News Archives: March, 2011

The Investment Company Institute's latest monthly "Trends in Mutual Fund Investing shows that money market mutual fund assets increased by $12.8 billion, or 0.5%, in February 2011 after falling $75.7 billion in January. ICI's report shows that overall mutual fund assets, however, continue to rebound, strengthening the balance sheets of asset managers.

The "Trends" report says, "The combined assets of the nation's mutual funds increased by $248.3 billion, or 2.1 percent, to $12.122 trillion in February, according to the Investment Company Institute's official survey of the mutual fund industry. In the survey, mutual fund companies report actual assets, sales, and redemptions to ICI."

It comments, "Money market funds had an inflow of $12.02 billion in February, compared with an outflow of $75.61 billion in January. Funds offered primarily to institutions had an inflow of $15.78 billion. Funds offered primarily to individuals had an outflow of $3.76 billion." ICI also shows that the number of money funds covered fell by 3 to 649, and the "liquid assets of stock mutual funds, or the percent of assets held in cash, remain near a record low 3.5%.

ICI's separate "Month-End Portfolio Holdings of Taxable Money Market Funds" shows Commercial Paper jumping by $23.5 billion to $413.6 billion in February. CP is the fourth largest money fund holding, according to ICI's categorization scheme and series, at 17.1%. `CDs, or Certificates of Deposit, remain the largest holding, at $563.5 billion, or 23.3% of assets. (Eurodollar CDs account for $103.3 billion of this total, or 4.3% of all taxable assets.)

Repurchase Agreements (Repo) total $499.4 billion, or 20.7%, while U.S. Government Agency Securities total $367.9 billion, or 15.2%. U.S. Treasury Bills and Other Treasury Securities account for $332.4 billion, or 13.8%, of the $2.418 trillion in taxable money funds. Corporate Notes and Bank Notes represent $154.2 billion, or 6.4% of assets. The number of money market mutual fund accounts outstanding rose by 65,495 in February to 27.296 million.

Fitch Ratings releases a study this morning entitled, "U.S. Money Fund Exposure to European Banks," which shows that money fund exposure to Europe overall remains high but exposure to "PIIGS" countries, save Italy, is zero. Fitch says, "Market sentiment on European sovereigns that have experienced heightened investor concern continues to affect the perceived credit risk of financial institutions in those countries. An important funding channel for European financial institutions and, therefore, a potential channel for eurozone sovereign risk, is U.S. prime money market funds (MMFs), which continue to have sizable exposures to European financial institutions."

The research piece continues, "This report updates Fitch Ratings' prior research on this topic (see December 2010 study, "U.S. Money Market Funds: Recent Trends in Exposure to European Banks") as of end-February 2011 and focuses on MMF exposures to banks' certificates of deposit (CDs), commercial paper (CP), asset-backed CP (ABCP), and, new for this report, repurchase agreements (repos)." (See Crane Data's latest Money Fund Portfolio Holdings series for statistics on exposure to individual names.)

Fitch explains, "MMF exposure to Spanish banks has declined significantly from peaks of roughly 3.0% of total MMF assets in 2008 and 2009 to just less than 0.2% as of February 2011 (see chart). This exposure was 1.7% as recently as 1H 2011. MMF exposure to Italian banks, which until recently has followed roughly similar patterns as Spanish banks, has not experienced the same sharp decline. For example, Italian banks represented approximately 1.3% of MMF total exposures in both 2H 2010 and as of February 2011."

It adds, "MMFs continue to have immaterial exposure to Portuguese and Irish banks after peaking in 1H 2009 (0.5% of total MMF assets) and 1H 2008 (1.5% of total MMF assets), respectively. MMF exposure across all European banks (including CD, CP, ABCP, and repos) remains significant at 44% of total MMF assets as of February 2011. This is down slightly from 2H 2010 of 45.9% (or approximately 40% if excluding repos). The largest European exposures are to banks in France (12.4% of total MMF assets) and the U.K. (8.6%)."

The Fitch study comments, "The 10 largest bank exposures (CD and CP) have changed significantly over the period of study (see Largest CD and CP Exposures table). For example, only two of the 10 largest exposures as of 2H 2007 (Societe Generale and Rabobank) remained in the top 10 as of February 2011. This change in composition partly reflects a shift in asset type, since several of the largest exposures as of 2H 2007 were to institutions that were active sponsors of ABCP programs, an asset class that has declined markedly over this period."

The report lists "Drivers of U.S. MMF Exposure to European Banks," saying, "There are several macro factors that help to explain the significant exposure of U.S. MMFs to European bank issuers." These include: Need for Dollar Funding: The dollar-denominated assets of European banks have grown rapidly over the past decade. Dollar-based European bank assets rose from approximately $2 trillion in 1999 to more than $8 trillion in 2008 according to the Bank for International Settlements (BIS).... U.S. money funds provide a natural source for short-term dollar financing (e.g., prime money fund total assets are approximately $1.63 trillion as of March 2011)."

Other Drivers include: "Financial Industry Consolidation: Industry consolidation and the failure of several financial institutions during the financial crisis have reduced the global universe of potential MMF investment targets, particularly in the U.S. For example, from the 1H 2007 through the beginning of 2011, the total number of financial institutions within this study's sample of MMFs dropped by approximately 20%.... This consolidation resulted in relatively more European institutions represented in the MMF investment mix. Shrinkage of the ABCP Market: Since the beginning of 2007, ABCP outstanding has dropped from $1.2 trillion to $390 billion currently, in part reflecting diminished MMF appetite for this asset class. European bank CD exposure has helped to fill the resulting void."

Yesterday morning, Karrie McMillan, General Counsel of the Investment Company Institute gave the Opening Remarks at the ICI and FBA's "Mutual Funds and Investment Management Conference" in Palm Desert, Calif. The talk, entitled, "Sunlight Through the Clouds: Emerging from the Financial Storm, mentioned money market funds in several sections. McMillan says, "What I can't promise you is certainty. Many of you were with us in Phoenix in March 2008, when Bear Stearns collapsed just before this conference started. Since then, our financial world has been in turmoil." (Note that ICI also reports that Director Eileen Rominger says the SEC and FSOC will hold a money fund roundtable in May.)

She continues, "I don't need to remind you of the events, the seemingly endless loop of crisis and response that we have endured since then -- who wants to remember all that? But clearly, this global financial crisis was a very real stress test for the funds you counsel. We've come a long way in the past three years. We rallied together, as an industry, to address the threats and find ways to continue to serve our shareholders, under enormous strains and pressures.... [W]e have definitely seen progress."

McMillan says, "The financial markets have regained their footing. The Federal Reserve has significantly reduced its emergency facilities. The SEC has adopted its amendments to Rule 2a-7 for money market funds. And Congress has weighed in with the passage last July of the Dodd-Frank Act. But certainty about our future? That's still a distant dream. Think about it -- we face a host of questions that will affect our businesses for years to come."

She asks, "Which financial institutions are going to be deemed 'systemically significant'? The new Financial Stability Oversight Council -- or 'FSOC' -- is aiming soon to start designating businesses outside of the banking world as SIFIs -- 'systemically important financial institutions.' We've been through two rounds of comment on how the FSOC will make these designations, and there's still not much that we can say for sure about which companies will be designated. Nor has the Fed developed the standards it will apply to SIFIs. Uncertainty."

McMillan also asks, "What's going to happen with money market funds? The President's Working Group has issued its Report on Money Market Fund Reform Options. ICI is pursuing its proposal for a liquidity facility -- a private-sector solution, created and financed by prime money market funds and their sponsors. We believe that such a facility could provide the liquidity backstop that funds may need if we ever again see market conditions like those of September 2008. We've presented the blueprint, in great detail, to the SEC, the Treasury, and the Federal Reserve -- and now we're still in wait-and-see mode. No certainty there."

The Opening Remarks add, "We also know that the debate on key issues has been robust. On such important questions as designation of systemically important financial institutions, commenters from a wide range of interests have weighed in with their views and analysis about how to identify and evaluate financial risk. Academic papers and conferences have been devoted to broadening the debate on these topics. That's how the policymaking process should work -- another cause for hope. We know that America's lawmakers continue to believe in our funds."

McMillan tells us, "And one more key thing we know. Even though we're living in an uncomfortable state of uncertainty, our investors have maintained their confidence in funds. We've seen that confidence clearly expressed in the debate over money market funds. Groups representing businesses, government, financial services, and consumers have stepped forward to register their support for the fundamental aspects of money market funds, particularly the stable $1.00 net asset value. This widespread endorsement has supported our efforts to avoid proposals that would seriously undermine the value of money market funds for fund shareholders."

She adds, "We see this confidence in the behavior of households, who continue to turn to funds to help them meet their financial goals. From 2008 through 2010 -- despite the worst financial crisis since the 1930s -- households' net purchases of funds totaled $900 billion. Put another way, 85 cents out every dollar that households invested in financial assets, on net, flowed into mutual funds, exchange-traded funds, variable annuities, and closed-end funds."

McMillan states, "As ICI's chairman, Ed Bernard of T. Rowe Price, likes to say -- the people who invest are a lot calmer than the people who just write about investing. Clearly, investors have faith that the foundations of our industry remain strong. And that brings me to some things that I can say with absolute certainty -- even in these times of questions and doubts. The model of fund investing that is enshrined in the 1940 Act -- transparent, diversified, with limited leverage, and subject to strict pricing disciplines -- demonstrated its worth during the financial crisis, serving both funds and their shareholders well."

Finally, she says, "So we'll face many questions and concerns in the months ahead. We won't have all the answers -- either here in the next three days or when we go back to our offices. But we always have the bedrock belief in our mission and our service to investors. And that, together with the faith they entrust in us, will ensure a strong future for us all."

Moody's Investors Service released the Industry Outlook "Money Market Funds 2010 Review and 2011 Outlook" last week, which was subtitled, "Credit, Interest Rates, and Regulatory Uncertainties to Define the Year." The 18-page report, written by Senior V.P. Henry Shilling and Senior V.P. Daniel Serrao, summarizes, "Our credit outlook for money market funds in 2011 remains stable, based on our view that volatility in general has diminished and conservative portfolio practices carried over from 2010 will persist into this year. Forces that shaped portfolio investment strategies last year will continue to dominate. They include historically low yields, credit, and sovereign concerns, and most recently geopolitical instability, supply constraints, declining assets under management (AUM), regulatory uncertainties, and further industry consolidation.

Moody's press release on the report, titled, "Money market funds outlook remains stable", comments, "The credit outlook for money market funds in 2011 remains stable, Moody's Investors Service says in its just published industry outlook. The rating agency notes that volatility in money market funds generally has diminished, and that the conservative portfolio management practices seen in 2010 likely will persist this year."

Shilling says, "The risk profile of money market funds has been dialed down in the past year. Funds are more liquid, assets' maturity-adjusted credit quality is higher and their average maturities have been reduced.... While we expect that proposed reforms, if enacted, will make the system safer for investors, they could also reduce the attractiveness of money market funds, in some cases by increasing costs and lowering yields."

The report explains, "[R]isks to funds might escalate later in the year due to rising interest rates and shareholder redemptions, while a combination of the two could cause net asset value (NAV) stress. The money fund industry also still faces regulatory risks, as concerns about its potential to destabilize the broader financial system could lead to reforms that transform the industry. These reforms could include the introduction of variable net asset value money funds or a two-tier system of money market funds with better protections for constant net asset value (CNAV) funds via a liquidity facility and capital buffers. Regardless, these developments are potentially credit positive for rated funds."

