds.

It's also important to understand a bit about just what it means when someone says a money fund owns subprime mortgages or has subprime exposure. Money market funds don't directly own subprime mortgages, period.

Rather, money funds invest in a variety of short-term debt instruments, ranging from CDs and other bank deposits to government securities to commercial paper, which is usually a very short-term IOU issued by a company.

There is also a type of commercial paper, known as ABCP or "asset backed commercial paper," that is backed by a pool of assets. In some cases, that pool of assets is a mix of debt obligations, such as credit-card debt, car loans, regular mortgages and subprime mortgages.

So when you hear about a money fund holding subprime mortgages, it's usually because the fund holds commercial paper that is backed by a pool of assets that includes subprime mortgages, although there are other ways for a fund to have subprime exposure.

In any case, money funds can't just buy any old type of investment. The Securities and Exchange Commission has strict quality standards that apply to all the investments a money fund might own, including commercial paper.

For example, SEC rules require that money funds keep at least 95 percent of their assets in securities that get the highest rating from ratings companies like Standard & Poor's and Moody's. No more than 5 percent of those top-rated securities can come from the same issuer.

Money funds are also allowed to invest up to 5 percent of their assets in securities with the second-highest rating. But in that case, the fund can't put more than 1 percent of assets in the securities of any one issuer.

These standards make it extremely unlikely that a money fund would suffer an actual loss. That said, I don't want to suggest that money funds are 100 percent bulletproof.

Issuers of highly rated commercial paper typically have bank lines of credit to fall back on if they can no longer sell new commercial paper to pay off the outstanding issues. But the credit markets are in such a tizzy today that it's not totally outside the realm of possibility that an issuer could have trouble paying off its paper.

But even in the unlikely event that a money fund owned commercial paper in default - or an issue that dropped in value because of the threat of a potential default - that doesn't mean the fund would automatically break the buck. Since money funds diversify among a broad number of investments, the amount of commercial paper from any one issuer is likely to be only a small percentage of the portfolio.

So you would need a substantial decline in the value of the commercial paper, plus that paper would have to represent a large enough percentage of the money fund's assets so that the combination was enough to pull the fund's share value below $1. Not impossible, but, again, not very likely.

Even then, I think it's probable (though by no means guaranteed) that the fund company running the money fund would step in and buy the suspect investment to prevent the fund from breaking the buck.

The reason isn't so much benevolence. Rather, the damage to a fund company's reputation would be so huge if its money fund broke the buck, that reputable companies would prefer to take the hit themselves and protect shareholders.

And, in fact, that has happened the handful of other times over the last 20 or so years when, like today, problems in the short-term debt markets have raised the specter of money fund losses. The tiny number of fund companies involved in episodes where a money fund's holdings have become problematic have stepped up to take the hit.

With one exception. A small fund that catered to institutional investors was liquidated for 94 cents on the dollar in 1994. (The investors later got another two cents, giving them 96 cents per share.) But never, to my knowledge at least, has an individual investor lost a cent in a money market fund.

Again that's no guarantee for the future. If conditions in the credit markets deteriorate to Armageddon-like conditions, I suppose anything could happen. (Although, for what it's worth, my assessment is that Fed chairman Big Ben Bernanke, while understandably reluctant to take precipitous action, will do what it takes to prevent any sort of all-out meltdown in the financial markets.)

But when you consider the diversity of investments, the quality standards and the strong incentive for fund companies not to break the buck, I think it's very, very unlikely that individuals would lose money in money market funds today. And. if despite the very long odds it did happen, I think we would be talking about pennies on the dollar.

So given this sort of outlook, what can money fund investors do?

Well, at this point, I don't think you need to do much, if anything.

If you're worried, you can always call your fund company and just ask them point blank whether the money fund you're in has any exposure to subprime mortgages and, if so, how and how much? If you don't like the answer, you can always get out. After all, since money fund shares don't appreciate, selling isn't a taxable event.

Another strategy is to stick to funds run by large well-known companies. Such funds may still have subprime exposure, but large companies with deep pockets and big brand names to protect are the ones most likely to take the hit for their investors and the ones with the most wherewithal to do so.

You could also move to a money market fund that invests exclusively in U.S. Treasurys. Of course, so many nervous investors have already been fleeing to the shelter of Treasury bills that they've bid up the price and pushed down the yields of T-bills so that they've lately trailed the yields on other short-term debt securities by 1-1/2 percentage to 2 percentage points. So you'll be paying for the extra safety in the form of a smaller payout.

If you're concerned enough that you would like to monitor ongoing developments in this area, you can check the daily money market news roundup at Crane Data, a site that collects information and tracks yields on money market funds. (I'll warn you in advance, though, that a lot of what you'll read is jargon-laced "inside baseball" talk geared more toward people who follow money funds for a living than individual investors.)

As with most things in life, there are no guarantees. And I wouldn't be surprised if at some point in the near future we see a few incidents of money funds having to get rid of short-term debt holdings that are experiencing problems.

But I think the possibility of a money fund breaking the buck is extremely low and the chances of money fund investors taking a loss are even lower. So I think the last thing you want to do is panic, or for that matter even spend your time obsessing about this. At least I know I won't. Top of page

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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.