Wells Fargo Advantage Funds' latest "Overview, strategy, and outlook", which we mentioned in our "Link of the Day" yesterday, contains a section on "Headline Risk" that we thought worth quoting. Wells' Dave Sylvester says, "All of this "noise" is not without effect. The frequent, minor rating changes, and the widening of CDS spreads in anticipation of and subsequent to these changes provides fodder for a seemingly endless series of negative press about the ongoing "credit crisis." After numerous articles about the negative implications of the review of French banks by Moody's, how many articles heralded the affirmation of BNP's rating? It was reported, but not in a series of page-one news stories unfolding over weeks and months."

He continues, "This negative news cycle contributes greatly to investor anxiety. In an effort to assuage investors, money funds manage their "headline risk" by avoiding issuers who are in the news. It only makes sense from the funds' perspective. Not only are these issuers subject to widening spreads due to selling resulting from the negative coverage, but owning them may prevent some investors from buying the funds' shares. Those who talk of money funds cutting off credit from borrowers do not seem to give sufficient weight to the role that the funds' investors play, or appreciate that, to a large degree, the funds' actions simply reflect the preferences of their shareholders. Is it not desirable that money market funds strive to be responsive to the expectations and preferences of their shareholders? Was this not the purpose of requiring funds to be more transparent about their holdings?"

Sylvester explains, "The problem with managing headline risk this way is that, as the supply of eligible investments continues to dwindle, replacement investments are not so easily found these days. At some point, money market participants may end up incrementally increasing real risk -- perhaps in quality, perhaps in concentration, perhaps in duration -- in order to reduce headline risk. At some point, there will be no pure "risk off" trade. Since they have a voice in how their funds are invested, money fund shareholders must ask themselves if this is the outcome that they want to further. Will they someday regret casting aside issuers of fundamentally high credit quality, like the French banks, for the sake of appearances?"

The Wells monthly concludes, "Low rates and negative news are wearing on the markets and contribute to the pervasive negative psychology. Investors are concerned about credit quality, but some of that concern may stem from over-active rating agencies and a reliance on CDS spreads as a measure of credit quality. As the negative press continues, funds will attempt to manage their "headline risk" in order to avoid those issuers that might have real problems or may simply drive customers away. Much of this negative feedback loop is now focused on the European banking sector."

Finally, Sylvester writes, "We recognize that there are significant challenges ahead for European political and financial leaders. The Euro-skeptics who said that monetary union without fiscal discipline was doomed may yet be proven right. We believe that the effects of the sovereign debt problems on the eurozone banks will be large, but they are not, at this point at least, unmanageable. We are glad to see that the focus of the European authorities seems to have changed from propping up the sovereigns to protecting the banks in an orderly wind-down of peripheral debt. However, we also recognize that the problem facing Europe is one of contagion, and that this contagion is exacerbated by the negative psychology that pervades the markets, especially the money markets. We believe that the constant barrage of negative news stemming from relatively minute changes in credit ratings, along with the increased volatility that investors see in the CDS market, are significant contributors to this negative psychology. Unfortunately, as seems to be the case with the economy, the patient's psychological symptoms may prove harder to cure than the fundamental illness itself."

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