Money Funds Get ‘Micro Bailouts’ as Disclosure Rules Take Effect

Money funds are covering small losses on their investments to avoid unsettling clients when tighter U.S. rules will require them to disclose even small shortfalls.

Charles Schwab Corp., based in San Francisco, spent $132 million last quarter and Baltimore’s T. Rowe Price Group Inc. said it will spend $17 million this quarter to eliminate losses from securities that went sour in 2008. The deficits weren’t big enough to push the funds’ share prices below $1.

“The reforms may usher in an era of micro-bailouts,” Peter Crane, president of Crane Data LLC, a money-fund research firm in Westborough, Massachusetts, said in an interview.

Starting this month, the Securities and Exchange Commission is requiring money funds to unveil a net asset value that reflects small, previously undisclosed realized and unrealized losses or gains, a figure known as a “shadow NAV.” Fund companies, including Fidelity Investments and Vanguard Group Inc., opposed the change, arguing it might confuse investors.

The firms want to avoid spooking clients after the 2008 failure of the $62.5 billion Reserve Primary Fund led to a run on money funds. Reserve Primary’s net asset value had fallen to 97 cents per share, because it held debt issued by bankrupt Lehman Brothers Holdings Inc.

‘Meaningful Dialogue’

“The SEC said this rule could result in a meaningful dialogue between investors and fund managers when there is a discount” in the shadow NAV, Joan Swirsky, an attorney at Philadelphia law firm Stradley Ronon Stevens & Young LLP who specializes in money-market funds, said in an interview.

The decisions by Schwab and T. Rowe Price, she said, “indicate that’s a dialogue the companies would rather not have.”

SEC spokesman John Heine declined to comment.

The predicament adds to woes for the industry caused by record low interest rates. Yields that average 0.08 percent for the biggest 100 taxable funds, according to Crane Data, have helped reduce assets by 14 percent this year to $2.8 trillion. Funds have also been forced to waive some fees in order to keep yields above zero. Crane estimated the industry’s fee revenue will fall below $7 billion this year, down from $11 billion in 2009.

“For smaller companies, this gives them another reason to re-evaluate why they have money funds and whether they want to continue,” said Mike Krasner, managing editor for research firm iMoneyNet Inc. in Westborough, Massachusetts.

$1 Share Price

Money-market funds maintain a $1 share price for investors by recording their holdings at or close to their expected value at maturity, and by rounding to the nearest penny. Using the maturity value allows funds to ignore day-to-day fluctuations in the market prices of holdings. The rounding serves to obscure realized losses that amount to less than half-a-cent a share, or 0.5 percent of assets.

Funds realize losses and gains when they sell a security below or above its maturity value, and commonly deviate from $1 by a few hundredths of a penny, according to Deborah Cunningham, head of taxable money funds at Federated Investors Inc., which managed $233.6 billion in money-market mutual funds as of Sept. 30.

As long as losses don’t surpass half a penny, a fund can eliminate them over time by offsetting losses with capital gains. Realized losses of more than half a penny force the firm to round the share price to 99 cents, a drop in value known as “breaking the buck.” Only two money-market mutual funds have ever broken the buck, the more recent being the Primary Reserve Fund in September 2008.

Shadow NAVs

Under the new rule, funds must report shadow NAVs to the SEC every month beginning at the end of November. The SEC will make those public 60 days later.

In addition to showing how the market prices of money fund holdings fluctuate, the shadow NAVs will also reveal more frequently and in a much clearer way than before any realized losses being carried by the funds.

The shadow NAV must be spelled out to four places past the decimal point, so a $2 billion fund carrying a $1 million loss will report a shadow NAV of $0.9995.

Crane said an unknown number of funds are still carrying losses stemming from the financial crisis. He said that while he expects many funds to report shadow NAVs below $1, anything below $0.9990 would be an “outlier.”

Standard & Poor’s, which rates money funds, asks for daily pricing reports whenever a fund dips below $0.9985. While that level is not necessarily cause for worry, it could alarm some investors, said Peter Rizzo, senior director of fund services at S&P in New York.

Lehman Debt

T. Rowe Price plans to spend $17 million, or about $10.5 million after taxes, to top up three funds, including two that are available to retail investors, the $5.5 billion Prime Reserve Fund and the $5.5 billion Summit Cash Reserves Fund, said Edward Giltenan, a spokesman for the firm.

“We took this action to allay any shareholder concerns or confusion as this new rule gets implemented,” Giltenan said in an e-mailed statement. “These funds, and all T. Rowe Price money-market funds, have never redeemed shares at a loss to shareholders.”

Prime Reserve had a $10.4 million realized loss as of Nov. 30, 2008, according to a regulatory filing, resulting in a NAV of $0.9984. Most of the loss resulted from debt issued by Lehman Brothers, Giltenan said. The NAV rose to $0.9985 as of May 31 of this year.

Summit Cash Reserve also held Lehman and reported a realized loss of $8.3 million, resulting in a net asset value of $0.9987 per share on Oct. 31, 2008. That rose to $0.9992 by April 30, 2010.

T. Rowe manages $14.3 billion in money market funds.

‘Educating Shareholders’

The Schwab losses, spread across seven money funds, all stem from holdings in Whistlejacket Capital Ltd., a structured investment vehicle that defaulted in February 2008. The funds sold the holdings at auction in April 2009, recording about a 20 percent loss on the debt, according to Greg Gable, a spokesman for Schwab.

“We believe the SEC’s recent money market reforms will help educate shareholders about the minor fluctuations that occur in a fund’s mark-to-market NAV,” Gable said in an e-mail. “However, Schwab and many other firms in the industry believe that not all shareholders may understand this initially.”

Schwab manages $151 billion in money market funds.

Fidelity, Vanguard

Boston-based Fidelity, Vanguard in Valley Forge, Pennsylvania and Pittsburgh’s Federated, three of the six largest U.S. money fund providers, according to Crane Data, each said that all their taxable money funds currently carry shadow NAVs at or above $1. Tax-exempt funds carry small realized losses for tax reasons, Federated’s Cunningham said.

Rizzo said some companies are being forced to weigh the cost of injecting money into funds they believe are safe against the risk of a panic by customers.

“It boils down to their feelings over whether shareholders understand what the shadow NAV means,” Rizzo said.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE