Money market funds have generally been thought to be as safe as cash. They work like mutual funds, yet can be dipped into like a savings account. Most come with no insurance and no guarantees but investors still flock to them as the ideal place to park their money. As of 2009, money market funds have "broken the buck" twice in their history, in 1994 and 2008, causing investors to lose part of their principal investments. So how does this happen? And are money market funds really that safe? Read on to find out. (For background reading, see Introduction to Money Market Mutual Funds.)

What Is "Breaking the Buck?"
Money market funds are a form of mutual fund, which means they attempt to keep a net asset value (NAV) of $1 per share. $1,000 is equal to 1,000 shares, and vice versa. These funds are invested to produce a return for investors, but money market funds are required by law to invest in low-risk debts (no more than 13 months in duration), such as government bonds, which means they typically return less than equities. (For more insight, see Do Money Market Funds Pay?)

What many people fail to understand about money market funds, however, is that low risk isn't the same as risk-free.

Because these funds are still an investment, it is possible for shares to lose value and dip below $1 per share. In this case, the fund is said to have broken the buck, a crucial benchmark in the financial sector.

While this is uncommon, it can and does happen, causing investors to lose money and fund managers lose their reputations. (See other risks of this investment in Are Money Market Funds Worth The Risk?)

Community Bankers Mutual Fund
Granted, money market funds have rarely crossed the "buck" threshold. Since their 1970 induction, money market funds have seen only two dips below $1 per share.

The first instance occurred in 1994, when a fund designed for bankers (not retail investors) slid to 96 cents per share. The fund, Community Bankers Mutual Fund, was liquidated with $82 million in assets. Since most of the fund's shares were owned by banks in the Midwestern United States, the consumer impact was low.

After an investigation by the Securities and Exchange Commission (SEC), the Denver-based fund was found to have broken SEC rules by putting more than 25% of its holdings in risky investments. (For more on investment risk, see How Risky Is Your Portfolio?)

According to law, money funds must keep their holdings in short-term investments, defined as the ability to receive the full principal and interest from the investment within 397 days. The average investment for a fund must not exceed 90 days.

A fund must also avoid:

  • Investments that are tied to high credit risk
  • Investments that are, or are comparable to, high-risk equities

The Community Bankers Mutual Fund fell victim to the derivatives meltdown of 1994, when they socked away nearly a quarter of their holdings in interest-rates packages. Derivatives gave the fund's advisors the chance to increase leverage in order to gain hefty rewards. Of course, like many institutions in 1994, the market turned against them and millions were lost. (For more on derivatives, see The Barnyard Basics Of Derivatives.)

On January 11, five years after the fund initially broke the buck, the SEC fined the fund's directors $5,000 apiece and imposed a $10,000 fine on fund president John Backlund. Backlund was also suspended from associating with any mutual fund or fund advisor for one year.

Reserve Primary Fund
The second time that a money market fund failed was on September 16, 2008, during the subprime meltdown. (Read more about this mess in our Subprime Special Feature.)

The Reserve Primary Fund saw its main fund drop to 97 cents per share; because this was a consumer-owned fund, the drop resulted in sweeping losses for investors and widespread panic.

The New York-based fund had $785 million invested in Lehman Brothers bonds and other debt holdings. When Lehman Brothers declared bankruptcy on September 15, 2008, the net worth of the holdings dropped to virtually zero. While the Reserve Primary Fund had more than $60 billion in other bonds and U.S. Treasury bills, the Lehman Brothers collapse led investors to pull money out of the fund quickly and in full force. By 3pm on the day of the announcement, the fund saw its net worth go from $62.6 billion to $23 billion - a hit of more than $40 billion in withdrawals. (To learn more about this, see Case Study: The Collapse Of Lehman Brothers.)

Gaining less notice than the Reserve Primary Fund was the downfall of two other, smaller funds:

  • Reserve Yield Plus Fund, which dropped to 97 cents per share
  • Reserve International Liquidity Fund, which dropped to 91 cents per share

The significance of the Reserve Primary Fund's collapse can be linked to its deep ties to money market history. The fund was developed by Bruce Bent, commonly referred to as the "father of the money fund industry", in 1970. It was the first consumer money market fund to operate in the open market and was thus thought to be generally stable. (For more insight, see The Fuel That Fed The Subprime Meltdown.)

Fallen Funds Saved
While only two money market funds have broken the buck publicly, many other funds have lost value in risky investments but have been saved by larger-asset parent companies before the impact reached shareholders.

For instance, in 1994, more than 20 money market funds were bailed out during the bankruptcy of Orange County, Calif. Many funds had holdings in the municipal debt of the County and the bankruptcy exposed them to liquidity problems.

Similarly, the 13-month stretch between August 2007 and October 2008 saw 21 parent companies infuse cash into their money market funds to avoid breaking the buck.

A parent company would assist a money fund for one of several reasons:

  • To keep their institution's reputation intact
  • To keep investor faith high
  • To keep asset liquidity high
  • To avoid market panic

Conclusion
Money market funds can have impressive returns, especially when stacked up against FDIC-insured bank accounts, but in tough economic times breaking the buck is a real possibility that smart investors can't ignore. (To learn more, read Money Markets Vs. Savings Accounts.)

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