It continues, "Looking ahead, the following considerations are likely to continue to dominate the money market funds sector and management firms in 2011: Historically low interest rates and near-term interest rate risks. Short-term interest rates are expected to remain at exceptionally low levels for the remainder of the year. But even with the imposition of the 60-day weighted average maturity (WAM), 120-day weighted average life (WAL), and one-to-seven day liquidity constraints, funds that engage in maturity extension via a barbell strategy could be exposed to incremental risk if interest rates unexpectedly move sharply higher and at the same time investors withdraw funds in favor of higher yielding direct or alternative investments."

Moody's says other considerations include: Credit uncertainties coupled with supply constraints. Credit conditions are expected to continue to challenge money market portfolios in the United States as well as overseas.... By our estimates, in excess of two-thirds of U.S. prime and tax-free money market funds, on average, are directly or indirectly exposed to banks, which is expected to continue to constrain approved securities lists and contribute to uncertainty.... Portfolios are more conservatively positioned generally and we expect this to persist. Credit, supply constraints, yields, and regulatory developments, as well as liquidity and fund flows, have helped shape the portfolio profiles of prime money market funds, and, to a lesser extent, those of tax-free funds. This is expected to extend into 2011."

Additional considerations are: "Liquidity management. At December 31, 2010, U.S. rated prime funds reported an average seven day liquidity position of 43% of total net assets, while for non-U.S. funds, across U.S. dollar, British pound sterling (GBP), and Euro currencies, the corresponding number was 36%.... Volatility in assets under management (AUM). While funds suffered from the migration of assets to banks, separate accounts and other alternative and in some cases riskier higher yielding investment products, for a total of $500 billion in net outflows during 2010, institutional assets in money funds have been bolstered by corporate investors who are maintaining significant cash balances on their balance sheets.... Regardless, we expect further erosion in total net assets in 2011."

Finally, Moody's lists as "considerations" for the outlook in 2011: Regulatory developments create uncertainty and Continuing consolidation. The report says, "The adoption and implementation to-date of various amendments, guidelines, and rules have already reduced the risk profile of money market funds in the U.S. and Europe, but funds and their management firms continue to face regulatory uncertainties. These center around options designed to reduce 'run risk' and related systemic risk. Whatever the outcome, they support stronger protections for investors at the expense of money fund sponsors but are viewed as credit positive for rated money funds. Investors, however, might be faced with higher fees in the intermediate to long-term. In any case, regulatory uncertainties could even extend into 2012.... The consolidation trend among money market funds in the United States is expected to continue due to rising operating costs and fee waivers combined with potential capital charges, liquidity charges, and potential costs in the form of parental support in the event of adverse credit developments."

The Investment Company Institute published the research report, "Trends in the Fees and Expenses of Mutual Funds, 2010," yesterday afternoon. It discusses fee trends in the mutual fund business, and says, "The average fees and expenses of money market funds declined sharply in 2010. The average expense ratio on money market funds fell 7 basis points, from 33 basis points in 2009 to 26 basis points in 2010. Expense ratios on money market funds fell sharply in 2010 because the great majority of funds waived expenses to ensure that net returns to investors remained positive in the current low interest rate environment."

ICI writes, "Over the past two decades, average fees and expenses paid by mutual fund investors have fallen by more than half. In 1990, investors on average paid 200 basis points, or $2.00 for every $100 in assets, to invest in stock funds. Fees and expenses averaged 95 basis points for stock fund investors in 2010, a decline of 53 percent from 1990. Similarly, the average fees and expenses paid by investors in bond funds declined 61 percent, from 185 basis points in 1990 to 72 basis points in 2010, while fees incurred by investors in money market funds dropped 52 percent, from 54 basis points in 1990 to 26 basis points in 2010."

The report explains, "The average expense ratio of money market funds was 26 basis points in 2010, a drop of 7 basis points from 2009. Because investors generally do not pay sales loads for investing in money market funds, the fees and expenses of money market funds are simply measured as the expense ratios of these funds."

It continues, "From 2001 to 2009, the declining average expense ratio of money market funds largely reflected an increase in the market share of institutional share classes of money market funds. Because institutional share classes serve fewer investors with larger average account balances, they tend to have lower expense ratios than retail share classes of money market funds. Thus, the increase in the institutional market share helped reduce the industry-wide average expense ratio of all money market funds."

ICI says, "By contrast, the market share of institutional share classes of money market funds dropped slightly in 2010 (to 67 percent from 68 percent in 2009), indicating that other factors pushed expenses down. Primarily, the steep decline in the average expense ratio of money market funds reflects developments stemming from the current low interest rate environment."

Authors Sean Collins and Michael Breuer state, "In 2007 and 2008, to stimulate the economy and respond to the financial crisis, the Federal Reserve sharply reduced short-term interest rates. Yields on money market funds, which closely track short-term interest rates, tumbled. In 2010, the average gross yield (the yield before deducting fund expense ratios) on taxable money market funds hit a historic low, hovering just above zero."

They explain, "In this setting, money market fund advisers increased expense waivers to ensure that fund net yields (the yields after deducting fund expense ratios) did not fall below zero. Waivers raise a fund's net yield by reducing the fund's expense ratio. Historically, money market funds have often waived expenses, usually for competitive reasons. For example, in 2006, before the onset of the financial crisis, 60 percent of money market fund share classes were waiving expenses. By the end of 2010, over 90 percent of money market fund share classes were waiving some or all expenses."

Finally, the report adds, "Expense waivers are paid for by money market fund advisers, who thus forego profits and bear more, if not all, of the costs of running their money market funds. Money market fund advisers waived an estimated $4.5 billion in expenses in 2010, over three times the amount waived in 2006. Thus, these waivers posed a substantial financial cost on fund advisers. In the future, if gross yields on money market funds rise, advisers may reduce or eliminate waivers, which could lead expense ratios on money market funds to rise somewhat."

Moody's Investors Service published an "Industry Outlook" report entitled, "Asset Management 2010 Review and 2011 Outlook: Industry Back on Firm Ground, but Challenges Remain" yesterday, which revises the ratings company's "outlook for the asset management industry to stable from negative." The report explains, "The revised outlook expresses our view that fundamental credit conditions for asset managers will not deteriorate over the next 12 to 18 months. We have had a negative outlook on the sector since April 2008.... The fundamental drivers of the outlook change are asset managers' significantly improved earnings capacity and their enhanced balance sheet strength, which have strengthened credit fundamentals overall. In addition, greater clarity around new regulations and the stability of the capital markets have improved the environment in which asset managers operate."

Moody's cites these factors: Earnings picture much improved. In 4Q10, aggregate quarterly EBITDA for Moody's-rated asset managers surpassed the peak levels of 4Q07. We expect Moody's-rated asset managers' earnings to continue to grow in 2011, albeit at a slower pace than in 4Q10.... Financial leverage declined and financial flexibility continues to improve. Debt/EBITDA leverage ratios should continue to improve in 2011 driven by higher levels of operating earnings. For Moody's-rated asset managers as a whole, balance sheet strength appears to be at or near an all-time high.... Less uncertainty over the impact of regulatory reform. As we enter 2011, asset managers are faced with a host of new regulations, but the impact of regulatory reform appears to be manageable in the near-term. That said, we continue to monitor a number of key areas, including the potential for regulatory changes related to: 1) money market funds; 2) 12b-1 fees; 3) fiduciary standard requirements; and 4) alternative asset managers." Finally, they mention that "Equity markets have trended upward as consumer confidence improves."

The report states, "2010 will remembered most as the year the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or the Act) became law, but there were many other regulatory changes and proposals in 2010 that affected the asset management industry. The U.S. Securities and Exchange Commission (SEC) amendments to Rule 2a-7 related to money market funds, proposed new rules on mutual fund distribution or 12b-1 fees, the potential implementation of a fiduciary standard for brokers and advisors, and the Department of Labor's 401(k) fee disclosure requirement were all significant regulatory issues for asset managers."

It continues, "For money market fund sponsors, the amendments to Rule 2a-7 further strengthen portfolio credit quality, reduce interest rate sensitivity, and strengthen liquidity, disclosure and operations of money market funds. These changes improve stability, but increase operating costs at a time when yields are low. Still unresolved, however, are fundamental concerns about the susceptibility of money market funds to runs and systemic liquidity risk. A number of potential mitigants to these risks have been posed by market participants and experts. If any of these are implemented, the profitability of this product likely will come under further pressure."

Among the report's "Key variables and trends under base case and stress case scenarios," Moody's lists, "Money market fund yields are as low as they can go, crimping profitability in this important asset class. Rising operating costs and continued regulatory uncertainties will drive further industry consolidation."

Finally, they comment, "Whatever the outcome of the debate on regulation, the economics of managing money market funds is likely to become more challenging, particularly in the existing low yield environment. The introduction of sponsor capital adequacy or liquidity provisioning requirements would be particularly problematic for asset managers because, to date, the money market fund business historically has not been too capital intensive. The requirement to hold capital against AUM would materially change the economics of the money market business."

Today, we reprint the remainder of our recent Money Fund Intelligence "profile" of Fidelity's Money Market Group President Robert Brown. We ask, Q: What are your thoughts on the future of money funds? Brown answers, "Looking out five years, I think the industry will be alive and well. It will continue to provide a low cost, convenient form of short-term financing for corporations, state, federal and local governments, and issuers in general. It will continue to provide a strong value proposition for shareholders. I'm saying that in a more normalized rate environment, but that value proposition will be there.... It will be a product that sustains the test of time."

Brown explains, "First, we think the changes put in place by the SEC in 2010 have significantly increased the resiliency of money funds. The lower WAMs reduce interest rate exposure; the new WAL requirement decreases spread risk; the new monthly holdings and Form N-MFP provide greater transparency; the lower Tier 2 amounts limit credit risk; plus, the board has new tools to suspend redemptions to limit the potential losses for shareholders in an emergency."

He adds, "The new liquidity requirements have created approximately $820 billion in ready liquidity in money market funds, without any government backing. I think that is critical to understand. Again, we have a significant opposition to the floating NAV and bank-like capital requirement for advisors. That is not something that Fidelity supports."

Q: Tell us about your PWG comments. Brown responds, "We are offering another option we feel may be most viable. The basic idea is to have a 'hold-back' of a small amount of income to allow a reserve or a buffer to build within each money fund. The buffer will rise over time and be an asset of the fund subject to board oversight. We think having this additional amount in the fund, which would be disclosed to shareholders monthly as part of Form N-MFP, would give investors even greater confidence in these funds. In our comment letter, we made reference to a hold-back similar in size to the cost of the Treasury guarantee program. We think the advantages are that this will be simple to implement and within the authority of the SEC to enact within the changes to 2a-7. Although there are tax changes that may be helpful, this idea can be implemented without changes in tax law."

He continues, "Liquidity has been significantly enhanced through the Rule 2a-7 changes that went through in May of 2010.... [I]f you go back and you look at, 'How does a fund actually create 30% liquidity?' Well, it requires in terms of the actual portfolio construction close to almost 50% of your securities now within a 30- day window.... We think liquidity has been addressed, and we are quite comfortable with how our funds are positioned. We do not necessarily see the need for additional liquidity requirements."

