Investor Alert: Money Market Dangers

Money market mutual funds could be in jeopardy thanks to sub-prime mortgages, which triggered the current financial meltdown. Yes, those bastions of safety, with yields higher than bank money-market accounts, might be hiding some nasty surprises. In fact, not long ago, one of the first money funds ever created did the unthinkable and "broke the buck," closing at 97 cents per share.

That caught the attention of the government, which announced recently that it will safeguard money market mutual funds in an effort to help alleviate the current financial crisis.

Our goal here is to alert, not alarm, so let us show you exactly what that means and tell you what you should do right now.

First, a little background. Money market funds were created to pay you a higher yield than a bank account by investing in short-term Treasury bills, commercial paper and other short-term loans (we'll explain this more in a moment). To ensure a higher return for investors, money market mutual funds are required by law to pay out 95% of their income to you.

The banks, on the other hand, decide what they're willing to pay on a money market account, which always seems to mean more money for the bank and less for us investors.

By the way, bank money market accounts only came into being after the creation of the money market fund. When banks started losing passbook investors, they had to try to compete. But even now yields on bank money market accounts are generally 1/2% to 1% lower than money market funds. That's why we highly recommend money market funds over money market accounts. (For more of our advice, see How to Choose the Right Money Market Fund.)

Safety-minded investors looking for a better yield for short periods of time or for the liquid part of their portfolio have used money market funds secure in the knowledge that no fund had ever "broken a buck." In other words, the funds have always kept a constant $1 value a share (which is the way it's supposed to be).

There have been a couple of occasions when a few money market funds made stupid investments that lost money. But rather than earn the distinction of being the first funds of this kind to "break a buck," the investment company behind the funds kicked in cash to keep the investors whole. For example, earlier this year Bank of America announced it was setting aside some cash in case it needed to do the same.

As we just saw, the next time this happens you may not be so lucky, and that's why this alert is so important. Let us show you why.

Sub-Prime Mortgages Mess Everything Up

Remember that we told you money market funds invest some of your money in what's called commercial paper? These are unsecured, short-term debt instruments issued by corporations to finance accounts receivable, inventories and to meet short-term liabilities. Commercial paper is not usually back by any collateral.

Money market funds can also invest in asset-backed commercial paper, which is also a short-term vehicle. These securities are usually issued by a bank or other financial institution and the paper is backed by physical assets. Sounds like this should be even more secure than unsecured paper, doesn't it?

Well, as the Hertz ads say, "Not exactly."

Next: What to Do Now