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Some Money Market Funds Have Large Subprime CDO Holdings

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Bloomberg Magazine, in “Unsafe Havens,” reports that money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley owned over $6 billion of CDOs with subprime debt in June.

The reason this is a serious issue is that money market funds have a $1 NAV, meaning “net asset value” rule. The funds are required by the SEC to invest conservatively. In practice, they always to maintain principal value. But as the article explains, this sort of investment puts the funds at risk of breaching the $1 NAV requirement.

What this article tells us, in effect, is that investors weren’t completely nuts to have dumped money market funds for Treasuries in August. Of course, they probably should have called the fund manager first, since most large fund management firms, such as Vanguard, correctly see this sort of paper as in appropriate for a money market fund.

The article is quite long but very much worth reading in its entirety; we’ve excepted the juicy bits. From Bloomberg Magazine:

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 backed by subprime mortgage loans….

Money market funds with total assets of $300 billion have invested in subprime debt this year….

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.”….

On Aug. 9, BNP Paribas SA, 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….

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,” Bent, 70, says. “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.

Even if a fund’s value dropped below a dollar, banks and fund companies wouldn’t allow investors to lose money, says Peter Crane, founder of Crane Data LLC, the Westborough, Massachusetts-based publisher of the Money Fund Intelligence Newsletter.

“Fund companies will support the funds,” he says. “They won’t let them break $1 a share. The odds of money market funds breaking the buck are virtually nil.”

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.

The fund had invested 27.5 percent of its assets in adjustable- rate securities, whose values were tied to interest rate changes, the SEC found. The fund lost money as interest rates increased….

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….

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 Corp. and WorldCom Inc., both of which filed for bankruptcy earlier in 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 Inc. 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,” he says. “They may be in for an unpleasant surprise.”

Money market managers buy CDO commercial paper even when prospectuses warn of the risks.


Zurich-based Credit Suisse, Morgan Stanley in New York and San Francisco-based Wells Fargo are among money market managers that poured more than $1 billion into commercial paper issued by the Buckingham series of CDOs managed by Chicago-based Deerfield Capital Management LLC.

“Reliable sources of statistical information do not exist with respect to the default rates for many of the types of collateral debt securities eligible to be purchased by the Issuer,” say both the 2005 and 2006 CDO prospectuses backing commercial paper held in the funds.

Deerfield’s three Buckingham CDOs have directed $1.5 billion, or 40 percent of their $3.8 billion in assets, into subprime debt, according to their trustee reports. Billionaire Nelson Peltz’s Triarc Cos. agreed to sell Deerfield in April.

Morgan Stanley spokesman Mark Lake and Wells Fargo’s John Roehm declined to comment.

Tim Wilson, head of Credit Suisse’s cash management portfolio desk, says he’s comfortable with CDO commercial paper because it has the highest credit ratings and because his funds hold the debt for only one to three months.

“We don’t have any concerns these are going to have any defaults in 90 days,” he says. “We’re obviously watching.” The paper matures within three months, and after that the fund doesn’t hold any subprime debt, unless Wilson decides to buy more.

Vanguard Group Inc., the second-largest mutual fund company in the U.S., has a policy of never buying CDO commercial paper for its $90 billion in money market funds or $325 billion in fixed- income mutual funds.

“It really gets down to transparency questions,” says John Hollyer, risk management director at Valley Forge, Pennsylvania- based Vanguard. “Can you understand what you have? And can you measure it appropriately? We haven’t been comfortable that we could.”

Bank of New York Mellon Corp.’s Dreyfus unit has banned CDO commercial paper from its $110 billion in money market funds because it has found that analyzing subprime holdings in CDOs is too difficult.

The firm’s money market investment committee decided in 2005 that such paper was too risky, Dreyfus spokeswoman Patrice Kozlowski says. “The committee questioned the fundamental structure of commercial paper of CDOs,” she says. Dreyfus has never purchased CDO commercial paper, she says.

CDOs create what is supposed to be a safety net for buyers of their commercial paper. CDO managers reach agreements with banks to purchase their paper when nobody else will, so the CDO can pay off debt when it’s due.

Some fund companies, including Dreyfus, say those contracts don’t reassure them because they’re conditional and they aren’t guarantees. “The banks can refuse to fund,” Kozlowski says.

CDO paper has other risks, former banker Das says. “CDO commercial paper has a lot more moving parts than other kinds of commercial paper,” says Das, who wrote “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives” (FT Prentice Hall, 2006).

“There’s a lot more that can go wrong,” he says. Das says that because so much subprime debt is held by CDOs, there is constant risk that the value of the investment can drop or collapse….

Two money market funds run by AIM have gotten the message. They stopped buying CDO commercial paper. “In today’s market, you really can’t trust any ratings,” says Lu Ann Katz, AIM’s director of cash management research.

As recently as June, two AIM money market funds owned $2.64 billion of CDO commercial paper that was invested in subprime debt. The debt made up 10.2 percent of the AIM STIT-Liquid Assets Portfolio and 4.5 percent of AIM STIT-STIC Prime Portfolio.

Katz says she’s stopped buying CDO investments because she doesn’t trust credit ratings and she thinks CDO paper in money market funds is too risky. AIM’s funds had included more than $1 billion of CDO commercial paper issued by CDOs managed by Bear Stearns before its hedge funds collapsed….

Money market managers are required to determine that their investments are safe and have high credit ratings, according to Rule 2a-7, a 1997 addition to the Investment Company Act of 1940.

“The money market fund shall limit its portfolio investments to those United States dollar-denominated securities that the fund’s board of directors determines present minimal credit risks,” the rule says.

Money market managers buy CDO commercial paper to boost returns and make their fund more attractive to investors, which in turn increases their income, money market fund inventor Bent says. “The higher rates sell more easily,” he says. “They’re doing it to suck the people in.”…

While CDOs aren’t regulated by the SEC, mutual funds –including money markets — are. The SEC disclosed in June it’s begun looking at some CDO investments, without releasing further details.

Former SEC Chief Accountant Turner says investors have cause to be concerned about money market funds’ holding subprime debt.”It does

n’t make you feel real good in the gut,” Turner says. “This stuff takes on a life of its own when it starts going south.”

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Some Money Market Funds Have Large Subprime CDO Holdings

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