Are Money Funds Safe?

In early September, the share price of the Reserve Primary Fund fell below $1 per share, the normally fixed price for all money funds. This fund actually declined 3 percent to $0.97 per share. While 3 percent is a small decline, especially compared with recent declines in the stock and real estate markets, investors in money market mutual funds have enjoyed and came to expect that the share price of their money funds would hold constant at $1 per share. Reserve lost some money on Lehman commercial paper that it owned that plunged in value when Lehman filed for bankruptcy protection.

Historically, over their 36 year history, money market funds have been extremely safe. Only one other fund broke the buck (by six percent) and that was a fund run by and invested in only by a modest number of institutional investors. Today, assets in all money funds total $3.4 trillion. Hundreds of trillions of dollars have flowed into and out of money funds over the decades without any retail investors losing principal.

Rather than keeping expenses low, some money funds take unnecessary risk going into riskier debt to boost a money fund's yields. That's one of several reasons why I recommend that when you invest in money market funds, you do so with a larger and conservatively managed investment company that keeps expenses low which is the only safe way to boost a money fund's yield. These firms don't generally stretch for a little extra yield by taking silly risks and in the highly unlikely event that they ever bought something problematic, they would surely make good on the $1 per share price.

The past two years, a couple dozen money fund owners have infused modest amounts of capital into their money funds to keep them from possibly breaking the buck when they held a security that may have had to be listed at a reduced value on the fund's books. Taking such action requires U.S. Securities & Exchange Commission (SEC) approval. Such requests are hardly new in recent years but their pace has dramatically increased in 2008 as the year has unfolded. Among fund companies having to take such action are: Allianz, HSBC Holdings, Legg Mason, Northern Trust, Ridgewood Investments, SEI Investments, TD Ameritrade, and Wells Fargo. (Interestingly, some industry insiders decline to share this information with the press because their businesses are dependent on the fund industry. Since I never have and never will do any work for companies - including lucrative speaking engagements which financial writers like Suze Orman and David Bach do partake of - in the financial services industry, I don't have such constraints!

According to law professor and industry observer Murcer Bullard, the law is unclear as to whether fund companies ever need to disclose to their shareholders that they sought relief for their money funds and were blessed to do so by the SEC.

U.S. Treasury Secretary Henry Paulson announced a new insurance plan which covers asset balances investors had in money funds on September 19th. A specific date was chosen as regulators don't want investors, especially large institutional investors, continuing to move money around trying to game the system. Some banks also complained that with insurance coverage now on money funds, bank depositors might move money from banks to the higher yielding money market funds. If banks and money funds both had insurance, why leave your money in a lower yielding bank account?

Money funds must choose to enroll in this new insurance program after the U.S. Treasury provides important details on the plan such as the cost, enrollment process, etc. There are also some important unanswered questions such as who will pay for this insurance cost - fund shareholders or fund management companies. This new insurance program is not intended as a long-term or permanent change for the money market mutual fund business. It is expected to last about one year.

Money market funds can be an excellent place to keep extra cash. They offer daily liquidity, have tax-free versions for higher tax bracket investors, and usually offer checkwriting for larger transactions (e.g. minimum of $250).

Tax-free yields, which are typically lower, are actually higher now than on taxable funds. Initially tax-free funds were excluded from the Treasury insurance program so that may have caused larger investors to withdraw more from such funds, thus depressing those securities prices which effectively raised their yield.

Money market funds don't offer FDIC insurance but FDIC coverage does not provide a 100 percent guarantee that you're going to get your money back. In addition to not covering amounts above their coverage limits of $100,000 per person, FDIC can only pay if the federal government which backs the plan, has the money to pay. Now, I'm not expecting the default of the U.S. government. But it's important to realize that there is no such thing as a completely risk-free investment.

Deciding between money funds and local bank accounts is a personal decision. If you prefer being able to conduct business in person locally and the FDIC coverage provides you with peace of mind, then that's a good reason to keep money in your local bank rather than in a money market mutual fund. My preference is to use money market funds. I like outfits like Vanguard which are conservatively run, keep fund management fees low (the only safe way to boost yield) and don't take foolish investment risks. Money funds are ultra-safe to begin with as they invest in short-term, high quality debt (issued by government agencies and the highest rated corporate commercial paper). If you like money funds but want the safety of government banking, you could invest in a Treasury only money fund which like a bank account, is backed by the federal government. But, you may find the best bank savings accounts paying the same or even a little more than a Treasury money fund.