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Yesterday, Bloomberg wrote "​SEC Said to Favor Capital Buffer Plan for Money Market Funds", which said, "Money-​market mutual funds would be forced to create capital buffers equaling 1 percent to 3 percent of assets to protect against losses under a plan now favored by staff at the U.​S. Securities and Exchange Commission, according to three people briefed on the regulator'​s deliberations." We discuss the Bloomberg piece below, and we also excerpt from the ICI'​s most recent round of weekly money fund assets, monthly mutual fund flow statistics, and monthly portfolio composition numbers.

Bloomberg explains, "Top SEC officials, seeking to make money funds safer, prefer the plan over another capital buffer idea crafted by Fidelity Investments and calls to eliminate the funds' stable share price, said the people, who asked not to be identified because they weren'​t authorized to speak publicly. The concept is based on recommendations submitted to the agency in January by university economists known as the Squam Lake Group. The SEC'​s staff remains undecided on several details of the plan, including exactly how big the buffer should be, two of the people said. If the plan is endorsed by agency staff, SEC commissioners will have to approve it and may still consider rival proposals, the people said. Florence Harmon, a spokeswoman for the SEC, declined to comment."

The article adds, "​The so-​called Squam Lake proposal would require funds to establish a segregated account holding cash or liquid assets such as U.​S. Treasuries. The money would be used to bail out a fund if it suffered investment losses. Any fund failing to maintain the required buffer would be forced to announce that failure and convert to a floating share price within 60 days, according to the proposal. Under the plan, funds would sell bonds, or subordinated shares, to raise money for the buffer from a separate group of investors. Those investors would lose money if the buffer were tapped to cover investment losses."

In other news, ICI'​s weekly "Money Market Mutual Fund Assets" comments, "Total money market mutual fund assets decreased by $​37.​53 billion to $​2.​634 trillion for the week ended Wednesday, July 27, the Investment Company Institute reported today. Taxable government funds decreased by $​26.​77 billion, taxable non-​government funds decreased by $​8.​12 billion, and tax-​exempt funds decreased by $​2.​64 billion." (Crane Data'​s Money Fund Intelligence Daily shows Treasury Institutional Money Funds with outflows of $​17.​0 billion, or 5.​0%, over the three days through July 27.)

Also, ICI'​s monthly "Trends in Mutual Fund Investing June 2011" says, "The combined assets of the nation'​s mutual funds decreased by $​179.​8 billion, or 1.​4 percent, to $​12.​224 trillion in June, according to the Investment Company Institute'​s official survey of the mutual fund industry.... Money market funds had an outflow of $​41.​12 billion in June, compared with an outflow of $​2.​74 billion in May. Funds offered primarily to institutions had an outflow of $​48.​01 billion. Funds offered primarily to individuals had an inflow of $​6.​89 billion."

Finally, ICI'​s latest "​Month-​End Portfolio Holdings of Taxable Money Market Funds" showed substantial declines in Certificates of Deposits (​down $​26.​0 billion to $​572.​2 billion, or 24.​0% of taxable money fund assets) Repurchase Agreements (​down $​23.​7 billion to $​467.​0 billion, or 19.​6%), and Commercial Paper (​down $​24.​0 billion to $​368.​6 billion, or 15.​5%) during the month of June. U.​S. Government Agency Security (​up $​21.​3 billion to $​367.​0 billion, or 15.​4%) and U.​S. Treasury Bill (​up $​10.​7 billion to $​348.​6 billion, or 14.​6%) holdings rose in June, according to ICI, likely due to the large shift from Prime to Government money funds last month.

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Given the surprisingly widespread interest in the impact of a U.​S. Treasury downgrade or default on money market mutual funds, we decided to reprint several sections of Rule 2a-​7 of the Investment Company Act, the regulations governing money funds, below. We review the definitions from the SEC'​s recently revised version (​marked to show changes) of the Rule covering Eligible Securities, First Tier Security, Second Tier Security, and Downgrades, Defaults, and Other Events." We also mention our only previous story (​12/​08) involving "Univested Cash," a line entry which has been spotted recently on the holdings reports of some Treasury money market funds.

In its initial definitions section, the SEC'​s Rule 2a-​7 says, "Eligible Security means: (​i) A Rated Security with a remaining maturity of 397 calendar days or less that has received a rating from the Requisite NRSROs in one of the two highest short-​term rating categories (​within which there may be sub-​categories or gradations indicating relative standing); or (​ii) An Unrated Security that is of comparable quality to a security meeting the requirements for a Rated Security ... as determined by the money market fund'​s board of directors." Note the reliance on short-​term ratings "​A-​1+/​P-​1/​F-​1" (​the highest levels for S&​P/​Moody'​s/​Fitch); most of the warnings are in regards to long-​term (​AAA) ratings.

It also states, "First Tier Security means any Eligible Security that: (​i) Is a Rated Security that has received a short-​term rating from the Requisite NRSROs in the highest short-​term rating category for debt obligations (​within which there may be sub-​categories or gradations indicating relative standing); (​ii) Is an Unrated Security that is of comparable quality to a security meeting the requirements for a Rated Security in paragraph (​a)(​1214)(​i) of this section, as determined by the fund'​s board of directors; (​iii) Is a security issued by a registered investment company that is a money market fund; or (​iv) Is a Government Security.... Second Tier Security means any Eligible Security that is not a First Tier Security." Note that any "Government Security" (​as defined elsewhere in section 2(​a)(​16) of the Act (​15 U.​S.​C. 80a-​2(​a)(​16))) that is an "Eliglible Security is automatically "​First Tier."

Finally, 2a-​7 comments, under "Downgrades, Defaults and Other Events," "(​i) Downgrades – (​A) General. Upon the occurrence of either of the events specified ... with respect to a portfolio security, the board of directors of the money market fund shall reassess promptly whether such security continues to present minimal credit risks and shall cause the fund to take such action as the board of directors determines is in the best interests of the money market fund and its shareholders: (​1) A portfolio security of a money market fund ceases to be a First Tier Security (​either because it no longer has the highest rating from the Requisite NRSROs or, in the case of an Unrated Security, the board of directors of the money market fund determines that it is no longer of comparable quality to a First Tier Security)." Note that historically, determining what "​is in the best interests of the money market fund and its shareholders" has rarely meant selling downgraded or defaulted securities into an impaired market, so this allows funds to hold impaired securities if need be.

Finally, in other news, we'​ve heard and seen a little bit about some Treasury and Government funds leaving cash uninvested in their fund. This is rare and tough to track (​since it'​s listed outside the fund'​s normal portfolio holdings), but we have seen some Treasury funds with as much as $​1 billion in "​Net Other Assets". The only previous mention we show in our Crane Data News is the December 2008 piece, "Uninvested Cash May Be Included in WAM Calcs Says Standard Poors." The piece says, "Standard & Poor'​s Ratings Services late last week issued a brief "​Clarifications For Rated Money-​Market Funds Involving Uninvested Cash And Weighted Average Maturity," which addressed several issues which have come up in the unprecedented near-​zero yield environment.... Under "Uninvested Cash Held In Noninterest-​Bearing Transaction Accounts," S&​P says, "Rated funds are permitted to hold more than 5% of total fund assets in uninvested cash with its custodian if the following provision is met: The fund and custodial bank represent to Standard & Poor'​s that uninvested cash is being held in a non-​interest-​bearing transaction account with a custodial bank that has elected to participate in the FDIC Temporary Liquidity Guarantee Program (​FDIC TLGP) and that those monies are covered without limit under the FDIC TLGP." [​Note that this program has continued under Dodd-​Frank.]"