Brown adds, "Advisors need to continue, as they have for many years, to do a very good job with making minimal credit risk determinations and position their portfolios accordingly. Our buffer concept really deals with market value NAV volatility, such as we experienced during the market stresses of '07 and '08 prior to the default of Lehman Brothers. We think this buffer would help provide more flexibility to portfolio managers to exit securities that they didn't deem appropriate for the fund at that time."

Q: Can you talk about Fidelity's customer base? He says, "From a taxable perspective, we're just slightly more overweight institutional vs. retail at this point. But it is practically 50-50. On the municipal side, it's predominantly retail investors. Through our various distribution channels, we have a well-defined set of principles in terms of the institutional money that we will actually ... take into the funds. It goes through a well-structured review in terms of: How long will the money be here? What is the size of the money? What is the potential liquidation date? How does it impact existing shareholders? Any dollars that we take in, we ensure that it has no negative impact on our existing shareholders."

"That conservative approach served us well in '07 and '08, and it continues to serve us well today. Most of our funds have a blend of different type of shareholders. Many funds are sold through intermediaries, who have been exceptional partners for us, and we view them as critical to our existing and future success," he explains.

Q: Overall, what has been the key to Fidelity's success? Finally, Brown tells us, "I would say that it goes back to the historical vision of the firm in terms of looking at the money market business as a franchise business and the view that success will come over decades, not over 12 months. It has been the continued investment in research, the underlying hallmark of Fidelity. It's in our name.... It's the consistency, in terms of the investment strategy, it's the consistency in terms of dedicated resources to this business, it's the consistency in the firm's approach to the long-term strategy and the franchise tag on this business for Fidelity. And, always, the number one focus is on our shareholder."

J.P. Morgan Asset Management recently released the results of its latest "Global Cash Management Survey," which shows that North American corporate treasurers allocate more surplus cash to money market funds (41%) than to bank deposits (35%), while European and Asian treasurers allocate more cash to bank deposits (58%). The J.P. Morgan Asset Management Global Cash Management Survey 2010 also shows access to daily liquidity, bank relationships, reputation/brand, and yield were the most important factors in selecting fund providers.

JPMAM Head of Global Liquidity Robert Deutsch comments in the survey introduction, "[T]he J.P. Morgan Global Cash Management Survey 2010 ... has provided an unbroken global benchmark for corporate treasurers every year since its launch in 1999. The 2010 survey is the most comprehensive yet, with a record 427 treasurers from around the world providing their views by online questionnaire between July and September.... [T]he strong response rate has helped uncover some particularly interesting cash management trends as the world continues to recover from the financial crisis and corporate balance sheets continue to strengthen.... As would be expected given the pre-eminence of the US economy and US companies, North American respondents made up the biggest group, but the survey also attracted significant responses from treasurers in Europe and Asia.... With its record response rate and broad coverage, the 2010 survey represents a global analysis of the cash management industry and provides a valuable reference resource for all corporate treasurers."

The Survey's "Executive summary" explains, "The repercussions of the financial crisis continue to be felt in treasury departments. Although extreme risk aversion is beginning to recede, the survey suggests that the lessons of the financial crisis will not be easily forgotten. Amid the severe dislocation of credit markets and the high profile banking failures experienced during the financial crisis, liquidity became paramount for corporate treasurers. In the 2009 survey, when treasurers were asked about concerns in their treasury department, liquidity was the most commonly cited response, and a year on, it remains the biggest concern."

It continues, "Treasurers also continue to focus on counterparty risk. Among the criteria treasurers use to select a primary bank, the bank's financial strength gained in importance for a second consecutive year, now ranking almost equally with the quality of relationship management and customer service. When selecting a pooled investment, too, the financial strength of the provider has become more important to treasurers. However, while liquidity and security undoubtedly remain the highest priorities, treasurers' priorities are gradually evolving as corporate balance sheets recover from the crisis. The survey pointed to the beginnings of a recovery in risk appetite, and suggested that after two years of very low yields, treasurers may be starting to look for improved returns from their cash investments."

The survey also says of its other key findings: "Liquidity remains a concern – Liquidity is the biggest concern in treasury departments today, and was also cited as the most important factor when selecting pooled investments from an asset management firm and the largest consideration for those who segment their surplus cash. Cash management is in focus – As a result of the deleveraging process many organisations have completed, treasurers have more surplus cash than they did in 2009.... Banking relationships are increasing – Treasurers increased their number of banking relationships again in 2010.... Bank deposits are still favoured by treasurers in EMEA and Asia – Despite the impact of the financial crisis on confidence in the banking system, bank deposits are the preferred cash management vehicle overall, and remain the most used vehicle among treasurers in EMEA and Asia. Treasurers in the US continue to favour money market funds – Treasurers in the US are most likely to use money market funds to manage their surplus cash, and less likely to use bank deposits.... Risk appetite is gradually beginning to return – ... After a prolonged period of very low returns on cash, treasurers are also beginning to look for higher yield, although they remain largely unwilling to take on higher risk in order to achieve it."

The JPM Global Cash Survey comments, "Among treasurers who use or are considering pooled instruments for their cash management, an emphasis on liquidity and credit quality is evident. Prime money market funds (AAA-rated stable value funds) are the most popular pooled vehicle, with over three quarters of treasurers either using them or considering doing so. Almost 70% of treasurers either use or are considering using Treasury money market funds (AAA-rated stable value funds that invest only in government securities). Prime money market funds were already the most popular in 2009's survey, but take-up has increased significantly over the past year, with 59% now using them, compared to 47% in 2009. Take-up of Treasury money market funds has also increased significantly. Growth has been driven by Asia (up from 21% in 2009 to 39% in 2010) and EMEA (up from 15% in 2009 to 43% in 2010)."

Finally, the survey adds, "The criteria treasurers use to select a pooled instrument reflect the emphasis on liquidity and security seen throughout this year's survey. In 2008, treasurers rated yield as the most important factor when selecting a money market fund, but in 2009 yield fell to second place, behind liquidity. In 2010, bank relationship and reputation/brand also overtook yield, moving up into second and third places, as treasury departments increased their focus on counterparty risk."

On Friday, we excerpted from the March issue of our Money Fund Intelligence newsletter, which profiled Bob Brown, President of Fidelity's Money Market Group. We feature part II of the interview today.... Brown says to MFI, "I think that we have a time-tested investment process that has certainly weathered what most would describe as a 100-year storm, and we continue to look to enhance that. We do it from the lens of a conservative approach. I think shareholders have really stated emphatically that yield is not their number one objective."

He adds, "There is a strong value proposition here, which is the diversification of your short term holdings. We pay out a market-based rate vs. a bank's administered rate. And there are also the benefits of what the product offers, in terms of the stable NAV, the check writing, and so forth."

Q: What are the funds buying now? What about new portfolio disclosures? He comments, "Given the size of bank issuance, we continue to focus a great deal of our efforts in this sector. We continue to like Canada, Australia, Switzerland, Japan and core Europe -- France and Germany, in particular."

Brown says, "The bank exposure in our prime funds is at its lowest that it's been in a long, long time. We have added floating rate exposure in the 6-12 month final maturity range. Our agency exposure is down; it is hard to really obtain significant amounts of value there vs. Treasuries. We're continuing to buy Treasuries across all funds to provide quality and liquidity in all of our taxable money market funds. Although they may not be the highest yielding alternatives, we feel that they often represent attractive value for our funds, and contribute to favorable risk adjusted returns."

Q: Are you hearing any customers concerns lately? Brown tells MFI, "In terms of our institutional customers, there is a level of focus on European bank exposures, given the overall sovereign debt crisis.... There is also a fair amount of interest on what were the implications from the first round of 2a-7 reform. Our customers are also interested in what is the most likely next step for future 2a-7 regulations and the recent PWG report."

Q: What's your outlook for rates? He answers, "The market expects the Fed to begin tightening in early 2012. It seems reasonable, given the better data that we've seen recently. Markets will clearly take rates higher in advance of the Fed, so we should see rates move higher in the second half of 2011 if economic activity continues to improve. A near-term concern about lower rates is driven by downward pressure on repo. Longer term, which for us is 6-9 months, the outlook is more positive. But for now there will continue to be pressures that will force short-term rates down."

Q: How are fee waivers impacting Fidelity's money funds? Brown says, "The business continues to be a franchise business for us. Given our scale and our size, and very competitive fee structure, we are able to navigate through this very difficult period of low rates.... [G]iven our asset base and our long term commitment to this business, we believe that we have the necessary resources ... to continue to reinvest in this business and deliver the product that our shareholders are looking for. That will not change.... If you look at the beginning of '07 to the end of January 2011, our money fund assets under management increased by approximately 63%, moving from $265 billion to $435 billion. That is only our 2a-7 registered funds. Our market share has gone from 11.4% to 16.1%."

Look for the final piece of our interview later this week or contact us to request the full issue of Money Fund Intelligence.

In its latest monthly "Fund Profile", the March issue of our Money Fund Intelligence newsletter ($500/yr) features an article entitled, "Research Is Fidelity's Middle Name in MMFs." We excerpt from the piece below.... This month, we interview the President of Fidelity's Money Market Group, Robert Brown, who succeeded Charlie Morrison in late 2009. (See our Fidelity profile in the January 2009 MFI, "Fidelity's Morrison on Money Market Funds.") Fidelity remains by far the largest manager of money funds in the U.S. with over $425 billion as of Feb. 28, 2011, according to Money Fund Intelligence XLS. Our Q&A follows.

Q: Tell us again about Fidelity's history with money funds. Brown responds, "We've been in this business for a long time. We launched our first money fund in May of 1974, Fidelity Daily Income Trust, which was the first fund to offer check writing and our first no-load fund. Fidelity Cash Reserves, launched in 1979, is now the largest retail fund in the industry. Our first tax-exempt fund, Fidelity Tax Exempt Money Market Trust, was launched in 1980."

He continues, "In November 1997, when we moved into our current trading facility in Merrimack, N.H., we had $193 billion in fixed income assets. Today, we have more than $700 billion. We are the largest money fund provider, with approximately a 16% market share.... We offer more than 40 funds, ranging from General Purpose, Government, Treasury, and Tax-Exempt mandates.... I worked with Charlie Morrison through the market crisis in '07 and '08 as the managing director of research, and subsequent to that was asked to take over my current responsibility."

He says, "When you look at, holistically, the risks that we manage in the funds, they include credit, structure, interest rate, and liquidity. We believe that managing all these risks well is essential, but monitoring credit risk has proven over time to be particularly critical. So my background, essentially 16 years in either analyzing credits, managing credit portfolios or trading credit securities ... really fits well into this role from an oversight perspective."

He adds, "We have more than 50 analysts dedicated to fixed income, primarily on the research side, but we are also building out our quantitative efforts.... Quantitative research was one area in particular that we felt required additional resources due to the required stress testing which was part of the most recent changes to Rule 2a-7, but also to boost our ongoing efforts in scenario analysis, risk adjusted returns, and overall risk management. We are continually reinvesting in this business and have dedicated significant resources to that effort."

