Another Crisis for Money Market Funds?

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When investors want to escape the volatility of the financial markets, they often head for the relative calm of money market funds. Yet for the second time in as many years, some investors have raised concerns over whether the cash that investors hold in money market funds is as safe as people think it is.

All eyes on Europe
Until recently, the European financial crisis has focused squarely on sovereign debt at the government level. In Greece, for example, most of the concerns have dealt with whether the Greek government would be able to rein in profligate spending with severe austerity measures before the country's total debt load grew out of control. Similar worries have spread across the European Union, as countries with larger economies, such as Italy and Spain, have joined investors' watch lists.

U.S. investors have certainly seen the impact of Europe's problems. Not only has the U.S. dollar soared against the euro, but stock markets around the world have been on edge as European policy makers try to work their way through the same general problems that the U.S. faced in the fall of 2008.

Now, though, some of those searching for the next potential dominoes to fall have found an unexpected danger point: money market funds. According to a study from Capital Advisors Group, over half of the assets in the 15 largest prime money market funds were invested in European financial institutions as of April 30. Although the banks near the top of the list, which include Royal Bank of Scotland (NYSE: RBS  ) , Deutsche Bank (NYSE: DB  ) , and Barclays (NYSE: BCS  ) , are from more financially stable parts of the continent, you'll also find Spanish bank Banco Bilbao (NYSE: BBVA  ) among top issuers of debt held by funds.

Cleaning it up
The interesting thing, though, is how different the response of money market funds has been to this crisis. Back in 2008, money market funds found themselves overexposed to a wide range of questionable short-term investments, ranging from Lehman Brothers commercial paper to almost impenetrable conduit financing arrangements. One money market fund actually broke the buck and eventually liquidated its assets, while funds at Legg Mason (NYSE: LM  ) and Bank of America (NYSE: BAC  ) had to make huge cash infusions to support their money market funds' $1 net asset value. After liquidity in the commercial paper market dried up, it took a federal bailout to jump-start the money markets again.

It's clear that money market funds have learned from their 2008 experience. This time around, they're divesting themselves of risky debt rather than waiting to see how things pan out. The Capital Advisors Group report found that funds have no direct Greek or Portuguese exposure. That has caused problems for banks trying to raise capital through the commercial paper market, as Banco Bilbao was unable to roll over around $1 billion in short-term debt last week. Banco Santander (NYSE: STD  ) , another Spanish bank which is also a popular holding among funds, could see similar issues if the crisis continues.

What you need to do
One reason why money market funds have taken proactive steps to preserve their assets is to avoid sending their investors into a panic, leading to mass redemptions and a repeat of conditions from two years ago. But for investors, the more important question is why they're keeping money in the funds in the first place.

Money market fund yields have been so low for so long that funds have had to take extraordinary measures like waiving fees just to keep their returns positive. Meanwhile, plenty of FDIC-insured banks offer yields of 1% or more. Sure, a single percentage point of interest won't make you rich, but you also don't have to worry about issuer risk with your money in an insured bank account.

In a rational world, Europe's woes wouldn't be the catalyst that delivers another potential death blow to money market funds. But with safer investments paying higher yields, the funds shouldn't be surprised to see money flow out in any event.

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Fool contributor Dan Caplinger loves FDIC insurance. He doesn't own shares of the companies mentioned in this article. The Fool owns shares of Legg Mason.Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy keeps you calm in a crisis.

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