A new paper entitled, "Assessing Credit Risk in Money Market Fund Portfolios," written by ICI Economists Sean Collins and Emily Gallagher, counters claims by Boston Federal Reserve President Eric Rosengren and others that money market funds take significant credit risk. The Abstract says, "This paper measures credit risk in prime money market funds (MMFs), studies how such credit risk evolved in 2011-2012, and tests the efficacy of the Securities and Exchange Commission's (SEC) January 2010 reforms, which were designed to improve the ability of MMFs to withstand severe market stresses. To accomplish this, we create a measure called "expected loss-to-maturity" or ELM. This is an estimate of the credit default swap premium (CDS) needed to insure the fund's portfolio against credit losses. We also calculate by Monte Carlo the cost of insuring a fund against losses amounting to over 50 basis points. We find that ELM for prime MMFs was 15 basis points on an asset-weighted average basis over 2011-2012. Credit risk of prime MMFs rose from June to December 2011 before receding in 2012. Contrary to common perceptions, this did not primarily reflect funds' credit exposure to eurozone banks because funds took measures to reduce this exposure. Instead, credit risk in prime MMFs rose because of the deteriorating credit outlook of banks in the Asia/Pacific region. Finally, we find evidence that the SEC's 2010 liquidity and weighted average life (WAL) requirements reduced the credit risk of prime MMFs."
The paper explains, "Money market funds (MMFs) are mutual funds that invest in short-term high quality money market instruments. Unlike banks, money market funds do not hold capital against credit losses, nor are they insured by the federal government. Instead, risks in money market funds are mitigated by SEC Rule 2a-7, which is promulgated under the Investment Company Act. Among other things, Rule 2a-7 sets strict maturity limits on a fund's portfolio, requires funds to hold short-term securities of high credit quality, imposes diversification limits, and requires MMFs to hold a significant portion of their portfolios in very liquid assets. Money market funds have no leverage and must hold only U.S. dollar-denominated assets. These limits are thus in many ways much more stringent than the rules under which banks operate."
It continues, "Money market funds, like banks and other financial institutions, faced extraordinary stresses in September 2008 in light of the U.S. federal government's decision to let Lehman Brothers fail. In January 2010, in an effort to improve the resiliency of money market funds to withstand severe market stresses, the Securities and Exchange Commission (SEC, 2010) adopted a number of wide-ranging revisions to Rule 2a-7. Since 2010, many regulators have called for further reforms to money market funds. One rationale offered for such reforms is the suggestion that money market funds take significant credit risk (Rosengren, 2012). However, to date, there has been little formal research assessing the credit risk in money market funds. This paper seeks to help fill that gap. This paper develops a methodology for assessing MMF credit risk and applies it to the period 2011-2012 to study the influence of the European debt crisis on the credit quality of money market fund portfolios and on the influence of the SEC's 2010 reforms on funds' credit risk."
The paper tells us, "At first glance, the most obvious way to estimate the credit risk on an MMF is by the difference between the yield on a prime money market fund and the yield on a comparable government-only money market fund. Prime MMFs are money market funds that invest in a range of money market securities, including commercial paper, bank CDs, medium-term and floating-rate notes, repurchase agreements (repos) and Treasury and agency securities. Government money market funds typically invest only in Treasury or agency securities or repos backed by Treasuries and agencies and therefore should be default-risk-free. Figure 1 plots month-end values of the difference between the average gross yield on prime MMFs and government MMFs. For comparison, the figure also plots month-end values of the Bloomberg index of 5-year credit default swap (CDS) premiums for U.S. banks, as well as of the iTraxx 5-year CDS premium index for senior European financial debt (which primarily reflects 5-year CDS premiums for eurozone banks). As seen, in comparison with the 5-year CDS premiums for banks, the prime-to-government yield spread is small. Over the period 2011 to 2012, this spread averaged 18 basis points and the maximum spread was 23 basis points. This suggests that the credit risk of prime money market funds is small."
It continues, "An issue arises, however, because money market funds price their portfolio holdings at amortized cost. A longstanding GAAP provision allows firms, both financial and nonfinancial, to value their holdings of money market securities at amortized cost. A provision of SEC Rule 2a-7, which has its historical roots in the longstanding GAAP provision, allows a money market fund to price all of its securities at amortized cost (but the fund must abide by the risk-limiting requirements of Rule 2a-7). The use of amortized cost may weaken the value of a prime-to-government yield spread as an indicator of a money market fund's credit risk. A fund calculates its yield as income accrued (on an amortized cost basis) over a given period (e.g., one month) divided by the fund's amortized cost value (generally $1.00 per share) at the beginning of the period. If a fund holds a security and that security's credit quality declines, the security's market price should also decline, boosting the security's market yield. But because funds use amortized cost accounting, the rise in the security's yield would not be immediately reflected in the fund's yield. Generally speaking, only if that security matures and the fund rolls over its holding of that security, would the fund's yield then rise to reflect the increased credit risk."
Collins and Gallagher write, "Consequently, it seems appropriate to consider alternative ways to assess the credit risk of prime MMFs. CDS premiums provide one alternative.... Rosengren (2012) uses CDS premiums in an attempt to assess the credit risk of prime money market funds. He matches CDS premiums issuer-by-issuer with the portfolio holdings of prime MMFs. His results suggest that prime MMFs take on significant credit risk: he indicates that 37 percent of the assets of prime money market funds have an associated CDS premium of nearly 300 basis points (287 basis points on an asset-weighted basis). If correct, that premium is large. A shortcoming of Rosengren's approach, however, is that he measures credit risk using 5-year CDS premiums. This is a concern because the term structure of CDS premiums is generally upward sloping for high quality issuers (Agrawal and Bohn, 2006; Han and Zhou, 2011). Thus, it should generally be less costly in terms of CDS premiums to insure against default on a portfolio composed of short-dated, high quality securities. Money market fund portfolios fit these characteristics. Under Rule 2a-7, MMFs must hold securities that mature or can be redeemed with 397 days. In addition, MMFs’ weighted average life (WAL) must be 120 days or less. In practice, many of prime funds maintain even lower WALs.... Thus, Rosengren's use of 5-year CDS premiums likely overstates the credit risk of prime MMFs, but the level of the overstatement is an empirical question."
