Sunday Musings: Breaking The Buck

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Among the daily news barrage about the Subprime/credit crisis, high oil prices and the ever worsening real estate down-turn, a little noticed item with potentially grave implications surfaced a week or so ago.

I had originally heard about it a few months ago when a friend of mine, who works for GE (General Electric), mentioned that some of his clients with money at GE where outraged when the cash holdings in their money market accounts were devalued below the $1 level per share. At that time, I suggested that surely GE would not let that happen permanently but infuse capital to maintain the steady $1 level.

Apparently, I was wrong. MSN featured an article titled “No shelter from the housing storm,” which addresses the fact that GE confirmed that it “broke the buck” on its Asset Management money fund, which is a nearly unprecedented event. I have to agree with the author when he posed the question:

“To do that instead of shoring up the fund, one wonders: How bad does GE think things are going to get?”

Writer Andrew Bary, on Barron’s Online on Wednesday, reported that the fund has “suffered losses in mortgage- and asset-backed securities and is offering investors the option to redeem their holdings at 96 cents on the dollar.”

Hmm, 96 cents on the dollar? That’s a sure 4% loss with no way to make it up. Why bring it up now?

As the economic picture worsens, you are likely to see this scenario repeated. Smart firms, if they can, will avoid this outcome by shoring up their money funds with an infusion of their own cash, such as Legg Mason did last week by adding $100 million to one of its money funds and providing $238 million in credit for two others.

Obviously, mutual funds will try as hard as they can to avoid this disaster; however, if pressed due to credit or liquidity problems, you will be left holding the ever shrinking bag.

What can you do about it?

For years, I have advocated the fact that when our Trend Tracking Indexes are in negative territory, and our holdings are in cash, safety is of the utmost importance. That means using a treasury-only money market.

Whenever I talk with new clients, undoubtedly one of the early questions is how much interest the money market account pays when we’re in cash. Usually, the rate has been somewhat lower than what you could get in the open market. My argument that safety is of primary concern when in money market funds has largely been ignored. Most every investor smugly tries to squeeze an extra ½% yield or so out of their cash holdings.

This has now become a dangerous game, and I suggest that you review your money market prospectus especially if your yield is too good to be true. Remember, there is no free lunch!

My view has always been that the yield of a money market account is unimportant; it will not make you rich unless you have a vast amount of cash to play with. Investing at the right time during an up trend, using sell stops and avoiding bear markets is what will grow your portfolio.

When that trend comes to an end, and you are headed for the sidelines, safety of capital should be your priority number one. Especially in today’s volatile, over-leveraged and non-transparent investment climate, don’t try to pick up nickels in front of a moving bulldozer.

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Comments 2

  1. your reference to the GE fund as a “money market fund” is disturbing. this fund is a short duration bond fund, a wholly separate asset class from money market mutual funds which operate under the guidelines of SEC rule 2a-7. investors in the GE fund assumed a greater degree of risk than they would have by investing in a 2a-7 fund. these risks would have been disclosed in the prospectus and should have been disclosed verbally by any agent selling the fund. comparing this situation to others at Legg Mason, etc where action was taken to shore up the NAVs of their 2a-7 money market funds is inappropriate and misleading. recent events could lead one to argue that the 2a-7 money fund industry has strayed from its mandate to preserve principal at all cost, however the GE episode is not the one to point to when making this argument.

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