Q: How did Fidelity weather the storm? Brown answers, "As you know, the period of '07 and '08 was unlike any that we've witnessed. I think the framework that we've had in place ... allowed Fidelity to navigate through the myriad of issues in the marketplace and position our funds appropriately for shareholders. In '07 and '08, we maintained the same type of conservative investment approach as it relates to our three primary tenets of how we manage money, which are principal preservation, liquidity and superior risk-adjusted returns, in that order.... The consistency of that message and the resources that are behind this business have not changed."

Q: What do you consider to be the biggest challenge today vs. historically? Brown responds, "It is certainly the low rate environment and a very challenging regulatory environment. Look at the Dodd-Frank bill, or Basel III. Banks are being forced to issue longer-dated securities while money funds, given the most recent wave of regulation with respect to the new 60 day WAM and 10% and 30% liquidity requirements, are being forced to invest in shorter dated securities. This leads to a disconnect where opposing regulatory forces create a strain on available supply."

He adds, "One of the positive attributes, I believe, is ... that general purpose funds ... are now carrying much more exposure to government and Treasury securities. In fact, Treasury securities now represent for most of our general purpose funds our single largest holding.... There have also been challenges created by the PIIGS crisis and the potential contagion risk from a European perspective. We continue to monitor that very, very closely."

Look for more excerpts from our Fidelity interview in coming days, or e-mail Pete to request the latest issue of Money Fund Intelligence.

Yesterday, the Senate Panel on Aging held a hearing entitled, "Securities Lending in Retirement Plans: Why the Banks Win, Even When You Lose," which interviewed market participants and which discussed the results of a report, "Securities Lending with Cash Collateral Reinvestment in Retirement Plans: Withdrawal Restrictions and Risk Raise Concerns". Senator Herb Kohl, Chairman of the panel, introduced the topic, saying, "In recent years, most workers have seen their savings take a hit, leaving many to wonder if they will ever be able to retire. The gap between what Americans will need in retirement and what they will actually have saved is estimated to be a staggering 6.6 trillion dollars. Now more than ever, we need to strengthen and protect our pension and 401(k) systems. That is why we are examining securities lending within retirement plans."

He explains, "In simple terms, securities lending is when a plan lends some of its stocks and bonds to a third party in exchange for cash as collateral that is then reinvested. Many plans participate in securities lending to generate a little extra revenue. For many years it seemed that there were only benefits to these arrangements for all sides. The economic downturn showed that securities lending is not a free lunch.... Securities lending is a complex financial transaction that goes on every day, often without employers and employees even knowing it is going on within their plans. And if they are aware, many do not understand the added risk. And ultimately that risk lies with 401(k) participants because banks share the cash collateral profits but not the losses -- so the banks always win."

Kohl adds, "Last November, this Committee began an investigation of the securities lending market which is being released today. We surveyed employers that sponsored the 30 largest 401(k) plans and found that all had at least one investment option that engaged in securities lending at some time in the previous five years. However, after the downturn, five of these employers stopped participating in securities lending. The Committee also surveyed the seven largest banks in the securities lending market. In 2010, these seven banks provided services to 570 different employer-sponsored plans with a total, of roughly $1.3 trillion in assets."

A separate GAO Report, "401k Plans: Issues Involving Securities Lending in Plan Investments,", explains, "Securities lending can be a relatively straightforward way for plan sponsors and participants to increase their return on 401(k) investments. However, securities lending can also present a number of challenges to plan participants and plan sponsors. GAO was asked to explain how securities lending with cash collateral reinvestment works in relation to 401(k) plan investments, who bears the risks, and what are some of the challenges plan participants and plan sponsors face in understanding securities lending with cash collateral reinvestment. In this testimony, GAO discusses its recent work regarding securities lending with cash collateral reinvestment."

Their report concludes, "It is clear that plan sponsors and participants need more transparent information about how securities lending arrangements work and a better understanding of the gains and losses from cash collateral pool investments that affect plan assets, and ultimately plan participants. Financial regulators and industry participants are beginning to make changes that can help plan sponsors fulfill their obligations. Labor can also takes steps to assist plan sponsors. Without more transparency and better understanding, securities lending arrangements with cash collateral reinvestment will continue as is, whereas plan sponsors and participants will remain, in some cases, unaware of these arrangements and the risk of loss they pose."

Steven Meier, Chief Investment Officer of Global Cash Management for State Street Global Advisors, told the panel in his testimony, "At State Street, we believe that securities lending can play a role in the development of a balanced investment program for professionally managed retirement plans. As you know, employee retirement plans typically earn dividends and interest from the plan's investment portfolio. However, if participants choose to invest in a plan option that engages in securities lending, the investment portfolio can earn additional incremental income. While the amount of this incremental income varies by portfolio and depends upon a number of factors such as prevailing interest rates and spreads between Federal funds and other credits, this incremental income can be significant."

He explains, "As this Committee is aware, the events of the recent global financial crisis that began in 2007 and worsened in 2008 were unprecedented. Our nation experienced a liquidity crisis in the fixed income sector as the secondary market for such securities essentially ceased functioning. Within the span of a few days in September 2008, we witnessed the failure of long-standing financial institutions and a large SEC-registered money market fund.... These events impacted lenders of securities in several ways, including a significant drain of liquidity from their cash collateral investment pools.... [D]uring the period from June 2008 to December 2008, State Street managed a nearly 50% decline in outstanding loan balances without any 401(k) plan investor invested in a Lending Fund realizing a loss due to a lack of cash collateral pool liquidity. However, this series of events caused significant impacts on cash collateral vehicles."

Meier adds, "Depending on their risk profiles and return objectives, collateral vehicles own assets of varying levels of liquidity, ranging from short-term cash and cash equivalents to high quality medium and long-term assets such as asset-backed securities and unsecured debt. If redemptions from a cash collateral vehicle (due to ongoing legal obligations to borrowers under the securities lending arrangement) exceed the vehicle's cash and cash equivalents and additional liquidity is required to meet its participants' obligations, the manager of the cash collateral vehicle will be forced to sell medium- and long-term assets to raise liquidity. In the market environment of 2008, such an imbalance made it virtually impossible to sell these assets, and if sales were possible, would have caused managers to sell assets at a substantial loss that did not reflect the intrinsic value of those securities, but rather reflected short-term illiquidity and unprecedented spread volatility in the markets."

Finally, he says, "State Street acted cautiously and thoughtfully to protect the interests of all of our securities lending clients. As a result, our Lending Fund investors did not incur any realized losses in connection with cash collateral reinvestment, unless they chose to take an in-kind distribution of securities and sell them at a loss. We are particularly proud of the way State Street has managed its securities lending program during the financial crisis over the last several years: We maintained 401(k) plan participants' full, unrestricted rights to make withdrawals from their retirement savings invested in Lending Funds; Due to our prudent management, none of the cash collateral pools realized material credit losses. As Chief Investment Officer, Global Cash management, I am particularly proud of this fact. We avoided the sale of strong credits into a distressed market and reinvested cash flow in highly liquid, short-term securities for a period of approximately one year before Lehman's default, building up the short-term liquidity in our cash collateral vehicles and managing the vehicles in an increasingly conservative manner."

Money fund manager BofA Global Capital Management recently posted another educational piece on money market securities. The one is entitled, "The Variable-Rate Demand Note: A Primer," and the subtitle explains, "This Important Investment Vehicle Enables Cash Investors to Capture the Benefits of Tax-Exempt Bonds without Assuming Excessive Risk." Senior Fixed Income Analyst Susan Dushock writes, "The weak economy and resulting shortfalls in tax revenue have left many states and municipalities facing substantial budget deficits. These fiscal challenges and the attendant drops in issuer credit ratings have raised concerns among investors about the suitability of tax-exempt bonds for cash portfolios."

She explains, "While investors are well aware of the risks presented by today's difficult fiscal environment, they likely are less familiar with a widely used tool to address those risks, the variable-rate demand note (VRDN). VRDNs effectively convert long-term municipal bonds into short-term, highly liquid instruments that are appropriate for cash portfolios. They do so through two important features: Periodic interest rate resets (usually daily or weekly), which ensure that the yields on VRDNs reflect the current interest rate environment. Liquidity facilities –- typically provided by highly rated financial institutions –- that allow investors to 'put' the VRDN at par value prior to the maturity date. By making the instrument more liquid than the underlying municipal security, the VRDN changes the risk profile of the issue, enabling the portfolio managers to deliver the tax advantages and diversification benefits presented by municipal bonds to cash investors."

DuShock says, "As noted above, defining features of a VRDN are its variable rate (through the rate reset) and the put feature. The put feature is particularly significant because it enables the manager of a money market fund or other cash portfolio to quickly exit an investment.... The provider of the liquidity facility is effectively the buyer of last resort for the VRDN, enabling the manager to exit the investment even if market conditions are not conducive to a sale."

She cautions, "It is important to note that a VRDN's put feature can be negated if certain events occur. These events, known as 'tender option termination events,' include: The failure of the issuer and credit facility to make interest and principal payments on the bonds or other bonds with the same security; The bankruptcy of the issuer; The lowering of the VRDN’s credit rating by all of the ratings agencies; [and] The revocation of a credit's tax-exempt status by the Internal Revenue Service. These events do not occur often, but when they do, they void the put feature."

DuShock adds, "This is why many VRDNs feature a second safeguard: the direct-pay letter of credit (LOC). Issued by a highly rated financial institution, a direct-pay LOC obligates the provider to pay principal and interest to bondholders. The LOC provider is reimbursed by the obligor of the bond within a certain time frame delineated in the bond documents. The provider of the LOC must meet its obligations even if the issuer of the VRDN fails to reimburse the LOC provider. Not all VRDNs include a LOC, but almost all of the VRDNs in BofA Global Capital Management's cash portfolios have the added protection of direct-pay letters of credit."

Finally, she writes, "For cash investors, VRDNs make it possible to capture the diversification benefits and the tax advantages offered by municipal bonds, while addressing the risks that otherwise would make tax-exempt securities unsuitable for cash portfolios. Indeed, the liquidity facility and the direct-pay letter of credit features enable cash investors to tap the tax-exempt bond market by addressing the central threats to the viability of short-term debt portfolios: the absence of liquidity and the loss of principal."

Last Thursday, the Federal Reserve released its latest quarterly "Flow of Funds Accounts of the United States" Z.1. statistics, which contains several tables on money market mutual fund investors and money fund holdings. The latest edition shows that money fund assets were basically flat in the fourth quarter of 2010, and that the household sector remains by far the largest holder of money fund shares, followed by funding corporations and nonfinancial corporate businesses. The Z.1. report also shows Security RPs, or repos, remained the largest holding of money funds for the third consecutive quarter.

The Z.1. Flow of Funds report contains four tables involving money market funds -- F.121 (p. 34) and L.121 (p. 79) on "Money Market Mutual Funds" (Holdings) Flows and Outstandings, respectively, and F.206 (p. 42) and L.206 (p. 87) on "Money Market Mutual Fund Shares" (Holders) Flows and Outstandings, respectively. The Fed's figures give a rare glimpse into the investor profile of money fund shareholders, and they give an alternative perspective on money fund portfolio composition.