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The Financial Stability Oversight Council issued its "2011 Annual Report" yesterday, saying, "On the heels of the first anniversary of the Dodd-​Frank Wall Street Reform and Consumer Protection Act, the Financial Stability Oversight Council released its 2011 Annual Report. The report -- the first of its kind issued by the U.​S. government -– was produced collaboratively by the members of the Council and their staff, and unanimously approved by the Council. Under the Dodd-​Frank Act, the Council must report annually to Congress on a range of issues, including the activities of the Council; significant financial market and regulatory developments; and potential emerging threats to the financial stability of the United States. The report must also make recommendations for promoting market discipline; maintaining investor confidence; and enhancing the integrity, efficiency, competitiveness, and stability of U.​S. financial markets."

FSOC Chairman and Treasury Secretary Tim Geithner comments, "The most important thing we can do right now to safeguard financial stability is lift the cloud of default hanging over our economy. As we move forward, however, we must also work to ensure that our regulatory framework keeps pace with the evolving global financial system. This report provides key recommendations that will build on the progress we'​ve made through the Dodd-​Frank Act and further strengthen the resilience of the financial markets and our economy."

Under the section "Financial Developments," the report says, "Assets have grown at insured depository institutions relative to other financial institutions since the crisis, following a long period in which financial activities moved from banks to markets. In particular, money market fund assets declined as investors transferred significant funds into insured bank deposits during the crisis. At the same time, the crisis reinforced the trend toward concentration and globalization in the banking industry, and foreign banking organizations have expanded their activities in the United States in recent years."

Regarding "Potential Emerging Threats to U.​S. Financial Stability," the FSOC writes, "There is significant market uncertainty in Europe, notably associated with the sovereign credit risk of Greece, Ireland, and Portugal. U.​S. financial institutions have very limited net direct exposure to these three countries. They have larger exposure and important ties to major financial institutions elsewhere in Europe that in turn have large exposures to Greece, Ireland, and Portugal. Some major European banks obtain substantial short-​term wholesale U.​S. dollar funding from U.​S. money market funds. Further, money market funds remain an important supplier of cash to the tri-​party repo market. Structural vulnerabilities in money market funds and tri-​party repo amplified a number of shocks in the financial crisis. Reforms undertaken since the crisis have improved resilience, and money market funds report de minimis exposure to Greece, Ireland, and Portugal; however, amplification of a shock through these channels is still possible."

The report adds, "The Council recommends reforms to address structural vulnerabilities in the tri-​party repo market, for money market mutual funds, and in mortgage servicing: Elimination of most intraday credit exposure and reform of collateral practices in the tri-​party repo market to strengthen the market. Given the vital importance and size of tri-​party repo financing and the broad array of financial institutions active in this market, the regulatory community should exert its supervisory authority over the industry'​s reform efforts to ensure that the Tri-​Party Repo Infrastructure Reform Task Force meets its commitments as promptly as possible. The Task Force'​s efforts should ultimately improve market functioning, but several important structural reform issues require coordinated supervisory and regulatory attention. Chief among these priorities are enhancing dealer liquidity risk management practices, alleviating the propensity of cash investors to withdraw funding and exit the market when risk surfaces, and implementing mechanisms to manage a potential dealer default. The fragility of broader market liquidity facilities and the constraints on the types of collateral that certain investors are prepared to take (particularly money market funds) heightens the risk of contagion in the market. Reform efforts should practically eliminate intraday credit exposures of clearing banks to borrowers and strengthen collateral management practices to improve the stability of this critical short term funding market."

The Council also recommends, "[​I]​mplement[​ing] structural reforms to mitigate run risk in money market funds. When the SEC adopted new rules for money market funds (​MMFs) in February 2010, it noted that a number of features still make MMFs susceptible to runs and should be addressed to mitigate vulnerabilities in this market. To increase stability, market discipline, and investor confidence in the MMF market by improving the market'​s functioning and resilience, the Council should examine, and the SEC should continue to pursue, further reform alternatives to reduce MMFs' susceptibility to runs, with a particular emphasis on (​1) a mandatory floating net asset value (​NAV), (​2) capital buffers to absorb fund losses to sustain a stable NAV, and (​3) deterrents to redemption, paired with capital buffers, to mitigate investor runs."

FSOC also writes, "While there have been a number of bank, thrift, and credit union failures -- including several high-​profile failures or near-​failures of large complex financial institutions -- the FDIC and the NCUA were able to prevent any disruptions in retail payments and transaction services as a result of the failure, or fear of failure, of an insured depository institution. In contrast, certain parts of the financial system, such as prime money market funds, experienced the equivalent of a bank run in late 2008 [​see report for chart]. The Transaction Account Guarantee Program (​TAGP) brought stability and confidence to deposit accounts that are commonly used for payroll and other business transaction purposes. Through the TAGP, the FDIC guaranteed, for a fee, noninterest-​bearing transaction accounts held at participating insured depository institutions.... The Dodd-​Frank Act replaced TAGP with a provision mandating unlimited deposit insurance coverage without a separate fee through December 2012 for certain noninterest-​bearing accounts at all insured depository institutions."

Under a section on "Guarantee Support," the report explains, "Temporary programs to guarantee deposits, unsecured bank debt, and investor assets in money market mutual funds helped stabilize investor confidence. In October 2008, at the peak of the financial crisis, the FDIC introduced the Temporary Liquidity Guarantee Program (​TLGP). In addition to the Transaction Account Guarantee Program, the TLGP guaranteed, for a fee, unsecured debt with a term of up to three years issued by financial entities participating in its Debt Guarantee Program (​DGP). The issuance of new guaranteed debt expired on October 31, 2009, and the guarantee on outstanding debt expires on December 31, 2012.... At the peak of the TLGP, the FDIC guaranteed almost $​350 billion of debt outstanding. As of June 30, 2011, the total amount of remaining FDIC-​guaranteed debt outstanding was $​236.​9 billion, of which $​70.​7 billion will mature in 2011 and the remaining $​166.​2 billion will mature in 2012. The majority of the debt exposure resides within the largest financial entities."

It adds, "The Treasury Department announced its temporary money market fund guarantee program on September 19, 2008, to stop the run on money market funds (​MMFs) [​chart in PDF]. Certain structural features of MMFs can produce incentives for investors to cash in shares if they fear that a fund will suffer a loss (​see Box D: Money Market Funds). The temporary guarantee program provided coverage to shareholders for amounts they held in participating MMFs at the close of business on September 19, 2008. The guarantee would have been triggered if a participating fund'​s net asset value fell below $​0.​995 per share. The temporary guarantee, along with Federal Reserve facilities aimed at stabilizing markets linked to MMFs, was successful in restoring investor confidence; it expired in September 2009 without any claims."

The FSOC Report contains a sidebar, "Box D: Money Market Funds," which explains, "The run on money market funds (​MMFs) added considerably to market stress during the financial crisis. Some of the key features of MMFs that make them susceptible to runs remain today.... MMFs generally invest in the highest rated (​A1/​P1-​rated) short-​term collateral. SEC Rule 2a-​7 places stringent limitations on MMF holdings of lower rated securities. MMFs must comply with the rule, which permits these funds to maintain a stable net asset value (​NAV) per share, typically $​1, through the use of amortized cost accounting and rounding. However, if the mark-​to-​market per share value of a fund'​s assets falls more than one-​half of 1 percent, or below $​0.​995, the fund must reprice its shares, an event known as "​breaking the buck." MMF investors benefit from the implicity and convenience of the stable NAV feature and from the risk management, monitoring, and diversification services that MMFs provide. However, several of these MMF features contribute to their fragility."

It says, "Given the unprecedented government support of MMFs during the crisis in 2008 and 2009, even sophisticated institutional investors and fund managers may have the impression that the government would be ready to support the industry again with the same tools. This expectation may give fund managers incentives to take greater risks than are prudent and may reduce sponsors' incentives to support funds in times of stress. Such expectations may be particularly misaligned given that Congress has since prohibited the Treasury from using the fund that it used to support the MMFs for this purpose."

