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Credit crisis turns spotlight on money markets

Increasingly popular money market funds hold commercial paper, which was a security seriously impacted by the recent financial storm. But thanks to strict SEC rules, these investment vehicles remain relatively safe.
/ Source: contributor

"Like money in the bank" — the phrase is synonymous with safety.  But after several weeks of headlines and turmoil in the financial markets — including televised images of depositors staging an old-fashioned run on a federally insured bank — is a new saying needed or maybe a mattress with a hidden safe in its springs?

“The big financial institutions are healthy,” Treasury Secretary Henry Paulson told CNBC last week during the thick of the financial markets’ meltdown. 

And ultimately so are the bank deposits in federally insured banks, both big and small. The Federal Deposit Insurance Corp. protects depositors against losses of up to $100,000 per account in the event of a bank failure. To access more information on deposit insurance see the FDIC’s Electronic Deposit Insurance Estimator.

Though Mr. Paulson’s reassurance about the financial system was welcome, his answer, as Chris Colvin pointed out in his Daily Nightly blog, did not really address reporter Steve Leisman’s question.  What he was asked was: “Are money markets safe?”

Apparently that question also did not register with most investors. For several weeks they have been pouring money into money market funds — which are not federally insured.

Assets at money market mutual funds rose by $75.35 billion to $2.777 trillion in the week ended August 21, 2007 according to the Investment Company Institute.  This established a new record.  The previous record was set a week earlier.

Leisman’s question has been on the minds of many financial professionals.  They know that money market funds hold commercial paper, a type of security seriously impacted by the financial storm.  According to ICI, money market funds hold nearly 30 percent of all outstanding commercial paper.

“At this point, advising people to ask their brokers or call their money market funds and ask what is in the portfolio is like asking for a tour of the meat packing plant — the end product is safe, but no one needs to see how it is done,” says Peter Crane, president of Crane Data LLC,  which publishes the Money Fund Intelligence newsletter.

While money market funds are not insured, the Securities and Exchange Commission requires their portfolios be invested only in the highest two grades of securities — meaning that the commercial paper they own is ‘prime.’  It also requires the portfolios be diversified so that no one security can impact the share value. The funds can, however, own as much U.S. Treasury and government-backed securities as they want.

“They are actually hyper-diversified and hold hundreds to thousands of securities,” says Crane. 

Security losses are rarely recognized because maturities are very short-term.  The SEC requires the portfolios’ average maturity be 90 days or less. This means by the time a security crisis plays out, the underlying investment probably will have matured.

“Money market funds are typically the first to get paid off,” adds Crane, even if a security’s issuer is troubled, as was the case for WorldCom several years ago, he noted. 

The restrictions are so tight it is illegal for a mutual fund to even call itself a money market fund if it does not adhere to SEC risk-limiting rules. By law, money market funds are also required to value their assets daily to ensure a stable net asset value of $1 per share is being maintained. 

“Breaking the buck” — as in letting a fund value fall below $1 — would mean "game over" to a fund.  This is why it is pretty safe to assume portfolio managers were already shifting assets into Treasury securities at the first whiff of the recent market turmoil. They will do anything to stay above a buck — even borrow money if they have to, which is why they keep bank lines of credit on hand just in case.

In the 24 years since the SEC imposed its risk-limiting rule there have been a number of financial crises.  Banks have disappeared, security issuers have defaulted, but only one small money market fund ever "broke the buck."  According to ICI that was in 1994. The total damage to the unlucky investors: For every invested dollar, 96 cents was returned.

“The SEC watches this area, so that individuals do not have to,” says Crane.

Even though the SEC has investors’ backs, John Nersesian, managing director of wealth management services at Nuveen Investments in Chicago, says that should not excuse individuals from understanding what they own, whether it is a bank product or shares in a mutual money market fund.

“When you see higher interest rates from banks, you need to ask yourself why do they need the money that much?” says Crane.  For mutual funds, the question is: What is in the portfolio?  The next question: "Am I OK with this?"

That is not to say higher yields should be avoided.  But returns are a shortcut to understanding the level of risk being taken on.

What else should investors know about their money market funds?  ICI offers an online guide to the security class. 

And Nersesian advises them to read the reports they receive or go online to sites like and look at these five measures:

  • The long-term track record of the fund
  • The duration (maturity) of the fund
  • The average credit quality of the fund
  • The financial strength of the management firm
  • The breakdown of the holdings in the portfolio

“We live in a complex world where we need to trust that the experts we hire to do these things for us — like managing our money market funds — know what they are doing,” says Crane.

But when it comes to their most conservative, liquid holdings, individuals will still want to periodically verify that wherever they keep their deposits, they remain "like money in the bank," safe and, to paraphrase Will Rogers, will not just earn a return but be returned when needed.