As if the wretched stock market and cratering economy weren't enough, another occupant is in our closet of anxieties these days: money market mutual funds.
Money funds are a fixture of today's financial marketplace. Individual investors use them to park cash when moving between investments. Big institutions use them to collect interest on money they may hold only overnight. Consumers put savings in to earn a little interest, in accounts that offer checking privileges, too.
But all is not well with the historically reliable money fund industry.
The collapse of the Reserve fund, the nation's oldest money fund, was just the most visible problem in a string of industry missteps. The government scrambled to reassure investors that their money funds were safe, instituting a temporary insurance program for the funds in September.
But the insurance program is to expire April 30, and regulators are trying to figure out the best way to fix the industry.
With $3.9 trillion lent to the U.S. government, major banks and giant corporations, "The money market is the financing vehicle for every financial institution out there," says Cathy Roy, chief investment officer for fixed income at the Calvert funds.
Clamping down too hard on the money fund industry could cripple a vital part of the nation's financial system. Doing nothing means the possibility of another mass exodus from a money fund, which could prolong the credit crunch and bring down other companies.
"What is key now is to make sure that funds aren't reaching for yield — which is what got them into this mess in the first place," Roy says.
Breaking the buck
The $60 billion Reserve fund shocked the financial world when it announced that its share price would fall below $1 — "breaking the buck," in money fund parlance. The fund had invested in short-term IOUs issued by Lehman Bros., which collapsed at the same time.
Breaking the buck is the cardinal sin in the money market industry. Money funds try to keep their share prices at $1 every day, so investors don't have to worry about day-to-day price fluctuations and can treat their investment much like an interest-bearing checking account.
Before Reserve, only one tiny institutional fund had broken the buck, in 1994. And, because the Reserve was run by Bruce Bent, the inventor of the money fund and a critic of the risks other money funds took, the shock was even worse.
In reality, investors shouldn't have been shocked.
Since the credit crisis began in 2007, more than two dozen companies that manage money market funds have had to step in and buy up their money funds' bad investments. Among the companies that have shored up their funds: Dreyfus, Columbia, Northern Trust, HSBC, Legg Mason, Wells Fargo, SEI, Allianz Dresdner, Bank of America and Evergreen.
"The fact that there have been deep pockets has substantially helped keep problems from trickling down to shareholders," says Doug Scheidt, associate director for the Securities and Exchange Commission's Division of Investment Management.
Funds rarely trumpet such moves, with reason. Money funds aren't bank accounts. They're mutual funds that pool investors' money and buy money market securities, short-term IOUs that mature in a year or less, although many come due in one day. By law, funds must buy only top-rated money market securities; their average dollar-weighted holding must mature in 90 days or less. Funds distribute interest to shareholders, minus expenses.
Money funds aren't just an investment vehicle, either. They're almost as important as commercial banks and investment banks.
The money market is a sprawling network of short-term borrowers and lenders: banks, corporations and the U.S. government. Banks use the money market to invest surplus funds or to borrow for short-term shortfalls.
Companies borrow in the money market to smooth cash flow: Funds own about 40% of commercial paper outstanding, says Connie Bugbee, editor of iMoneyNet Money Fund Report, a newsletter. And the government continually borrows money in the money market to finance its debt.
When the money market freezes, as it did last year, it can be fatal for companies, such as investment banks, that rely on a continual flow of short-term funds. And if the public loses faith in money funds, the money market could lose a major source of funds. "I feel less confident in money market mutual funds," says investor Tim Zuraff of Concord, N.C. "In fact, I believe there have to be some serious questions about the integrity of the financial system and its regulators, given the recent history."
Because the funds invest in high-quality, liquid securities, they typically have no problem meeting redemption requests. But the funds have several vulnerable points, which regulators are trying to figure out how to fix:
•Bad investments. The law requires money funds to invest in securities issued by the most creditworthy borrowers, those rated in the two highest categories by credit-rating companies, such as Standard & Poor's and Moody's Investors Service.
But top-rated companies can plunge quickly to the bottom, as funds found out when Lehman Bros. collapsed. If a fund has a significant position in those securities, its share price could fall below $1, meaning shareholders could lose money unless fund management steps in and buys those securities from the fund's portfolio.
Although big fund companies do step in, the Reserve didn't have enough cash. A big worry: Other smaller, independent money market funds might not have the cash to rescue their funds.
•Low liquidity. Normally, an investment that matures in a year will yield more than one that matures tomorrow. Current law requires only that a fund's average holding matures in 90 days or less. In the case of the Reserve, a few holdings matured in 13 months, meaning that investors may have to wait that long to get all their money back.
The law requires only that a money fund give you your money in seven days from the time you ask for it. But some funds — again, like Reserve — promise to give you your money the same day you ask for it. If only 2% of the fund's assets mature on that day, however, a big wave of redemptions could force the fund to sell some securities at a loss. And that, in turn, means they could break the buck.
•Low rates. Like all mutual funds, money funds take a percentage of the fund's assets to pay expenses: salaries, rent, printing and transaction costs. Currently, however, a three-month Treasury bill yields 0.2%. Few companies can turn a profit by charging just 0.2%. For some funds, low rates led to bad behavior. "As rates fell, money funds took on more and more risk," says Calvert's Roy.
The average money fund now yields just 0.29%, according to iMoneyNet, which tracks the funds. Funds that invest just in Treasury securities yield an average 0.05%, and many yield 0%. As a result, some fund companies, such as Vanguard, are closing off their Treasury funds to new investment.
One thing's sure: The money fund of tomorrow will be different from the one of today.
The Group of Thirty, an influential international body of financial leaders, released a report spearheaded by Paul Volcker, a former chairman of the Federal Reserve Board. Under the Group of Thirty's proposal, money funds that guarantee a constant $1 price per share would become a special type of bank, with federal deposit insurance and additional regulations. Like banks, money funds would have to pay for deposit insurance, lowering yields.
The Investment Company Institute, the funds' trade group, opposes the Group of Thirty plan. And some fund managers wonder if the Group of Thirty's plan is a way to drive investors from money funds to banks, which need deposits as sources of relatively stable capital. The ICI's own report and recommendations are due at the end of March.
Fed Chairman Benjamin Bernanke, in a speech last week, favors tighter regulations, but not the sweeping changes recommended by the Group of Thirty. The SEC, which oversees funds, favors similar changes. Among them:
•Tighter restrictions on the type of securities a money fund can own. Some funds can put 5% of assets in second-tier investments, securities issued by somewhat less creditworthy issuers. The SEC is mulling a rule to require all money funds be 100% in top-tier securities.
•Limits on maturities. Funds might also have to invest in shorter-term investments, which would let them meet redemption demands more quickly.
•A limited insurance system. The Treasury's current insurance system will expire on April 30.
"I thought (Bernanke's speech) was fabulous news for money funds and money fund investors," says Peter Crane of Crane Data, which follows funds. "It means radical change is off the agenda."
Any regulation that reduces money fund risk will ultimately reduce their returns — which some say will make them less appealing to investors. Nevertheless, the funds have attracted more than $300 billion in new assets the past 12 months, even as yields have dwindled.
Ultimately, it may be funds' safety, not their yield, that determines how popular they are in the future. "It could be that there's a market for insured and uninsured money funds," the SEC's Scheidt says.