What are the Risks of Money Market Funds
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Most people are used to taking for granted that when they have money in the bank, it's "insured" by the government. If the bank goes out of business, the taxpayers will bail them out. However, money market accounts (MMA) are not insured by the FDIC.
Therefore, general purpose funds can be considered somewhat risky.
In practice, this risk of money market fund accounts has proven to be effectively nothing
In 1990, 1994 and 1999 some commercial notes owned by some money market funds did default, despite the high ratings of the issuers. However, the losses were absorbed by the money market fund itself. Individual account holders did not see any problem.
Therefore, the financial community at large believes that money markets will never "break the buck" -- or allow the net asset value (NAV) of an account to go below $1.
All debt securities are only as good as the companies issuing them
And short-term debt is particularly safe, simply because a company must either pay it off or declare bankruptcy. And The Securities and Exchange Commission does require funds to invest only in the paper of companies with high credit ratings.
It's not impossible for them to go out of business (in the early 1970s Penn Central declared bankruptcy and defaulted on its commercial paper), but it's not likely. And even if it happens, short-term debt can be paid the quickest and easiest.
In 1994 an institutional money fund used some derivatives for leverage and this back-fired. The institutions that made up the fund decided to liquidate it, and the liquidation rate was 94 cents on the dollar, so they lost 6%. This fund did not have any individual account holders.
No person has lost money due to the NAV of a money fund going breaking the buck below $1
Commercial paper is rated by agencies just like bonds are. The highest rates are: A1/P1 (or A1+/P1).
Moody's highest rating is Prime-1 or P1. Standard & Poor's is A1.
If you invest in tax-exempt money funds, then your money depends on the taxing ability of the local government that issued those general oblifation securities, or on the money-making ability of particular agencies (such as those that operate toll roads). It's not impossible for a local government to declare bankruptcy. The Washington Power Supply and Orange County California have done so.
However, the broad diversification of securities, as well as their short-term status, protects you
In the (historically) unlikely event of a default of one security, the fund still owns many more.
Of course, it's not impossible that someday we'll see a broad economic collapse and a large number of corporate and local government bankruptcies. But if that happens, you're probably have many more problems to think about than your money market funding breaking the buck. Keep some gold and silver coins buried in your back yard.
If you want to eliminate all default risk, go with funds that invest solely in Treasury bills and other U.S. government agency securities. These are backed up by the full faith and force (and taxing power and printing press power) of the U.S. government.
If you want to have the comfort of being insured by the U.S. government's Federal Deposit Insurance Corporation (FDIC), you should learn what are money market deposit accounts (MMDA)
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