When the Safest Investment Turns Risky

This article published with permission from InvestmentU.com.

Many investors lump money market funds in with Treasury bills and certificates of deposit (CDs). Don’t be one of them.

Treasury bills and CDs are backed by the full faith and credit of the United States government. Money market funds are not.

Yes, the federal government had its credit rating taken down a notch last year. But a U.S. government guarantee still means something powerful and important in a risky and uncertain world.

Read your history and you’ll find that the money market industry has a few blemishes. In 1994, for instance, Community Bankers U.S. Government Money Market Fund “broke the buck.” The fund’s net asset value dropped to 96 cents on the dollar, a shock to shareholders who believed their money was “completely safe.”

In 2008, thanks to the collapse of Lehman Brothers, the Reserve Primary Fund broke the buck again. This time investors fared a little better, receiving 99.04% of their funds. But it also sparked a panic.

Investors rushed to liquidate their money market funds and move them into guaranteed bank accounts. Their actions destabilized an already fragile financial system. The federal government took the unprecedented step of backstopping money market funds to avert a meltdown.

“Losses are entirely possible again”

Of course, the financial crisis is behind us now and money markets are safe again, right?

Hold on. For starters, the federal guarantee on money market funds ended nearly three years ago, on Sept. 18, 2009. Losses are entirely possible again. And money market fund assets have grown from roughly $4 billion in the mid-1970s to approximately $2.5 trillion today. As economist Art Laffer points out, this is the size of the Federal Reserve’s entire balance sheet.

Also, the Securities and Exchange Commission recently turned down a couple of sensible proposed regulations. And investors are the worse off for it.

Don’t get me wrong. I’m an unrepentant capitalist and sharp critic of senseless or burdensome regulations. But the primary proposal here was to establish reserve requirements and require that money market fund share values be marked to market, rather than held at the fixed one-dollar level that has been the industry practice since money markets were created in 1971.

If you were the shareholder of an uninsured, unguaranteed fund whose assets were falling in value, wouldn’t you want to know about it as soon as possible rather than hold on to an illusion? Me too. But the interests of the mutual fund industry — not to mention all the corporations and municipalities who use money markets as a vehicle for short-term funding — won out over the interests of fund shareholders.

“An uninsured mutual fund”

What should you do? First, understand that a money market is an uninsured mutual fund. And while the government may step up again in a full-blown financial crisis, there is no guarantee of this.

Most money funds, commonly called “prime” funds, invest in commercial paper and repurchase agreements, as well as Treasuries. But if you are highly risk-averse or have large cash balances, you should hold money market funds that invest solely in U.S. Treasury securities. Yes, the income is taxable and the yields are pathetically low, but we’re talking about safety here. You will almost certainly lose ground to inflation, but your principal is secure.

Some will say this is only necessary for the truly paranoid. But I disagree. True, the chances of losing money in a regular money market fund are small. But since all money markets pay next to nothing at the moment, the cost of this insurance is low.

In the event of another financial crisis, you’ll have peace of mind. And you won’t find yourself using technical jargon like shoulda, woulda or coulda.

Alexander Green is the chief investment strategist at InvestmentU.com. See more articles by Alexander here.