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Shakeout from last fall's money-market fund collapse just starting to sink in

By MARK JEWELL | AP Personal Finance Writer

3:46 PM CDT, March 12, 2009

BOSTON (AP) — It's not the sexiest investment around, but the money-market mutual fund has become a high-demand safe haven for those who can no longer stomach the stock market.

Think again, however, if you believe you've found quiet refuge among the growing ranks of play-it-safe types who have nearly $3.9 trillion stashed in these investments.

Money funds are generally safe places to park cash because they invest in the safest types of debt. Many buy government bonds such as Treasury bills, while so-called prime funds seek slightly higher yields but accept marginal risk by venturing into short-term corporate bonds.

The downside of such risk hit home last fall when a soured investment in Lehman Brothers debt spooked investors who suddenly pulled cash out of the Reserve Primary Fund. While that run was triggered by the fund's institutional clients, individual investors could end up losing roughly 8 cents on each dollar invested. The fund's collapse marked just the second instance that money fund investors have been exposed to losses in the nearly four decades money funds have been around.

To prevent another such debacle, the industry and government regulators are weighing fundamental changes in how money funds operate. Their moves could make money funds even safer, but trim their already tiny yields.

A program to temporarily provide money funds with government guarantees similar to FDIC bank deposit insurance is due to expire April 30, although it's expected to be extended. And some observers expect fund companies will eventually replace the government backing with their own industry insurance program.

Meanwhile, yields on taxable money funds — a category that includes Treasury funds and prime funds — fell to an all-time low average of 0.29 percent this week, according to the Money Fund Report, published by iMoneyNet.

The extended period of low yields has triggered a competitive shakeup. When it's over, the number of companies offering the more than 1,700 funds is expected to shrink, reducing consumers' money fund options.

The changes are swirling around an investment that's usually so low-profile it's typically compared with bank certificates of deposit.

"Everybody will look forward to a time when money funds are boring again," said Peter Crane, publisher of the newsletter Money Fund Intelligence.

Still, experts say there are no indications that investors will suffer losses anytime soon in any other money funds. But the Reserve mess spurred proposals for changes that are just beginning to ripple across the money fund industry, which now holds about 40 percent of the total $9.4 trillion in all U.S. mutual fund assets. Some of the changes:

—GUARANTEES CAN BE FLEETING: With money fund assets at a record high, the guarantee program prompted by the Primary Fund's troubles is expected to be extended, possibly to Sept. 18 — a year after the guarantees started.

Fund companies have paid more than $800 million so far in fees to extend government backing to their funds and bolster investor confidence. No claims have been paid out — the Reserve Primary Fund didn't meet the coverage criteria.

The industry's trade group isn't counting on the guarantees sticking around. Paul Schott Stevens, the Investment Company Institute's chief executive, told a Senate panel Tuesday that ICI looks forward to "an orderly transition" out of the program.

A panel of fund industry leaders that the ICI recently convened expects to recommend money fund changes later this month.

While ICI isn't yet saying what it envisions, an adviser to institutional investors expects the industry will eventually dig into its pockets to create a private insurance system.

"Investors are looking to something to hang onto, even though money fund managers may have full confidence they don't need insurance," said Lance Pan, a research director at Newton, Mass.-based Capital Advisors Group.

—DOLLAR-FOR-DOLLAR RULE CHALLENGED: Money funds are supposed to hold at least $1 in assets for each investor dollar put in. That's the safety benchmark that the Primary Fund violated when it "broke the buck" after a rush of investor redemptions forced it to quickly unload assets.

Some critics argue the dollar-for-dollar target is too strict, and should allow fluctuations. That way, the thinking goes, investors afraid of seeing a fund break the buck would be less inclined to suddenly pull out.

Federal Reserve Chairman Ben Bernanke touched on the issue on Tuesday, saying that policymakers "should consider how to increase the resiliency of those funds that are susceptible to runs." Bernanke said possible approaches include tighter restrictions on the type of investments funds can make, and an insurance system to prevent instances of breaking the buck.

Robert Plaze, associate director of the Securities and Exchange Commission's Division of Investment Management, said in an interview that his agency was examining ways to prevent individual investors from being hurt by institutional investors who can destabilize a fund by suddenly pulling out a huge sum.

In contrast, small-time investors "move in and out on a fairly predictable basis," Plaze said.

—YIELD SHAKEUP: With money fund yields near zero, some companies' returns are barely enough to offset expenses to run their lowest-yielding funds. That's led to several recent cases of providers closing Treasury-only funds to new investors, or limiting new investments by existing clients. Others are trimming or waiving management fees to ensure clients see modest returns. But eventually, providers may pass on higher fees to investors.

Crane, of Crane Data, said the competitive balance will increasingly tip in favor of bigger providers. And should a fund see one of its investments sour, bigger companies are more likely to have cash to temporarily prop up the fund and prevent it from breaking the buck.

In the end, said Crane: "The pressure will grow on some of those smaller players to exit the market."

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Questions? E-mail the AP at investorinsight@ap.org.