Why the Outlook has Brightened for Money Market Funds

How Government and Industry are Supporting Money Funds

Amidst all the chatter over the pros and cons of the various government sponsored programs designed to cure the financial markets, it is worth noting that some of the targeted programs have produced positive results by any standard. The Treasury Department's Temporary Guarantee for Money Market Mutual Funds (Temporary Guarantee program), the Fed's Asset Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF), and Money Market Investor Funding Facility (MMIFF) have largely achieved their objectives. These programs stemmed a potentially devastating run on the money fund industry, instilled confidence across the retail and institutional investor populations and restored an active, liquid market for both issuers and buyers of high quality, short-term corporate debt.

On September 16, the Reserve's Primary Fund became only the second fund in history to "break-the-buck", resulting in close to $400 billion being pulled from prime money funds over the following two weeks. Although much of this money moved to government and Treasury funds, $123 billion left money funds altogether. Realizing that a sustained exodus from money funds would negatively impact far more than just the funds' investors, the Treasury Department stepped in to insure these assets against loss through the Temporary Guarantee program. The Treasury Department is well aware of the importance of money funds to the global economy. Companies rely on money funds to buy their short-term debt in order to finance payroll and meet other obligations. In short, money funds allow many of the most critical contributors to the global economy to stay open for business.

Since the announcement of the Temporary Guarantee program, assets have started flowing back into money funds. According to the Investment Company Institute, as of February 11, 2009 total money fund assets have climbed to $3.9 trillion from $3.4 trillion on October 1, 2008. Total prime fund assets have climbed from $1.7 trillion to $1.9 trillion over the same time period. While investors' confidence in money funds may have been justifiably shaken, government support as well as the support provided by many of the funds' sponsors has restored that confidence considerably.

But what does the future hold for the money fund industry? In the wake of the Reserve buck-breaking episode, a report issued by the Group of 30 - whose members include Paul Volcker among others - recommends a dismantling of the money fund industry as we know it. Their idea is to transform money funds into "special purpose banks" where the funds would be regulated like banks and deposits would be insured much like bank accounts. Banks would certainly view this proposal as a threat to their ability to attract deposits. Based upon the uproar voiced by banking industry groups when the Temporary Guarantee for Money Market Funds program was announced, it is hard to envision a quiet acceptance of a more permanent and dramatic proposal.

Some of the Group of 30's recommendations include a requirement that money funds "only offer a conservative investment option" and that funds should "clearly be differentiated from federally-insured deposits offered by banks. . .with no explicit or implicit assurances that funds can be withdrawn on demand at a stable NAV." But in the vast majority of cases, money funds have abided by these recommendations since they were first created over 30 years ago. The run on money funds was not due to lack of regulatory oversight, but rather was a result of widespread fear among investors.

Dismantling the money fund industry seems highly unlikely given the critical role it plays in providing liquidity and stability to the global economy. As evidence of demand for its products, the industry continues to expand with multiple examples of new money funds filing with the SEC over the past 90 days. With that in mind, what actions can fund sponsors and regulators take to ensure money funds remain a viable option for investors and a profitable business for sponsors?

Fund Company Actions

One of the issues facing fund sponsors has been the large shift out of prime funds and into Treasury funds where fees are often being waived to avoid negative yields. In order to relieve the pressure on these funds, sponsors will need to encourage flows back into prime funds, where the fees are not threatened by exceedingly low gross yields. To accomplish this, investors will need to be comfortable with the holdings in prime portfolios. Investors will eschew holdings enveloped in headline risk, and esoteric descriptions like Structured Investment Vehicles. Now more than ever, prime fund managers must place a premium on investments that display a high degree of liquidity in any market environment. Ten to twenty percent in overnight holdings will not be unusual.

Holdings in industrials, government agencies and even Treasuries (typically shunned by prime funds) will likely comprise larger percentages of many prime fund holdings. With a few domestic exceptions, exposure to financials will likely decrease, especially in the European and Asian banks. As the Treasury continues to flood the market with new issues, the spreads between government securities and the highest quality industrial commercial paper will continue to compress. In this market, a prime fund manager looking at a ten or twenty basis point spread between a government and a corporate is more likely to choose the government for the enhanced safety and liquidity. It will not be uncommon to see government holdings ranging anywhere from ten to thirty percent in prime funds.

To the extent debt under the Temporary Liquidity Guarantee Program (TLGP) is issued in the money fund eligible maturity range, there should be a demand for it. This program allows participating financial institutions to issue debt with a government guarantee, essentially making it the credit equivalent of a Treasury. To date, most of the debt issued under this program has been longer term and thus not eligible for money funds.

Regulatory Actions on the Horizon

Many in the money fund industry are speculating about potential changes to SEC Rule 2a-7, which regulates money market funds. As early as last May, SEC staff began considering a proposal to remove any explicit reference to nationally recognized statistical ratings organizations (NRSROs) from the rule. The rationale being that money funds relied too heavily on credit ratings, and not enough on their own due diligence into the securities they purchased. This proposal seems urealistic. It would be difficult to apply the high credit standards Rule 2a-7 seeks without some reliance on a third party agency at least as a starting point. A likelier outcome would be the inclusion of more specific, stricter language about internal research. In its present form Rule 2a-7 specifies that an independent minimal credit risk determination " must be based on factors pertaining to the credit quality in addition to any rating assigned to such securities by an NRSRO. " Establishing more specifics in this section of the rule would hold fund sponsors more accountable for their investment decisions.

Other potential regulatory actions might involve changes to some of the maturity restrictions contained in Rule 2a-7. Currently, any fund regulated under the rule cannot have a weighted average maturity (WAM) greater than 90 days. A shorter WAM reduces interest rate risk further and thus provides more protection to investors. Another version of this idea would be to tighten the requirements around variable and floating rate securities. Today, funds may deem the next interest rate reset date of these securities (which can be as short as one day) as the maturity, as opposed to the security's actual final maturity which is often much longer.

Regulators might choose to mandate specific liquidity requirements. For example, the rule could stipulate that a certain percentage of the fund's portfolio must mature between one and seven days. Although a requirement like this might be viewed as overly intrusive by some fund managers, it does not seem entirely implausible given how much of the recent turmoil was liquidity related as opposed to a deterioration in underlying credits.

While it is still unknown if and when any regulatory changes will impact the money fund industry, it seems reasonable to expect changes to occur.

Conclusion

We believe that despite the daunting market challenges faced by the money fund industry, there is reason for optimism about the future. Given the recent growth in institutional as well as retail money fund assets, it seems clear corporate treasurers remain bullish about the industry. Corporate cash managers gradually seem to be emerging from their "Treasury-only" strategies. With recent declines in Treasury fund assets corresponding almost exactly to increases in prime fund assets, dissatisfaction with abysmally low Treasury yields seems to be taking root. If more transparency into prime holdings combined with meaningful regulatory changes is on the horizon, this trend should continue. It is worth remembering that aside from the situation with the Reserve's Primary Fund, no other money fund investor has lost a penny in principal throughout this financial crisis. While other supposedly "safe" investment options like auction rate securities and "enhanced" cash funds have wreaked havoc on investors, money market funds continue to serve as the safe haven of choice for investors across the globe.