Talk of recession is nothing new in 2008. Most financial publications have been talking about this since early 2007 (if not mid 2006), so it’s no big secret that a confluence of negative forces conspire to wreak havoc on the US economy. But this is the first time that Ben Bernanke sounds worried.
A recession may drag down the stock market at the same time that the housing market is in its worst slump in decades. So stocks and real estate may take big hits. Money markets are still safe, right? Maybe not.
There’s been a lot of debate recently about money market funds and whether they risk exposure to the subprime collapse. Most experts have said that normal investors have nothing to worry about and that these funds — really mutual funds made of bank CDs, Treasury bonds, corporate debt, etc — are solid. The not-so fine print on any of these funds say that unlike savings accounts, money markets are not FDIC insured (though some of their holdings, such as bank loans, are insured.) The $1 price per share can theoretically fluctuate.
In practice, this has never happened. CBS reports that in the history of money market funds, $1 peg was reduced only once, and only to $.96. This was during the 1994 derivatives crisis, which most experts believe was far more expansive than our current financial crisis.
But how safe are money markets? The answer is that most are still very, very safe. But it depends on the type of fund you’re in, the kind of investments the fund holds, and finally on the size of the company managing the fund.
1. First, go back to the fund prospectus and read the goals of the fund. Are they in line with your risk-tolerance and your goals? Does it say they primarily invest in government debt or does it seek the best return. You need to make sure the fund’s objectives are in-line with your goals, and don’t simply pick the one with the highest percentage return. Don’t assume your money market is safe simply because it’s a money market. You might be getting a higher percentage return than a savings account, but you’re making far less than a stock fund and you may be exposed to far more risk than you believe.
2. Second, check the most recent version of your fund’s holdings to see where they’re investing your money. The prospectus usually only gives you the overview, so check the most recent shareholder update. “Commercial paper” or corporate debt is one red flag. The important thing for you to understand is what kind of collateral the company put up against the debt. It may say something like mortgage obligations or it may say something more cryptic like “collateralized debt”.
Collateralized Debt Obligations (CDOs) were one of the darling inventions of the financial industry robber-barrons. Theoretically, they were a way to take a pile of debt — say a few hundred million in mortgage debt, from good to terrible — chop it into pieces (or “tranches”) ranging from low to high risk, and resell it for more than it was originally worth. And in doing so, the issuer of the CDO (a bank or mortgage company) gets the loan off its books and can lend more money than it probably should. The problem, of course, is that even the choicest cuts of these repackaged loans were hooey compared to their advertised ratings, but the willingness of large institutions to assume these debts has exposed the greater economy to the subprime collapse.
I’m not qualified to tell you everything is fine or that collapse is imminent, but if your money market fund is heavily invested in mortgage-backed commercial paper, you need to evaluate your investments quickly. The fund rating director at S&P found that of the 200 funds he rates, the average holdings in commercial paper was 40-50%.
3. Finally, do some research on your investment company. Make sure they’re preparing to protect the value of their money market funds. The bigger banks and institutions are better equipped to absorb the hit that their mortgage-backed loans take. Some companies have allocated cash to ensure that their funds don’t dip below $1/share. They have every incentive not to allow this, since it would derail all consumer confidence in them and customers would take their money and run for the lifeboats.
But don’t rely on market incentives either; take care of yourself. In the next few weeks, corporations and banks will announce their quarterly numbers. There will likely be huge writedowns due to losses on bad debt, and no one quite understands how deep the problem runs.
You don’t need to reallocate your holdings if you are comfortable with the risk vs. reward of the fund you’re in.