FSOC also writes, "In February 2010, the SEC adopted new rules for MMFs to make these funds more resilient to market volatility and to credit and liquidity risk. First, the SEC introduced new risk-​limiting restrictions, including increased liquidity requirements, restrictions on the ability of MMFs to purchase lower quality securities, and maturity restrictions that reduce the maximum allowable weighted average maturity of funds' portfolios.... Finally, the new rules impose requirements to disclose portfolio holdings and mark-​to-​market (​shadow) NAV, which gives the SEC a window on MMF activity and helps investors impose strong market discipline. Although these new rules are a positive first step, the SEC recognizes that they address only some of the features that make MMFs susceptible to runs, and that more should be done to address systemic risks posed by MMFs and their structural vulnerabilities.... The MMF sector has grown significantly in recent decades and now plays a dominant role in some short-​term credit markets. While total assets under management have declined since their peak in 2009, MMFs continue to purchase a large share of private short-​term debt issuance."

Finally, the FSOC Annual Report says, "One of the key factors that contributed to the financial crisis was insufficient analysis and management of liquidity risk by participants in short-​term money markets. During the crisis, weaknesses in the liquidity risk profiles of financial institutions became evident and required a significant expansion of government support that went well beyond the traditional safety net extended to regulated depository institutions. Exposure of these weaknesses has given financial institutions and market participants a better understanding of the vulnerabilities in these markets and, in particular, of the importance of liquidity risk management. Liquidity risk in the U.​S. financial sector has fallen since the crisis, as financial institutions have more liquid assets and more stable liabilities on their balance sheets.... Since the crisis, assets managed by MMFs have declined. Council members have been tracking the exposures that domestic MMFs have to Europe [​see chart in PDF]. Their direct exposure to the countries that have been most affected by the sovereign debt crisis is minimal, although some major European banks obtain substantial short-​term wholesale U.​S. dollar funding from U.​S. money market funds."

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Reuters writes "​Exclusive: Fed president hints at broad money-​market fix", which says, "​A senior Federal Reserve official is prescribing sweeping medicine to stabilize the $​2.​5 trillion money market mutual fund industry, which would be rattled by potential downgrades of the government securities that are among its key holdings. Boston Federal Reserve President Eric Rosengren told Reuters that a "​combination" of solutions will be needed to reduce the risks faced by the short-​term funds and their investors -- including one resisted by many fund marketers that would no longer fix the net asset value (​NAV) of a fund share at $​1."

The Reuters piece quotes a Rosengren statement, "​We still need to make further progress in reducing the risk that money-​market funds could be a source of instability resulting from an unanticipated credit shock. While several proposals have been suggested, some combination of capital buffers, floating rate NAVs and enhanced disclosure seems the best way forward."

It adds, "'​Capital buffers' apparently refers to various proposals suggested by participants in the market to ensure that individual funds have the ability to offset withdrawals if investors moved to sell shares quickly. Versions of the concept have been suggested by Fidelity Investments and Charles Schwab Corp, and by a group of economists, among others. If that is what Rosengren is supporting, the buffers could gain ground over a competing proposal for an industrywide "​liquidity bank" backed by fund companies that include Federated Investors Inc, said Peter Crane, whose Cranedata.​com site follows money-​market funds."

"​The liquidity bank would be able to borrow money from the Fed in an emergency, but Crane said a contingency might be politically unfeasible at a time of such budget uncertainty and following so closely on the banking industry bailouts provided by the Fed." "​Anything that involves regulators helping is taboo," Reuters quotes Crane.

The article explains, "Money funds are causing trepidation because they hold short-​term securities from issuers very much in the hot seat: European banks holding debt of Greece and other peripheral nations, and the U.​S. government whose credit rating may be downgraded short of a budget deal in Washington. The U.​S. Securities and Exchange Commission is leading a review of possible new rules for money funds, but the Fed also has input. The Boston Federal Reserve Bank, one of the overseers of backstops to the money-​fund industry during the financial crisis, carries strong influence."

Finally, Reuters says, "Some new rules for have already been imposed, including more frequent disclosure of money fund holdings. But key issues such as whether to let NAVs float are still being debated, SEC Chairman Mary Schapiro said last week. Advocates of a "​floating NAV" said it would condition investors to expect swings in value of the funds and cut the chances of runs on them in times of crisis. In a speech at Stanford University on June 3, Rosengren said money funds could be affected by European debt woes but noted that '​no one solution has been settled on" regarding floating NAVs, buffers or insurance.'"

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Last Wednesday, we excerpted the first half of Money Fund Intelligence'​s latest fund manager "​profile," "State Street Global'​s Meier & Smith on MMFs." MFI interviewed `​SSgA'​s Steve Meier and Barry Smith and discussed the Boston-​based manager'​s history with cash, recent challenges in the short-​term markets including concerns about Europe, and the regulatory outlook for money funds. We reprint the second half of the piece below.... Our last excerpt asked about French banks at the end.

Meier told MFI, "Some French banks have exposure to Greek debt. We have been very conservative in terms of our assessment by assuming that at some point Greek debt may be restructured and there may be a 50% reduction in the principal value of holdings. But even if this were to occur, it would be a relatively small percentage of core capital for those institutions, only one to two quarters of earnings. You need to be selective, but we are still very constructive on several French banks. European bank obligations are a very significant component of the market. We'​re four years into this global financial crisis, and those banks have done a fairly good job in terms of diversifying their sources of funding, extending their liabilities, and reducing their reliance on wholesale funding. All of that makes us more comfortable.

But the other consideration is headline risk. We want to buy high credit quality securities for these portfolios that have safe yield. But you also buy these institutions on a relatively short basis to mitigate the risk of a concern if there is a deterioration of credit quality or liquidation down the road. We aim to be transparent with our clients by providing context around why we are comfortable with specific banks, and we strive to mitigate risks associated with liquidity drains at these institutions by keeping maturity relatively short.

Q: Are you guys getting customer calls? Smith: We are getting calls from clients, and I think that is a good thing. One of the most important lessons investors have hopefully learned from the financial crisis is that cash as an asset class requires the same up-​front due diligence and ongoing monitoring as any other asset class. The calls we are getting are from clients who are seeing something going on in the marketplace, making a connection to holdings in their own portfolio, and then making a reasonable inquiry of their asset manager. What we have not been seeing in recent weeks is the kind of panic response to news that you would have seen at the height of the financial crisis.

Q: How are low yields impacting the business? Is State Street committed to cash? Smith: State Street is absolutely committed to this business. We are one of the largest managers of cash assets globally and we are well-​diversified. While registered 2a-​7 funds are a critical component of our cash business, it is just one piece.... We run everything from securities lending cash collateral accounts, to pool funds, to separate accounts. As we look forward, one thing that won'​t change is our clients' need to invest cash assets. I am confident that State Street has the breadth of resources and investment expertise to be able to respond to any changes that may come about and will continue to help our clients meet those needs. As far as the fee waivers, I would say that they are an impediment to our revenue stream, but the business is not unprofitable. There may be an individual fund, particularly the Treasury funds, etc., but when you look at the business as a whole it is still a healthy and commercial business.

Q: Are you guys seeing more demand for yield or separate accounts? Smith: There is a lot of concern about the low rate environment and that has a lot of people asking what they can do to increase their returns. In most cases, we are hearing, 'The low rates on money funds are killing me. What can you do to get me a higher rate of return'? These conversations generally focus on a separate account as an alternative. But I am concerned that this is being asked without consideration for the risk/​reward payoff in doing that. These discussions need to be about risk and return, not just higher yields. However, while I hear a tremendous amount of conversation on this topic, I do not see a significant number of clients across the industry funding new separate accounts. It is unclear at this point whether that will change when the rate environment changes.

Q: What about the future? Smith: It'​s difficult to say what is going to happen. There are a variety of ideas out there, some of which we like more than others. The one thing I hope for is that any changes that do come about actually make the product stronger and better and don'​t just represent change for change sake. The financial crisis was the proverbial 100-​year flood for our industry. I think any additional proposed changes should be benchmarked against that crisis and be required to demonstrate that it meaningfully adds resilience to that environment.

