The risk of 'breaking the buck'

The government will no longer guarantee money market funds, but that might not mean what you think.

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By Walter Updegrave, Money Magazine senior editor

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Walter Updegrave is a senior editor with Money Magazine and is the author of "How to Retire Rich in a Totally Changed World: Why You're Not in Kansas Anymore" (Three Rivers Press 2005)

NEW YORK (Money) -- Question: I just heard that the federal government is no longer insuring money market accounts for their $1 per share value. Is that correct? --Terry, Las Vegas, Nevada

Answer: I think some people may have misunderstood the reports they've heard about the Treasury Department's announcement last week that it was letting its temporary money market fund guarantee program expire.

The first thing you need to understand is that there are actually two types of money market vehicles that are sometimes confused with one another: money market accounts and money market funds. Even though their names are similar, however, they are actually two very different types of investments that offer very different types of protection.

Money market accounts are a type of savings account offered by banks. Typically they have limited check-writing privileges and pay higher yields than regular savings and checking accounts. Essentially, the bank sets an annual yield that can fluctuate daily depending on what the bank feels it needs to pay to attract depositors. Recently, the average yield for money market accounts was 1.15%, although if you're willing to invest $10,000 or more, many banks will boost that rate.

Since money market accounts are bank deposits, they qualify for FDIC insurance. Generally, money market and other bank deposit accounts are now covered for up to $250,000.

Money market funds, on the other hand, are not bank deposit accounts; they're a type of mutual fund. Many banks offer mutual funds, including money market funds. But even if you invest in a money market fund through your bank, it is still a mutual fund, not a bank account.

Money market mutual funds also pay yields that can fluctuate daily. But unlike the payout rate on money market accounts, which is determined by the bank, the yield on a money market mutual fund is tied to the market for short-term debt such as commercial paper, Treasury bills, certain asset-backed securities and other credit instruments. When the yield on these securities rises or falls, so too does the yield on money market funds.

Although money market funds are not covered by the FDIC, they provide security another way -- namely, by attempting to keep a stable price or net asset value of $1 per share. By law, money market funds must limit themselves to high-quality debt securities. That reduces the chances of any of their holdings defaulting. Money market funds are also required to stick to debt with very short maturities, which makes it unlikely the value of their portfolios will drop when interest rates rise.

While money market funds have never guaranteed that they would be able to maintain a stable value of $1 per share, over the years they established a very good record of doing just that. Indeed, the industry could claim that no retail investor had ever lost a dime in a money market fund -- that is, until the failure of Lehman Brothers.

After that happened, a well-known and respected money market fund that had held Lehman debt, The Reserve Primary Fund, "broke the buck." That event, not to mention all the other problems that were surfacing at the time, sent shock waves through the financial system and ultimately resulted in several investment firms having to shore up their money market funds with their own money to prevent them from slipping below the $1 share price.

Fearing the chaos that would result if skittish investors began yanking all their money out of money market funds, the Treasury Department stepped in with its guarantee program for money market funds. Originally scheduled to run for just three months from September 19, 2008, the program was subsequently amended to last for one year. Although the guarantee never actually put the Treasury on the hook for all money market fund assets, it provided enough coverage to soothe the worries of anxious money market fund investors.

It was this program that Treasury pulled the plug on, as scheduled, last Friday.

Which is right for you?

So now that the federal government is no longer acting as a backstop are money market funds still a secure place to keep your cash?

I believe the answer is yes, although you certainly need to be aware of the limits of the protection they offer.

If you look at both the long-term and more recent history of money market funds, I think it's clear that during normal economic times -- even during "normal" recessions -- money market funds have been able to provide competitive returns with an extremely high degree of safety.

It's also clear, however, that during rare episodes of extreme economic and financial stress money market funds are more vulnerable. They depend on a well-functioning market for short-term debt. But when you have the kind of near-death financial experience like we had last year, the fact is that no investment outside of FDIC-insured bank accounts and the shortest-maturity Treasury bills can guarantee total security of principal.

It appears now that the financial crisis has largely passed and we're moving toward economic recovery, which is a plus as far as the security of money market funds is concerned. What's more, the Securities and Exchange Commission has proposed new rules that would further enhance the security of money market funds. The SEC has also asked for comment on whether money market funds should allow their share prices to float with market values rather than fixing them at $1 per share. We'll have to see what changes, if any, result.

In the meantime, though, I believe money market funds are a perfectly acceptable place to keep the cash portion of your investment portfolio, the money you need for near-term living expenses and emergency funds.

For a bit extra security, you may want to opt for the money market funds of large investment firms that have the resources to provide assistance to their money funds if they run into difficulties.

And if you're really security conscious, you can always stick with money market funds that invest only in government securities or, for that matter, only short-term Treasuries. By now, it should almost go without saying that anyone truly risk averse should be skeptical of funds that tout far higher yields than competitors. Unless that advantage is the result of much lower expenses, it's usually a sign the fund is taking on above-average risk.

Safety aside, there is one reason you might prefer a money market account to a money market fund at the moment: You may be able to get an extra half a percentage point or so of extra yield. Money market accounts don't usually provide higher yields than money funds, however, and how long they will retain their current edge is anyone's guess.

Bottom Iine: I don't see the expiration of Treasury's money market fund guarantee as cause for alarm. Quite the contrary, I'd take it as a positive sign that the financial markets are getting back to normal.

If you feel differently, there's always the option of going with FDIC-backed money market accounts, CDs or other bank accounts. But if you choose that route, be sure to stay within the FDIC coverage guidelines. Otherwise, your money may not be as safe as you think. To top of page

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