As we mentioned, the Household sector remains the largest holder of money fund assets with $1.131 trillion, or 41.1%, of the $2.755 trillion total as of Dec. 31, 2010. This is up $6 billion from the previous quarter, but down $182 billion, or 13.8%, from a year ago. Funding corporations, which include Securities lenders, continue to be the second largest shareholder with $704 billion, or 25.6% of the total. Assets in this segment have declined by a steep $209 billion since Q4'09, or 22.9%, the largest drop of any shareholder type in both dollar and percentage terms.

Nonfinancial corporate business holdings of money funds remained the third largest slice, with $537 billion, or 19.5% of assets. These investors reduced money fund holdings by $94 billion, or 14.8%, over the past year. The remainder of money fund investors represent just single digit segments. These include: Private pension funds ($96 billion, or 3.5%); State and local governments ($91 billion, or 3.3%); Nonfarm noncorporate business ($66 billion, or 2.4%); Rest of the world ($61 billion, or 2.2%); Life insurance companies ($28 billion, or 1.0%); Property casualty insurance ($26 billion, or 1.0%); and State and local government retirement ($14 billion, or 0.5%).

The Fed's Z.1 Table L.121 "Money Market Mutual Funds" shows Security RPs accounting for $479 billion, or 17.4%, of all money fund assets. This is down just $1 billion from a year ago, while overall holdings of money fund assets decreased by $503 billion, or 15.4%. Time and savings deposits ranked second with $468 billion, or 17.0% of the total. These holdings declined by $105 billion, or 18.4%, since Q4'09. Agency and GSE backed securities ranked third among holdings with $403 billion, or 14.6%.

The Fed's Open market paper category, which we assume is Commercial Paper, was the fourth largest segment with $394 billion, or 14.3%. Other money fund holdings listed in the Fed's tables include: Treasury securities ($335 billion, or 12.2%); Municipal securities ($334 billion, or 12.1%); Corporate and foreign bonds ($154 billion, or 5.6%); Foreign deposits ($106 billion, or 3.8%); Miscellaneous assets ($67 billion, or 2.4%); and Checkable deposits and currency ($14 billion, or 0.5%).

To see the full "Flows of Funds" Z.1. release, go www.federalreserve.gov/releases/z1/Current/z1.pdf, or e-mail Pete Crane to request Crane Data's spreadsheet excerpts of the Fed's series. Also, watch for `Crane Data's latest Money Fund Portfolio Holdings files, part of our Money Fund Wisdom premium database service, to be released with Feb. 28, 2011 data early tomorrow.

Late last week, a press release entitled, "Fidelity Investments Launches Conservative Income Bond Fund," announced the latest entrant into the "enhanced cash" or ultra-short bond fund space. The subtitle says, "Short-Duration Bond Fund Seeks to Obtain High Level of Current Income Consistent With Preservation of Capital," and the release explains "Fidelity Investments today announced the launch of Fidelity Conservative Income Bond Fund, a bond fund that invests primarily in a combination of money market and high quality, investment-grade debt securities with short durations."

It adds, "The new fund will be managed by James K. 'Kim' Miller, a 20-year Fidelity veteran with significant experience in managing funds with a primary focus on capital preservation." Miller previously managed Fidelity's largest taxable institutional money funds, the $66 billion Fidelity Inst MM: MM Portfolio and the $70 billion Fidelity Inst MM: Prime.

Miller says, "The aging U.S demographics and the recent volatility in both the equity and fixed-income markets have heightened demand by investors of all types for shorter-term investment products to help them manage risk within their portfolios. Fidelity Conservative Income Bond Fund should appeal to relatively conservative, income-oriented investors with a time frame of at least six months to one year who are looking for exposure to high quality debt securities with short durations and are willing to accept some fluctuation in their fund's share price."

The release continues, "Fidelity Conservative Income Bond Fund seeks to obtain a high level of current income consistent with preservation of capital by normally investing at least 80% of its assets in U.S. dollar-denominated money market and high quality, investment-grade debt securities of all types, and repurchase agreements for those securities. The fund's benchmark index is the Barclays Capital 3-6 Month U.S. Treasury Bills Index and it will normally maintain a dollar-weighted average maturity of 0.75 years or less. It offers two share classes -- a retail class (FCONX) and an Institutional class (FCNVX)."

Miller explains, "Over the years, Fidelity has developed great expertise in bond and money market investing. I intend to utilize that experience for this fund.... Recent developments have led to the creation of additional potential investments for fixed-income funds along the shorter segment of the yield curve, and Fidelity Conservative Income Bond Fund will seek to take advantage of those opportunities. Through extensive fundamental credit and quantitative research, I will look to identify relative value opportunities within the universe of high quality, short duration instruments."

Finally, the release says, "Miller joined Fidelity in 1991 as a municipal bond credit analyst. He became a municipal bond trader in 1998, and later that year, accepted a position as a taxable credit analyst. From 2001 to 2003, Miller managed a number of Fidelity municipal money market funds. He managed VIP Money Market Portfolio from 2003 to 2011, and managed Fidelity Institutional Prime Money Market Portfolio from 2004 to 2010, and Fidelity Institutional Money Market Portfolio from 2003 to 2011. He will continue to manage institutional separate accounts and comingled pools."

Fidelity's offering is the latest entrant in the newly nascent ultra-short bond or "enhanced cash" market. (See our Oct. 1, 2010, Crane Data News, "JPMorgan Rolls Out Ultra-​Short Money Mkt Fund, Enhanced Cash Fund and see information on Dreyfus Institutional Income Advantage Fund (DLASX).) The space beyond money market funds has been attracting interest due to the near zero yields on "cash". But unlike the space's previous rise and fall, the launches this time around are steering clear of any stable NAV offerings or any hint of being a money fund "plus" offering.

A press release entitled, "Moody's finalizes new methodology for money market funds," sent out yesterday says, Moody's Investors Service has published its new global methodology for rating money market funds.... The new rating methodology reflects experience gained from the tumultuous period in late 2008 when disruptions in short-term funding markets caused market value declines and record outflows from prime money market funds." The final ratings changes reflect an about-face after a firestorm of criticism over Moody's initial proposals, which included abandoning the triple-A scale and heavily weighting parental support in fund ratings. (See our Sept. 8, 2010, Crane Data News news article, "Moody's Proposes New Money Market Fund Rating Methodology, Symbols," and our Jan. 19, 2011, piece, "Moodys Backs Down From MMF Ratings Change Proposals, Keeps AAA.")

The full paper, "Moody’s Revised Money Market Fund Rating Methodology and Symbols," says, " In this report, we present our revised rating methodology for rating money market funds. The analytical framework uses a set of objective measures to assess portfolio credit quality as well as market and liquidity risks in stress scenarios in order to differentiate among funds. In addition, we are introducing a new set of rating symbols and definitions that better address the unique risks of money market funds and distinguish our money market fund ratings from our credit ratings. This new rating methodology is scheduled to become effective on 20 May 2011, and all existing money market ratings will be migrated then to the new rating symbols based on the new methodology."

It explains, "Our revised money market fund rating methodology incorporates market feedback that we received after publishing our Request for Comment on the same subject in September 2010. Once effective, the new methodology will supersede the following principal methodologies as they apply to money market funds: "Moody's Managed Funds Credit Quality Ratings Methodology" and "Moody's Money Market and Bond Fund Market Risk Ratings", both published in 2004."

Moody's new Rating Methodology continues, "The introduction of Moody's revised money market fund methodology reflects experience gained from the tumultuous period in late 2008 when disruptions in short-term funding markets caused market value declines and record outflows from prime money market funds. During this period, a large money market fund -- The Reserve Primary Fund -- 'broke the buck' and suspended redemptions together with funds managed by the same fund family. Many other funds experienced stress within their portfolios and elevated redemptions at the same time, heightening systemic risk. Ultimately, support from the US Treasury, via the introduction of a guaranty fund for money market fund investors, served to stem investor outflows and prevent a disorderly unwind of money market funds."

It adds, "The financial crisis had a significant impact on investors in money market funds. Some, particularly those invested in Reserve Management Funds, suffered payment delays and principal losses. As a result, investors have become more sensitive to the differences among money market funds and increasingly focused on the wide range of money market fund risks including: 1) vulnerability to market and liquidity risks -- despite portfolios consisting of highly-rated assets -- in addition to credit risk; 2) susceptibility to redemption risk, particularly if there is a concentrated investor base; 3) the quality and stability of the fund sponsor, whose support was generally forthcoming in the crisis, but not certain."

The press release explains "The main elements of the final methodology are: Ratings based on two distinct analytic assessments -- the portfolio credit profile (based on the credit quality of the fund's assets), and portfolio stability profile (including market and liquidity risks); A new set of rating symbols to reflect the distinct meaning of the money market fund ratings compared to Moody's credit ratings on long-term bonds, using a "mf" modifier to highlight the distinct meaning of money market fund ratings (namely, Aaa-mf, Aa-mf, A-mf, Baa-mf, B-mf, C-mf)."

Yaron Ernst, Managing Director of Moody's Managed Investments Group, comments, "Based on extensive engagement with market participants, we believe that our new methodology will benefit investors by clearly identifying rating drivers and by emphasizing the market and liquidity risks associated with money market funds."

On Tuesday, Sandra Krieger, an Executive Vice President at the Federal Reserve Bank of New York, gave a speech entitled, "Reducing the Systemic Risk in Shadow Maturity Transformation," which discussed ABCP, repo, and money market funds extensively. She said, "My objective today is to talk about the systemic risk that can be created by financial intermediaries that do not have direct and explicit access to official liquidity -- the so-called shadow banks -- and how these risks might be reduced. My focus is on maturity transformation activities -- that is, the use of short-term funding to finance longer term, risky assets. These activities exploded during the credit bubble. And they popped along with the bubble, killing or nearly killing the sponsoring institutions with the toxic (and nontoxic) assets therein." (See her slides here.)

Krieger explained, "[T]his talk is about the reforms that have occurred or need to occur to reduce the degree of systemic risk associated with shadow maturity transformation. Much regulatory reform is focused on making the link between banks and these activities more explicit and more properly supported by liquidity and capital. Other reforms are focused on reducing reliance on traditional banks, by having the shadow banking entities themselves provide for the necessary credit and liquidity backstops or by forcing shadow bank investors to bear the ex ante economic cost of their activities. This topic is one of many systemic risk issues of importance to the Federal Reserve."

She commented, "Today's more opaque and complex system of banks and shadow banks can nonetheless be distilled down to a basic element of financial intermediation: the transformation of long-term risky assets into very short-term liabilities. It is this maturity transformation that renders financial intermediaries intrinsically fragile since, by definition, an intermediary engaging in maturity transformation cannot honor a sudden request for full withdrawals."

Krieger continued, "The degree of maturity transformation undertaken in the shadow of our financial system was dramatically exposed in each of the darkest moments of the recent financial crisis. I am going to discuss shadow maturity transformation and reforms in three market segments: ABCP, tri-party repo and money market mutual funds. The collapse of the ABCP market drove pressure on the U.S. dollar LIBOR interest rate in August 2007. The withdrawal of tri-party repo funding from Bear Stearns in March 2008 was a large contributor to that firm's collapse and triggered significant knock-on effects in the market for the underlying collateral and in markets more broadly. Pressure on money market mutual funds in September 2008 exacerbated the problems created by the failure of Lehman Brothers, which itself was driven in part by issues that firm faced in tri-party repo funding."

