Bernanke's New Entourage

Why the Fed is spending more time with the managers of money-market funds

The Federal Reserve has long taken the pulse of the markets by staying in close touch with traders at firms like Goldman Sachs Group (GS) and Merrill Lynch (MER). But as credit market turmoil intensifies, the Fed is widening its contact with the mutual fund industry. In particular, it's holding frequent talks with managers of the funds most investors consider super-safe: money-market funds.

Last year, concerns about subprime mortgage holdings raised the prospect of losses in money funds, prompting the Fed to reach out to a new crew—top fund managers at Fidelity Investments, T. Rowe Price Group (TROW), Federated Investors (FII), and others. Lately, the Fed has been calling this group about a new, though related, concern: fear that liquidity for short-term muni securities will dry up as worries mount about the creditworthiness of companies that insure those bonds. If a bond insurer is downgraded, the ratings of the bonds it insures also drop, as does the price.

What's happening is that tax-free money funds are dumping billions worth of muni securities backed by shaky insurers, and these bonds aren't attracting many buyers. Funds have the right to sell securities back to their brokers. On occasion, doing this is one way muni managers can meet customer redemptions. But now they're using it as a convenient exit strategy to get out of troubled securities before they're downgraded.

An Ounce of Prevention

The Fed worries that banks could wind up stuck with more of these bonds on their books. That would eat up valuable capital reserves. "The Fed wants banks to lend to corporations and personal borrowers, not to act as a holder of last resort," says Robert Auwaerter, who oversees $440 billion in fixed-income assets, including $48 billion in muni money-market funds, at Vanguard Group. Retail muni money-market funds have assets of $289.5 billion; institutional versions of the funds hold $182.4 billion.

Fixed-income managers are talking directly with the Fed's Open Market Operations desk in New York. That's where the central bank's traders buy and sell government securities to keep short-term interest rates close to Fed targets. (A Fed spokesman says the bank speaks with a variety of market participants.) "Overall, this benefits our shareholders immensely by cutting off mistakes before they happen—mistakes that might keep the Fed from understanding some of the illiquidity in the market," says Chief Investment Officer Deborah Cunningham of Federated, who oversees $237 billion in money-market funds.

Fed Chairman Ben Bernanke himself agreed to meet 13 fixed-income chiefs in Washington last Nov. 13. Much of the discussion centered around poor liquidity in the debt markets and the role of credit rating agencies in the subprime meltdown. "It was like meeting a rock star," Auwaerter says. "I give them a lot of credit for listening to us."

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