Meier: The SEC did go a long way with 2a-​7 reform, most significantly by imposing an overnight and 7-​day liquidity requirement and placing a limit on the weighted average life of a portfolio. This does a lot to reduce the spread duration risk of the funds. But I don'​t think you can eliminate all the risks associated with managing money, be it an equity fund, bond fund or cash portfolio. Smith: I think one of the biggest challenges is that both my and Steve'​s jobs have become a lot more interesting. Our goal at SSgA is to help make cash management boring again.

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We continue to see an inordinate amount of time being spent on the debt ceiling and its potential impact on money market funds, and we also got a glimpse of the SEC'​s thinking on regulations and European concerns. USA Today'​s John Waggoner writes "Could U.​S. debt default ding money market funds?." He says, "How would a government default affect money funds? Money funds have $​684 billion in U.​S. government debt. In the event of a default -- the government not paying interest or principal -- funds are generally required to sell that security in an orderly fashion.... The likelihood of a government default is fairly low, but it increases every day Congress fails to act. If Congress raises the debt ceiling without any meaningful effort to reduce the annual federal budget deficit, ratings agencies have warned that they may reduce the nation'​s credit rating. In that case, it'​s unlikely that Uncle Sam'​s credit rating would fall enough to make funds sell their T-​bills."

Standard & Poor'​s also released a publication on the debt ceiling issue entitled, "The Implications Of The U.​S. Debt Ceiling Standoff For Global Financial Institutions." It gives 3 scenarios, including: "Scenario 1: We affirm the '​AAA/​A-​1+' ratings on the U.​S., remove them from CreditWatch, and assign a negative outlook ; Scenario 2: We remove the ratings on the U.​S. from CreditWatch, lower the long-​term rating to '​AA+' with a negative outlook, and affirm the '​A-​1+' short-​term rating; and, Scenario 3: We revise the ratings on the U.​S. to '​SD' (​selective default) and then raise them to '​AA/​A-​1+' with a negative outlook a few weeks later. In this scenario, we would expect a systemic market disruption to follow the revision to '​SD', which would have a significant impact on ratings in the financial institutions sector. If a selective default occurs, but without a systemic market disruption, we would expect this scenario to have less of an impact on global financial institutions ratings."

S&​P explains, "Money market funds issue and redeem shares at $​1.​00, provided that their marked-​to-​market net asset value (​NAV) per share is between $​0.​995 and $​1.​005. Given this very small margin of error, deviations of greater than plus or minus 0.​5% can create a situation in which a fund sells and redeems shares at a price other than $​1.​00, or, in other words, "​breaks the buck." Should a market disruption caused by an '​SD' event lead to a decline in the prices of U.​S. Treasury and government securities (​and other short-​term money market instruments), money market funds may experience a precipitous drop in their NAVs, increasing the likelihood of money funds breaking the buck. Principal stability fund ratings (​PSFRs) are assigned to money market funds and address a fund'​s ability to maintain principal value. Therefore, a downward movement in a money fund'​s NAV could trigger a downgrade, including to '​Dm', if a fund has failed to maintain its principal value (​i.​e., $​1.​00 per share). PSFRs are closely linked to the short-​term ratings on the U.​S. government because a fund'​s investments should have a Standard & Poor'​s short-​term rating of '​A-​1+' or '​A-​1' for the fund to be rated investment grade. A downgrade of the U.​S. sovereign rating to below '​A-​1+' would have significant implications for principal stability funds that invest a majority of their assets in U.​S. government debt."

While she barely mentioned money funds in her prepared remarks, Reuters reports that SEC Chairman Mary Shapiro commented on money funds in the Q&​A and afterwards in their story, "Floating money funds rate under discussion: Schapiro." The article says, "Regulators are discussing whether to abandon the $​1-​per-​share standard value long used by money market funds, Securities and Exchange Commission Chairman Mary Schapiro said on Thursday. Regulators have been tightening oversight of banks and brokerages after the collapse of Lehman Brothers in September 2008 forced the government to backstop the industry."

Reuters writes, "Schapiro said that doing away with the $​1 standard and allowing net asset values (​NAV) to "​float" is one of several issues under discussion." They quote her, "​I would say nothing has been decided," Schapiro told the Senate Banking Committee at a hearing on the one-​year anniversary of the Dodd-​Frank financial oversight law."

The piece also says, "Some market analysts have raised concerns in recent weeks about money market funds' exposure to European banks amid anxiety that a smaller euro zone country could default on its debt. Schapiro disputed that notion, in an interview following the hearing. "We know that there'​s little or no direct money market fund exposure to the peripherals," she said. "​But there is significant exposure to European banks, which may in turn be exposed to the peripheral countries, so it is something we are all watching very closely."

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The Investment Company Institute weighed in on the issue of a U.​S. Treasury debt downgrade or default with the publication of a "Viewpoint", entitled, "Debt Ceiling Scenarios: ICI Addresses Key Questions Regarding Possible Impact on Money Market Funds, written by Karrie McMillan and Brian Reid, as well as a more extensive "Frequently Asked Questions About Money Market Funds and Credit Ratings on U.​S. Treasury Securities." ICI says, "​As Paul Schott Stevens wrote on ICI Viewpoints earlier, a downgrade or default of U.​S. Treasury securities would have grave implications for investors, markets, and economies around the world. This prospect raises a number of questions for funds and their shareholders, particularly for money market funds. We'​ve prepared a set of "frequently asked questions," focused on money market funds, to further address the key issues and dispel some of the uncertainty produced by this unprecedented policy situation."

The piece continues, "For example, what would be the impact for U.​S. money market funds of a downgrade in the credit rating of U.​S. sovereign debt (​debt issued by the U.​S. Treasury or government agencies)? One of the most important factors is whether any downgrade affects only the U.​S. government'​s long-​term credit rating, or applies to both long-​term and short-​term debt. A money market fund'​s ability to purchase or hold a rated security depends on the issuer'​s short-​term credit rating. Most of the discussion to date has focused on downgrades to the AAA/​Aaa rating on the United States' long-​term debt. However, unless the major credit rating agencies also downgrade short-​term debt issued by Treasury and other federal agencies, money market funds would not be affected by any change in the AAA/​Aaa rating."

The FAQ asks, "Why are news accounts and analysts discussing the impact of the U.​S. debt ceiling and deficit debates on money market funds? Failure to increase the U.​S. debt ceiling or address the long-​term U.​S. spending and fiscal imbalance has the potential to adversely affect investors, markets, and economies across the globe -- with severe consequences for interest rates, stock prices, investor confidence, and the day-​to-​day activities of businesses and consumers. Money market funds own $​684 billion in U.​S. sovereign debt -- securities issued by the U.​S. Treasury and government agencies -- and hold another $​491 billion in repurchase agreements, most of which is collateralized by U.​S. government debt. Money market funds are required to invest only in short-​term, highly liquid securities that present minimal credit risk. Analysts and news reports have focused on the repercussions of any policy or market developments that might affect the liquidity or credit quality of U.​S. government securities."

ICI also queries, "Would a downgrade in the short-​term credit rating for U.​S. sovereign debt force money market funds to dispose of their holdings of U.​S. government debt? That'​s unlikely. Credit rating agencies would have to cut their ratings on short-​term U.​S. government securities steeply -- by an amount roughly equivalent to eight steps on the long-​term rating scale -- to force such an action. None of the major credit rating agencies has discussed a downgrade of U.​S. government debt of that severity.... A downgrade ... would not preclude money market funds from purchasing or holding U.​S. government securities. Nor would it require money market funds to sell their current holdings of Treasury and other government securities. Downgrading the U.​S. government'​s short-​term rating below Second Tier would be the equivalent of taking its long-​term credit rating down by approximately eight steps, from AAA/​Aaa to BBB+/​Baa2."

