Cash Management

Money Fund Ratings Aim at Crisis’s Roots

Moody's proposed rating methodology for money-market funds incorporates stability and sponsor support, but is drawing fire from critics.
Vincent RyanDecember 7, 2010

Do money-market funds need a new credit-rating system? Moody’s believes so. In early fall, the agency proposed a new rating methodology it says would give corporate-cash investors greater insight into a fund’s ability to stay liquid and preserve capital. But some treasury professionals are calling aspects of the plan into question, and say the system could create problems in the short-term cash investment market.

Moody’s proposal comes in light of the turmoil that engulfed money-market funds during the financial crisis. In September 2008, 31 rated funds suspended redemptions and delayed distributions as institutional investors lost confidence in them, according to the agency. Shareholders in two funds had principal losses. Between August 2007 and December 31, 2009, there were 36 cases in the United States and 26 in Europe in which ailing funds received financial and balance-sheet support from their sponsors or parent companies.

The proposed new approach to rating money-market funds is based on the risks exposed by the financial crisis: funds’ vulnerability to market and liquidity risks, the impact of a fund’s investor base on the susceptibility of the fund to redemption risk, and the ability and willingness of sponsors to provide financial support to troubled funds.

Since Moody’s believes neither its current long-term (Aaa to C) nor short-term (Prime-1 to Not Prime) credit-rating scales are suitable, it proposes a new rating scale of MF+1 to MF4 (MF stands for “managed fund”). Money-market funds rated MF1+ and MF1, and some rated MF2, would “exhibit ultimate recoveries consistent with highly rated bonds but with a lower level of certainty regarding the timing of such receipts,” the agency says.

Moody’s would use new metrics to generate the ratings. To evaluate a fund’s stability, for example, the agency would examine its asset profile, liquidity position, and sensitivity to market risk. In the case of asset profiles, a fund’s weighted average maturity and its concentration of investments — whether by obligor, security type, or geography — would be paramount.

On the liquidity side, Moody’s would look at the degree to which the fund is invested in liquid securities, particularly Aaa-rated government securities and securities with maturities of less than seven days. A liquidity assessment would also depend on a fund’s shareholder base. “A diversified investor base would help to reduce the volatility of outflows that could occur for a fund with a concentrated investor base,” says Moody’s. The agency would be particularly interested in evaluating a fund’s top three investors.

To measure a fund’s exposure to market risks, Moody’s plans to stress-test the fund’s mark-to-market value using the following scenarios: a 150 basis-point yield-curve shift across all securities, a 50 basis-point increase in spread, a two-notch downgrade of 10% of the investments in the portfolio, and a 40% overnight redemption rate. The redemption-rate test would “simulate the need to sell at least 40% of a fund’s assets in order to meet investor redemptions,” says Moody’s.

A key aspect of the new ratings would be sponsor support — the ability of a sponsor to support a fund during a crisis, and its willingness to do so. Regarding the former, Moody’s says an MF1+ rating would be achievable when the fund sponsor’s long-term credit profile is at least single-A quality, although the agency would be willing to make exceptions based on other criteria. Regarding willingness to provide support, in the absence of an existing contract that guarantees fund support, Moody’s says it would consider among other things the strategic importance of the asset-management franchise to the sponsor and the sponsor’s track record of supporting its funds.

The sponsor-support piece of the proposal is drawing fire. Consulting firm Treasury Strategies, in a comment letter written by partner Anthony J. Carfang and John F.O. Bilson, a professor of finance at the Illinois Institute of Technology, has heavily criticized it, saying “sponsor’s creditworthiness is an illusory measure of the likelihood that it will support a distressed fund.” Few if any money-market funds have written guarantees of support from their sponsors, say the authors, and a qualitative assessment of a sponsor’s willingness to provide support would be “highly subjective and speculative conjecture.” Also, investors might gravitate to funds that have implicit support from sponsors, creating large funds that are “too-big-to-fail.”

Carfang and Bilson contend that Moody’s rating system would also create moral hazard, because it would “reward funds that take on additional risk with backing of a strong sponsor.” Buttressing their argument, they point to a Federal Reserve report that found that funds receiving sponsor support during the financial crisis were less prudently managed than those not receiving support.

The Association for Corporate Treasurers (ACT) has also weighed in on Moody’s proposal, questioning the proposed equal weighting of a money-market fund’s stability profile and credit profile. “While we welcome the inclusion of the portfolio stabilities we wonder whether the underlying credit strength of the portfolio should remain the predominant driver of the overall rating,” said ACT in a statement.

Responding to the criticisms, a Moody’s spokesman says: “The purpose of a request for comment is to encourage market feedback. We will consider all commentary submitted to Moody’s before deciding on the final methodology.”

Whether the new rating system flies or not, corporate treasurers will soon have greater access to data about money-market funds. By the end of 2010, according to the Securities and Exchange Commission’s new 2a-7 rules, the funds will have to report monthly holdings within five business days of the month’s end. More-detailed reports will go to the SEC on a 60-day lagged basis. In addition, the 2a-7 rules require money funds to be even more liquid. Funds now have to hold 10% of their portfolios in instruments maturing overnight and 30% in investments maturing within 7 days. A fund’s weighted average maturity also has to be 60 days or less, down from 90 days.

Regulatory and rating-agency reform of the money fund market comes at a time when the popularity of the instruments is waning. Only 25.1% of the average treasury portfolio is in money-market funds now, according to a recent survey by the Association for Financial Professionals. That’s down from 39.4% in 2008.

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