Money Market Issues

Bank of America, stung by the fallout in subprime mortgages, acted to safeguard its money market mutual funds. The bank planned to set aside $600 million to cover potential losses in its money market funds and an institutional cash management fund. The action is the largest recent step by a financial institution to ensure that its money funds aren't forced to reduce the value of their shares below $1.

The crisis in subprime mortgages has jolted the market for the short-term securities in which money funds invest. Bank of America's move is a sign of how the crisis has gone beyond complex institutional portfolios to potentially affect everyday savers. The bank said $300 million will be used by a group of its money funds that are offered to individuals. The other $300 million will support an institutional cash fund, which isn't technically a money fund. The money would help keep the funds' share price at $1 if some of their holdings defaulted.

Several other financial institutions have also bolstered their money funds:
• SEI, an institutional money manager, has set aside $129 million to support two of its money funds.
• Legg Mason has set up a $238 million line of credit for two money funds. It also invested $100 million to buoy an offshore money fund.
• SunTrust Bank has received SEC permission to set up credit lines for two money funds.

What's tripped up many funds are investments in Structured Investment Vehicles. SIVs use short-term loans to buy longer-term assets, such as mortgage-backed securities, that pay higher rates. The SIVs with the worst problems were often invested in subprime mortgages. As a result, some SIVs have stuck money funds with losses.

Money funds fear that if any fund "broke the buck," falling below $1 a share, investors would flee. That's why they're moving fast to try to avoid defaults.

The USA Today article does not mention (online, the print version does) that the only time in history when a money fund has broken the buck was Community Bankers U.S. Government Fund, a small institutional fund run by Community Bankers Mutual Fund in Denver, which liquidated in 1994 because of losses on interest-rate derivatives. The fund, which had more than 27% of its assets in the derivatives, paid investors 96 cents on the dollar.

The reason the fund lost money despite US Government in its name explains the problems that it (and a lot of other funds in that period) got into trouble in the first place. While US Treasuries are of course guaranteed by the US government with regards to both principal and interest, derivatives based on them such as Interest-Only bonds (IOs) or Principal-Only bonds (POs) can rise or drop in price because of movements in interest rates. That caused losses at many money funds although only Community Bankers actually broke the buck. Money funds had no business investing in IOs and POs in the first place.