Questions the ICI also addresses include: "Are there credit factors other than ratings that money market funds must consider when buying or holding securities? Yes. A money market fund must limit its investments to securities that pose a "​minimal credit risk," as determined by the fund'​s board. That determination is made independently of any credit rating. The board of directors normally delegates the power to make that determination to the fund adviser, following policies set by the board. Would money market funds be able to add U.​S. government securities to their portfolios if the U.​S. government'​s short-​term credit rating falls to Second Tier? Yes. The SEC'​s Rule 2a-​7 -- the rule governing money market funds -- deems government securities to be First Tier securities so long as they are eligible for purchase (​i.​e., rated in the First or Second Tier by two or more NRSROs).... [​The] diversification requirement does not apply to U.​S. government securities."

They also ask, "For a money market fund, what would constitute "​default" in a U.​S. government security? If the U.​S. government fails to pay interest or principal when due on a security in a money market fund'​s portfolio, the fund must dispose of the security in an orderly way, unless the fund'​s board determines that disposing of the security would not be in the best interests of the fund and its shareholders. The board may consider market conditions, among other factors, in making that decision. If the security accounts for 0.​5 percent or more of the fund'​s portfolio, the fund also must report the default to the SEC. In addition, the U.​S. government'​s failure to pay its obligations could trigger a severe downgrade of its short-​term credit rating by NRSROs.

Finally, ICI comments, "Why might a money market fund'​s board of directors choose not to dispose of a defaulted or severely downgraded security? Rule 2a-​7 requires a money market fund to dispose of a security that is no longer eligible (​i.​e., First Tier or Second Tier) or has defaulted "​as soon as practicable consistent with achieving an orderly disposition," unless the board finds that "​disposal of the security would not be in the best interests of the money market fund (​which determination may take into account, among other factors, market conditions that could affect the orderly disposition of the portfolio security)..." In unsettled markets following a default on U.​S. government securities, a board may determine that disposal of its U.​S. Treasury securities would not be in the best interests of the fund or its shareholders, particularly if the default promised to be of short duration."

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The latest fund manager "​profile" in Crane Data'​s Money Fund Intelligence features the article, "State Street Global'​s Meier & Smith on MMFs." MFI interviews State Street Global Advisors' Steve Meier, Chief Investment Officer for Global Cash, and Barry Smith, Global Head of SSgA'​s Cash Business. Money fund veterans Meier and Smith discuss the Boston-​based manager'​s history with cash, recent challenges in the short-​term markets including concerns about Europe, and the regulatory outlook for money funds. We excerpt from the first half of the piece below.

Q: How long has State Street been running cash? Meier: We'​ve been managing cash portfolios since 1978. It'​s a core competency for State Street Global Advisors and an area that gets a lot of institutional focus given our size and various businesses that touch cash across the State Street Corporation, including securities lending cash collateral. Smith: As you know, SSgA is one of the largest managers of cash globally with assets of just about $​450 billion dollars as of March 31, 2011. What is interesting though is if we look at the composition of those assets they tend to be heavily weighted towards securities lending cash collateral, as well as other captive sources from within the company. This would include such as STIF sweep accounts, for example. We'​ve had less of a focus on marketing to the more traditional cash market of corporate treasurers, and other institutional investors. So our current focus in the cash business, and a key reason I joined SSgA just over a year ago, is to bring the best in class investment, credit research, and risk management capabilities that are resident here -- and have made us the second largest manager of cash globally -- to a corner of the market that is not as aware of SSgA as a significant force in this asset class.

Q: What are your biggest challenges? Meier: The real challenge for us now is finding safe yield. We'​ve been operating in a zero to 25 bps Fed funds environment since December 2008, which is challenging in its own right. More recently, though, we'​ve seen tremendous yield compression, a flattening of the yield curve, and up until recent days, a flattening of the credit spread curve as well. Some of that had to do more with market technicals and the change in the FDIC'​s methodology for accessing insurance premiums on banks, focusing more on liabilities and less on deposits. The FDIC change resulted in about $​60+ billion worth of Treasury Repo being taken out of the marketplace. The lack of an increased debt ceiling has impacted Treasury issuance and repurchase agreement availability as well. Also, focusing on portfolio liquidity has been a core requirement on our side.

Q: Has it been a challenge to grow the business? Smith: There is more cash than ever sitting on corporate balance sheets, and the list of providers that large corporations feel comfortable with is relatively short. As we'​ve increased the awareness of SSgA'​s capabilities in this marketplace, we are actually bucking the asset flow trends you are seeing across the industry. I think what people are finding is that we are a little bit of a best-​kept secret, because when they do their due diligence on us, they are finding that we are among the best in the industry at managing this particular asset class -- and one of the largest. But we are somebody that maybe they haven'​t evaluated in the past. As they are looking to add capacity and they are looking for places where they can put those additional dollars that they'​re keeping on the balance sheets, State Street is showing up again and again as the provider that they are turning to.

Q: What are you buying now? Meier: Our focus on very high credit quality issuers has always been a priority at State Street Global Advisors. We'​ve been buying top-​tier banks located in Canada, Australia and Scandinavia, and sound banking institutions here in the States. We have also been buying extendible floating rate securities to provide a little more yield as the market continues to repair and credit spreads further compress. We continue to buy Asset Backed Commercial Paper that has 100% liquidity support provided by banks that we feel very comfortable with from a credit quality and liquidity standpoint. We'​ve also been very involved in repurchase agreements as core liquidity. The focus for the money funds and the registered funds has been on traditional collateral, specifically Treasuries, agencies, and agency mortgage-​backed securities. But we also have a fairly significant presence and relevance in financing alternative collateral through fully secured over collateralized tri-​party repurchase agreements, including those that have been collateralized by investment-​grade corporates, money market instruments, and equities for appropriate portfolios.

Q: How about the French banks? Meier: From a credit quality perspective, we are very comfortable with a limited universe of top French banks. The Moody'​s action, putting several on watch for potential downgrade, focuses on their long-​term not short-​term credit ratings. Those institutions are rated AA1 to AA2, and relative to the current S&​P ratings they'​re still highly rated by Moody'​s. From a liquidity perspective, those institutions have been diversifying their sources of funding, they'​ve reduced their reliance on wholesale funding and money funds in particular. In addition, they have significant unencumbered assets which can be repo'​d to the ECB if their wholesale funding goes away. (​Look for more excerpts from SSgA and more on French banks in coming days.)

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A new report entitled, "Money Market Funds: What a U.​S. Default Would Mean, says, "While Fitch Ratings continues to believe that an agreement will ultimately be reached to raise the U.​S. debt ceiling, it has been asked by market participants to explore the potential ramifications for U.​S. dollar-​denominated money market funds (​MMFs) should the U.​S. government fail to make timely payments on its debt obligations." Fitch says, "MMFs hold $​1.​3 trillion in direct and indirect exposures via holdings of U.​S. Treasury and government agency securities as well repurchase agreements (​repos) collateralized by such securities." (​Note that this includes "​offshore" money funds; Crane Data shows the U.​S. total amount at $​1.​014 trillion as of June 30, 2011 -- $​346 billion in Treasury debt, $​348 billion in Government agency debt, $​210 billion in agency-​backed repo, and $​111 billion in Treasury-​backed repo.)

Fitch'​s report continues, "The risk of one or more MMFs '​breaking the buck' due to mark-​to-​market declines on U.​S. government exposures appears manageable, absent significant redemption activity. This view reflects MMFs' low weighted average maturities.... MMFs would not be required to sell U.​S. Treasury securities in the event of a downgrade. Thus, any liquidity pressures would more likely arise from increased redemption activity. Thus far, the reaction of MMF investors has been fairly muted, with U.​S. government MMFs experiencing net inflows of late. That said, the lesson of 2008 is that MMFs can be vulnerable to confidence-​driven runs."

