Subprime Infects $300 Billion of Money Market Funds, Hikes Risk

By David Evans
Aug 20, 2007 (Bloomberg)

Money market funds were invented 37 years ago to offer investors better returns than bank savings accounts while providing a high degree of safety. Most of the $2.5 trillion sitting in these funds is invested in such assets as U.S. Treasury bills, certificates of deposit and short-term commercial debt.

Unlike bank accounts, money market funds aren't insured by the federal government. They almost never fail.

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.

CDOs are packages of bonds and loans, and almost half of all CDOs sold in the U.S. in 2006 contained subprime debt, according to a March report by Moody's Investors Service.

U.S. money market funds run by Bank of America Corp., Credit Suisse Group, Fidelity Investments and Morgan Stanley held more than $6 billion of CDOs with subprime debt in June, according to fund managers and filings with the U.S. Securities and Exchange Commission. Money market funds with total assets of $300 billion have invested in subprime debt this year.

The danger of owning even highly rated CDOs containing subprime loans was thrown into sharp relief in June, when two Bear Stearns Cos. hedge funds that were holding subprime CDOs collapsed.

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.''
Global financial markets were rocked in July and August, first by the collapse of the Bear Stearns hedge funds and then when banks and insurance companies worldwide disclosed their U.S. subprime debt holdings.

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.

During the first two weeks in August, central banks in Europe, Japan and Australia and the U.S. Federal Reserve lent more than $300 billion to banks to stem a collapse in credit markets.
On Friday, the Federal Reserve lowered the interest rate it charges to banks to 5.75 percent from 6.25 percent in an attempt to contain the subprime mortgage collapse.

Until recently, CDOs had been the fasted-growing debt market -- outpacing corporate and municipal bond sales by dollar total -- with about $500 billion sold in 2006, up from $99 billion in 2003, according to Morgan Stanley.

CDO Slump

About a quarter of the content of all CDOs sold last year in the U.S. was made up of securitized subprime mortgage loans. CDO sales slumped to $11.9 billion in July from $36.9 billion in June, according to JPMorgan Chase & Co.

Each time a bank or financial firm creates a CDO, it forms a free-standing company incorporated offshore, usually in the Cayman Islands, which doesn't tax corporations. All CDOs have a trustee, usually a bank, that prepares monthly reports on the changing contents of the debt package.

The trail that connects subprime debt to money market funds usually starts with a mortgage broker who makes a loan to a homebuyer with poor credit. A middleman then bundles hundreds of these subprime mortgages into so-called asset-backed securities.

Next, a CDO manager buys hundreds of these securities for collateral for a CDO. Some CDOs issue commercial paper, and brokers can then sell that paper to money market funds.

Commercial paper, which is typically issued by banks and large companies, is debt maturing in less than 270 days.

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.

Investors are accustomed to treating money market funds as if they were bank savings accounts. The last thing they expect is that the subprime debt turmoil would enter their safe cash havens. And now it has.

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