Reserve Primary Fund: Investors May Lose

Money market fund's breaking of the buck is called an "anomaly."

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The money market industry was shaken yesterday when the shares of one of its oldest and largest funds—the Reserve Primary Fund—fell below $1, making it only the second money market fund in history to "break the buck." Once the fund crossed that threshold, its adviser slapped a seven-day freeze on redemptions as investors bolted for the door.

Said Peter Crane of Crane Research Data (via Marketwatch), "This appears to be the first case where a retail investor will lose money in a money market fund." After all, investors have come to know money markets as safe havens for their short-term or emergency cash. Crane called the situation an "anomaly."

As of last Friday, the fund held $62.6 billion in assets, including $785 million in bonds issued by Lehman Brothers. The Reserve announced late yesterday afternoon that it was marking down those holdings to zero, spurring a flood of redemptions. Chuck Jaffe of Marketwatch points out that the fund's Lehman bonds represent only 1.2 percent of its assets, a relatively small amount: "In fact, the paper of Fannie Mae and Freddie Mac amounted to about 2 percent of the assets of the ordinary money fund, and yet it didn't move most investors to rush the exits."

Late yesterday, many fund companies—including Fidelity, Vanguard, Wells Fargo, and Schwab—released a flurry of statements, spilling their money market holdings and assuring investors that they held no Lehman paper. The Investment Company Institute issued this statement from president and CEO Paul Schott Stevens:

The fundamental structure of money market funds remains sound. These funds are subject to strict regulation governing credit quality, liquidity, diversification, and transparency. Rule 2a-7, administered by the [Securities and Exchange Commission], strictly limits the types of securities in which money market funds can invest. Securities held by money market funds must be judged highly credit-worthy by both objective and subjective tests.

So money market investors should remain calm, but what about investors still in the Reserve Primary Fund? Jaffe of Marketwatch advises:

Getting out of the Primary fund now not only locks in the loss but negates much chance at recovery.... While Lehman's value is not going to pop up to what it was before the crisis, it's entirely possible there will be deals in place that will somehow allow the company—or another firm that buys it—to make the ultimate value of Lehman's paper more than zero. If that happens, it gives back some of the losses in the Primary fund; since it can't be valued at less than zero, the Lehman paper can't hurt the fund more than it has already.

My take: Anomaly or not, this is why you should know where your brokerage parks your cash. Many people have no clue what interest rate their money market fund yields, let alone what it invests in.