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Originally published August 21, 2007 at 12:00 AM | Page modified August 21, 2007 at 2:03 AM


Subprime infects $300 billion of money-market funds

Money-market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree...

Bloomberg News

Money-market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree of safety. Most of the $2.5 trillion sitting in these funds is invested in such assets as U.S. Treasury bills, certificates of deposit and short-term commercial debt.

Unlike bank accounts, money-market funds aren't insured by the federal government. They hardly ever fail.

Unbeknownst to most investors, some of the largest money-market funds today are putting part of their cash into one of the riskiest debt investments in the world: collateralized debt obligations (CDOs) backed by subprime mortgage loans.

CDOs are packages of bonds and loans, and almost half of all CDOs sold in the U.S. in 2006 contained subprime debt, according to a March report by Moody's Investors Service.

U.S. money-market funds run by Bank of America, Credit Suisse, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission (SEC). Money-market funds with total assets of $300 billion have invested in subprime debt this year.

The danger of owning even highly rated CDOs containing subprime loans was thrown into sharp relief in June, when two Bear Stearns hedge funds that were holding subprime CDOs collapsed.

At the center of that storm was Ralph Cioffi, a senior managing director at Bear Stearns who ran the hedge funds. Cioffi, 51, wore another, less publicized hat. He managed more than $13 billion of CDOs, according to Fitch Ratings — and money-market funds and other investors bought all of it.

Cioffi-managed CDOs filled with subprime debt have been purchased by money-market funds run by Invesco's AIM Investment Service, Marsh & McLennan's Putnam Investments and Wells Fargo.

Under SEC rules, money-market managers must invest in securities with "minimal credit risks." Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department, says subprime debt in money-market funds is far from safe.

"This creates tremendous risk for today's money-market investors," says Mason, who wrote an 84-page report on CDOs this year. "Right now, I'm not comfortable investing anything in CDOs."

Global financial markets were rocked in July and this month, first by the collapse of the Bear Stearns hedge funds and then when banks and insurance companies worldwide disclosed their U.S. subprime debt holdings.

On Aug. 9, BNP Paribas, France's biggest bank by market value, froze withdrawals on three investment funds with assets of 2 billion euros because the bank couldn't find a way to value its U.S. subprime bonds and other assets. CDOs aren't bought and sold on exchanges and their trading has little transparency.


Money-market funds have become a staple for investors. There are 38.4 million money-market fund accounts in the U.S., according to the Investment Company Institute (ICI).

People use a money-market account both to hold savings and serve as an account to buy securities and place the proceeds of sales. Bruce Bent, who in 1970 created the first money-market fund, The Reserve Fund, says no money-market fund should invest in subprime debt.

"It's inappropriate," says Bent, 70. "It doesn't have a place in money-market funds. When I created the first money-market fund, I said you have to have immediate liquidity, safety and a reasonable rate of return. You also have to have a situation where you're not giving people headline risk."

Investors have sought safety during the subprime meltdown by moving their holdings to U.S. Treasuries and money-market funds. On Aug. 8, just after the Bear Stearns hedge funds filed for bankruptcy protection, U.S. money-market fund total assets reached a record high of $2.66 trillion, with investors pouring $49 billion into such funds in one week, according to the ICI.

As a sign of stability, money-market funds never allow their share price to rise above or fall under $1 for each dollar invested.

A money-market fund that invests in subprime debt increases the risk that its share price could drop below $1. If 5 percent of a fund's holding is subprime debt, and in a worst-case situation that asset collapses, then the value of the fund could drop to 95 cents.

Just once has a money-market fund failed. In 1994, a fund run by Community Bankers Mutual Fund of Denver invested in securities that defaulted. Investors were paid 96 cents a share, and the fund was liquidated.

Lynn Turner, chief accountant of the SEC from 1998 to 2001, says the SEC will likely look into money-market funds investing in CDOs, particularly because the value of subprime collateral of CDOs can collapse suddenly.

"I'm betting some people at the SEC will be concerned," he says. "And they'll be more concerned in six months. How quickly did the Bear Stearns hedge fund evaporate?"

Each time a bank or financial firm creates a CDO, it forms a free-standing company incorporated offshore, usually in the Cayman Islands, which doesn't tax corporations.

The trail that connects subprime debt to money-market funds usually starts with a mortgage broker who makes a loan to a homebuyer with poor credit. A middleman then bundles hundreds of these subprime mortgages into so-called asset-backed securities.

Next, a CDO manager buys hundreds of these securities for collateral for a CDO. Some CDOs issue commercial paper, and brokers can then sell that paper to money-market funds. Commercial paper, which is typically issued by banks and large companies, is debt maturing in less than 270 days.

Commercial paper pays relatively low interest rates, which averaged about 5.3 percent in June and July, because it rarely defaults. There have been occasional exceptions, such as paper issued by Enron and WorldCom, both of which filed for bankruptcy earlier this decade.

CDO commercial paper, often loaded with subprime debt, pays higher returns than corporate paper, and it paid as much as 6.5 percent in August.

This year, CDOs have sold more than $11 billion in the form of investment-grade commercial paper to money-market funds, SEC filings show. The paper has the highest credit rating because Fitch Ratings, Moody's and S&P give AAA or Aaa ratings to the top portions of CDOs, which are the source of all CDO commercial paper.

Satyajit Das, a former Citigroup banker and author of 10 books on debt analysis, says those ratings are very misleading.

"I don't think the typical money-market investor, in his wildest dreams, would assume he has exposure to the risk of subprime CDOs," Das says. "They may be in for an unpleasant surprise."

Copyright © 2007 The Seattle Times Company

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