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Firms Drop Default Insurance as Costs Rise

Default insurance on money market funds has spiked so sharply over the past year that a growing number of fund companies are dropping coverage rather than paying rates that have increased as much as 400%, according to industry executives.

Putnam Investments has become the latest firm to drop its default insurance coverage on its four money market funds. The firm's policy, which covered up to $30 million in losses, expired in December and the firm decided not to renew, said Laura McNamara, a company spokeswoman. Putnam will file a prospectus update later this month indicating the change, she said. As of the first of the year, the firm held approximately $5.2 billion in assets in the four funds.

Rising insurance costs coupled with money market funds' sagging yields have forced many firms to search for ways to cut expenses, said Peter Crane, VP and managing editor of iMoneyNet, a Web site that tracks money market funds. Default insurance is increasingly being scrutinized, he said. Driving the increase in costs is a rise in the overall default rate as well as the Sept. 11 tragedy, he said.

Moreover, some notable failures by seemingly stable companies like energy companies PG&E and Enron have exacerbated an already bad situation, Crane said. "Money funds weren't exposed to Enron, but any blow-up will have an effect," he said. "Now you can have a triple rating go to default. Blue chippers are no longer safe." Even firms that were once considered sterling, like Ford and GM, are being eyed with caution by the commercial paper market, he said.

As of early December, some 229 issuers had defaulted on more than $94.5 billion of bonds, Moody's reported. That was up significantly from the prior year when just 167 issuers defaulted on $49.1 billion of bonds. And it is likely to get worse before it gets better. Moody's predicts that the speculative grade default rate will peak near 10.5% in the first quarter of this year and hover around 10% for the entire year. That's up from 5.8% last year and just shy of the 13% post-Depression default rate record set in July 1991.

Default insurance costs have become prohibitive, with increases as high as 400%, according to Jim Griffin, a spokesman with Fidelity Investments. Fidelity, which is the largest player in the money market fund arena with 8.63% market share and $193 billion in assets under management as of the first of the year, rang in the new year by dropping its default insurance on all of its money market funds.

Fidelity's move follows a similar decision made by USAA. The Texas-based insurance giant decided to drop its default insurance in December because the costs of providing coverage combined with extremely thin yields raised the possibility of negative returns, according to a company spokesperson.

And Pioneer and INVESCO have cut fees on their money market funds to avoid having negative yields.

Other companies have chosen not to add the insurance, instead implementing other safeguards. For instance, AIM Capital Management's money market funds hold only triple-A quality securities said Karen Dunn Kelley, a senior VP and head of AIM's money market and government securities funds. Because the funds' hold the highest rated securities and are managed using a series of controls to closely monitor the funds, the firm decided that the value of carrying default insurance did not justify the cost. Still, the risk of default is a constant concern, Kelley said.

The rise in insurance costs is not just coming from the insurance providers, but is part of the rising cost of securing reinsurance as well, said Natalie Shirley, president of the ICI Mutual Insurance Group, an affiliate of the Investment Company Institute. "Everytime I turn around, it goes up. When we look at reinsurance, the price goes up regularly. It's gone up anywhere from 30% to 60% in the last year," she said. "To the extent that it is reinsurance costs, you have no choice [on the price increases]."

The ICI Mutual Insurance Group was formed in 1998 by ICI and now provides approximately 20% of all default insurance on money market funds, making it one of the largest providers of such insurance, Shirley said.