Your 'safe' money isn't so safe

Investors are fleeing the volatility of the stock market at the year-end, according to industry data, and stashing the proceeds in supposedly nice, safe money market funds at the scorching rate of $18 billion per week.

Yet investors might only be exiting one danger zone and entering another, as a close look at money market funds at major U.S. brokerages reveals that most are invested in the same sort of dubious paper that has rocked the financial world in the past six months.

Although many money market funds have the word "cash" in their names -- leading investors to think that they are no more risky than a handful of paper money -- many are thinly veiled bets on the deteriorating mortgage market, a bet that has gone very bad for Wall Street, to the tune of hundreds of billions of dollars. The question now is how bad it could get for these supposedly safe funds.

Of SIVs and sieves

Yet a little detective work reveals that the 4.5%-plus annual yields on money market funds -- where most of the cash in brokerage accounts resides -- doesn't come from rock-solid U.S. Treasury bonds or bank certificates of deposit. Instead, the yields have been generated by a relatively new brand of mortgage-focused investment companies called structured investment vehicles, or SIVs, that lately have been withering in value.

This is where the subprime-mortgage crisis really hits home, even for homeowners in good standing who have felt that the industry's difficulties were somebody else's problem. If you are among the tens of thousands of Charles Schwab customers who keep cash in the Schwab Value Advantage Money Fund (SWVXX), for instance, then you have had a subprime time bomb ticking away in your brokerage account. Likewise if you are a Smith Barney customer who keeps cash in that brokerage's gigantic Western Asset Money Market Fund (SBCXX). Sadly, these funds are just two among many.

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Brokerages have pledged to shrink their exposure to SIVs and tacitly pledged to support money market funds' values in the event that the mortgage-backed securities in which they are invested go belly-up. But they are not obligated to do so -- and in a doomsday scenario, which is not all that hard to imagine, brokerages will have a snowball's chance in hell of making good on their winks and nods, considering more than $3 trillion is at risk.

Though that may sound surprising, the brokers concede this in the footnotes they attach to their money fund materials, easily found on the companies' Web sites. The footnotes at Schwab read, in part: "Cash may include bank deposits and nonbank balances. . . . Nondeposit investment products are held by Charles Schwab & Co., Inc. . . . and its affiliates and ARE NOT FDIC INSURED, MAY LOSE VALUE, AND ARE NOT BANK GUARANTEED."

If you take the time to read fund prospectuses -- the most recent available detail holdings through Sept. 30 -- you will see these funds held large quantities of commercial paper, which normally refers to short-term debt issued by corporations. But if your fund currently pays a yield of more than 4.25%, then at least some of the commercial paper was issued by SIVs.

This is a problem because SIVs are the bastard stepchildren of financial services. They are basically limited liability corporations run out of the back door of major banks -- "off balance sheet" is the technical term of art -- specifically to earn a profit by gathering funds from yield-seeking investors and then turning around and using that money to invest in financial instruments paying higher rates of return.

Profit and peril in grade inflation

For a few years, creating and running SIVs was almost like minting money, and their fees and profits fattened the bottom lines of the biggest sponsor banks, such as Citigroup (C, news, msgs) in the United States, Dresdner Bank in Germany and Rabobank Groep in the Netherlands.

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But in the past few months we have come to realize that the AAA-rated securities in which the SIVs were invested were little more than gussied-up bundles of mortgage-backed securities known as collateralized debt obligations, or CDOs, and in some extreme cases highly leveraged versions of the same idea known as CDO squared. Because of their varying risks, different CDO slices -- called "tranches" in the trade -- paid the SIVs 6% to 10% yields. You can see why these outfits were so lucrative. They issued commercial paper to borrow your sweep account money for a few months at an annualized rate of 5% and then invested it in CDOs earning, say, 8%. If you can earn a couple of percentage points a year on $100 billion, you're talking real money.

Everyone wanted in on the game, but few took to it like Citibank, which owns the huge brokerage Smith Barney. Its seven largest SIVs were called Beta Finance, Centauri, Dorada, Five Finance, Sedna Finance, Vetra Finance and Zela Finance -- and if you look down the list of commercial paper owned by most money market funds in the third quarter, you will see these names as the issuers of one-month to six-month paper yielding around 5.5%.

Continued: When the smart look dumb

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