Q&A: Five Years After The Credit Crisis, Money Market Funds Adapt To Changes

Primary Credit Analyst: Joel C Friedman, New York (1) 212-438-5043; joel.friedman@standardandpoors.com Secondary Contacts: Andrew Paranthoiene, London (44) 20-7176-8416; andrew.paranthoiene@standardandpoors.com Guyna G Johnson, Chicago (1) 312-233-7008; guyna.johnson@standardandpoors.com

Table Of Contents
Questions And Answers

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Q&A: Five Years After The Credit Crisis, Money Market Funds Adapt To Changes
(Editor's Note: The following is one of a series of question-and-answer articles in which Standard & Poor's Ratings Services' analysts assess changes in the financial industry in the five years since the economic and credit crisis that began in September 2008 with the collapse of Lehman Brothers.) In the wake of Lehman Brothers' bankruptcy, the Reserve Primary Fund, a money market fund with about $62 billion of assets, experienced large redemptions and "broke the buck"--that is, it paid out less than $1 per share of net asset value (NAV). This event, which had only occurred one other time in the history of money market funds, sparked redemptions in other prime money market funds, which contributed to the global liquidity crunch in the short-term fixed-income markets. In this light, money market funds, which typically invest in short-term assets such as commercial paper and Treasury securities and provide important liquidity to financial markets and corporations, have undergone a number of notable changes.

Questions And Answers

What has been the most significant development regarding regulation of the industry in the five years since the onset of the credit crisis?
In January 2010, the U.S. SEC revised rule 2a-7 of the Investment Company Act of 1940 to strengthen the resiliency of money market funds. The revisions include: Reduced funds' maximum weighted average maturity to 60 days from 90 days; Lowered the maximum holdings of "second-tier" securities, which are those with short-term ratings in the second-highest category (e.g., Standard & Poor's rating of 'A-2'); Established minimum daily and weekly liquidity requirements; and Created periodic stress-testing requirements to ensure that the funds can maintain a stable NAV under extreme market conditions. The SEC is now considering several additional reforms. In June, it proposed to tighten regulations further and suggested two alternative reforms that can be adopted alone or in combination with other requirements, including stronger diversification of holdings, improved reporting, and enhanced disclosure and stress testing. In evaluating how these proposals could affect Standard & Poor's principal stability fund ratings (PSFRs), we focus on whether they could impair funds' ability to maintain principal value. In Europe, where there were no standard regulations for money market funds before 2008, EU regulators have recently introduced some proposals that we believe could have significant effects on the industry. However, because of what could be a drawn-out political process in moving forward, as well as the uncertainty about potential standards, it's difficult to say when or how changes could come about.

How has the behavior of fund managers changed in the past five years?
In general, money fund and cash managers have become more conservative, with more of an emphasis on the return of principal rather than return on principal. We have noticed that funds have been focused on liquidity, and that is the

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Q&A: Five Years After The Credit Crisis, Money Market Funds Adapt To Changes

No. 1 thing that managers saw in 2008: Liquidity was at a premium. So managers have enhanced their liquidity and may have done so even without the 2a-7 changes. In the U.S., funds have looked for opportunities to diversify outside of the financial services sector, whether into municipal bonds or eligible corporate debt. Fund managers have found it isn't always easy to get away from the headline risks related to the banking sectors, given most of the issuance is from that sector. Meanwhile, there's been a reduction in the supply of assets that funds can invest in--most notably in asset-backed commercial paper and floating-rate notes. And ratings on many assets have fallen, which further limits investment opportunity. And while historically low interest rates have taken a back seat as a concern as funds adapt to new regulations, memories are often short, and funds' search for yield may soon come back into play.

What are some of the most significant ways in which Standard & Poor's has changed its approach to rating this industry?
We are continually refining and adapting the methodology for our PSFR criteria. In 2011, we published updated criteria, titled "Methodology: Principal Stability Fund Ratings," to enhance transparency and to help market participants better understand our approach to rating fixed-income funds that seek to maintain a stable or accumulating NAV. Our criteria are global, and we consider the sources of risk in a managed fund's portfolio and investment strategy, and we assess the impact that these risks could have on a fund's ability to maintain a stable NAV and/or accumulating NAV. These risks include credit quality, investment maturity, liquidity, portfolio diversification, index and spread risk, management, and security-specific risks. The methodology uses a weak-link approach, meaning that a fund would need to meet all the key quantitative criteria under the categories of credit quality, maturity, diversification, and internal controls at a given rating level in order to receive that rating. We've also come up with additional metrics. As with 2a-7, we had no set weighted average life (WAL) requirement, although our criteria did limit final maturities on floating-rate notes to two years. We have since introduced WAL criteria, which, in our methodology, is called weighted average maturity to final, or WAM to final. And although we don't set liquidity guidelines, we are focused on fund managers being able to manage their own liquidity and understand their shareholders' cash flows. To add transparency, we've also established "cure periods" for when a fund breaches a quantitative criteria threshold. For example, if a fund manager purchases commercial paper that matures in 90 days with an issuer that represents 4% of the fund, and two weeks later a large redemption pushes that exposure to 6%, causing the fund to exceed a threshold, we would apply a cure period of 10 business days for diversification. Furthermore, if a security is downgraded to 'A-2', the cure periods for investments downgraded below 'A-1' would apply, based on the exposure percentage and maturity of the affected investment. In addition, if a fund consistently breaches a metric or threshold over a 12-month period that is not the result of a specific management action, we would lower the rating by one category.

How have PSFRs performed during this period?

Money fund ratings have performed very well, remaining stable despite low interest rates, worries about Europe, and asset scarcity. We monitor funds on a weekly basis, and we have a Web-based reporting system in which the

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Q&A: Five Years After The Credit Crisis, Money Market Funds Adapt To Changes

administrator or custodian regularly uploads a lot of detailed information, including a fund's holdings. With any types of exceptions to our criteria, we communicate directly with fund managers to find out what might have caused an issue. And once a year we typically sit face-to-face with them to talk about current market events, trends in the past year, and what we have been seeing. So it is quite interactive with all the various fund managers. We understand that these funds are actively managed, so our view is that problems can often be quickly rectified before they warrant a rating action.

What is Standard & Poor's outlook for the industry?

The good news thus far is that, even during this prolonged period of extremely low interest rates, investors have stuck with money funds because they like the product. So, barring any very significant change to that product, we think funds will retain a good amount of their assets. The big question is, which regulatory proposals will be adopted, and how will that alter the industry landscape? With respect to our criteria, we will evaluate the regulatory changes and make any adjustments we feel are needed to assign ratings that reflect relative risk. Meanwhile, many larger funds have absorbed smaller ones, and we believe the industry could undergo some further consolidation. Writer: Joe Maguire

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