They state, "Collins, Gallagher, Heinrichs, and Plantier (2013) seek to improve on Rosengren's approach by matching money market funds' holdings with maturity-appropriate CDS premiums. For example, if a fund holds a Ford Motor medium term note that has a remaining maturity of 6 months, that note is matched with a 6-month CDS quote for Ford Motor. Aggregating (on an asset-weighted basis) across all of a fund's holdings provides an estimate of the CDS premium needed to insure the fund's portfolio against any and all credit losses under the assumption that the fund holds each security until it matures (or defaults). We call this credit risk measure "expected loss-to-maturity" (ELM). Collins et al. (2013) find that the expected-loss-to maturity on all prime money market funds averaged 27 basis points in 2011, again suggesting that the credit risk of prime money market funds is small."
The paper also says, "As noted, money market funds hold the bulk of their assets in very short-term securities, typically those maturing in 3 months or less. But CDS premiums are generally not quoted at maturities of less than 6 months. To deal with this, Collins et al. (2013) assume that the CDS premium on a security with one month to maturity is one-fourth the 6-month CDS premium for the same issuer. Collins et al. (2013) present some evidence from short-term credit spreads that this one-fourth assumption is not implausible. Quotes for intervening maturities (say 2 months) are then interpolated from the 6-month quote and 1-month estimate. However, this method does not acknowledge that the CDS market may be thinly traded for some issuers, especially at the 6-month horizon."
It explains, "This paper seeks to improve further on the credit risk measure of Collins et al. (2013) by synthetically creating CDS premiums for short-dated securities using default probabilities collected from the Risk Management Institute (RMI) of the National University of Singapore. RMI generates forward-looking probabilities for about 50,000 worldwide issuers on a daily basis for maturities of 1, 3, 6, 9, 12, 18, and 24 months ahead. RMI produces these default probabilities using a reduced form model of issuer credit risk, which among other things, incorporates the Merton (1974) distance-to-default concept, as well as firm-specific and macroeconomic variables. Research (Chen, 2013) indicates that RMI's default probabilities have a good track record, especially for issuers in developed countries, at maturities of 6 months or less, which is the horizon we are most concerned with in this paper. Given the RMI default probabilities, the estimated (synthetic) CDS premium for a given issuer and given remaining maturity is the relevant default probability times the expected loss given default. We use standard CDS market assumptions about expected loss given default. By interpolating, we are able to obtain estimated CDS premiums for the vast majority of assets that money market funds hold. This, in turn, allows us to calculate ELM for individual prime money market funds and for prime money market funds as a group."
The paper continues, "Investors, fund managers, and policymakers may, however, also be interested in the cost of insuring against the likelihood that a money market fund might "break the dollar." Under Rule 2a-7, a money market fund may offer a per-share price of $1.00 only if its mark-to-market value remains within 1/2 cent (50 basis points) of $1.00. If its mark-to-market value drops below $.995, the fund must lower its per-share price to $.99. This is colloquially known as "breaking the dollar." Policymakers and other experts have expressed concerns that this could lead to a run on money market funds. We assess the cost of insuring against such an event, which we call BDI(l, u), for Break the Dollar Insurance. We allow for a insurance deductible l and a maximum loss of u (u could be the entire value of the fund), where l and u are measured in basis points of a fund's assets."
It tells us, "To undertake the analysis, we create a new dataset comprising the entire record of the portfolio holdings of each prime money market fund over the period January 2011 to December 2012. We obtain funds' portfolio holdings from SEC form N-MFP. This form, which all money market funds have been required to report since November 2010, collects monthly data on a fund's entire list of portfolio securities. By hand, we match the month-end portfolio holdings of prime money market funds issuer-by-issuer and maturity-by-maturity with default probabilities obtained from RMI (Section 3 provide details). We are able to match roughly 90 percent of the assets of prime money market funds with estimated (synthetic) CDS premiums."
Collins and Gallagher add, "Our results indicate that there is generally limited credit risk-to-maturity in prime money market funds. Over the 24 months between January 2011 and December 2012, prime money market funds had an (asset-weighted) average ELM of 15 basis points. The credit risk exposure of prime funds did evolve over this period. Credit exposure was lower (11 basis points) in early 2011. It rose somewhat in the fall of 2011 to a maximum (on an asset-weighted average basis) of 22 basis points in November and December 2011. Thereafter, average credit risk receded and by the end of 2012 was just 9 basis points."
They conclude, "Finally, using fund-by-fund values of ELM, we examine whether the SEC's 2010 reforms reduced the credit risk of money market funds. Using a panel data regression, we find that ELM declines as a fund's liquidity rises and its WAL declines. This suggests that the SEC's decision to impose a minimum liquidity standard and a maximum WAL on MMFs in January 2010 reduced the credit risk of prime funds. It is difficult to gauge how sizable the effect was because funds did not report their monthly portfolio holdings,WALs, or weekly liquidity (according to the SEC definition of weekly liquidity) before November 2010. However, using plausible assumptions about the levels of weekly liquidity and fund WALs before 2010, we show that these two new provisions had the potential to substantially lower a fund's credit risk."
