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Credit crunch highlights risks in money markets

Funds exposed to defaults, volatility

How safe is your money- market fund?

For investors who do not have the stomach for the ups and downs of the stock market, money-market funds have boomed in recent years as a haven for consumers to park their money. Boston mutual-fund giant Fidelity Investments manages $326 billion in money-market funds, up 67 percent since the end of 2004. Investments can earn almost 5 percent annually in some of the biggest funds, supposedly without the risks associated with stock markets.

Supposedly. But since summer, problems have cropped up in several large money-market funds, showing that to achieve higher returns and attract more customers, some money-market managers may have been investing in riskier holdings.

Earlier this month, Wachovia Corp. of Charlotte, N.C., disclosed a $40 million loss tied to money-market funds at its Evergreen Investments unit in Boston. Evergreen's largest money-market fund holds a stake in at least one of what are known as "structured investment vehicles," or SIVs, complex financial instruments that have become difficult to trade as credit problems have spread throughout the economy since the summer.

US Treasury Secretary Henry Paulson has proposed that banks create a fund of about $80 billion to prop up the market for SIVs.

Fidelity and another large Boston-based fund company, Bank of America Corp.'s Columbia funds, also have significant holdings in SIVs, corporate filings show.

The institutions say their funds are in good shape overall. But money-market managers might be in for a difficult time, said Henry Shilling, leader of a money-market team at Moody's Investors Service, a rating agency in New York.

Money-market funds "are very safe, but clearly they're experiencing unprecedented volatility," Shilling said. Moody's knows of 145 serious cases of money-market fund problems since 1972, including the recent writedown at Evergreen, Shilling said, adding, "I suspect there will be others in the future."

On the other hand, the problems have not dampened investors' enthusiasm for money-market funds overall, said Peter Crane, whose website based in Westborough, cranedata.us, tracks the industry. He says investors have put more money into these funds than they have withdrawn nearly every week since August. Total holdings in US money-market funds are approaching the $3 trillion mark.

"Call them lazy, or call them genius, but US investors haven't blinked," he said.

Unlike mutual funds that invest in stocks for the long term, money-market funds invest in US Treasury bills and other short-term securities that allow them to pay slightly more interest than products like certificates of deposit. Money-market funds aren't insured like bank accounts but are perceived as safe because most invest in government securities, or government-backed mortgages. To increase their returns, many also invest a portion of their funds in "commercial paper" such as mortgage loans packaged into SIVs or corporate debt backed by assets like real estate. Fund companies earn lucrative fees managing money-market funds.

The price of a share in a money-market fund is fixed at $1. If the value of the holdings in the fund falls much below $1 a share - a disaster known as "breaking the buck" - the fund company must take steps that can include eating the losses or dissolving the fund. The worst case dates to 1994 when investors lost 6 cents on every dollar they had put into a fund managed in Denver, Community Bankers US Government Money Market Fund.

Crane said those losses for investors were minor, however, compared with the returns to investors in previous years. Overvalued holdings in money-market funds are more likely to be a serious problem for fund companies than for investors.

At Fidelity, for example, the money-market funds hold debt issued by various SIVs, including the largest, Sigma Finance Corp., operated by a London firm called Gordian Knot Ltd. Other Fidelity holdings include two run by Citigroup Inc., Beta Finance Corp. and Centauri Corp. Some specialists wonder if Fidelity has invested in SIVs too aggressively as it sought to boost the interest rates it can pay investors.

"Fidelity seems to be one of the biggest culprits as far as chasing yield," said Joseph Mason, a Drexel University finance professor.

Fidelity spokesman Vincent Loporchio said in response that "our first priority is to ensure that credit quality of the holdings in the funds is of the highest order" and noted the management meets SEC requirements. As of Sept. 30, he said, debt securities were just 2.3 percent of money-market assets.

Loporchio said further that "Fidelity has a rigorous research process to approve SIV debt securities for purchase in the money-market funds. We have been very selective in this approval process and have an in-depth understanding of each SIV investment manager, the quality of their asset portfolio, liability management, and overall operations."

SIVs generally buy longterm securities including some backed by mortgage portfolios, financing them by issuing their own shorter-term securities like notes or commercial paper. These securities have become more difficult to sell lately as they mature, however, raising the chance of default. As of Oct. 12, for instance, Bank of America's Columbia Cash Management money-market fund held $644 million worth of Cheyne Finance LLC, a SIV run by a British hedge fund that was forced to sell some holdings to repay other obligations and had its credit ratings cut to default last week by Standard & Poor's.

"To date, no SIV has had a significant negative impact on our money-market funds," said Columbia spokesman Jon Goldstein, noting that the SIV represented about 1 percent of the fund's total holdings of $67 billion.

An Evergreen spokeswoman declined to discuss the fund's SIV holdings in detail or describe the reasons for the $40 million writeoff. Evergreen and Wachovia have said previously that they are "committed to preservation of capital in the money-market funds" - in this case meaning the parent would make good on losses in the funds so that investors would not be harmed.

Ross Kerber can be reached at kerber@globe.com.

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