Mania for Money Market Funds

Small investors get a better deal, but some banks are hurting

How to preserve capital in a time of double-digit inflation and depressed stock prices? Frustrated savers and unhappy investors are turning to the same solution. In record amounts, Americans are buying into the relatively new money market mutual funds. They offer minimum risk and yields of 10% to 13%, double or more the low rates set by the Government on passbook savings accounts.

The money funds invest not in stocks or gold or commodities but in high-quality, high-interest bank certificates of deposit, commercial paper, Treasury Bills and other U.S. Government securities.

The idea of investing in this money market is hardly new, but the minimum stakes are so hefty that trading used to be done only by rich people, corporations and institutions looking to park their idle cash. This discrimination has been ended by the swelling number of money funds that have been formed by mutual fund companies and brokerage firms to pool small investors' assets. Since the returns rise along with surging interest rates--and the highest bank prime lending rate rose to 15 1/4% last week--money market funds are booming. About 75 such funds now handle nearly $40 billion in assets, way up from $11 billion in January and only $4 billion early last year. William Donoghue, publisher of Donoghue's Money Fund Report, estimates that new funds are being created at a rate of two a month to handle money that is continuing to pour in at a net rate of about $175 million a day.

Most funds demand a minimum initial investment, which generally ranges from $500 to $5,000 but can be partly withdrawn once the account is open. The funds make money for themselves by paying out to shareholders slightly less interest (usually one-half of 1%) than the investments earn. One of the most appealing features is liquidity. Nearly all offer instant withdrawal without penalty, and most allow shareholders to write checks to third parties against their investment balance, thus ensuring that savings earn interest right up to the day the check is presented for payment. Still others offer credit lines so that shareholders can borrow against their investment.

People transfer money into funds primarily by selling off stocks and withdrawing deposits from banks and savings and loan associations. This shift away from shares could further damage capital formation; companies ideally tend to raise long-term investment money in the stock and bond markets but go to the money market for short-term borrowings to cover operating expenses. The move out of savings is badly hurting the thrift institutions. They face a tremendous competitive disadvantage and a sharp outflow of funds because the Federal Reserve's Regulation Q prohibits them from paying more than 5 1/2% on passbook savings. A bill before the Senate would slowly phase out the interest rate ceilings by 1990. Meanwhile, says Robert Garver, president of Boston's Charlestown Savings Bank: "The money market funds are killing us."

The net outflow from mutual savings banks in September hit $1 billion, a record for that month. Some banks are so pressed for funds that they have stopped making mortgage loans. Federal bank officials are sufficiently worried that they are preparing contingency plans to rescue any troubled institutions.

Fighting a rearguard action against the money funds, many bankers trumpet that their deposits are guaranteed by the Federal Deposit Insurance Corporation, and that money market funds are riskier. There is a slight risk, but since the funds are put largely into top bank and corporate securities, a number of banks and cor porations would have to go broke before the typical money market investor would suffer much loss. He would not even lose, but his yields would go down, if interest rates declined. If they dropped far enough, he might have been wiser to invest in a long-term bank note. For example, a nine-year certificate of deposit now pays about 9%; that, of course, is less than most money market funds, but it is guaranteed for the longer term.

In any case, the money fund yield is not so large as it seems. The interest paid by most funds is subject to federal, state and local income taxes, just as are savings.

Those levies pull the yield down well below the inflation rate. Sums up Donoghue:

"If you put your money into a savings bank account at 5 1/2% while inflation is more than 13%, you get poor very quickly. With money market funds, at least you get poor slowly."

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