Propping up money funds may be costly

Emergency steps by regulators Friday to shore up money-market funds appeared to restore confidence in the $3.4 trillion industry, after a week that raised alarming questions about investments that were considered risk-free.

But the rescue package also presented new questions for money-market funds and their customers. They may soon be facing higher costs, tighter investment restrictions and more complicated regulations.

A key element of the money-fund rescue was the Treasury Department's announcement Friday to make available, at least temporarily, $50 billion to guarantee the funds against losses that would force their share prices below a dollar, known as breaking the buck.

This week, a big fund broke the buck because of a stake it held in Lehman Brothers, which is bankrupt, and many institutional investors have pulled billions of dollars from the industry in the last week.

The steps announced by the Treasury and the Federal Reserve on Friday were aimed at stemming that flood of panicky withdrawals — and, in the short run, they succeeded, fund-industry executives said.

"It seems to have restored a sense of normalcy," said Paul Schott Stevens, president of the Investment Company Institute, a trade association. "I have said that this was supposed to be the Treasury's version of shock and awe, and it has been."

But the guaranty plan also drew immediate attack from the American Bankers Association (ABA), whose members compete with the money-fund industry. The ABA's leaders warned that the plan could encourage investors to pull money out of an already-stressed banking system to seek higher yields in money funds.

Program expanded

Another important element of the plan was the Federal Reserve's decision to expand an emergency-lending program so that commercial banks could buy asset-backed securities from money funds. That step immediately began to ease industry fears that money funds would not be able to find buyers if they needed to sell assets to meet withdrawals.

"If the markets are operating as they should, it would be my hope and expectation that the temporary guaranty plan would never be needed," Stevens added.

Charles Schwab, founder of that giant fund family said the intervention was essential to "give the financial system time to re-establish its equilibrium."

Money-market funds are essentially mutual funds that invest in short-term government securities, certificates of deposit, asset-backed commercial paper and other highly liquid securities.

Earning interest

Since their inception, the funds have typically maintained a price of a dollar a share, providing investors with a way to earn interest on their savings without risking the loss of their principal.

That unofficial dollar floor, while not guaranteed by any prospectus or regulation, had become an article of faith among money-fund investors, big and small, who all assumed that each dollar invested in a money fund would always retain its full value.

Institutional investors began to question that premise on Tuesday, after the Reserve Fund, the company whose founder invented the money-fund concept in the early 1970s, announced that several of its funds had broken the buck.

The decline — only the second time a money fund had ever broken the buck — came after the funds wrote down the value of their stake in various securities issued by Lehman Brothers, which filed for bankruptcy on Monday.

Industry figures released Thursday afternoon showed that those professional investors had pulled more than $173 billion out of money funds in the previous week.

By then, it was clear that more money funds would break the buck unless withdrawals could be reduced and the market for short-term securities could be stabilized. That led to the plan announced by the Treasury and the Fed on Friday.

Taken together, the steps represent the most sweeping intervention of banking regulators into the mutual-fund industry since its inception in the 1930s.

"I've never seen anything like it in my 57 years in the industry," said John Bogle, founder of the Vanguard fund family.