Downgrades of banks and broker-dealers Monday by Standard & Poor's have raised the possibility that some of these could eventually be in danger of becoming "Second Tier" issuers, which would limit the amount of debt that money market mutual funds could buy. J.P. Morgan Securities published a research piece yesterday, written by Alex Roever and Cie-Jai Brown, entitled, "S&P ratings actions challenge funding for Lehman and Merrill", which discussed this issue.
The note talks about the downgrades of long-term debt ratings on Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JPMorgan, but notes that all of these remain comfortably "First Tier" for now. However, Lehman and Merrill's long-term debt ratings were reduced to 'A'. The JPM report says, "S&P has effectively lowered the ratings for these issuers to the precipice of A-2, a rating level that is still considered investment grade, but can only be held in limited amounts by many short-term investors."
Rule 2a-7 of the Investment Company Act of 1940, the quality, diversity and maturity regulations governing money market mutual funds, says that funds may only invest in "First Tier" or "Second Tier" securities. First Tier means at least two of the top short-term ratings, such as A-1, P-1, F-1, while Second Tier means ratings at or above A-2, P-2, F-2, etc. Funds may invest up to 5% of assets in First Tier names, but just 1% per issuer in Second Tier (with a 5% total Second Tier bucket).
Roever says, "A further downgrade by S&P would create an issue for money market investors governed by rule 2a-7.... The rub here is that rule 2-a7 imposes explicit restrictions on the amount of Second Tier securities a fund can hold." But he adds, even with a downgrade, Lehman and Merrill, "would continue to qualify as First Tier securities... since at least two NRSROs continue to rate these firms in the agencies highest short-term rating categories."
"Many prime funds take some or all of their broker exposure in the form of repurchase agreements (repo) which do not necessarily count for purposes of calculating issuer concentrations. Rule 2a-7's portfolio diversification standards permit a fund to 'look-through' a repo to the underlying collateral," says the research note.
Finally, the report says, "With recent events having dramatically elevated the level of risk aversion among money funds and other short term investors, it would seem that the willingness of investors to weather market challenges is more limited than normal." But JPM doesn't believe the events are a "near-term threat to overall solvency", citing the Fed's Term Securities Lending Facility (TSLF) and Primary Dealer Lending Facility (PDLF), as well as other funding sources.
