Even 'safe' funds play with fire

NEW YORK (Fortune) -- A large Bank of America money market fund has over $600 million of exposure to Cheyne Finance, the structured investment vehicle (SIV) that recently defaulted on its obligations.

As of Oct. 12, Bank of America's $67-billion Columbia Cash Reserves fund had approximately $640 million - or just under 1% of its assets - invested in Cheyne, according to Jon Goldstein, a Bank of America spokesman. "Up until now, Cheyne has been paying its maturities as they come due," Goldstein said. He added that Deloitte, the firm acting as receiver for Cheyne, said this week that it was pleased with the progress of efforts to refinance and shore up the troubled SIV.

It's but the latest blow to SIVs - large, lightly-regulated debt funds that have run into a liquidity squeeze as investors have balked at buying the securities that SIVs issue to fund themselves. Experts estimate that some $400 billion is tied up in SIVs. Banks like Citigroup (Charts, Fortune 500) have set up SIVs themselves and have been allowed to keep them off their balance sheets - an omission which causes problems for investors and regulators because they can't easily gauge the banks' true exposure to SIVs.

Banks and other financial firms are also exposed to the SIVs because they have bought securities issued by the SIVs. Along with banks like Bank of America (Charts, Fortune 500) and JP Morgan Chase, the U.S. Treasury is trying to organize support for the SIVs, because they fear that, without such help, the SIVs may have to sell off their assets to raise funds, which could drive markets lower. Friday's steep dive in stock prices reflects, in part, fears that credit markets will deteriorate still further.

Thus far, the SIV crisis has been almost exclusively contained among big institutional investors; the impact of SIVs on money market funds could be a development that brings the SIV problems into the lives of retail investors. As of Oct. 12, Bank of America's Columbia Cash Reserve fund appeared to hold securities issued by at least five other SIVs, according to a list of holdings published on the fund's website. Asscher Finance, Axon Financial Funding, Cullinan Finance, Five Finance, Sedna Finance and Whistlejacket Capital all appear on the fund's list of holdings, and all appear on lists of SIVs published by rating agencies.

Because the public sees money market funds as very conservative investments, banks will almost always step in to support them and ensure that investors in them don't take a loss on their original investment in the fund. Bank of America's Goldstein says that investors in the Columbia Cash Reserves fund have not suffered such a loss. He adds that the vast majority of the SIV securities held in Bank of America money market funds have high credit ratings.

Money market funds like Columbia Cash Reserves typically take investors' money and invest in short-term notes and bonds that carry very high credit ratings. However, in a bid to increase returns, some money market funds may have invested in debt securities that were not as safe as they looked, like the SIV securities.

Other financial institutions have had to deal with the negative impact of SIVs on their money market funds. On Friday, Wachovia (Charts, Fortune 500) said it booked a $40 million loss related to the purchase of "certain asset-backed commercial paper" from money market funds run by its Evergreen asset management arm. (One of the things SIVs issue is asset-backed commercial paper, which is basically short-term debt that is collateralized with assets, although those assets may just be other types of debt.) It appears that the banking arm of Wachovia took that writeoff to make sure that its money market funds didn't have to take a loss. "Evergreen has reduced and eliminated exposure to asset-backed commercial paper," says Laura Fay of Evergreen.

JP Morgan Chase also manages large money market funds. Just under 5% of the assets held by its $103 billion Prime Money Market fund are securities issued by SIVs. JP Morgan Chase (Charts, Fortune 500) declined to comment.

As of Sept. 30, Fidelity's $305 billion of money market funds had 2.3% of their holdings - or about $7 billion - in SIV debt securities, according to company spokesman Alexi Maravel. The SIVs in question are Asscher Finance, Beta Finance, Centauri Corp., Dorada Finance, Cullinan Finance, K2 Finance, Links Finance and Nightingale Finance. Fidelity's Maravel says: "We can state unequivocally that Fidelity's money market funds continue to provide safety and security for our clients' cash investments. We continue to invest in money market securities of the highest quality, and our clients continue to have full access to their holdings to invest as they wish."

Maravel adds that ensuring that investors never take a loss on their original investment in a money market fund "always has been our top objective when it comes to managing money market funds." And certainly that is what most money market customers believe is the case - but then few are likely to have known that some of their funds ended up in SIVs.