Money Market Mayhem Continues!

Although Wall Street has been partying like it’s 1999 or 2007 or some other happy time, I recently saw yet another stark reminder that our recent financial crisis did in fact just happen … and that the dangers were real and long-lasting and still far from over.

No, I’m not talking about the fact that half our big banks still need more money. Or the fact that they’ll be issuing a bunch of new stock to try and raise that capital.

Instead, I’m talking about the fact that the SEC has formerly charged the father of the money market mutual fund industry with fraud.

It’s the latest turn in a fascinating story, and as I’m going to show you today, it proves that we are still just beginning to learn how unsafe - and unsavory - even some of the so-called safest investments have been throughout this crisis.

Let’s start from the beginning …

Money Market Funds Find Favor With 1970s Investors Seeking Safety

Although they’re commonplace today, money market funds have only been around since 1972.

That’s when the idea of pooling together investor assets in order to take advantage of higher yields from ultra-conservative assets originated with two men - Henry B.R. Brown and Bruce Bent, partners at an upstart investment firm. The concept quickly caught on with both investors and rivals and literally created the trillion-dollar money market mutual fund industry that we know today.

Despite the similar names, these funds are decidedly different than money market (deposit) accounts, which are interest-earning savings accounts offered by FDIC-insured financial institutions.

Money market funds are highly regulated mutual funds that invest solely in short-term debt.

The SEC requires the average maturity of investments in money market funds to be less than 90 days, and the idea is that each fund’s share price should always equal $1. Only the interest rate fluctuates. And although they typically run a tight race, money market funds’ yields do vary because there are still plenty of different assets that they can legally invest in.

For a long time, Mr. Bent and his company - Reserve Management Co. - maintained that only things like CDs and Treasury bonds belonged in money market funds. In fact, they adamantly - and very publicly - opposed the idea of buying short-term corporate loans (known as commercial paper) to juice yield.

Bruce Bent publicly railed against the notion of putting riskier assets into money market fund portfolios, but his company ultimately went ahead and did it anyway.

But as other money market funds stretched for yield by buying up commercial paper and other riskier assets, the heated competition apparently got the best of Bent & Co. Records show that in the spring of 2006, Reserve’s flagship fund changed its prospectus, began buying commercial paper, and never looked back.

Predictably, its yield began rising and investors flocked to the fund, tripling its assets under management within two years. Then the credit crunch began hitting in full force during fall 2008 …

The Reserve Primary Fund Breaks the Buck (And Maybe the Law, Too!)

It turns out that while Bent was still out talking the talk, the Reserve Primary fund was busy buying Lehman Brothers’ debt. And as you can imagine, the value of that commercial paper plummeted when news hit the wires that Lehman was on the ropes financially.

Initially, Reserve said everything was still hunky dory. But the fund’s depositors weren’t buying it, and they began pulling billions of dollars out of the fund in short order.

Only after the fact, did Reserve Primary come out and say the value of its Lehman paper was essentially worthless. It stopped allowing withdrawals. And it said the net asset value of the fund had fallen below one dollar!

Now, this was not the first time that a money market fund had “broken the buck.” Another much smaller institutional fund had done so back in 1994. And since then, plenty of other firms had been forced to shore up their own money market funds with outside cash to avoid the same fate.

But this was a money market fund with an illustrious past … literally the fund that started it all. It had more than $60 billion in assets. And even days before the meltdown, its leader was railing against other funds for chasing yield with more speculative investments.

The investment world was shocked, and trust in the entire category of money market funds was shaken. So much so that the U.S. Treasury department was forced to step in and temporarily guarantee them all against further losses!

This has been all history, of course. But the latest news indicates that there’s even more to the story:

In a formal complaint logged on May 5, the SEC now alleges that Mr. Bent and his sons “failed to provide key material information to investors, the fund’s board of trustees, and rating agencies as Lehman Brothers filed for bankruptcy protection on September 15.”

I will loosely translate the rest of the complaint for you: These guys probably lied through their teeth. They probably lied about their exposure to Lehman. They probably lied about their willingness to shore up their fund. And they probably lied about the number of investors frantically pulling money out of the fund to stop others from doing so.

How this will all play out remains to be seen. And you shouldn’t expect to see the verdict in your local paper.

After all, this scandal today is getting very little mainstream media attention. Yet in many ways, it is far worse than the Bernie Madoff affair!

No, the numbers don’t compare. Nor does the inherent drama or human interest angle.

But anyone with half a brain should have realized that nobody gets double-digit returns year in and year out ad infinitum.

Meanwhile, plenty of average investors trusted the Reserve Primary to at least keep their money safe. All they asked in return was a couple of lousy percent every year!

The fact that Bent’s firm not only failed in that regard, but may have also failed to fess up when the music stopped, is downright pitiful.

Yet Again: Caution Remains the Keyword

It’s hard to believe, but this money market swindle is less than a year old.

Sure, great strides have been made in propping up the financial sector since then. But are we really completely out of the woods already?

I’m generally an optimistic guy, but I have a hard time believing it. And this story is a great reminder why.

We cannot expect something for nothing. We cannot chase yields with reckless abandon. We cannot consider any investment 100% safe.

Greed recently rose to new heights across our nation, and it spread around the world. Can we really unwind all of it in just a few short months and with just a few swift fiscal stimulus packages?

I’m not so sure.

That’s why I continue to suggest you plan for the long-term by holding a quality basket of dividend stocks and select bonds, while taking any recent speculative profits off the table as markets rally.

I also think a little downside protection is now in order, and advocate keeping your cash reserves in only the safest of places.

To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive.

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