Remember when you ran a lemonade stand as a kid? No matter whether you messed up when setting your prices, mixing the drinks, buying too many or too few ingredients, or not having the liquidity to break a $20 bill, you could probably count on your parents to bail you out.
Banks are now lemonade stands, and the government is their parent. Unfortunately, as the customer, you might still get stiffed on your cup of lemonade if you have cash in money market funds.
Too many lemons
Money market funds have an unglamorous name, and rightfully so -- each share of a fund is supposed to represent $1 and earn comparatively low interest but allow the investor quick liquidity. Banks invest a fund's assets into a variety of typically safe short-term bonds, treasury bills, municipal bonds, and similar investments. Unlike bank deposits, though, the government does not usually insure money in these funds.
In 2008, when looking for bigger yields to entice more investors for money market funds, some funds took on risky bets. The $62 billion Reserve Primary Fund had exposure to $785 million in Lehman Brothers debt, and when Lehman went bankrupt, $1 in the fund then was worth $0.97. Investors were looking at a 3% loss on something they were told would, for the most part, be nearly as safe as cash.
A stampede began to ensue, and to stem a run on the banks, the government set up temporary insurance for these funds for up to $50 billion in losses, which saved at least 21 funds from returning less than $1 for each share. One Legg Mason (NYSE: LM ) fund received over $50 million in support that saved investors from a potential 1.4% loss.
Too little lemonade
Now, with historically low treasury yields, money market funds are finding it tough to make enough money to cover their expenses and sustain themselves. Meanwhile, the SEC is struggling with itself to determine whether funds should report their actual value, which typically floats between $0.995 and $1.005 per share, or back the funds with sufficient capital to protect investors from losses. Proponents claim that this would help remove the picture of invincibility that these funds have, and hopefully protect investors without requiring the government to step in and prop up poorly run funds.
Opponents claim that more regulation will close off convenient access to short-term bonds, treasuries, and other paper, as well as hurt municipalities that use the funds to help build infrastructure, and funnel more money into already too-big-to-fail, actually government-insured bank accounts. Additionally, fund managers claim that investors already know of the inherent risks of money market funds.
Avoiding the lemonade stand
To take one example, one of Charles Schwab's (NYSE: SCHW ) money market funds earned a whopping 0.01% year to date. Its top holdings are issued by JPMorgan Chase (NYSE: JPM ) , Barclays (NYSE: BCS ) , and Credit Suisse (NYSE: CS ) . Now, while its holdings are rated extremely safe, after this past year there's no mistake that's beyond belief that could put their liquidity into question: whether a rogue trader loses $6 billion for JPMorgan that goes misreported in financial statements; or Barclays colludes with several other banks to set LIBOR, a key interest rate, and is fined $450 million while losing its CEO and chairman; or even just too much European debt causes the Swiss central bank to warn Credit Suisse to shed risk.
The government would likely step in again if money market funds were severely threatened -- the $2.6 trillion size of the industry should qualify for too-big-to-fail. However, even with this implicit safety net, the returns from high-yield savings accounts can outdo money market funds and have the explicit FDIC insurance. Take CIT Group's savings bank yield of over 1% annually, which is much more attractive than 0.01%.
Watch out for yourself
Money market funds are on the least exciting and least volatile spectrum of banking products, and that's where they should stay. While the SEC sorts out just how it may try to protect investors from a future money market fund collapse, make sure to protect yourself and evaluate the prospectus and holdings of any money market fund you hold. Additionally, if you aren't happy with the returns, check into other relatively guaranteed investments like the old-fashioned savings account.
Alternatively, if you have a larger appetite for risk, you could actually invest in a bank stock that yields dividends far beyond any current money market fund or savings account. To find out which bank, along with how it seeks to avoid risk unlike some of its brethren, grab your copy of our free report on "The Only Big Bank Built to Last."