So far, so good for money funds in US debt crisis

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BOSTON (AP) ? Money-market mutual funds have passed their first big test since the 2008 financial crisis.

Risks of a U.S. debt default sent investors fleeing the low-risk cash investments in recent weeks, stirring up memories of a money fund’s collapse triggered by the bankruptcy of Lehman Brothers.

This time, money funds’ perceived weaknesses were their huge investments in Treasury bonds, and fears that the government might not make good on those IOUs.

As talks to lift the nation’s debt ceiling stumbled, investors withdrew a net $122 billion from money funds in the seven-day period ended Monday, according to industry researcher Crane Data. That exodus trimmed almost 5 percent of the $2.6 trillion that the funds hold, with much of it transferred to bank accounts.

It was comparable to the rush out of money funds in September 2008 when one of the largest funds collapsed, leaving investors temporarily unable to access cash, and facing small losses on their investments. The debacle marred a near-perfect safety record for money market funds in terms of protecting investors from losses.

There haven’t been any indications that any funds have run into such troubles this time around, with no investment losses or frozen cash. The outlook brightened when President Obama signed the debt deal into law Tuesday, and Uncle Sam avoided the risk of default. Investors promptly reversed course, depositing a net $6 billion into money funds that day.

It’s expected that investors will continue to seek shelter from the stock market declines driven by recent disappointing economic news, and pour their cash into money funds.

“They have definitely dodged the bigger crisis,” says Peter Rizzo, a credit analyst who rates money funds for Standard & Poor’s. “Had the government gone into default, there’s a domino effect that could have occurred.”

Similar concerns were echoed by Fitch Ratings, which warned last month that a government default could send investors rushing to the exits again. In turn, that could have forced money fund managers to sell holdings at discounted prices so they could return cash to their investors on demand. Fitch noted that U.S. money market funds hold about $1.3 trillion in government-backed debt, about half of all money fund assets.

Those investments may still leave money funds vulnerable to a potential downgrade of U.S. debt. The latest warning came Tuesday, when Moody’s Investors Service assigned a negative outlook to U.S. debt, but confirmed its AAA rating, for now. A negative outlook means the rating could be lowered in the next 12 to 18 months.

Yet S&P’s Rizzo sees minimal risks to money fund investors from any downgrades. Should that happen, the wild card is whether investors will choose to pull their money out of money funds again, despite new rules that further restrict how money funds invest.

If investors react rationally to a downgrade, there should not be a shock to money funds, Rizzo says.

Here are a few basics about money funds, and reasons why investors face low risks of losses or lack of access to cash in case of a downgrade:

?Money funds defined: Money funds put clients’ cash to work by investing in short-term debt. They’re restricted to the most credit-worthy securities, such as Treasurys, and short-term corporate bonds called commercial paper. They’re designed to be safe harbors where individuals and professional money managers park cash, keeping it easily accessible until they decide it’s time to put the money to work in stocks, bonds or other investments.

Money-market mutual funds differ from money-market accounts at banks. Money-market accounts and checking accounts are guaranteed by the FDIC, while funds are investments that carry the possibility of losses. Temporary money fund guarantees that the government extended during the financial crisis expired nearly two years ago.

?Returns: Historically, money funds have delivered slightly higher returns than bank accounts. But investors have pulled huge sums from money funds over the past two years because low interest rates are keeping returns at historic lows. Yields normally ranging from 2 percent to 4 percent have recently averaged around 0.02 percent ? $2 a year for each $10,000 invested. But you can’t get much more from various bank alternatives now. For example, the best rates available nationally for one-year certificates of deposit barely exceed 1 percent.

?Credit quality: If U.S. government debt is downgraded, money funds won’t be forced to sell their Treasurys and other debt. They could continue to hold and even buy AA-rated securities, provided a fund’s managers determine those investments pose a “minimal credit risk” ? a legal requirement for money fund holdings. Rizzo says Treasurys would still be fair game under any downgrade scenario now envisioned

Also, any downgrade might lower the government’s long-term debt rating, but leave its AAA short-term rating intact. Money funds are restricted to investing in short-term debt, so a long-term downgrade wouldn’t directly affect money funds.

? Cash access: Regulations strengthened last year require money funds to hold a larger proportion of their portfolio in cash than they were allowed previously. This helps ensure investors can get money back on demand. Also, bond investments must have an average maturity of no more than 60 days.

The vast majority of money funds are exceeding minimum regulatory requirements, with a recent trend toward even more conservatism, Rizzo says.

?Transparency: Money funds now are required to publish portfolio holdings on their websites every month. This is intended to help prevent another situation like the one in September 2008, when investors worried that their funds might share the weakness that brought down the Reserve Primary Fund ? a soured investment in Lehman Brothers debt. Many investors quickly withdrew cash, not knowing what investments were in their fund’s portfolio, and figured it was better to be safe than sorry.

With the new disclosure rules, “there’s much less of a risk of panic from someone yelling ‘Fire!’ in a theater,” Rizzo says.

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Questions? E-mail investorinsight(at)ap.org.