The threat to your money-market fund

Ripples spreading from the financial-market crisis will bring a dip in
yield for the average money-market fund in the coming months. Here's
why the crisis is going to cost you.

Latest Market Update
September 14, 2007 -- 16:20 ET
By Jim Jubak,

Money-market funds, almost certainly the core cash position in your
portfolio, are now at the center of the financial-market crisis that
started with the meltdown in the market for subprime mortgages.

In fact, I'd say money-market funds are the locus of the panic that
has frozen big swaths of the debt markets.

What's this going to cost you?

Not your whole nest egg. Relax about that. But your money-market fund
is going to pay you less in interest because of this crisis.

It is likely that in the next few months some money-market fund will
announce losses so big that they threaten the $1-a-share price that
investors regard as guaranteed. I'd say the odds are that such an
announcement will come from a so-called enhanced fund, one that took
on additional risk to pay an extra bit of interest to investors.

But it is unlikely that any money-market fund run by a major mutual-
fund company, the Fidelitys and the Vanguards of the market, will run
into problems big enough to threaten what investors have come to
believe is a guarantee against loss of capital by the money-market
funds. As long as you don't panic on the news and do something stupid
when the talking heads lose theirs and predict the end of the
financial world, any cash you've got socked away in a name-brand,
plain-vanilla money-market fund should be safe just where it is.

That doesn't mean, however, that money-fund worries won't cost you
anything. I think we're likely to see a dip in yield for the average
money-market fund over the next 12 months -- beyond whatever the
lowering of interest rates the Federal Reserve may engineer -- just
when interest rates on bank certificates of deposit are likely to
climb. In the months ahead it will be worth watching interest rates to
see whether switching some of your cash from a money-market fund to a
short-term CD makes sense.

So you'll be ahead of the curve -- and beyond panic -- when a bozo
money-fund manager confesses that he or she did something really
stupid with fund assets, I'm going to tell you how conservative money-
market funds got sucked into this awful debt-market mess.

It all starts with the market for commercial paper. This is short-term
debt with maturities anywhere from a couple of days to 270 days. The
average maturity recently has been about 45 days.

Traditionally, companies have used this paper to finance operations,
borrowing cash they need to meet a payroll or buy inventory. They
borrowed short-term money because it gave them flexibility and because
it was cheaper than long-term debt most of the time. To extend the
maturity of this short-term debt, effectively turning short-term debt
into long-term debt at short-term interest rates, all they had to do
was roll over the debt when it matured. And traditionally, commercial
paper was backed by the credit of the entire company.

In the past few years the commercial-paper market has seen massive
changes. First, it has grown to $2.2 trillion in July 2007 from $1.6
trillion at the end of 2005, or 38% in roughly 18 months.

And the kinds of paper have changed. About half, $1.2 trillion, of the
commercial-paper market is now made up of asset-backed commercial
paper. This is short-term debt backed not by the name and assets of an
entire company but by a designated pool of specific assets, such as
credit card debt, car loans and mortgages, including subprime
mortgages, of course. The asset-backed part of the commercial-paper
market added up to only $400 billion in 2002.

Asset-backed commercial paper grew so rapidly because it offered big
advantages to both the issuers and buyers of debt. It opened up the
commercial-paper market to a whole new level of companies that hadn't
been creditworthy enough to tap this source of funding before.

A company with a credit rating so low that tapping the commercial-
paper market was difficult could now put together a package of credit
card receivables, the debt that card borrowers had run up doing
business with the company. Because that paper was backed by a
predictable flow of credit card payments, that issue of asset-backed
commercial paper would find ready buyers.

The Fed seems determined to ride to the rescue of banks and the stock
market. But don't expect to benefit personally from any interest-rate
cut, says MSN Money's Jim Jubak. Instead, you can count on higher bank
fees.

For buyers, the advantage of asset-backed commercial paper was very
simple: It paid more than traditional commercial paper did. The
difference wasn't much -- 0.1 or 0.2 percentage point, maybe -- but to
managers of money-market funds clawing for market share and investors,
adding a fraction of a percentage point to a fund's yield could make a
huge difference.


Money-market funds are huge buyers of commercial paper because it
offers them a slightly higher yield than, say, Treasury notes. Money-
market funds, with about $4 trillion in assets globally, make up about
30% of the commercial-paper market. The move to asset-backed
commercial paper was just another step down the same road. About 40%
of the commercial paper owned by money-market funds is asset-backed.

In theory, all commercial paper carries very low risk. What can go
wrong if you're holding paper that matures in, say, 60 days?

That low risk is true, it turns out, in the traditional market for
commercial paper where the "what can go wrong" is some negative event
in a company's business. But it's not true, investors have discovered,
in the market for asset-backed commercial paper. In that market,
higher-than-expected default rates on the underlying mortgages or
loans and mistakes in credit ratings that gave AA ratings to what
turns out to have been risky C have cut prices of some asset-backed
paper by 10%, 20% or more almost overnight.

That's when there is a price at all. In the asset-backed market,
specific issues of commercial paper are infrequently traded. Between
trades, no one knows what they're worth at all.

This has led to a buyers strike in the commercial-paper market in
general. Nobody wants to buy something for $100 if it's worth only
$75, of course, so you can understand why potential buyers want to sit
on the sidelines.

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