She added, "The Federal Reserve created seven emergency liquidity facilities to deal with the unwind of shadow credit transformation: the term auction credit facility, foreign exchange swaps with foreign central banks (not new but used in an expanded manner), a primary dealer credit facility (PDCF), a term securities lending facility (TSLF), an asset backed commercial paper money market mutual fund liquidity facility (AMLF), a commercial paper funding facility (CPFF) and a money market investor funding facility (MMIFF). While successful in achieving their unique goals, these facilities were merely a bridge to more normal markets, buying time for well-needed structural reform."

Krieger said about "Money market mutual funds," "Money funds exist in the parallel banking system and the value proposition for investors derives from the elements that we have been discussing: investors earn returns that benefit from a maturity mismatch between the investor funding and the investments from which the return is generated -- and investors can withdraw on demand and with almost immediate execution. Money funds have little ability to absorb losses and, as with other parallel banking activities, have no official liquidity or credit support, although the Federal Reserve and Treasury stepped in during the financial crisis, using emergency powers.... This fragility of MMMFs can quickly spread to other financial firms and the broader economy given the size of the money fund industry and its prominence in short-term financing markets."

She explained, "The fragility of money funds, and potential broader consequences was front and center in September 2008 when Lehman failed; all of what I just said occurred: the confidence shock, and then rapid changes in money fund risk profiles and investor risk appetite moving in opposite directions. In this environment, the Prime Reserve Fund [sic], a well-established money market fund that had exposure to Lehman CP, 'broke the buck.' Money market fund investors at other funds voted with their feet regarding their discomfort with the lack of guaranteed credit and liquidity support for these activities, withdrawing large amounts from funds that invested in instruments that did not have full and direct government support or clearly sufficient parent support. Fund managers reacted by selling assets and investing at only the shortest of maturities, thereby exacerbating the funding difficulties for other instruments such as commercial paper."

Krieger later said, "The goal of MMMF reform is to reduce the fragility of these institutions and their susceptibility to runs, the rapid flight of investors, which can destabilize the broader financial system. To date, the Securities and Exchange Commission (SEC) has approved amendments to the rules applicable to MMMFs that focus on reducing risk on the asset side of funds' balance sheets.... The President's Working Group (PWG) has proposed a range of reform options for consideration by the Financial Stability Oversight Council. In general, these were intended to address the fact that MMMFs have a number of characteristics -- including a stable NAV, redemption upon demand, and extremely risk-averse investors -- which interact to make these entities vulnerable to runs. Several of these proposals entail the creation of liquidity and capital buffers. The former provide additional near-cash assets to deal with redemptions, while the latter enhances the loss absorption capacity available to deal with a credit event. Broadly speaking, two kinds of buffers can be set up: ex ante and ex post."

Finally, she commented, "In summary, regulators have certainly made some significant improvements to the structure of the MMMF industry which may reduce the likelihood of runs and improve its resiliency. However, until more significant reforms are undertaken, a clear systemic vulnerability remains. It is important to note that there may well be no single measure that adequately addresses this issue, and some combination of measures may ultimately be the most appropriate course."

Though the deadline for comment letters on the President's Working Group Report on Money Market Fund Reform was officially January 10, 2011, the Securities & Exchange Commission continues to post additional late entrants. The most recent addition is a letter from John Hawke, Jr., from Arnold Porter, on behalf of Federated Investors. Hawke writes, "We are writing on behalf of our client, Federated Investors, Inc. and its subsidiaries, to provide a supplemental comment in response to the U.S. Securities and Exchange Commission's request for comments on the President's Working Group Report on Money Market Fund Reform. We supplement Federated's earlier comments submitted in this docket in order to respond to a comment letter filed after the close of the comment period by The Squam Lake Group, which is a consortium of academic economists."

The letter explains, "We agree with the Squam Letter on one major point: moving Money Funds to a floating NAV is a fundamentally unsound idea that, if acted upon, would not only make Money Funds unattractive to investors, it would also significantly increase systemic risk in the banking industry. This view, that moving Money Funds to a floating NAV would be a very bad idea, is also shared by a broad cross section of other commenters representing consumers and investors, academia, businesses, business journalists, state and local governments, and investment management firms. We disagree with the Squam Letter, however, on two other basic points: (1) the premise of the Squam Letter that the current way in which Money Funds are structured and regulated is flawed and creates systemic risk; and (2) the conclusion of the Squam Letter that there is a need to fundamentally change the capital structure of Money Funds to address the alleged systemic risk."

Hawke tells us, "On the first point, the Squam Letter notes that during the financial crisis, one Money Fund, the Reserve Primary Fund, broke a buck and was forced to halt redemptions and liquidate. The Squam Letter goes on to note that 36 other Money Funds received financial support from their sponsors.... From this, the Squam Letter posits that there is a systemic risk posed by Money Funds. We see these numbers in a very different way. As of the beginning of 2008, there were 807 Money Funds in existence. Of these 807 Money Funds, 771 -- over 95% -- did not receive any financial support from their sponsors. Moreover, of these 807 Money Funds, 806 did not break a buck during the worst financial crisis since the Great Depression. In other words, roughly 99.9% of Money Funds did not break a buck during a financial crisis the likes of which most of us had never before seen. The Reserve Primary Fund, the only Money Fund to break a buck, was liquidated and it shareholders received back 99.2% of their money.... That is phenomenally good performance, during a period of near economic chaos."

He says, "The sudden collapse of Lehman Brothers and the weakness of a number of other large financial firms that were major issuers of commercial paper caused the problem in the money markets in September 2008 and caused the Reserve Primary Fund to break a buck. Money Funds did not cause the problems at the issuers or in the money markets, but instead experienced redemptions and credit quality concerns that reflected the problems at commercial paper issuers. Those concerns over the issuers of commercial paper led to illiquidity in the money markets in 2008, much as was the case in 1974 when Penn Central defaulted on its commercial paper obligations. Changing the capital structure of Money Funds would do nothing to address credit quality or liquidity issues among the issuers of commercial paper and the impact that problems at one or more major issuers can cause to the money markets as a whole. However, the focus in Title I of the Dodd Frank Act on improving the transparency, capital and liquidity standards of significant bank and nonbank financial firms that are major commercial paper issuers, and the actions that the regulators will take to implement those requirements, will have the beneficial effect of reducing risk and increasing stability in the money markets. Greater stability among the major issuers of commercial paper into the money markets will translate into lower risks at Money Funds."

Hawke also tells the SEC, "We note that an additional destabilizing factor, which has been largely overlooked in the discussion, was an increase in deposit insurance limits and a competing money management deposit product introduced suddenly by Congress and the FDIC in the midst of the crisis. On October 3, 2008, Congress temporarily increased deposit insurance coverage for all bank depositors to $250,000 (up from $100,000), and on October 13, 2008, the FDIC issued an unlimited federal insurance guarantee of bank deposits bearing an interest rate of 0.5% (a rate defined in the FDIC rules as "noninterest bearing," but that was actually a very competitive rate at the time for federally-insured money) or less."

Hawke writes, "The stable performance of Money Funds during the recent financial crisis is consistent with how stable Money Funds have been over the entire 40 years that there have been Money Funds. Since 1971, only two Money Funds have broken the buck -- the Reserve Primary Fund mentioned above, and the Community Bankers U.S. Government Fund, a small institutional fund.... Now let us compare that record with the solvency records of banks during the same period. Since 1971 over 2,800 banks have failed, and an additional 592 were kept afloat through federal bailouts, at a total cost to the federal government of over $164 billion. During the financial crisis, from January 2008 through February 18, 2010, 344 banks failed in the United States. Keep in mind that U.S. banks are policed by an army of 26,000 federal bank regulators."

He continues, "Yet, surprisingly, the Squam Letter proposes a 'solution' to the 'problem' at Money Funds in the form of an entirely new capital structure that looks like, well, the capital structure of banks.... This approach has not worked well at banks and there is no reason to believe it would work at Money Funds. First, the most immediate problem during the financial crisis, as in the start of the Great Depression, was not asset quality. It was liquidity. A few percentage points of junior capital does little or nothing to address liquidity problems. Instead, maintaining a short-term fixed income portfolio, which holds a large chunk of ready cash and near-cash assets and essentially self-liquidates in its entirety in a relatively short period of time, provides a much better protection against a "run." This is the approach taken by the SEC in Rule 2a-7, and these liquidity requirements have been made even more stringent through the 2010 amendments to that rule."

Finally, Hawke writes, "We also note that the capital structure proposed by the Squam Letter also bears a striking resemblance to the capital structures formerly used for asset securitization and structured finance vehicles.... Those vehicles failed dramatically during the recent financial crisis. It is not clear why the authors of the Squam Letter would resurrect that structure as a model for Money Funds, although we note that the complex securitization vehicle capital structure, like the one proposed here by the Squam Letter for Money Funds, was developed by academics and rating agencies. Finally, we note that the general thrust of the Squam Letter proposal is a variation on the theme of increased sponsor support of Money Funds as a means to reduce the investment concerns of risk-averse investors, a position that has been championed by one of the rating agencies. A major goal of financial reform is to reduce systemic risk. Tying the solvency of Money Funds to sponsor support for those funds as a means to reduce the concerns of risk-averse investors, is fundamentally the wrong direction to go in order to reduce systemic risk."

Early yesterday, Crane Data published the March issue of its flagship Money Fund Intelligence newsletter, along with its monthly performance rankings as of Feb. 28, 2011. The latest MFI features the articles, "Consolidation & Changes Continue Among MMFs," which discusses the spate of recent liquidations, name changes and mergers among funds; "Research Is Fidelity's Middle Name in MMFs," which interviews Fidelity money-market head Bob Brown; and, "Removing Ratings from 2a-7; Other NRSRO Issues," which discusses the SEC's recent proposal to change the regulatory definitions of "First Tier" and "Second Tier". Crane's monthly newsletter also features money fund news briefs, performance tables, rankings, our Crane Indexes and top-performing fund tables.

The Consolidation & Changes piece says, "Since we last wrote about consolidation in the money market fund space (MFI 10/10, "More Changes in Money Fund Land"), we've continued to see liquidations, name changes and lineup tweaks. Though it hasn't exactly been an exodus, several fringe players have fallen since our last update. Below, we briefly review recent developments, and we update our table of changes."

Our Fidelity Profile states, "This month, we interview the President of Fidelity's Money Market Group, Robert Brown, who succeeded Charlie Morrison in late 2009. (See our Fidelity profile in the January 2009 MFI, "Fidelity's Morrison on Money Market Funds.") Fidelity remains by far the largest manager of money funds in the U.S. with over $425 billion as of Feb. 28, 2011, according to Money Fund Intelligence XLS. Our Q&A follows." Look for excerpts from our interview on www.cranedata.com in coming weeks.

MFI also discusses the new "shadow" NAV disclosures. The article says, "Last week, the SEC issued a release entitled, 'Removal of Credit Rating References from Certain Investment Company Act Rules and Forms,' and held an Open Meeting on the topic of changing the definition of 'First Tier' in Rule 2a-7 (​among other things)."

The piece quotes SEC Chairman Mary Shapiro, "The focus of these efforts is to eliminate over-​reliance on credit ratings by both regulators and investors -- and to encourage an independent assessment of creditworthiness rather than a potentially misguided reliance on a credit rating. One of the more significant rules we are considering today is Rule 2a-​7 money market funds by imposing risk-​limiting conditions on the investments a money market fund can make. The core use of ratings under Rule 2a-​7 relates to determining which securities are eligible for purchase by a money market fund."

