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Is Europe's Crisis threatening U.S. money market funds?

Ron DeLegge

Although Europe's sovereign debt crisis seems far away from U.S. shores, its significance and impact to your investments should not be minimized. This is particularly true with money market funds - which have long been known as a quiet and calm investment category. What's the problem?The mutual fund industry has denied that Europe's crisis threatens money market funds, but is it true? How much exposure do money funds have to European banks and how much of a problem could it be?Money Market Funds 101Money market funds, which are sometimes referred to as 'cash,' are an important component to the financial system because they provide investors with a place to park cash. Money funds are regulated under the Investment Company Act of 1940 and are typically sold as a 'safe' place to invest cash because they are designed to keep a steady net asset value of $1 per share. How do they achieve this goal? By investing in commercial paper, U.S. Treasuries and other short-term financial instruments. The first U.S. money market fund was started in 1971 by Bruce R. Bent and Henry B. R. Brown. It was called the Reserve Fund and the idea was to provide investors with a cash management tool that would give them stability and liquidity. In subsequent years, other money market funds offered from banks and fund companies followed. A typically dull investment category can quickly turn treacherous when money funds start taking higher risk to squeeze a few extra basis points of return. This is precisely happened with the storied Reserve Primary Fund during the 2008 financial crisis. Reserve's share price fell below $1 as a result of bad investments it made in Lehman Brothers corporate debt.Unfortunately, history is repeating itself again. Today's low interest rate environment has lured money funds to abandon safety by chasing higher yielding assets in Europe and elsewhere.Problems GaloreAs Greece struggles to avoid bankruptcy, its public debt is estimated to reach a whopping 155 percent of its GDP this year. Last week Portugal's credit rating was downgraded to junk level. But Greece, Portugal and Ireland (NYSEArca: EIRL - News) may not necessarily be the euro-zone's biggest problem. It's the next roster of troubled countries like Spain (NYSEArca: EWP - News) and Italy that are the problem.Italy (NYSEArca: EWI - News) is Europe's (NYSEArca: IEV - News) third-largest economy and yet it suffers from political instability and stagnate economic growth. The country's Economy Minister Giulio Tremonti and its prime minister, Silvio Berlusconi are at odds, causing dissention about which financial plan Italy should follow. Furthermore, Italy's annual growth rate of 0.25 percent has lagged the rest of Europe by almost 1 percent. Here's the problem: Italy's debt is 120 percent of its GDP, so cutting government debt in a low growth environment will be a challenging task.Cash AlternativesETFguide's newsletter ETF pick from June 30 analyzed the Fidelity Cash Reserves Fund (Nasdaq: FDRXX - News) which has around $116.10 billion in assets making it the largest fund of its kind. We selected FDRXX, not to pick on it, but rather to illustrate how investing assets in financial products from European banks (NYSEArca: EUFN - News) is commonplace throughout the entire marketplace for U.S. money market funds. Here's the main point: Exposure to Greece and Portugal could be dwarfed by exposure to sovereign debt issued by Italy and Spain.What does it mean for anyone holding cash inside money market funds?Because of the potential risk to European banks, it's advisable for U.S. investors to error on the side of caution. As such, the prudent course of action is to lineup cash alternatives, which our ETF pick highlighted. When is the best time to protect your capital? It's always before the storm, not as it's occurring.Banks and Your Money Market FundsAs U.S. banks got into trouble during the 2008 credit crisis, money market mutual funds piled into European banks which in turn was heavily invested in garbage quality sovereign debt. This has raised serious questions about the stability of U.S. money market funds should Europe's problems continue to escalate.At the end of June, there was $2.69 trillion in money market funds, according to the Investment Company Institute. Have the problems in the global banking system already spread to this usually quiet and dull corner of the market? Could this be a major setup for round two of a run on money market funds?While the mutual fund industry argues that Europe's crisis isn't a problem, a healthy dose of doubt is in order. Or as George Bernard Shaw explained, 'The power of accurate observation is commonly called cynicism by those who haven't got it.'