Can Money Market Funds Fail?

November 27, 2007

Got money? Then there's a good chance some of it's in money market funds. Investors now own over $3 trillion in these buck-per-share mutual funds that offer the liquidity of cash, the yield of Treasury bills, and the safety of …. well, that’s the part that's now in question.

Money market funds have only been around for about three decades, making them the young'ns of a mutual fund business that's existed in one form or another since before the Great Depression. Whenever we suffer a credit crisis of some sort, the same question comes up – are money market funds safe?

The number of articles written about the money fund industry's current troubles has been climbing in lockstep with the number of financial institutions taking multi-billion dollar write-offs related to mortgage “investments” (and we use the term loosely).

In last week’s Wall Street Journal, for example:

The risk to money-market funds is that a decline in the value of a single investment can cause them to "break the buck," or allow their net asset value to fall below the $1 level the funds are required to maintain.

FAF Advisors [a unit of U.S. Bancorp] is the latest in a string of about a half-dozen financial institutions that have taken steps to protect their money-market funds. The others include Bank of America Corp.'s Columbia Management Group, Credit Suisse Group's Credit Suisse Asset Management and Wachovia Corp.'s Evergreen Investments. No money-market fund has broken the buck in the recent turmoil.”

Like a top-40 radio station, the (mortgage) hits just keep on coming. This latest evolution of the mortgage disaster is now placing even the safest category of mutual funds in jeopardy. But just how risky are these funds?

Money market funds are certainly not risk-free investments. They're not FDIC insured or backed by the good faith and credit of the U.S. government (although their portfolio holdings may be). According to Vanguard’s website, “Although a money market mutual fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.”

Money market funds are, however, the safest type of mutual fund you can buy. Strict rules governing the portfolio's makeup mean losing significant chunks of your account (over 20%) would require a crisis of epic proportions, and perhaps even a bit of fraud.

Money market funds maintain stable fund prices by owning very short-term, high-quality debt securities. With little time to maturity and high ratings, it's very unlikely that portfolio holdings could fall in price enough to go below a dollar per share (breaking the buck). We'd have to see a default (or expectation of default) by the issuer for that to occur.

This is not to say that money market funds have never dropped in value. We just rarely get to see a 1% - 10% drop in fund price, because the firms behind the funds shore up the bad investments (as they are doing now) to make good. Nobody wants their good name sullied as the proprietor of a money market fund that slipped miserably into the abyss.

Before all is said and done with this latest mortgage nightmare, we’ll probably see more money market funds shored up, more even than the fifty or so we witnessed in the 1994 derivatives debacle – when rapidly rising rates sunk some derivatives bets (and bankrupted Orange County, CA in the process). As long as fund families can afford to support the funds, there's minimal real risk to investors.

So what’s a risk-averse fund investor to do?

If you don't want to assume any risk at all, buy bank products like CDs, savings accounts, or bank-issued, FDIC insured money market accounts. One good choice is HSBC’s online savings account, which yields about the same as a typical money market fund, only with FDIC insurance. Government T-bills are also risk-free, for all practical purposes.

Only slightly riskier than bank and government products are the money market funds run by giant fund companies like Fidelity, Vanguard, American Century, and American Funds. Unlike some banks, large fund companies won’t go bankrupt in the mortgage crisis (banks take on more risk than fund companies, so if bank investments go bad, those banks fail, but if fund investments go bad, it's the fund shareholders who take a bath.)

For more security, choose the safest money market funds (the ones that own mostly government-backed debt). You can identify these by reading the fund prospectus and also by the fact that their yields will be lower (for funds with similar expense ratios). In addition, higher-risk money market funds use words like “Prime” to denote corporate commercial paper (short-term corporate debt). Safer funds often include “U.S. Treasury or U.S. Government” in the fund name. Vanguard Treasury Money Market Fund now yields just 4.02%, compared to their marginally riskier Prime Money Market Fund's 4.29% yield. Be aware, however, that some banks sell ordinary mutual funds that are not FDIC insured, often with a sales load to boot.

The simple truth is this: any asset class can become risky if its investors begin selling their shares in a panic. Whenever there's a wave of panic selling, fund managers are forced to unload their holdings in order to meet liquidation requests, and without any buyers, any investment could fall to the floor. So far, investors have remained calm. In fact, they added $25 billion to money market funds just two weeks ago. No fund family could support a true meltdown. Fidelity’s largest money market fund has over $100 billion in assets. Try supporting that if the bottom falls out.