They explain, "MMFs rely on repos and to a lesser extent direct U.​S. Treasury securities as a primary source of liquidity. If MMFs were facing net outflows, a failure by the U.​S. government to rollover maturing U.​S. Treasury securities could have an immediate liquidity impact for MMFs. Potentially more problematic would be a material disruption of the repo markets given their interconnectedness and importance to MMFs' liquidity."

Finally, Fitch says, "Liquidity risk is a concern for MMFs in a scenario where the U.​S. debt ceiling is not raised and the U.​S. defaults. MMFs with financially stronger sponsors may be better positioned to weather any liquidity pressures.... A failure to meet timely redemptions and maintain preservation of capital, consistent with Fitch distinct rating scale and criteria for MMFs, would have negative rating implications. A lower rating on the U.​S. (​for example, in the '​AA' category) also could negatively impact MMFs rated '​AAAmmf' from the standpoint of daily and weekly liquidity and repo collateral. As events unfold over the next few weeks, Fitch will dialogue with advisors to rated MMFs seeking to understand their liquidity positions and risk management plans as well as the reaction of broader markets in the event of a U.​S. government default or downgrade."

On another note, we were reminded recently by a regulator that the text of Rule 2a-​7 of the Investment Company Act defines "Eligible Security" as, "A Rated Security with a remaining maturity of 397 calendar days or less that has received a rating from the Requisite NRSROs in one of the two highest short-​term rating categories.... or, An Unrated Security that is of comparable quality to a security meeting the requirements for a Rated Security ... as determined by the money market fund'​s board of directors." "First Tier Security is defined as "[​A]​ny Eligible Security that: Is a Rated Security that has received a short-​term rating from the Requisite NRSROs in the highest short-​term rating category for debt obligations ... or Is an Unrated Security that is of comparable quality ...; or Is a Government Security." Thus, Eligible Government Securities are automatically considered "​First Tier" by 2a-​7. Note too that funds classified as "​Treasury" by Crane Data, which primarily buy U.​S. Treasury securities and repo, hold $​351.​6 billion, or 13.​9% of all money fund assets.

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For our July 5 Crane Data daily News, we wrote "​June MFI Excerpt: Reich and Tang Does Daily MMFs and FDIC Sweeps, which excerpted from our Money Fund Intelligence interview with Tom Nelson, Chief Strategist for Reich & Tang. We reprint the second half of the interview below.... Nelson tells MFI, "As I mentioned earlier, FDIC-​insured sweep products are growing in popularity and will eventually become as standard as the money fund sweep has been historically. Whichever product eventually wins out in this popularity contest will have a lot to do with what becomes of the next wave of regulations placed around them. We could see a floating NAV on money funds potentially tip that balance, but let'​s cross that bridge if/​when we come to it. In the mean time, let'​s continue to offer investors what they deserve -- choice."

Q: What'​s the biggest challenge in cash management today? [​Nelson responds] The biggest challenge today at the fund level is the interest rate environment and the fallout in the repo market. It makes it tough for all of us to find attractive paper. Rates are low, and US Treasury and Government funds have been at 0% for way too long now. Muni and prime funds continue to offer clients and shareholders some yield, but it'​s thin to say the least. And at the macro level, the regulatory uncertainty makes you wonder what the landscape will look like, and ultimately how the business will be run in the next couple of years. Floating rate NAVs would erode investor confidence in funds, and a liquidity facility, by placing additional costs on the shareholder, is not a great solution either. So we remain staring at this dark cloud on the horizon waiting to see how it will impact the way we invest ... and how it will affect the way individuals and American businesses address their short-​term cash management needs.

Q: How are fee waivers impacting the Daily money funds? Is R&​T committed to the business? Can small firms compete? Reich & Tang has never been more committed to its funds business. With all that is surrounding us in the industry, and fee waivers eating away at everyone'​s profitability, there are two main themes on which we are focused—​client service and innovation. For existing clients and shareholders, we continue to educate and inform, be a daily resource, and just plain old service the heck out of them. Keeping existing clients on the books is always paramount, but even more so in a highly commoditized business like money funds.

Our goal is to de-​commoditize through our processes, investment philosophy, and innovation. As with any company in any industry, failure to innovate will ensure a loss of market share. The [​Daily] RNT Natixis Liquid Prime Portfolio is what we consider an innovative step by addressing the most pressing needs of investors in general, while not compromising our philosophy or high standards. It'​s kind of a "​if you build it, they will come" type of thing. We are sure we will see the benefits of this innovation in the months to come. So, yes, small firms can compete -- if they have the right strategy and willingness to innovate. Microsoft was a small firm at one point.

Q: What are your thoughts on the future of money funds and the PWG report? Money funds will continue to serve as a critical component to the way individuals and businesses invest their short-​term cash and working capital, and we see their future as being bright. There will be bumps along the way, the market will adapt, and we will continue to see some consolidation and fund mergers. And as interest rates begin their eventual rise, fee waivers will go away, yield to shareholders and fund profitability will begin to grow again, and the strong will have survived.

What we cannot discount is the incredible value money funds have offered investors for the past 40 years. It is undeniable, and the need for them will always be there. However, its future is rooted in a stable NAV. Without that original tenet in place, the model becomes broken and investors will quickly find somewhere else to place their cash and working capital -- and the speed in which that process takes place should not be taken lightly.

We will continue to support measures that increase liquidity and capital strength of money funds as we saw happen with the SEC Money Market Reforms that were put in place last year. We believe these measures helped to shore up investor confidence in funds and overall were a positive for our industry. We are, however, quite surprised with the overall lack of industry dialogue regarding the differences in behavior of retail and institutional investors. There are events that can precipitate asset flight, or a "​run on the fund" scenario. In the circumstance of a credit event, it affects both retail and institutional investors relatively the same, in that most will be running for the door.

However, in the case of a liquidity event brought on by a systemic problem or a significant interest rate differential, there is a vast difference in the behavior of retail and institutional shareholders. Retail assets would likely remain quite stable while institutional assets will tip the balance. So, in all of this talk about money market fund reform, it seems retail shareholders are unfairly carrying the burden in providing a solution for institutional clients. More discussions need to take place in this regard.

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Two recent articles indicate that next week'​s repeal of Regulation Q'​s ban on interest for business checking accounts shouldn'​t have a big impact on the money markets, at least for now. On Tuesday, Treasury & Risk magazine wrote, "Response Tepid as Reg Q Repeal Nears: Low rates to tamp demand for interest-​bearing accounts for now, saying, "As mandated by the Dodd-​Frank Act, on July 21 Reg Q, which has prohibited banks from paying interest on business checking accounts since the 1930s, will disappear. But thanks to low interest rates and unlimited deposit insurance available on non-​interest-​bearing accounts until 2012, banks expect don'​t expect a huge dash for interest-​bearing accounts."

The article comments, "Citi plans to offer interest-​bearing accounts to business customers, and expects no more than 1% to 2% of corporate and institutional balances to shift to interest-​bearing demand deposit accounts, says Michael Berkowitz, head of North American liquidity, investments and information services at Citi Global Transaction Services." Berkowitz tells T&​R, "There are already so many investment options out there that enable a client to get a return on their balances."

It explains, "Many companies are already compensated for the balances they hold in business checking accounts with an earnings credit rate (​ECR) that they use to offset treasury management fees. Companies can also use sweep accounts that move excess funds into a separate account where they'​re invested. Bank of America will also create a new product to take advantage of the end of Reg Q, but "it will likely not offer an aggressive rate" given the cost to the bank to create the instrument, says Dub Newman, head of global treasury sales at Bank of America Merrill Lynch."

The Treasury & Risk piece adds, "Newman also cites the unlimited FDIC insurance that is available through the end of 2012 on all accounts that don'​t pay interest." "​To the degree that a client is focused on that, particularly in a low-​rate environment where they'​re not seeing a lot of return regardless of the instrument they'​re in, that extra safety of FDIC [​coverage] has a value to it," he tells the magazine.