Finally, MFI's "Money Fund News" also features briefs about `Paul Volcker's comment letter to the SEC on the President's Working Group Report, the ICI's comment letter to FSOC on whether money funds should be designated as systematically important, and more. Crane Data's Money Fund Intelligence is $500 a year and includes access to archived issues and additional tools via www.cranedata.com. E-mail Pete to request the latest issue or call 1-508-439-4419 to subscribe.

Last week, the Investment Company Institute's Chief Economist Brian Reid wrote a letter entitled, "40 Years Later, Money Market Funds Still Aren't Banks," in response to former Federal Reserve Chairman Paul Volcker's comment letter to the SEC on the President's Working Group Report on Money Market Fund Reform. Reid says, "Paul A. Volcker is a distinguished leader who for decades has devoted his prodigious talents to the service of our country. However, as he makes clear in his recent comment letter to the Securities and Exchange Commission, his long opposition to money market funds -- dating back almost 40 years -- hasn't ended."

ICI's Reid explains, "Volcker's animus is based in a fundamental misunderstanding: he believes that money market funds are unregulated banks, which he says will pose massive risks unless they get bank charters and insurance. The former Federal Reserve chairman -- who has spent his career in banking -- appears to believe that bank regulation is the gold standard of security and safety. Of course, the latest global financial meltdown was first and foremost a banking crisis. The extreme market conditions in the depths of that meltdown exposed some potential vulnerabilities of money market funds. The fund industry has taken the lead in addressing those problems, and the SEC has adopted significant reforms to make money market funds better able to withstand severe market conditions."

He continues, "We've explained on many occasions -- most recently in our own SEC comment letter on the President's Working Group Report -- why prudential banking regulation and insurance are neither necessary nor appropriate for money market funds. Banking regulation would not have addressed the problem that hit those funds in September 2008 -- a sudden and widespread liquidity freeze in the money market. So we're forging ahead to develop a liquidity facility for prime money market funds, and are open to other ideas that make money market funds stronger without undermining their core characteristics."

Reid comments, "Volcker's prescription, by contrast, would turn back the clock 40 years. His plan would layer onto stable-price money market funds all of the costs of banking regulation, on top of the risk-limiting regulations that money market funds already follow. Volcker recognizes that imposing two sets of rules on these funds would seriously undermine their ability to serve investors -- but he welcomes that. He believes household savers and institutional cash managers would be forced back into the banking system, which would gain an implicit subsidy as investors accept low-yielding deposits. What Volcker ignores is the enormous damage his proposal would do to investors -- and to the economy."

He says, "There's also substantial risk that money market fund investors would not put their cash into banks. Instead, billions of dollars could flow to less-regulated or unregulated cash pools, here and abroad, that aren't bound by the risk-limited regulations applied to money market funds. Those alternatives would be more subject to unexpected losses and runs than today's money market funds. Volcker merely waves off that hazard -- but clearly his proposal could increase, rather than reduce, risks to the financial system."

Finally, Reid writes, "Over almost 40 years, money market funds have emerged as a steady, predictable mainstay of the financial marketplace and a key component of the American economy. Their track record proves that the Paul Volcker who fought money market funds in the 1970s was wrong. We're sorry that today's Paul Volcker still won't see that."

On Friday, the Institute also posted a piece entitled, "ICI Will Scrutinize Proposal Removing Ratings Requirement from Money Market Fund Rules," which says, "On Wednesday, the Securities and Exchange Commission voted unanimously in favor of a proposal that would eliminate credit ratings as a required element in determining which securities are permissible investments for money market funds. The proposal stems from the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires federal agencies to review regulations and replace credit ratings as an assessment of creditworthiness. Under current law, money market funds conduct their own thorough credit risk analysis for investments through a two-part test. First, a money market fund can only invest in securities that are 'first-tier' or 'second-tier' securities, based on a rating agency granting those securities the highest or second-highest short-term credit rating. The second test is more subjective: a money market fund's board of directors (or its delegate) must determine that a security presents minimal credit risks, based on factors relating to credit quality."

The final agenda is now set and registrations are now open for Crane's Money Fund Symposium, which will take place on June 22-24, 2011, at The Philadelphia Marriott Downtown. Since our inaugural 2009 conference in Providence, Money Fund Symposium has quickly grown to become the largest gathering of money market mutual fund and cash investment professionals in the world. Over 330 money fund managers and marketers, money market securities issuers and dealers, cash investors, regulators and servicers attended last summer's Boston event, and we expect our Philadelphia shows to attract a similarly robust crowd.

With almost 20 sponsors signed up to date and a lineup of the most senior speakers in the money fund industry, Money Fund Symposium 2011 is almost certain to be THE event in the money markets. Sessions on Day 1 include: "Money Market Funds Still Matter" by Jack Brennan of The Vanguard Group; "Cash Strategies for the Next Decade" by Simon Mendelson of BlackRock; a panel on "Major Money Fund Issues" with Charlie Cardona of The Dreyfus Corporation, Robert Deutsche of J.P. Morgan Asset Management, and Michael Morin of Fidelity Investments; and a "Regulatory Update: What's Next for MMFs?" with Jane Heinrichs of the Investment Company Institute, Robert Plaze of the Securities & Exchange Commission, and Joan Swirsky of Stradley Ronan.

Symposium's Day 2 morning agenda includes: "State of The Money Market Fund Industry" with Peter Crane of Crane Data and Brian Reid of ICI; "Manager Perspectives on Major Issues" with Debbie Cunningham of Federated Investors, Jim McCarthy of Goldman Sachs Asset Management, and Dave Sylvester of Wells Fargo Advantage Funds; "Finding Yield in a Low-Rate Environment with Esther Chance of Invesco and Kevin Kennedy of Western Asset Management; and, a "Municipal Money Fund Market Update" with Mary Jo Ochson of Federated Investors and Pam Tynan of Vanguard.

The afternoon of Day 2 includes sessions on: "New Securities, Supply & Issuer's Strategies" with Stewart Cutler of Barclays Capital, Jean-Luc Sinniger of Citi Global Markets, Maureen Coen of Credit Suisse, and Per Paullson of Natixis; "Separately Managed Account Developments" with Jon Carlson of BofA Global Capital Management and Lance Pan of Capital Advisors Group; "Fund Ratings & NRSRO Update" with Peter Rizzo of Standard & Poor's, Roger Merritt of Fitch Ratings, and Sean Egan of Egan Jones; and "Portal Tools, Transparency & MF Analytics" with John Carter of Citi, Greg Fortuna of State Street's Fund Connect, and Tory Hazard of Institutional Cash Distributors.

Day 3 of Money Fund Symposium includes sessions on: "Interest Rates, Repo, Govt & Fed Issues" with Alex Roever of J.P. Morgan Securities, Brian Smedley of Bank of America Merrill Lynch, and Joseph Abate of Barclays Capital; "Corporate Sweeps, Reg Q & Banking Regs" with Jeff Avers of SunTrust and Tony Carfang of Treasury Strategies; and, "Brokerage Cash, Sweeps & FDIC" with Mark Brooks of Promontory Interfinancial and Eric Edstrom of Janney Montgomery Scott.

Registration to Crane's Money Fund Symposium is $750 and Exhibit tables are $3,000. Contact Crane Data to request a brochure or for sponsorship options, and visit www.moneyfundsymposium.com to register or for more information. Finally, thanks for the generous support of our Symposium Sponsors to date: Bank of America Merrill Lynch, Barclays Capital, Dreyfus, J.P. Morgan Securities, BlackRock, Federated Investors, Fidelity Investments, Invesco, Capital Advisors, Citi, Fund Connect, Standard & Poor's, Wells Fargo Advantage Funds, Western Asset, Dexia, Fitch Ratings, and Natixis. We hope to see you in Philly!

Early yesterday, the SEC issued a press release entitled, "Removal of Credit Rating References from Certain Investment Company Act Rules and Forms," and held an Open Meeting on the topic of changing the definition of "First Tier" (among other things). The release says, "The Commission will consider whether to propose amendments that would remove references to credit ratings in two rules and four forms under the Investment Company Act of 1940. The proposals stem from the Dodd-Frank Wall Street Reform and Consumer Protection Act.... The amendments would make changes to the money market fund rule among others."

SEC Chairman Mary Shapiro comments in her "Opening Statement Regarding Proposal to Remove Credit Rating References from Investment Company Act Rules and Forms," "Under the Dodd-Frank Act, federal agencies must review how their existing regulations rely on credit ratings as an assessment of creditworthiness. At the conclusion of this review, each agency is required to remove these references and replace them with alternative standards that the agency determines to be appropriate. The focus of these efforts is to eliminate over-reliance on credit ratings by both regulators and investors -- and to encourage an independent assessment of creditworthiness rather than a potentially misguided reliance on a credit rating. One of the more significant rules we are considering today is Rule 2a-7. This rule plays a critical role in protecting investors in money market funds by imposing risk-limiting conditions on the investments a money market fund can make. The core use of ratings under Rule 2a-7 relates to determining which securities are eligible for purchase by a money market fund."

The Proposal, "Removing References to Credit Ratings of Money-Market Fund Investments," was passed by the Commission. The release comments on the "Current Rule," "Rule 2a-7 under the Investment Company Act governs the operations of money market funds and requires these funds to invest only in highly liquid short-term investments of the highest quality. To ensure that the funds are invested in high-quality, short-term securities, Rule 2a-7 sets forth several requirements: First, money market funds can only invest in securities that: Are 'first tier' -- meaning they have received the highest short-term rating or are 'second tier' -- meaning they have received the second highest short-term rating. At least 97 percent of a money market fund's portfolio must be invested in 'first tier' securities. If a security is not rated, the funds must evaluate the credit quality of the security and deem it be of comparable quality to a security receiving one of the two highest short-term ratings. Second, a money market fund's board of directors (or its delegate) must determine that the security presents minimal credit risks, based on factors relating to credit quality, in addition to any rating the security may have received."

It continues, "Proposed Amendments: The proposed amendments would eliminate the credit ratings requirements for money market fund investments. The amended rule would set forth new requirements: First, money market funds would have to assess the credit quality of the security and determine that each portfolio security presents minimal credit risks. Second, money market funds would have to determine whether the portfolio security is a 'first tier' or 'second tier' security, using new definitions for those terms. A security would be first tier only if the fund's board of directors (or its delegate) has determined that the security's issuer has the highest capacity to meet its short term financial obligations. Like the current rule, a money market fund would be required to invest at least 97 percent of its assets in first tier securities. A security would be second tier if the board (or its delegate) has determined the security presents minimal credit risks, even if it is not a first tier security."

It adds, "Some debt securities have a feature that allows an investor to sell the security (at cost plus accrued interest) back to the issuer or to a third party. Some of these 'demand features' limit an investor's ability to demand payment for the security under certain circumstances. Under existing Rule 2a-7, a money market fund may invest in a security subject to such a 'conditional demand feature' only if, among other things, the underlying security has received one of the two highest ratings. The proposed rules would eliminate the credit rating requirement. Instead, the fund's board (or its delegate) would be required to determine that the underlying security is of high quality and subject to very low credit risk.... The Commission also will consider proposing amendments to Form N-MFP, which money market funds use to report their portfolio schedules to the SEC each month. The proposed amendments would eliminate items in the form that require disclosure of the ratings of the securities in the portfolio."

