How Safe is Your Money Market?

The following is provided courtesy of Marotta Asset Management:

The first U.S. money market fund was created by Bruce Bent in 1970. The Reserve Fund, as it was called, offered investors a way to preserve their cash liquidity and still earn a small rate of return. Today 22% of all mutual fund assets are invested in nearly 900 money market funds.

Money market funds are a type of mutual fund that usually sells and redeems their shares for $1. The value to the consumer is the interest earnings plus the stability of getting their principle back. Unlike other mutual funds, money market funds are restricted to investing only in the highest quality debt with average maturities less than 90 days.

While money market funds typically are very stable, it's important to note that money market funds are neither insured nor guaranteed by the Federal Deposit Insurance Corporation (FDIC) or any other government agency. Money market funds seek to keep their share price at exactly $1.00, but this is not guaranteed. It is possible to lose money by investing in these funds.

Protecting the consumer, several rules govern those who offer money market funds. They must invest at least 95% of their assets in securities that get the highest credit rating. Money market funds cannot have more than 5% of the portfolio invested in debt from the same issuer, except for the federal government debt. They can invest in Asset Backed Commercial Paper (ABCP) which is backed by a pool of assets that can include credit card debt, car loans, regular mortgages and subprime mortgages. Money market funds can invest up to 5% of their assets in securities with the second highest rating, but cannot put more than 1% with any one issuer. When an issuer's credit rating drops from the best credit rating to the second best credit rating, a money market fund will be on alert to sell the position quickly in order to satisfy SEC rules.

Some money market funds have lent money to what are called structured investment vehicles (SIV). Since they promise to pay the money back within a short period of time, SIVs can qualify as legitimate money market investment. The SIVs then take the money and invest it in high-yielding risky investments such as subprime mortgage debt. The SIVs then repay their debt by bundling and selling this mortgage debt and making their repayment deadline. They make money by collecting much more in interest and the sale of the loans than the cost of borrowing the money in the first place.

The difficulty is that it has become much more difficult for SIVs to sell their subprime mortgages. When there is a rise of foreclosures and defaults, companies devalue the bundle of mortgages which increases the likelihood of SIVs being unable to repay their loans from the money market funds. The ratings on some of this commercial paper have dropped with the increasing defaults on subprime mortgages.

Because of the rules that govern money market funds and their diversification requirements, the credit risk problems of subprime defaults are limited. A good manager should be diversified enough to weather these storms without showing losses in the money market.

Money market funds have several purposes in an investment portfolio.

They provide a liquid stable place to park free cash. They provide a place to keep money for rebalancing your portfolio in case of a market run up or a market correction. And they provide a place to collect interest and dividend payments.

Money market funds can also serve as an investment class by itself. In the decade of the 1970's with its rampant inflation, money market was the investment category with the highest returns at the end of the decade.

When interest rates are falling, longer term bonds with higher fixed interest rates will appreciate in value. But if interest rates are rising, these same long term bonds will lose the most value. In a period of rising interest rates, your money market investments will adjust quickly and simply pay a higher rate of interest.

Some money market fund investors are worried about losing their money. If a money market fund holds bad debt, the money market fund's value could drop below $1.00 and "break the buck". A money market fund has broken the buck when you go to get your money out of your account, and they return less than you put in.

So far, only one money market fund "broke the buck." They paid their investors only $0.96 per share. Although only one fund has dropped below a dollar, there have been a number of cases where the banks have bailed out their money market fund by pumping in more capital in order to show a positive return.

Any brokerage firm that showed a loss on a money market fund would ruin their reputation and their future business. Brokers would rather spend a fraction of their marketing budget supplementing their returns than face the public relations nightmare of their money market losing money.

It is not impossible that a money market fund would lose money, but if it did, it would probably take down the company running it as well. As a result, I would expect the company running the fund to take the hit themselves and supplement the fund's return if it were at all possible. Large companies with highly visible reputations and expensive marketing budgets are the most likely to bail out a money market rather than break the buck.

Money market investments are clearly not the safest place to hide all your savings, but they are a reasonable and strategic place to allocate a portion of them in a well balanced and actively managed portfolio.

Comments

[Jake]

This was much more well-reasoned than Marotta's last post about the cash being "the riskiest investment since 2002", in which it was claimed that inflation over the last 5 years was about 50% (if I recall correctly). I won't post a link because FMF discouraged that and I want to respect his wishes. But if Marotta really thinks that cash is really "the riskiest investment", then this article seems inconsistant with their broader view. For example, if cash is the riskiest investment out there, then why does the extremely minute risk of your mutual fund "breaking the buck" even matter in comparison? If investing in cash is, in their view, conceeding massive losses to inflation and currency devaluation, why is holding a money market fund so "strategic"?

An alternative view is that a money market fund really is the safest place you can put your money, besides treasury bonds and FDIC insured accounts. The odds of a Fidelity or a Legg Mason breaking the buck are almost zero, especially now that the size of the SIV and ABCP market has shrunk to a tiny fraction of what it was just 1 year ago. If they do "break the buck", customers are likely to lose only a penny or two on the dollar. For reference, that's less than the stock market went down *today alone*. Money Market Funds are the safest non-government-insured investments in the world, a fact proven by the sector's ability to weather the extreme crisis of ABCP and SIVs in 2007. If Marotta thinks that they are "clearly" not the safest investment, I would ask what they think is safer. Prehaps commodity companies (like mining companies and oil companies) are safer in Marotta's mind, despite not being safer by any measurable, historical standard. That is what they've seemed to suggest in the past.

As an advisor, Marotta Asset Management is strongly incentivized to advocate more active management of money and more complicated investment strategies than boring, predictable money market funds etc. That way, more people will be convinced that they need the help of a financial planner or a full-service broker. Prehaps they are hoping to pick up a few new customers who are suddenly very scared of their money market funds and cash accounts, and want to go into "safer" investments like gold mining stocks.

[Independent George]

Ack, I just realized my last comment looks suspiciously like spam. Just to be clear, I am not a robot - that link really is relevant!

[tracy ho]

Thanks for your article,

Tracy ho
wisdomgettingloaded

[Justeen Martin]

Purchasing a car is a dream that everyone wants to realize. But not everyone can afford to buy a car at one go. Availing a loan is not a bad idea in such a situation. But what to do if a person is having a bad credit status? Bad creditors find it difficult to apply for any loan but due to the tight competition existing in the market, lenders are now ready to advance loan to such people. Car loans for people with bad credit is also one such loan.