“Dark Shadows” by John Edward

John Edward, a resident of Chelmsford who earned his master’s degree at UMass Lowell and who teaches economics at Bentley University and UMass Lowell, contributes the following column.

Investing is not for the faint of heart. Danger lurks in these unstable times. Thankfully, money market funds offer a risk-free place to protect your money.

Or not.

During the financial crisis, the “shadow banking system” gained notoriety. People on Main Street heard more than they ever wanted to about obscure Wall Street contraptions such as collateralized debt obligations and credit default swaps.

The money market is part of the shadow banking system. Money market funds need to come out of the dark shadows. They may not be as safe as you think. There are steps you can take for your own safety – more on that later.

A money market is just what it sounds like. It is a place to borrow or lend money.

Businesses, and governments, often need to borrow money for just a few days or weeks. For example, a company needs to cut paychecks before customers pay bills. Going to a bank requires too much overhead and the interest rate might be too high. Instead, they borrow in a money market.

The money market is for exchanging IOUs. The Securities and Exchange Commission (SEC) requires that IOUs in money market funds have a high credit rating. Any IOUs they invest in must have a short length of time before payment is due. At the end of July the average maturity for money market fund IOUs was 45 days. Money markets are considered safe due to the high credit rating and short duration of the loans.

There is plenty of evidence that savers consider money market mutual funds to be perfectly safe. The evidence is the 2.5 trillion dollars deposited in these funds. That is a lot of money tied up in an investment with an average return of 0.03 percent. With inflation, shareholders are effectively paying more than two percent to park their money in what they think of as a safe place.

If you have money in a money market account, you are lending money. Lending is risky. Borrowers do not always pay up. The financial crisis started with homeowners failing to make mortgage payments. Many of the securities based on mortgage IOUs also had a high credit rating.

Like other mutual funds, money market funds have a share price. With stock and bond funds, the share price reflects the value of the underlying securities. Those values, and therefore the share prices, can be quite volatile.

With money market mutual funds, the share price is always $1.00. Well, almost always.

The prospectus for Fidelity Cash Reserves (one of the largest money market mutual funds) says: “Although the fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in the fund.”

Fidelity Investments is a hugely successful money manager, and they want to stay that way. Cash Reserves has $115 billion in assets. If one of the hundreds of IOUs the fund owns is not paid, Fidelity will absorb the loss to avoid breaking the buck.

Money market mutual funds were first established in 1972. There have been over 300 cases where fund managers had to absorb losses to preserve the one-dollar share price.

There have been two cases of mutual funds “breaking the buck” – lowering the share price below $1.00. One happened in 2008 during the financial crisis.

Reserve Primary Fund – the oldest money market mutual fund, owned Lehman Brothers IOUs. When Lehman defaulted, fund managers dropped the share price to 97 cents. People who thought they were in a risk-free investment lost 3 percent of their money.

For a while, it looked like there would be a panic run in the money market. If fund companies and the Federal Reserve had not stepped in, it would have gotten ugly.

The Federal Reserve Bank of Boston just released a report on the “The Stability of Prime Money Market Mutual Funds.” They found that during the crisis at least 31 other funds would have broken the buck without “sponsor support.”

As the crisis worsened, the Fed temporarily guaranteed money market funds and agreed to purchase money market IOUs. The guarantee has expired. Now there are tighter restrictions on what IOUs the Fed can buy. In the next shadow banking crisis things could get much worse.

Eric Rosengren, President of the Federal Reserve Bank of Boston, supports an SEC proposal to address conditions that “obscure the credit risk taken by these funds.” They are recommending that either money market mutual funds increase their cash holdings as a safety net, or that fund companies be honest with customers and let the share price fluctuate.

To no one’s surprise, Fidelity is fighting the proposal. With $415 billion in money market assets under management, they have a lot to lose.

What should you do if you cannot afford to lose cash you have in a money market account? Here are some simple steps to create your own safety net.

Since 1982, banks can offer money market deposit accounts. They have the advantage of being FDIC insured (or NCUA insured for Credit Unions). They may also pay a much higher rate than a money market mutual fund. The Money Market Savings account at Jeanne D’Arc Credit Union is currently paying between 0.20 and 0.70 percent based on the balance in the account. (As revealed in a previous column I am a customer of Jeanne D’Arc.)

Funds that invest in federal or state government IOUs are in general safer. However, these funds do not offer a guarantee. The first case of a fund breaking the buck occurred in 1984. A government fund was also dealing in adjustable-rate derivatives.

Follow the advice “don’t keep all your eggs in one basket.” If you are lucky enough to have a lot of cash, consider investing in multiple money market accounts or funds.

If you are not lucky, and you cannot afford to lose any of your money, you should be careful. The chances of losing money are slim. However, in a financial crisis it could happen with some money market funds.

There is no need to panic. Keep in mind that money market funds are far less risky than stock and bond funds.

There is reason to pay attention. There are no guarantees in life except for death, taxes, and Tim Burton casting Johnny Depp as Barnabas Collins. There is certainly no guarantee regulators will do something about this part of the shadow banking system.

I have done what I can to shine a light on this dark shadow. Protect yourself.