Money Market Funds Safe, with Caveats

Money market funds have built their reputation on being liquid and solid, maintaining a constant value of $1 per share.

As the market roiled this past year, their assets have climbed 45 percent, to $3.5 trillion.

Still, with the credit crunch casting a shadow over many formerly considered safe securities, investors are wondering just how safe money funds really are.

Some experts say their concerns are valid.

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"There is so much less risk with money market funds relative to other funds that people view them as risk-free,” Robert Plaze, an associate director in the Securities and Exchange Commission’s division of investment management told Fortune.

"But they’re not insured by the government. Saying there’s no chance for problems is not accurate.”

That’s because many of these "safe and dependable” money funds have been exposed to risk during the credit crunch.

Money market funds typically hold a mix of short-term corporate bonds, Treasury bills, and other high-quality debt. But they recently also bought more exotic stuff, like paper issued by structured investment vehicles (SIVs).

SIVs of course have been at the heart of the recent market turmoil because of the difficulty in selling some of them.

In fact, "last August, over half of money fund managers were buying SIV-related debt, which amounted to about 5 percent of money market fund holdings,” says money fund expert Peter Crane, president and CEO of Crane Data, which tracks money market funds,

According to The Wall Street Journal, as of December 2007 funds recently holding some of those SIVs included Barclays Global Investors; UBS; Charles Schwab; Deutsche Bank; BNY Hamilton Funds, and Morgan Stanley.

The funds ranged in asset size from $2 billion to $36 billion and held about 1 percent to 2 percent of their investments in some of the SIVs.

While the percentages are small, they can theoretically still pose a risk because if even a relatively small portion of a money-market fund’s assets were to lose all of its value, a fund could technically be termed to have "broken the buck,” or violated the requirement to maintain a $1-a-share value,

So when the market for a security dries up, as it did for SIV debt, the value drops, even if the risk of default hasn’t increased, Crane explains.

In fact, Crane told Fortune that he’s seen 13 asset management companies buy securities from their portfolios or take other actions to prevent a drop in price.

Legg Mason has already set aside almost $2 billion since November to shore up three money funds against losses on debt issued by SIVs. According to Bloomberg, the company intends to raise $1 billion by selling 20 million equity units, its second cash infusion in the past six months.

According to Bloomberg, Bank of America and Janus Capital Group also bailed out funds that have invested in SIVs. Debt issued by SIVs totaled $4.5 billion, or 2.6 percent of Legg Mason’s $170.3 billion of money-market assets, at the end of market. The funds held $2.9 billion in non-bank-sponsored SIVs.

So what can investors do to protect themselves from questionable money-fund holdings?

For starters, they should make sure they’re invested in a true money market mutual fund and not a look-alike investment like a floating-rate bank loan fund or seven-day-paper fund.

Even more important, say the experts, stick with funds operated by major companies such as Fidelity, Merrill Lynch, T. Rowe Price, and Vanguard.

Companies like these are much better off absorbing a small loss to avoid breaking the buck than suffering permanent harm to their credibility, says Crane.

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