updated 9/17/2008 5:36:06 PM ET 2008-09-17T21:36:06

A soured investment in Lehman Brothers Holdings Inc. debt slashed two-thirds of the asset value of the oldest U.S. money-market fund, exposing clients to losses despite their investments in a financial product normally seen as a safe haven even in volatile markets.

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The sudden setback at the Reserve Primary Fund caused it to "break the buck" — leaving investors unlikely to get back all the cash they put in because the fund failed to maintain assets of at least $1 for every dollar invested.

It was only the second such instance in the nearly four decades-long history of money funds, which started in 1970 when the Primary Fund ushered in a popular way to invest while keeping money readily available if needed.

The fund's troubles are expected to heighten anxieties of investors seeing fewer safe places to sock away cash. This includes money-market funds that have collectively grown to $3.5 trillion in assets because of their conservative reputation compared with riskier investments such as stocks.

"The Primary Fund was really the pioneer in the industry, so this is not only a big problem for that firm, but for investors," said Lawrence Jones, a mutual fund analyst at research firm Morningstar Inc.

After the Primary Fund's manager, Reserve Management Co., announced Tuesday night it was breaking the buck, several money fund firms issued statements Wednesday trying to reassure investors. One of the biggest, Vanguard Group Inc., posted a statement on its Web site saying it "continues to manage its money market funds very conservatively and with extreme prudence, focusing on the highest-quality short-term money market instruments."

The Investment Company Institute, an industry organization, called the Reserve case "extremely rare," and said the "fundamental structure of money market funds remains sound."

New York-based Reserve said the value of $785 million in unsecured debt issued by Lehman and held by the Primary Fund were written down to zero on Tuesday — a consequence of Lehman's collapse and bankruptcy after the federal government failed to bail out the investment bank. The Primary Fund had $23 billion in assets on Tuesday afternoon, down from $65 billion Aug. 31, fund spokeswoman Ming Lee Hatch said.

Reserve said that decline reduced the value of the fund's holdings to 97 cents for each $1 put in by investors, and investor redemptions to remove money will be delayed seven days.

In the first instance of a fund breaking the buck in 1994, investors in the Community Bankers Mutual Fund ultimately lost about 4 cents on the dollar. That fund differed from the Primary Fund case because it was for a group of bankers, not retail investors.

In most instances in which a fund is in danger of breaking the buck, the fund's parent firm supplies cash from its own holdings or finds money elsewhere on the open market to maintain an adequate fund balance, said Peter Crane, president of Crane Data, publisher of the money-market fund newsletter, Money Fund Intelligence.

"Most funds would take action long before the $1 net asset value was jeopardized," Crane said.

But Reserve "is really an anomaly, because they are one of the few advisers that is privately held, and doesn't have a large financial institution as a parent," Crane said.

Morningstar's Jones said recent market volatility and Primary Fund's troubles demonstrate the importance for investors choosing a money-market fund to look beyond the yield that a fund promotes in its advertisements.

A small fund firm that relies heavily on one type of investment product or service rather than several may be more likely to run into trouble propping up a fund than a large firm with diversified operations, Jones said.

"You will want an institution that isn't going to have the kind of culture where they are going to stretch for yield when it's difficult to come by," Jones said.

Lance Pan, research director at Capital Advisors Group, a Newton, Massachusetts-based adviser to institutional clients, said the 10 largest U.S. money-market fund families combined hold about 75 percent of all money fund assets, and most of those 10 are diversified.

But Pan also said because money funds often invest in companies in the recently hard-hit financial sector via short-term corporate debt, the safety of some money funds is in question.

"With financial firms in distress, that calls into question how the money-market funds can protect their holdings," Pan said.

Money-market funds are restricted by federal regulation to make conservative investments in low-risk securities, although they lack the federal deposit insurance that other safe investments such as bank deposits offer. The Primary Fund's Lehman investment likely didn't run afoul of investment regulations, since Lehman's debt continued to remain at an investment-grade level shortly before its collapse, Pan said.

Copyright 2008 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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