Money Market ETF Not as Safe as it Appears

The subprime mortgage crisis and credit crunch have spilled into the $2.5 trillion muni bond market. Munis swooned in August when some troubled hedge funds dumped them to raise cash. They recovered some of the lost ground in September and October as the credit markets stabilized, but over the past few weeks, there have been fresh signs of trouble.

This time the fear is that companies like Ambac Financial Group(ABK Quote) and MBIA(MBI Quote) that insure muni bonds will run into trouble. These same companies also insure securities backed by subprime mortgages, and as more of these loans go bad, the insurers are being called on to cover missed interest and principal payments.

"The floating-rate market in munis is in turmoil," says Matt Fabian, senior analyst at Municipal Market Advisors, an independent research and strategy firm. "There is a lot of concern about the bond insurers in VRDOs.

Fitch Ratings has already raised questions about the cash reserves of several bond insurers. If the insurers are downgraded and lose their triple-A ratings, the muni bonds they insure would lose some value. "In the near-term, trading and liquidity would likely be disrupted," says Fabian. He says that might induce holders of VRDOs to demand repayment, depleting the cash reserves of the banks that provide liquidity.

"It appears to be very poor timing for the ETF because of all the concerns about the big bond insurers," says Peter Crane, president and publisher of Crane Data and Money Fund Intelligence.

He notes that the subprime mortgage crisis has made investors extremely averse to complex instruments such as the securities backed by mortgages. "And anything with 'variable' in the name means structure, complex or both," he says, referring to VRDOs.

VRDO investors are by nature cautious, so any market disruption would likely be compounded by the number heading for the exits. "Currently tax-free and municipal money market mutual funds hold 75% of their assets in rated demand notes," says Connie Bugbee, managing editor of Imoney.net. "I would hate to say they are no longer safe."

Safe or not, now might not be the best time to buy the VRDO ETF.