Also, The Wall Street Journal'​s new "​CFO Report" featured a piece Wednesday entitled, "Companies Show Little Interest in Interest. It says, "U.​S. companies have billions in their checking accounts, but most will forego the chance to earn interest on those balances in order to keep government guarantees on their money in place. Companies can start earning interest on new accounts banks are rolling out with the July 21 expiry of Regulation Q, a Depression-​era ban on interest-​bearing corporate checking accounts. But with that opportunity comes risk most companies apparently aren'​t willing to bear: giving up a blanket guarantee on their money from the Federal Deposit Insurance Corporation. Low interest rates makes the trade off particularly unappealing."

CFO Journal says, "Phil Lindow, head of liquidity in JP Morgan'​s treasury and securities services group, said he didn'​t expect many companies to leap at the chance to get into interest bearing accounts, given general economic uncertainty. The decision to leave money on the table highlights how risk averse U.​S. companies remain years after the worst of the financial crisis -- and well into a period of record profitability. The new checking account options also bring attention to a little known corner of the corporate cash management world. In lieu of the interest they were banned from paying under Regulation Q, over the years banks have developed so-​called earnings credit rate accounts. These pay credits based on the size of deposits that can be used to reduce the transaction fees that banks normally charge for basic services such as wire transfers or check processing."

The blog adds, "Such accounts currently offer corporations anywhere between 0.​20% and 0.​65% in credits based on the size of their deposits, depending on the account and the institution. [​AMC Theatre'​s Terry] Crawford said that he'​s seen rates between 0.​30% and 0.​65% at the banks he deals with. While low, the rates are still much higher than the 0.​03% yield of three-​month Treasuries, or the 0.​13% company would earn by investing in three-​month commercial paper. Making the accounts more attractive: the FDIC offers a 100% guarantee on all deposits in non-​interest bearing accounts. The guarantee was first offered under the agency'​s temporary liquidity guarantee program in November 2008 to protect banks who were worried that companies would begin pulling money out of their accounts. First slated to expire at the beginning of 2010, protection was extended by the Dodd-​Frank financial system reform act to Dec. 31, 2012."

Finally, the article says, "Companies had about $​543 billion in ECR checking accounts as of October 2010, according to consulting firm Treasury Strategies Inc. The accounts are an important source of core deposits for the banks, which also see them as a way to strengthen relationships with businesses. Being at the center of companies' cash management efforts allows banks the chance to provide more lucrative services, including M&​A and capital markets advice."

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Moody'​s Investors Service published a "Special Comment" yesterday entitled, "Money Market Funds Navigate Risks From Europe'​s Credit Concerns," which says, "The ongoing sovereign debt crisis in Europe has had little impact to date on money market fund investors, with fund managers having moved early to de-​risk portfolios by shortening maturities and reducing sovereign and bank exposures as risk within banking systems rose. With their relatively short-​duration portfolios, money market funds have been able to transition their holdings away from deteriorating sovereign and banking credits. In regard to Greece, Ireland, and Portugal, the managers of all Moody’​s-​rated money market funds have eliminated their exposures altogether by December 2010."

The report, authored by VP & Senior Analyst Robert Callagy, says, "Looking forward, we expect fund managers to remain sensitive to the short-​term transition risks associated with sovereign credits and related banks in Eurozone countries experiencing higher levels of stress. Active portfolio management has and should continue to improve credit quality for money funds by reducing single-​obligor concentrations and broadening geographic diversification. However, while these steps should also enable fund managers to avoid most credit risks, some exposure to unexpected and correlated shocks will remain intrinsic to their structure, particularly as investment opportunities dwindle. Further, while we believe credit risk is being carefully managed, '​run' risk remains, and negative headlines or credit degradation of European sovereigns and/​or financial institutions may prompt investors to redeem their investments first and ask questions later."

Moody'​s continues, "While prime money market funds' exposure to Eurozone countries remains high, active risk management on the part of fund managers has led to a reduction in overall Eurozone exposure. With respect to countries experiencing higher levels of stress, money market funds have become even more conservative, shortening maturities and reducing single-​name exposures or, as in the case of Greece, Ireland, and Portugal, eliminating the exposure altogether. This has limited the impact of increased credit spread volatility on mark-​to-​market net asset values."

The report explains, "Given the de-​risking of funds' portfolios and their greater diversification, we believe that Moody'​s-​rated prime money market funds with European exposure are better positioned today than they were at the beginning of 2010 to withstand the credit transition of individual banks or groups of banks in the Eurozone periphery. For example, Moody'​s-​rated prime money market funds currently have no exposure to Greek, Irish, and Portuguese financial institutions, less than 1% exposure to investments in Spanish financial institutions, and no exposure to any of these countries' sovereign debt. The ongoing sovereign debt crisis has awakened money fund managers to the potential for meaningful credit transition out of financially stressed sovereigns and banking systems, and as a result they have increased their investments in the strongest financial institutions."

Finally, Callagy writes, "While we have observed a gradual reduction in investment exposure to a number of European countries in Moody'​s-​rated prime money market funds over the past 15 months, United Kingdom, Switzerland, Netherlands, Germany, and France remain among the exceptions. In fact, investment exposure to Germany and France over that time has ebbed and flowed but remained fairly constant, from 18% of total prime fund assets at December 2009 to a high of 20% in December 2010, and ending April 2011 at 18%. Germany and France are generally considered to be two of the Eurozone'​s stronger economies, and thus may be viewed by money market funds as safe havens."

Note that early indication are that money funds gradually reduced their European holdings in June, but that they continue to invest in Eurozone credits. J.​P.​Morgan published a brief entitled, "`​Update on prime money fund holdings for June 2011" yesterday, and Crane Data is expected to release its comprehensive Money Fund Portfolio Holdings series on Friday. Money funds have also seen inflows overall and into Prime Institutional funds in particular on three of the last 5 days, according to our Money Fund Intelligence Daily, indicating that the relatively modest outflows these funds experienced in the second half of June appear to have subsided.

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We'​ve been getting questions on the debt ceiling recently, and just found another article on the topic. Invesco writes in a recent "​Cash Viewpoint" "​Understanding the U.​S. Debt Ceiling Debate and Its Impact on Money Market Funds." It asks, "What is the debt ceiling?" The piece says, "​A statutory limit has restricted total federal debt since 1917.... It is a limit set by Congress on the total amount of debt that the Federal government can have outstanding at any one point in time.... Once the limit is reached, the Treasury has no authority to borrow, meaning it cannot issue new debt in order to meet interest payments and to finance the primary deficit."

Invesco explains, "Even before hitting the debt ceiling on May 16, Treasury Secretary Geithner put into motion a series of measures with the aim of creating breathing room under the debt ceiling until August 2, including suspending investments in and redeeming debt issued to federal retirement funds, and suspending the issuance of State and Local Government Series (​SLGS) Treasury securities, thereby bringing the debt back down below the ceiling and allowing the government to continue borrowing. Also helping push the deadline forward is the fact that tax revenues this year were stronger than expected.... Ultimately, however, when all of these measures are exhausted, the deadline cannot be exhausted."

They continue, "If an agreement is not reached to raise the debt ceiling by the August 2 deadline, the U.​S Government could be in default if it does not pay the interest coming due on its outstanding debt obligations. It does not mean, however, that the U.​S. Government would be insolvent. A '​technical default' means that the Treasury could continue to service its debt, without an increase in the debt ceiling, by rolling over maturities (​replacing principal that has come due) and prioritizing the payment of interest for general revenue.... The point is that at the end of the day someone -- be it a debt holder, a social security beneficiary, etc. -- will not get paid by the U.​S. Government."

