Thoughts on money market funds "breaking the buck"

Much attention has been paid this past week to the concept of money market funds "breaking the buck" (having the Net Asset Value fall below the conventional baseline$1.00).

The first one to do so was the Reserve Primary Fund:

The New York-based Reserve Primary fund, which had $65 billion in assets at the end of August, said it cut its share price to 97 cents after marking down the value of $785 million in Lehman debt securities after the brokerage's filing for Bankruptcy Court protection Monday.

This isn't the first time that a money fund has run into trouble with dicey securities since the credit crunch began a year ago. Indeed, Crane said 20 money fund companies have had to contend with IOUs that could have caused their money funds to break the buck.

The difference with Reserve Primary fund is that it lacked a "deep-pocketed" parent company willing to step in and buy out the Lehman IOUs to keep shareholders whole, Crane said. That is historically how other fund firms have resolved troubles with their portfolio holdings.

Indeed, our family received an email from one of our MMfunds which informed us that the fund had incurred losses on some assets, but that the parent company (T. Rowe Price) would make up the losses out of reserves, and the NAV would remain at $1.00.

It's fully appropriate that this event should have been publicized, but shame on federal officials for trying to "scare up" support for the big bailout by suggesting (or declaring) that without a bailout, everyone's MMFunds would be in jeopardy of severe major losses.

There are, of course, many "flavors" of money market funds. The safest ones invest in Treasuries or other securities backed by the full faith and taxing power of the federal government. Others stretch for increased yield by incorporating corporate paper or other money instruments. The Reserve Primary Fund's objective was to "generate the highest possible yield without incurring significant risk." Obviously some of the "highly rated prime bank debts" they chose to purchase were ill-advised (though the fault may lay as much with the rating agencies and with the fund).

Some investors don't understand this, as exemplified by this complaint from a Reserve Primary Fund investor:

"We put it in a money market, how can you make it safer than that ?" said 48-year-old Rocheford of Elko.

But note that this "failed" money market fund has fallen to 0.97 or a 3% loss on current assets. That's not a tragic outcome in view of the fact that for some prolonged period of time investors in the fund may have received an average, say, 6.5% yield while safer MM funds were yielding 5.5% or whatever.

I think it's actually good that some MM funds may fall below $1.00. The American investing public needs to have it driven home that increased rewards are achieved by taking on increased risk, and with that risk comes the chance of loss. If the bailout package is somehow contrived in a way that no one loses money, the moral hazard accompanying such a maneuver will mean that after things settle down again, people will just return to the same pattern of searching for high yield while assuming they can't lose money, thus perpetuating the market demand for contrived instruments such as the toxic CMOs.