Both SEC Commissioner Luis Aguilar and Commissioner Troy Paredes expressed reservations. Aguilar's Speech says, "Under the current requirements of the rule, both ratings and judgment are currently required. Thus, it seems this is a reference that has no effective substitute and is already accompanied by a requirement to conduct analysis above and beyond ascertaining the credit rating." Paredes' speech adds, "I support the proposal but do have questions about its practical effect, particularly insofar as rule 2a-7 is concerned. I look forward to the comments we will receive." Public comments on the proposed amendments should be received by April 25, 2011.

Late last week, the Investment Company Institute, the trade group for the mutual fund industry, wrote a letter to the Financial Stability Oversight Council entitled, "Authority to Require Supervision and Regulation of Certain Nonbank Financial Companies (FSOC-2011-0001-0001)." It says, "The Investment Company Institute appreciates the opportunity to provide further comment as the Financial Stability Oversight Council ('FSOC' or 'Council') seeks to develop the process by which it will designate certain nonbank financial companies for heightened supervision pursuant to Section 113 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. As both issuers of securities and large investors in U.S. and international financial markets, ICI's registered investment company members are keenly interested in policies that promote a well functioning financial system able to withstand the periodic shocks that are an inevitable part of our complex, global marketplace."

The letter explains, "It is disappointing that the proposed rule does not specify how the FSOC intends to apply the criteria set forth in Section 113 when analyzing whether a particular company should be designated as a systemically important financial institution ('SIFI'). For example, while the Release outlines a proposed analytical framework for assessing the ten specific statutory criteria, the rule text contains no evidence of that framework. In addition, the Release gives little indication as to the Council's views on the specific criteria, and simply summarizes the views of commenters on its advance notice of proposed rulemaking ('ANPR'). We realize that the Council may wish to preserve sufficient flexibility to respond, as circumstances dictate, to new or emerging risks to the financial system. The need for flexibility must be balanced, however, against the needs of financial market participants for clarity regarding the 'rules of the road.'"

ICI says, "In our view, the broad scope of these ... authorities should allow the FSOC to reserve SIFI designation for those circumstances in which the risks to the financial system as a whole are both large and quite plain, and nothing less than designation will suffice to address them. Finally, we turn to the suggestion by some commenters that certain (presumably larger) money market funds should be designated for heightened supervision pursuant to Section 113. We explain why such designation would not be an appropriate regulatory tool for further strengthening the resilience of money market funds to severe market distress."

The letter continues, "As the Release indicates, the six categories identified by the FSOC -- size, lack of substitutes, interconnectedness, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny -- reflect different dimensions of a company's potential to pose risk to the financial system."

It explains, "A financial company that already is highly regulated is more likely to have robust internal controls and compliance procedures. Moreover, its primary regulator is the 'subject matter expert' regarding the applicable regulatory scheme, and will be knowledgeable about the industry of which the company is a part, industry best practices, areas of regulatory concern, and the markets in which the company operates. These circumstances may mititate against the need for imposing additional regulation by the Federal Reserve Board, as is required for any company designated by the FSOC under Section 113. Further, the FSOC should look specifically at the degree to which the regulatory requirements already applicable to that company serve to limit or control risk. As a general matter, a financial company that must adhere to risk-limiting requirements is less likely to warrant a SIFI designation. Funds are subject to a comprehensive regulatory regime under the Investment Company Act of 1940, the most significant protections of which relate to leverage, custody of assets, transparency, mark-to-market valuation of fund assets, and transactions with affiliates. Fund investment advisers also are highly regulated."

"ICI believes one important reason for restraint with respect to SIFI designations is that it should help ensure that the FSOC and other financial regulators use the 'right tool for the job.' In the context of designations under Section 113, we think this means, among other things, that the FSOC should have a reasonable expectation that the 'remedies' that would flow from SIFI designation are necessary and will be effective to address the specific risk(s) that the FSOC seeks to minimize. This is particularly important because, in practice, designation decisions -- once made -- will have significant consequences that are unlikely to be reversed," the comment adds.

It continues, "Judicious use of the FSOC's Section 113 designation authority also is consistent with legislative intent, as described by former Senate Banking Committee Chairman Christopher S. Dodd. In a Senate colloquy, Chairman Dodd stated: 'The Banking Committee intends that only a limited number of high-risk, nonbank financial companies would join large bank holding companies in being regulated and supervised by the Federal Reserve.' Federal Reserve Board Chairman Ben Bernanke likewise has expressed his view that Section 113 designations should be limited in number."

Under "SIFI Designation Not Appropriate for Money Market Funds," ICI writes, "Some commenters have suggested that the FSOC should use its authority under Section 113 to designate certain (presumably larger) money market funds for enhanced supervision and regulation by the Federal Reserve Board. We strongly disagree, for the reasons discussed below.... Analysis of the application of the Section 113 criteria using the six broad categories proposed by the FSOC (size, lack of substitutes, interconnectedness, leverage, liquidity risk and maturity mismatch, and existing regulatory scrutiny) to money market funds would be similar to the analysis for mutual funds generally, as discussed in ICI's ANPR Response and above. In fact, money market funds must comply with an additional set of regulatory requirements beyond the comprehensive requirements of the Investment Company Act to which all registered investment companies are subject. These legal requirements include stringent credit quality, liquidity, maturity, and diversification standards. The basic objective of money market fund regulation is to limit a fund's exposure to credit risk, interest rate risk, liquidity risk, and the risk that certain shareholders may act precipitously to seek large redemptions."

ICI states, "Building upon the lessons of the financial crisis, the Securities and Exchange Commission in early 2010 put in place significant enhancements to these requirements that were designed to better enable money market funds to withstand certain short-term market risks. The SEC's amendments raised credit standards and shortened the maturity of money market funds' portfolios -- further reducing credit and interest rate risk. The rule changes also require more frequent disclosure of money market funds' holdings and mark-to-market prices, so both regulators and investors will better understand funds' portfolios. In the recent financial crisis, some money market funds had to liquidate assets quickly to meet unusually high redemption requests. The SEC's amendments directly addressed this liquidity challenge by imposing for the first time explicit daily and weekly liquidity requirements."

They add, "To the extent there is a desire to bolster yet further the resilience of money market funds to severe market stress, designating each of the 652 money market funds or even each of the 277 prime money market funds offered in the U.S. market as a SIFI and subjecting each to ongoing prudential supervision by the Federal Reserve Board is not the way to accomplish this. Nor does it make sense to pick and choose among money market funds or complexes for this purpose, or to designate a fund adviser solely on the basis of its money market fund activities. Rather, a process to assist the FSOC in determining the appropriate course of action is already well underway. And that process, quite appropriately, is focused on industry-wide solutions."

Finally, the ICI comment letter says, "More specifically, last October, the President's Working Group on Financial Markets issued a report discussing several options for further reform of money market funds and recommending that the FSOC examine those options. These options range from measures that could be implemented by the SEC under current statutory authorities to broader changes that would require new legislation, coordination by multiple government agencies, and the creation of new private entities. Nowhere in its detailed and thoughtful analysis of money market funds, however, does the PWG even suggest that the FSOC consider taking a fund-by-fund, complex-by-complex, or adviser-by-adviser approach under Section 113. To the extent the FSOC has any remaining concerns with respect to money market funds, we urge it to evaluate money market funds under this separate path as outlined in the PWG Report. In our comment letter on the PWG Report, we explained that after examining the reform options outlined in the PWG Report, we believe that creating a private emergency facility to serve as a back-up source of liquidity for all prime money market funds in the event of unusual market stress is the best way to strengthen money market funds and mitigate any remaining risks these funds pose to the U.S. financial system with the least negative consequences. We would welcome any further opportunities to discuss this proposal with the FSOC."

As we began collecing our money fund performance data for the month ended Feb. 28, 2011, we noticed a couple of changes in our fund listings. The GE Money Market Fund has recently been renamed Highland Money Market Fund II, and the Scout Money Funds appear to be approaching their full final liquidation dates. See the Prospectus supplement for the GE Money Fund changes, and see our Dec. 8, 2010, Link of The Day, "Scout to Liquidate Money Funds". (Note that Crane Data will be removing these funds from our pending March issue of Money Fund Intelligence, which is due out Monday.)

The Highland filing says, "Effective today, Highland Funds Asset Management, L.P. is now the investment adviser for each Fund. GE Asset Management Incorporated is now the investment sub-adviser responsible for the day-to-day portfolio management for each of the Funds, other than Highland Small-Cap Equity Fund, which continues to be sub-advised by Palisade Capital Management, L.L.C. and Champlain Investment Partners, LLC.... Such changes were approved by the Board of Trustees of the Trust on September 20, 2010, subject to the approval of the shareholders of the Funds, and subsequently approved by shareholders of the Funds on December 21, 2010."

It continues, "The proposals, as approved by shareholders, are described below. For all Funds: 1. A new investment advisory agreement for each Fund with Highland, to replace the current advisory agreement between each Fund and GEAM.... 2. New sub-advisory agreements between Highland and GEAM, and new sub-advisory agreements between Highland and certain of GE Small-Cap Equity Fund's existing sub-advisers, as follows: A. a new sub-advisory agreement with GEAM for each Fund, except GE Small-Cap Equity Fund; B. a new sub-advisory agreement for GE Small-Cap Equity Fund, with its existing sub-adviser, Palisade; and C. a new sub-advisory agreement for GE Small-Cap Equity Fund, with its existing sub-adviser, Champlain."

A previous press release says, "GE Asset Management today announced that the GE Funds Board of Trustees has approved a proposal for Highland Funds Asset Management, L.P. to become the GE Funds' new investment advisor, pending shareholder approval. Under the arrangement, Highland Funds would serve as the funds' advisor. GEAM would continue to manage the assets of all of the GE Funds.... The GE Funds family is comprised of 16 mutual funds for individual investors with approximately $1 billion in total assets. Highland Funds is an affiliate of Highland Capital Management, L.P., which currently offers a family of mutual funds for individuals and has $2.1 billion in total retail assets under management. The GE Funds' array of offerings complements Highland's lineup and provides Highland with a broader product range."

Assets on several Scout money funds have declined to zero, though several funds remain for now. Our previous story, which quoted from the Scout filing, said, "Upon the recommendation of Scout Investment Advisors, Inc., the Scout Funds Board of Trustees has adopted a Plan of Liquidation to cease operations of the Scout Money Market Fund – Federal Portfolio, Scout Money Market Fund – Prime Portfolio and Scout Tax-Free Money Market Fund and liquidate the Funds. While the Funds have served for many years as high quality money market fund investment options for clients and customers of the Advisor and UMB Financial Corporation, the Advisor has determined that it is no longer economically viable to continue operating the Funds in view of their size and future prospects for growth. The liquidation is expected to be completed in early 2011."

The GE money market fund complex is the 58th largest manager of money funds, as of Jan. 31, according to our monthly Money Fund Intelligence XLS with $822 million. The Scout money funds, formerly the UMB Scout money funds, ranked 59th out of 80 managers tracked by Crane Data with $766 million as of last month.