Date: October 20, 1998
Question: "How secure are the money market funds?"
It depends. Read the prospectus and the fine print. Even AAA rated underlying collateral does not preclude a fund from "breaking the buck" level.
In efforts to enhance or boost yields many funds engage in repurchase agreements or "repos." This form of lending activity facilitates the inventorying or financing of securities positions.
However, losses can occur when the collateral value is impaired. This impairment is the market price. It can change suddenly due to interest rate swings, prepayments, downgrades or defaults.
The current problem with a number of banks and brokerage firms relates to their lending activities to hedge funds. The operation is verisimilar for money market funds though most are not as highly leveraged.
In the not too distant past - early 1990's - some money market funds experienced declines in value of 20 percent or so. This was because AAA rated CMOs and related derivatives experienced drastic declines in value.
These declines were triggered by changes in interest rates and prepayments.
One section to analyze is the portfolio section of the money market prospectus is how much exposure in the repo market.
Next, and perhaps more importantly how much of the short-term paper is of brokerage or banking origin? A commercial paper default by a major organization can be quite tramatic for the money markets.
The bottom line on these transactions is that they are only as good as the counterparty is. Sometimes, an excellent credit rating for the collateral is not enough.
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