Even More Unstable Value Funds?

by: David Merkel, CFA

There’s a lot that I don’t know here, but what I do know concerns me. Stable Value funds are a murky part of the market. They are murky because they don’t report the value of the underlying assets, but only the smoothed value of assets, and the rate that they are currently crediting. (Note: for those that want the grand tour of Stable Value Funds, I wrote this piece at RealMoney, The Biggest Asset Class You Never Heard Of.

Other articles I have written:

I have debated as to whether I should write a piece like this, but at this point I figure that someone will eventually point this out, so better for me to do it, than for it to come from another quarter. Let’s start with the question, “How does a stable value manager manage the fund?”

In the old days, it meant buying Guaranteed Investment Contracts [GICs] from insurance companies, and buying the highest rate offered, because they were all AAA in the late 80s. Even before defaults happened, the stable value funds found that there was not enough capacity in the insurance industry to write GICs at reasonable rates. As a result, they began buying AAA assets in the structured product markets, and purchase wrap agreements that allowed those assets to be carried at book value rather than market value.

The difference is this: book value is for savers. Just take their deposit, and credit interest to them. No volatility. That’s the beauty of stable value; it seemingly eliminates the volatility of the markets, and lets savers be savers.

But what is going on under the hood? Many AAA asset classes have done poorly in the recent past, and I am not talking about CDOs.

Stable value funds have an average maturity of around 2 years. If I look at AAA asset-backed, commercial mortgage-backed, or corporate securities in the 2-year maturity bucket, I see dollar prices that average around $90. Stable value funds may have $90 of assets at current market value backing $100 of book value.

This is not a stable situation, no joke intended. If I were in this situation, I would move all of my money to the most stable option in my DC plan that I could, because of the possibility of a run on the fund. Now, if few withdraw on net, after 2-3 years, this situation will likely resolve itself.

But who can rely on the intelligence of other fundholders? This is like the prisoner’s dilemma, where he can act and get something, harming others in the process, or get harmed himself. Consider your own needs here; my own view is that we will see failures of stable value funds within 2009.