Liquid or Solid?

For three decades, money market funds have been a popular way to invest and save for the future. If you’re brand new to investing, you need to know a few basics about how these funds operate before you become a shareholder. That’s especially true in today’s uncertain economic climate, because the risk of an investment in money market funds has increased. (We’ll explain why in a few minutes, but first provide some background.)

Money market funds operate like mutual funds, but instead of investing your money in corporate stocks and bonds they invest in the money markets. Let’s first make a clear distinction between the terms “money market” and “money market funds” since we’ll refer to both in this article.

• The money market can best be described as the market where financial institutions trade short-term, low-risk financial instruments such as commercial paper, U.S. Treasury bills and certificates of deposit. Banks and other lending institutions, insurance companies, corporate treasurers and fund managers use the money market for short-term and long-term borrowing and lending. In the money market, prices fluctuate slightly from day to day.

• Money market funds pool investors’ money and trade the same short-term, low-risk instruments. In essence, fund managers bet that they can buy low, sell high—and return a profit to the investors over a period of time.

Both Liquid and Solid

Money market funds have gained a reputation for being both liquid and solid. They’re liquid because you’re allowed to withdraw your money anytime you like without penalty, and most offer check-writing privileges with a minimum amount per check required.

The funds are considered solid because, unlike stocks and other securities, share prices are fixed at one dollar so shareholders won't lose money from daily fluctuations in the value of the funds' holdings. Interest on the balance of the accounts is calculated daily and paid out at the end of each month. Shareholders get slightly better returns than standard savings accounts, Treasury Bills, or certificates of deposits.

Money market funds have long been considered a secure place to park your money. In fact there is so little risk associated with money market funds relative to other funds, that investors have viewed them as risk-free.

But if that were true, then why does the word “risk” even appear in the title of this article? Here’s why: in the midst of a downward spiraling economy, analysts are concerned that a few cracks might be starting to appear in the previously invulnerable foundation of the money market fund industry.

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Is it Safe?

How Safe is Your Money?

Money market fund managers naturally have to make a profit for themselves and their companies. They do this by investing your money in a variety of instruments that, while yielding conservative returns, still see a higher return than they pay back to their shareholders. These investments include the rather vanilla and relatively safe choices we’ve already mentioned that are available in the money markets— U.S. Treasury bills, certificates of deposit and so forth.

But the value used for the money market rate fluctuates either up or down, meaning that the amount earned on the money market fund’s investments on a monthly basis is never fixed. This is especially true in the current volatile economic environment that is having a dramatically adverse effect on the money markets.

On September 16th, it was announced that the cost of borrowing in dollars had more than doubled overnight to the highest level since 2001. With the collapse of Lehman Brothers Holdings Inc. and credit downgrades of American International Group Inc. banks were suddenly forced to tighten up their cash.

More recently, on September 19th, the U.S. federal government stepped in to bolster the money-market mutual fund industry, to prevent a potential wave of withdrawals from anxious institutional investors. The Treasury Department will withdraw money from a $50 billion fund created during the Depression, to provide temporary guarantees for nearly 38 million money market accounts. Investors will still have access to their funds and can withdraw cash if needed, but they will only see modest returns.

The plan is similar to the FDIC insurance for U.S. bank accounts, though is only temporary and doesn't carry the same $100,000 limit on reimbursements.

Exotic choices – MBS and SIVs

One reason for this unprecedented move by the government is the fact that in recent years some money market fund managers have been venturing off the beaten path and making more exotic choices with your money, such as investing in mortgage-backed securities (MBS) or loaning to structured investment vehicles (SIVs).

The problem with MBS is the direct link to the sub-prime mortgage-lending crisis. Basically, mortgages are bundled and sold off as investments and the cash flows are backed by the principal and interest payments from the loans. But with the spike in mortgage defaults, there are legitimate concerns about the quality of such debt.

To understand the ramifications of loaning to SIVs, here is a brief overview:
An SIV is a third party entity set up by banks and lending institutions as a way to move debt off their own balance sheets. The SIV makes a profit by issuing short-term securities with low interest rates and then using the proceeds from the sales to buy long-term securities with higher interest rates. SIVs operate on a non-stop revolving wheel of buying new assets as the old ones mature.

What does that mean? Let’s say you convinced ten of your neighbors to loan you one hundred dollars each for six months and each neighbor agreed to only charge you five percent interest. You then immediately loan the combined one thousand dollars to somebody else willing to pay you double or triple the interest rate after one year. The ten neighbors expect to be paid with interest in six months, so you have to keep this borrowing and lending cycle going to be sure you have enough to pay off the previous loans. (This example is oversimplified, but you get the picture.)

When you consider that SIVs range between $1 billion and $30 billion in assets, you can see huge sums of money are in play. And when you consider that SIVs invest in a wide range of asset-backed securities, you can begin to sense how much risk is involved. To add yet another layer of risk, the SIV manager is not obligated to disclose what investments are being purchased and sold.

The big worry now, and what has caused the government to step in to shore up the $3 trillion money market fund industry, is what would happen if the SIVs can’t repay their debts to the money market funds because the SIV’s assets lost value.

Be Proactive

Does this mean you should avoid money market funds altogether, or immediately pull your money out if you’ve already invested? Of course not.

What we are saying is: Be proactive. If you’re about to invest in a money market fund or if you’re already a shareholder, request and read the prospectus, call its investor relations hotline, and find out exactly what kind of investments are in its portfolio. Unlike SIV managers, money market fund managers are obligated to be transparent and forthcoming about how they invest your money.

© 2008 Jose D. Roncal