August 22, 2007

What's Going On With Money Market Funds?

The father of money funds--Bruce Bent--explains

Money market funds--something almost everyone takes for granted--are not supposed to be newsworthy. But during the first two weeks of August. Standard & Poor's put securities from four corporate issuers on its negative CreditWatch list, which can be a warning of a potential problem with an issuer, or upcoming downgrade of a particular security. These are securities that were or are part of the portfolios of some money market funds.

Is it possible that there's more risk in money market funds than we thought? How likely is it that some money fund will break the buck, and instead of standing behind the buck, will instead say to investors: Read the prospectus--the buck isn't guaranteed? Years ago on the rare occasion that a money market fund had broken the buck, sponsors have stood behind the $1.00 NAV and made investors whole.

As advisors well know, money market fund prospectuses generally say that they seek to preserve the NAV at $1.00, but that they are not FDIC insured and therefore investors could lose money by investing in the funds. But "there is no contractual guarantee," though the repercussions for investors and fund companies would certainly be enormous if investors felt that they couldn't trust the "implicit guarantee" of the buck NAV for money funds, says Bruce Bent, father of the money market fund, and founder and chairman of The Reserve, a cash management company in New York, New York. Bent's firm created the first money management fund in 1970. The Reserve now has over $70 billion in assets, with $5 billion added in the week before we talked with him, on August 17th.

Bent asserts that the whole subprime mortgage mess is misunderstood. "The total amount in the subprime market in 2006 is $800 billion," in the mortgages, says Bent. He figures that if 20% of those subprime borrowers default, that's $160 billion worth of mortgages, and if the lenders foreclose and sell the homes that collateralize those mortgages at 80% of their mortgaged amount, "now you have a 20% loss on $160 billion that winds up to [be] $32 billion," but "there is $3 trillion in money market funds, so that's a meaningless figure."

"When I created the money fund 35 years ago the principles were clear: it's safety of principal, it's liquidity, it is a reasonable rate of interest," meaning, "you're not going to get rich in a money fund, you're going to get your money back and a reasonable rate of interest," Bent notes. "Your money fund is supposed to bore you into a sound night's sleep--you're not supposed to read about your money fund holding KKR paper; you're not supposed to read about your money fund holding subprime debt paper."

The issue for advisors and their clients is the money market funds that "have reached for yield, that have compromised this sleep-well attitude--it's that they have violated an implicit guarantee which is: We're not going to distract you from your business, which is taking care of clients." Advisors can see which funds may be reaching for yield by visiting the Crane Data Web site and viewing the average money fund's yield, and then checking for money funds that are "consistently high performers." Those outliers that consistently outperform the average money fund may be reaching for yield by buying lower-quality, higher-paying money market securities, according to Bent.

So how do you know what's in the money market fund that's available to your clients? Bent argues that it is very important to know, but not as easy as it would seem, to see what is in these accounts, because many firms will not tell what is currently in their money fund portfolios. Bent asserts that they may be afraid of front running. He says The Reserve puts it money portfolios on the Web once a week and will disclose what's in the portfolio "anytime."

For more on money funds from their inventor, please listen to two IA Podcasts on the podcast portion of our site.

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