Much of Federated Investors Q2 earnings conference call (see transcript here) was dominated by discussion of the SEC's July 23rd adoption of new money fund rules, but President and CEO Chris Donahue made it clear that the focus will be on making sure "no client is left behind" as the company prepares for the changes to take effect in two years. Federated's earnings release says, "Money-market assets were $245.2 billion at June 30, 2014, down $23.3 billion or 9 percent from $268.5 billion at June 30, 2013 and down $18.4 billion or 7 percent from $263.6 billion at March 31, 2014. Money-market mutual fund assets were $212.4 billion at June 30, 2014, down $20.5 billion or 9 percent from $232.9 billion at June 30, 2013 and down $15.1 billion or 7 percent from $227.5 billion at March 31, 2014. Revenue decreased by $10.8 million or 5 percent primarily due to an increase in voluntary fee waivers related to certain money market funds in order for those funds to maintain positive or zero net yields and a decrease in revenue due to lower average money-market and fixed-income assets." During Q2 Federated derived 32 percent of its revenues from money-market assets. (Note: The SEC just posted a version of the new rules "Marked to Show Changes from Previous Rule 2a-7" on its "Final Rules" page, but it has yet to post the "Federal Register" version of the rules.)
On the Friday morning earnings conference call, Donahue said, "Certainly money-market funds are in the news with the SEC's recent release of the new regulations.... Our market share at quarter end was approximately 8.3% down about 1% from a year ago. We continue to see yield-based pressure from bank deposits and other cash vehicles and distribution pressure including certain competitors waiving additional fees in order to produce additional yield."
He explained, "The SEC released on Wednesday new rules for money-market funds, importantly, treasury, government and retail funds as defined were exempted from the floating NAV requirements. However, Federated is disappointed that the SEC has voted to adopt a floating NAV for institutional prime and institutional municipal money market funds. Federated remains committed to providing a variety of liquidity management solutions to our clients, including those that meet the needs of our institutional prime and institutional municipal fund shareholders. We offer a variety of cash management solutions and are developing new products for our customers. We intend to create privately placed funds that will likely mirror existing Federated money market funds to serve the needs of groups of qualified investors as soon as reasonably practicable."
He added, "We will be reviewing the details contained in the Commission's 869-page rulemaking as we consider next steps. The new rules will be subject to a lengthy implementation process including two years for the floating NAVs. We are communicating with our clients to work through the full breadth and scope of the final regulations. The new rules also creates significant new operational burdens. For example, regarding the tax release announced yesterday, the SEC stated that the tax compliance burden has been lifted for investors, in floating NAV money funds. We believe that money market funds sponsors and investors should have had an opportunity to review and comment on the proposed solution to the tax issues caused by floating the NAV in order to provide the SEC and the Treasury with a complete evaluation of the cost and benefits of their proposal and related tax release prior to final adoption. In our view such notice and opportunity to comment is essential if the ultimate goal is good public policy."
On the call, CFO Tom Donahue commented on waivers, "Looking at money funds' minimum yield waivers, the impact to pre-tax income in Q2 was $30 million, based on current assets and assuming overnight repo rates for treasury and mortgage-backed securities run at roughly 5 to 7 basis points over the quarter and T-bills stay in the 2 to 5 basis point range. The impact of these waivers to pre-tax income in Q3 would be about $31 million. `Looking forward and holding all other variables constant, we estimate that gaining 10 basis points in gross yields would likely reduce the impact of minimum yield waivers by about 45%. And a 25 basis point increase would reduce the impact by about 70%."
Money funds also came up several times in the Q&A portion of the earnings call. On costs and new products, Chris Donahue said, "Well, we're not in a position to put any kind of a number on that yet. We're in the process of going through the kinds of products that we might want to come up with in order to respond to capture clients that don't fall into a group that would qualify for a private fund and a retail exemption. And when you have a lot of clients that are on omnibus accounts where you have both types of clients inside that omnibus it is very difficult for us to figure out what has to happen in the day and a half since the regs came out. So I am not in a position to give you a number on our costs. I would say the costs will be substantial in terms of industry because you have got a lot of products to change around. And if you are going to maintain a floating net asset value product you're going to have to go to four decimal places and we have commented extensively on those kinds of costs. Whether those products remain viable remains to be seen, so it's pretty much up in the air right now as to what those costs will be."
Later in the call he elaborated further on potential new products. "There's another idea floating around -- although it doesn't look all that viable now because of the rate environment -- which is the all 60-day and under [maturity] prime fund... In a different rate environment, that would work. And its economics would be very comparable to the current fund. There are other ideas that you could come up with, for example, a collective fund that would only be for retirement accounts." Later he added, "We were already underway with an an internal review of the entire money market fund lineup -- just to take a look at it and see what should be done and what should be changed in any event. So right now, [money market reform] just accelerates it and focuses it on taking care of the clients so that we do the best we can to leave no client behind."
Donahue went on, "We had a call with 600-700 clients yesterday, the theme of what we presented was, basically, 'Look, you've got a 2 year implementation. Nothing changes right now; digest what is in the rule, give us a shot at figuring out what kind of products can work.' I have not had a client talking about shifting assets from this column to that column as of yet."
On the long term viability of the cash management business he said, "With $2.6 trillion in money funds with very low yields for a very extended period, it tells you that there is a certain love for a cash management product as a cash management service so the underlying customer demand is certainly there." He adds, "I think you're going to see a little more consolidation in the business as others take a look at this and throw in the towel. I think that the focus of this firm [on money market funds], as one of our key businesses, will enable us to be very competitive.... The cash management business is very viable and we think that our earnings power will be excellent."
In other news, Barclays strategist Joseph Abate released a report Friday, "Reform and the Shortage of Short-Term Supply." Writes Abate, "This week, the SEC voted to require institutional money funds to adopt floating NAVs. But by significantly increasing the demand for government safe assets, the reform will likely exacerbate the logjam created by the shortage of short-term market supply. The regulatory effect on short rates of money fund reform depends on three key unknowns: how much capital leaves money funds, where it will go, and how quickly it will shift."
Adds Abate, "We expect balances leaving prime funds to shift primarily into government-only funds, increasing the demand for bills, agencies, and repo by 10-25%. But limited dealer balance sheets and potentially capped allotments at the Fed's RRP program may cause a logjam in short-term markets, pushing rates on these instruments to the RRP floor. As long as banks are long short-term liquidity and can offset some of the decline in wholesale unsecured funding with deposits, we do not expect CP and CD spreads to widen. The outlook for short-term rates depends critically on how quickly investors in soon-to-float prime funds shift their balances to alternative products. In a rising rate environment and with a 2-year SEC adjustment window, the departure rate might be slower than feared."
