Your Money : Money Funds Face New Woes Over Derivatives
The problems apparently are not yet over for money market mutual funds that invested in so-called derivative securities, and at least one affected fund may be searching among its peers for a bailout.
Sources at the Investment Company Institute, the Washington-based trade group for mutual funds, say that several money funds have contacted the ICI since July 1 “asking for advice on how to handle their problems” related to derivatives.
In addition, one money fund “asked for suggestions on others that might be interested in acquiring it,” an ICI official said.
The likelihood of a new round of losses in supposedly “safe” money market funds may come as a shock to the public, industry observers worry. A handful of money funds announced derivative-related problems in June, but the sponsors of those funds were large enough to quickly cover the losses without hurting shareholders.
The industry’s great fear is that a money fund will be forced to mark down its per-share value from the standard $1 level, because of an unexpected decline in the underlying value of the fund’s securities.
That could set off a nationwide chain reaction among money-fund shareholders, who might begin to doubt the security of their investment. Money fund assets now total $595 billion, and the ICI estimates that Americans have more than 21 million money-fund accounts.
Traditionally, money funds have invested only in extremely safe, short-term, debt instruments of the U.S. government, major banks or large corporations. Because most of the securities mature within a period of months, they fluctuate little in value--which allows the money funds to maintain a stable asset value of $1 a share under normal circumstances.
That share-price stability, as opposed to the fluctuating share prices of stock and bond funds, has been a hallmark of money funds since they were introduced in the mid-1970s. Yet in effect, money funds’ stability has created a perception problem for the industry: Most shareholders believe they can’t lose in a money fund, even though the funds don’t guarantee that.
Now, the emergence of derivative securities as investments has changed the risk equation for some money funds and for mutual funds in general.
Derivatives are securities whose value or returns often are tied to, or derived from, financial market trends rather than the fortunes of the particular issuer. In 1993, as conventional money-market security yields hovered at 30-year lows, Wall Street brokerages dangled a number of money-market derivatives before money fund managers, usually offering above-average yields.
The catch on most of the derivatives was that their value would plummet if market interest rates began to move up sharply again. Because few money managers expected a surge in rates this year, derivatives in 1993 and early this year appeared to offer a reasonable bet to some money-fund managers who were trying to juice-up their dismally low yields.
Since the Federal Reserve Board began to push market rates higher in February, however, the result has been havoc in the bond market, and particularly in the market for derivatives.
In the spring, a long line of companies, and a handful of bond mutual funds, announced that they had suffered major losses on derivative bets that went awry as interest rates jumped.
Few money market funds, in contrast, publicly admitted to derivative losses in the spring, though a number of funds are believed to have quietly covered small losses without fanfare. The worst disaster was at two of BankAmerica Corp.’s Pacific Horizon money funds. BofA was forced to infuse a total of $68 million to make up for derivative losses that otherwise might have caused the funds’ share prices to fall below the $1 level.
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Now, however, more money funds are expected to announce that they must realize losses on their portfolios because of derivative securities held since winter or spring. Though the number of funds with derivative-related problems is believed to be small, any publicity generated nonetheless could affect all money funds.
“In the fund industry, everyone suffers from the failures of the few,” notes Don Phillips, a principal at fund-tracker Morningstar Inc. in Chicago.
The new round of derivative-security loss disclosures may result directly from a warning issued by the Securities and Exchange Commission to money funds on June 30. The SEC told the funds to get rid of derivatives that don’t fit the parameters the agency has previously laid out for “safe” money fund investments.
Though the SEC wants the funds to divest those securities in an “orderly” manner, there may be no alternative for some of the funds but to take a loss by selling the derivatives, some analysts say.
And that is raising the question of whether the sponsors of the newly troubled funds are willing or able to cover the losses, as BofA did--or whether these funds will force shareholders to accept the loss by devaluing their share price from $1 to 99 cents or less.
That the ICI admits at least one money fund is actively seeking an acquirer suggests that the sponsor of that fund may not have the resources to cover its losses by itself.
Thus, the ICI may face a crisis it has long feared: Whether to let a money fund “break” the $1-a-share level, or whether to organize an industry-wide bailout of the fund.
An ICI spokesman said Thursday that discussion of an ICI-organized bailout of troubled money funds “is not underway.” He also said that the group has no formal policy on the bailout question.
The issue poses a true dilemma for the industry. Forcing shareholders of one fund to eat a loss could cause a ripple effect, fueling unwarranted concerns about other money funds’ stability.
On the other hand, with the full extent of derivative problems in money funds and other mutual funds still unclear, an industry bailout of one fund would set a dangerous precedent. As one industry executive put it, “We don’t know how many other beggars are at the door.”
Fund Flows Stay Down: In other mutual fund news, the ICI reported Thursday that investor demand for stock and bond funds remained relatively depressed in June, reflecting jitters about the markets’ next moves.
Net new cash flow--a measure of the net amount of money entering the funds, after accounting for redemptions and exchanges among funds--was a negative $1.7 billion for bond funds, and a positive $7.7 billion for stock funds.
In July, many fund companies say stock fund inflows improved somewhat--especially for international funds--while bond funds continued to experience outflows, though at a modest pace.
Fund Cash Flows
Investors are still pulling money out of bond mutual funds, on balance, but stock funds are continuing to attract new money, though at a slower pace. Net, new cash flow into stock and bond funds, monthly in 1994, in billions of dollars:
STOCK FUNDS, June, 1994: $7.7
BOND FUNDS, June, 1994: -$1.7
Source: Investment Company Institute.
