Managers of money funds may take the hit
Financial advisors like to say that there is no free lunch in investing. If you expect to earn above-average returns, you must be willing to take above-average risk.
But we know that isn’t true with federally insured bank deposits. Because all banks offer exactly the same insurance from Uncle Sam, there’s usually no reason to avoid the banks that pay the highest yields.
Now we’re reminded that the free lunch concept extends to money market mutual funds, which hold nearly $3 trillion in assets, including the savings of millions of Americans.
Although there’s no government guarantee on money funds, some fund management companies in recent months have demonstrated that there’s an implicit guarantee against loss on the funds, even though the companies can’t officially say as much.
Amid the global credit crunch that has riled markets since late summer, some fund management firms have asked the Securities and Exchange Commission for permission to buy certain potentially dicey debt securities from their money funds, just to get those IOUs out of the funds’ portfolios.
The SEC confirms this, but won’t identify which fund companies have made such requests or say how many have done so. The industry buzz is that the number is about a dozen.
Money funds invest in short-term IOUs of companies, banks and government units, and pass through to investors the interest earned on the securities.
The portfolios also are designed to keep their share prices steady, typically at $1 a share. Because of that feature most investors have come to view the funds as rock solid.
Which also means that the industry could face a horrific crisis of confidence if a big money fund were to face an unexpected loss on investments that would cause its share value to slip below $1, perhaps just to 98 or 99 cents. That would be “breaking the buck,” in industry parlance.
It has happened just once, in the case of a small Colorado money fund in 1994.
But the credit crunch of recent months has raised the specter of other money funds breaking the buck, if market conditions were to deteriorate drastically.
In mid-August, as panic struck the credit markets over rising defaults on U.S. home mortgages, investors began to balk at buying a type of IOU that had been popular with some money funds: asset-backed commercial paper, which is short-term debt backed by long-term assets such as mortgages.
On Wall Street, concerns were raised that even some high-quality issuers of asset-backed commercial paper might be unable to pay off the securities when they matured. That could leave money funds and other investors holding the bag.
The market’s worst fears haven’t come to pass, however -- in part because the Federal Reserve has pumped money into the financial system to try to calm the situation. The dreaded defaults on short-term IOUs haven’t occurred. But the credit markets remain unsettled, to say the least.
Some money fund managers have opted not to tempt fate. The fund firms that have gone to the SEC have sought permission for what’s known as an affiliated transaction. They want to buy certain IOUs from their funds, at full value, and take the securities onto the firms’ own books.
The risk of default, then, would be borne by the fund company, not money fund shareholders.
Some fund managers have publicly disclosed making such a move. Banking giant Wachovia Corp. said in its third-quarter earnings report that it recorded a $40-million loss on the value of certain IOUs it purchased from its Evergreen line of money market funds. The company hasn’t said whether the funds’ share prices would have been in danger of falling below $1 if the IOUs hadn’t been taken out.
In the case of other funds, shareholders may only find out they were beneficiaries of such interventions in the fine print of future fund financial reports, says Pete Crane, head of fund tracker Crane Data in Westborough, Mass.
“You might just see a footnote in a semiannual report six months from now,” he said.
Most money fund shareholders may have no problem with that. If investors have figured all along that their fund company would never allow the portfolio to break the buck, then in their eyes the industry is just doing what it’s supposed to do.
But there are conflicts here, including for the SEC.
Barry Barbash, who was head of mutual fund regulation at the agency from 1993 to 1998 and now is a partner at law firm Wilkie, Farr & Gallagher, says the SEC is “internally inconsistent” in allowing fund companies to buy iffy securities from their money funds.
Mutual funds aren’t supposed to encourage investors to believe their money is perfectly safe from loss, Barbash said. The SEC wants investors to do their homework in choosing a fund and to know what’s in the portfolio. Likewise, it wants market forces to discipline fund managers.
At the same time, “One of the principal mandates of the SEC is to protect investors,” Barbash said. If the agency knows that a fund firm’s intervention could keep a money fund from breaking the buck, “they have to decide to do what’s right for investors.”
Given the mortgage-related losses that have hammered such Wall Street titans as Merrill Lynch & Co. and Citigroup Inc., trouble in the money fund business is about the last thing the financial industry needs.
Investors obviously believe they have nothing to fear in money funds. Assets have surged this year to record levels. That has given fund managers more breathing room to wait out the credit mess, Crane said. If investors had yanked their cash, the pressure on managers to get rid of higher-risk securities could have intensified.
What if the credit crunch worsens? Most money fund investors probably can assume their cash is safe. For the fund companies, however, that implicit guarantee could get expensive in a hurry.
