The cash shortage that is facing U.S. Financial institutions is putting a strain on their ability to cover liquid investments, such as Money Market Funds. These funds typically pay out 4 – 5 percent interest, which rivals any CD or other short-term investment. The problem is that Money Market Funds are NOT insured up to $100,000 like your bank account. That means that if the bank needs your money to make up deficits elsewhere, they can take it right out of your account and not pay it back.
When a money market fund pays out less than what was invested, it’s called “Breaking the Buck”. In recent history, such a scenario has occurred twice, once in the late 1970’s and once in 2008. However, we are currently witness to a decline in home prices, and rise in foreclosure rates unparalleled in American history. There could be some rough waters still ahead for financial markets, which might require financial institutions to “steal” from money market funds.
Many Americans have huge sums of money tucked away in MM funds sponsored by Smith Barney or Charles Schwab, for instance. Many of those funds are invested in mortgage-backed securities, which may lose most or all of their value in the coming months. If you are concerned about the stability of your Money Market fund, the best thing to do is to contact your financial institution and check into switching to a government-backed fund. It will probably yield a lower interest rate, but could be much safer than your traditional money market fund.
The recent downturn in the mortgage and housing markets hit some of the big financial institutions really hard in 2007. Outfits like Citi (C), Washington Mutual (WM), and Countrywide Financial (CFC) have seen their stock prices drop dramatically in the last six months. That’s not to mention the companies like New Century Financial (NEW), who went completely bankrupt.
The majority of problems in the financial industry have been caused by huge investments in mortgage-backed securities. These investment vehicles have been difficult to value because it was often not known what percentage of the mortgages were those made to risky customers. Thus, those who land money to the big financial institutions have started to pull back their funds, and the banks have had to look elsewhere (such as overseas) for funding. In fact, Citibank has received huge cash infusions from Arab investors twice in the last three months, and may need more very soon.