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Money Market Funds Face Outflows

Institutions Placing Money in Bank Accounts Instead

Money market funds are poised to experience net outflows this year for the first time since 1983, and an announcement from Lehman Brothers of New York is likely to trigger billions of dollars in further losses.

Lehman is the latest major brokerage firm to begin putting excess cash from its investment accounts into proprietary bank accounts instead of into money market funds, where investment firms have typically parked excess cash.

The firms are moving assets out of money markets because they prefer to maintain control of their assets at one of their own banking divisions, where they can invest or lend the money at higher rates than the nominal fees they charge investors in money market accounts.

Individual investors, however, can still direct the firms to invest their excess assets in money market funds instead of bank accounts.

Merrill Lynch of New York began shifting its excess cash from money markets into bank accounts in the summer of 2000, and Salomon Smith Barney of New York did so one year later. In total, approximately $100 billion has been shifted from money funds to bank deposit accounts over the last two years, according to Peter Crane, vice president at iMoneyNet, a money market fund tracker in Westborough, Mass.

The brokerage firms' banking divisions offered, as Lehman is doing, a one-year "teaser" bank deposit yield just slightly above normal yields. After one year, yields return to typical bank deposit yields, which currently are slightly lower than average money fund yields, according to iMoneyNet.

Merrill initially transferred approximately $80 billion from money funds to bank accounts, but $20 billion of that flowed back when the teaser rate disappeared, Crane said. Salomon Smith Barney transferred about $20 billion out of money funds in 2001, and other brokerage units at firms, including Wells Fargo & Co. of San Francisco and Wachovia Corp. of Charlotte, N.C., have transferred another $20 billion, according to iMoneyNet.

The brokerage units maintain that they are making the change to give investors an additional option. "It's simply another service we can offer clients," said Jason Fargo, a spokesman for Lehman. However, the firms benefit by maintaining control of their assets, which they can loan or invest. By putting these assets in money market funds, the firms can only charge investors a small fee, typically around 0.5%.

Although Fargo, the Lehman spokesman, said that firms have no estimates of how much money this will take from money funds, Crane expects it to be in the billions. And unlike the other firms, which previously held the money in their own proprietary money funds, Lehman uses Pittsburgh-based Federated Investors' money market funds, which will likely soon see significant outflows. Federated did not return calls by press time.

Despite the $100 billion movement over the past two years, money market funds grew tremendously in 2000 and 2001, with inflows of $159.6 billion and $374.6 billion, respectively, according to the Investment Company Institute. However, through March of this year, money funds have experienced net outflows of $44.6 billion. Crane expects that further net outflows this year are likely.

Consumers, in particular, are moving out of money funds because of their low rates, Crane said. Institutional investors also will most likely move out of money market funds if the Federal Reserve raises interest rates, and brokerage firms are now taking money out of money funds and putting it in bank deposit accounts, Crane added.

"It's a triple whammy for money funds this year," Crane said.

At least for the time being, most investors will either not notice or not care about the transfer of their money, as long as it is safe, Crane said. That could change if money market yields begin to climb, however.

Higher FDIC Premiums?

Moreover, as bank account assets rise, the Federal Deposit Insurance Corp. (FDIC) premiums that brokerage firms pay may rise. This would make it less attractive for firms to keep their assets in bank accounts.

The federal insurance fund operated by the FDIC now stands at about 1.26% of insured deposits. If that falls below 1.25%, the FDIC can charge banks a premium of 23 basis points (0.23%) of their total assets, which would cost them millions, Crane said.

That fund has been fully funded for the past five years, so banks have not had to pay any premium and the brokerage firms have gotten a free ride on their bank assets, Crane said. But bank deposit assets have risen dramatically because of relatively higher rates and these brokerage sweeps, and the insurance fund has decreased because the FDIC has had to set aside money for an increased number of banks at risk of failing. Consequently, the FDIC may soon charge a premium on assets. Last Tuesday, the FDIC warned that such assessments would be made later this year.

Bank asset premiums could be especially damaging to the brokerage firms because it is possible that banks that paid asset premiums to the insurance fund in the past would receive a credit, and the majority of the burden would fall on the banks that have paid little or nothing, Crane said. Congress is currently assessing legislation to give the FDIC more flexibility in this area, but it is not clear what, if anything, will come of it.

"It's a total wild card what Congress will do," Crane said. "I wouldn't be surprised if they took no action, with everything else on their agenda, but we'll soon find out."