Finally, Invesco asks, "How will the debt ceiling affect money market yields? They answer, "​First, let'​s look at where money market rates are and how they got there. Short-​term yields have been trending lower in the weeks leading up to the May 16 deadline as the supply of short-​term money market instruments has dried up, especially since the Treasury began rolling back its Supplemental Financing Bill (​SFB) program from $​200 billion to $​5 billion back in Feb. More recently, concerns of an economic slowdown and the introduction of the new FDIC assessment rule on April 1 put additional downward pressure on yields.... In no significant progress is made on raising the debt ceiling by mid-​July, Moody'​s and Fitch rating agencies announced that they would put the U.​S. Government debt rating under review for a possible downgrade.... [​S]​upply constraints are expected to persist in the near future, keeping money market yields low, possibly edging lower. Even following a resolution in which the debt ceiling is raised, it is expected to take several weeks until supply constraints ease as the SFB program resumes."

The article doesn'​t address the admittedly far-​fetched theoretical question of '​What happens to Treasury money market funds in the case of a technical default?' Note that money fund regulations prohibit the purchase of securities not in the highest short-​term rating category, but it allows some leeway with securities already held by a fund. Should a default occur, it'​s possible that Treasury funds would stop buying new securities, and might even consider returning shareholder funds. Finally, note that in the case of a default by the Treasury, FDIC-​insured bank products would likely have their implied "​ratings" and security called into question, given the Treasury'​s ultimate backing of the deposit fund and the banking system. (​So theoretically, savers might have nowhere else to go.)

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Wells Fargo Advantage Funds' Dave Sylvester writes in the latest "Portfolio Manager Commentary: Overview, strategy, and outlook," "As everyone focuses on the current situation in Europe, much has been written about money funds' exposure to foreign banks or, more specifically, European banks. Yet if one really wanted to focus on the core issue, it would be banks in the eurozone or, even more appropriately, a few banks in the eurozone. How did a problem that began in Greece, a relatively small country on the edge of Europe, become a topic that brought money funds back into the spotlight? What are the real concerns, and is there any reason to be at all optimistic?"

He says, "So what does this have to do with money market funds? As part of their diversified portfolios, money market funds hold obligations of banks, including foreign banks. Despite protestations from the editorial boards at leading financial publications that they are shocked -- shocked! -- to find foreign bank debt in U.​S. money funds, we are not in Kansas anymore. We have had an interconnected and global financial system for many, many years, and money funds lend to high quality issuers across the developed world. Some speculate that money funds' exposure to foreign banks has increased as yields have declined, but that'​s simply not the case. In fact ... U.​S. money funds' exposure to foreign banks has remained fairly constant for the past five years, at 40% to 50% of money fund assets."

Sylvester continues, "​Why have money funds invested in foreign banks? In part, it is simply a supply issue. While the total supply of U.​S. dollar denominated investments that are eligible to be purchased by prime money market funds exceeds $​9 trillion, when U.​S. government securities and repurchase agreements (​repos) are excluded, that number drops to a level closer to $​2 trillion. Of that $​2 trillion, we estimate that foreign banks and their affiliates issue about 40%. Therefore, money fund exposure to foreign banks is not outsized but in line with the composition of the money markets themselves. It has been no secret that supply in the money markets is very constrained; we have addressed the topic here on a number of occasions."

He explains, "To us, it is not surprising that money funds have continued to keep a fairly high level of exposure to foreign banks. U.​S.-​based issuers have been dropping out of the domestic money markets for a couple of years now. As the economic woes have taken a toll in the financials sector, a number of banking institutions were absorbed or purchased by stronger entities. Other firms just no longer meet money funds' requirement that issuers present minimal credit risk. Both of these factors reduced the number of available issuing entities. In addition, as interest rates have plummeted, the remaining high-​quality issuers have been taking advantage of these favorable rates by issuing long-​term debt. However, foreign banks remained key issuers in the short end. Most have continued to improve their fundamental credit profiles and issue into the money markets."

The latest Wells commentary comments, "​What have foreign banks been doing with the money raised by all of this issuance? To a great extent, they'​ve been using it to build their cash reserves. Data from the Federal Reserve (​the Fed) shows that the cash balances at foreign-​related institutions have more than doubled in the past year to approximately $​1 trillion. Much of the increase has come in the last several months, as foreign banks' cash reserves have increased from $​500 billion at the end of February. Some market observers estimate that of the $​1.​5 trillion in excess reserves held at the Fed, more than $​850 billion is held by the U.​S. branches of foreign banks."

It says, "​Now, we are back to Greece. What happens to the European banks if Greece defaults, or even if the bondholders have to take a large haircut? Clearly, the exposure to Greece varies among banks, as does the amount of capital that each bank holds. But we do not underestimate the contagion risk, and we suspect that this would lead to further problems for Portugal and Ireland. In our assessment of whether or not an issuer presents minimal credit risk, we believe that one relevant measure is to examine the level of capital of each bank in relation to its exposure to the peripheral nations. We believe that the efforts to shore up bank capital over the past several years have put many of the large eurozone banks in a position where they have sufficient capital to absorb significant losses on their holdings of the sovereign debt of the peripheral nations, should such a loss be necessary."

Sylvester writes, "We also do not underestimate the risk of a credit freeze. In the past, market participants have shut off credit availability to all issuers in a sector when trouble strikes, no matter what the underlying credit fundamentals might be. However, the fact that foreign banks have such large cash balances and excess reserves held at the Fed gives us a very different set of circumstances in the current environment. In previous episodes, borrowers were financing long-​term illiquid assets with short-​term funding. When the funding was cut off, those borrowers struggled to replace the funding as the price of the assets declined. In the case of foreign banks today, the assets are largely demand deposits at the Federal Reserve. Quality, liquidity, and price stability of these deposits are beyond question. If money funds and other market participants choose to not roll over their maturing commercial paper (​CP) and certificates of deposit (​CDs), those banks could simply draw down their reserves at the Fed. Additionally, European banks have access to liquidity provided by the ECB, which, along with other central banks around the world, has in place swap lines with our own Federal Reserve. As such, it appears that there is plenty of liquidity to back up near-​term maturities. The fact that in mid-​June we saw a sharp drop of $​123 billion in cash held by foreign banks in the U.​S. may indicate that this unwinding process is already under way."

Finally, he writes, "Does this mean that we are totally complacent? Absolutely not! The widening of credit spreads and the attendant price risk is still a concern, as is the potential for another shift out of prime funds. This is why, for some time now, we have been in favor of short and highly liquid portfolios, sometimes at the expense of yield. We believe that these steps will help to minimize the effects of any short-​term price volatility caused by these events. Finally, it is notable that one of the reasons for the heightened focus on money funds during this episode is increased levels of transparency. Unlike almost every other segment of the financial services industry, people can look through money funds and see exactly what they hold. Data is reported regularly and in a standardized format."

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Fitch Ratings released a statement Friday, saying, "A review by Fitch Ratings concludes that European exposures do not, at this time, pose rating concerns for rated money market funds (​MMFs). At this time, MMFs rated '​AAAmmf' maintain high credit quality exposures to banks located in the '​core' European countries of France, the United Kingdom and Germany, focusing mainly on systemically important entities rated '​F1+' and limiting the weighted average maturities of their portfolios." Fitch says these "direct exposures do not pose near-​term concerns."

The release says, "​As of May 31, 2011, Fitch rated 54 U.​S. and European '​prime' MMFs, whose investment policies permit investments in securities issued by financial and non-​financial entities. Combined assets under management of these prime MMFs were approximately $​823.​9 billion (​the list of Fitch-​rated prime MMFs can be found on Fitch'​s website). Fitch-​rated prime MMFs, on average, allocated 20.​3% of their total assets to French issuers and 15.​4% and 7.​5% of their total assets to issuers headquartered in the United Kingdom and Germany, respectively. These allocations include direct and indirect exposures gained via investments in asset-​backed commercial paper backed by liquidity lines provided by respective banks. Collateralized exposures to respective entities acting as counterparties in repurchase agreement transactions are also included in the tallies."

Fitch explains, "Exposures to Europe were diversified among large, financially stable banks with international franchises. Many of these banks are systemically important entities that should be well positioned to manage their own exposures to peripheral Europe, especially Greece, as discussed in '​Major French Banks' Exposure to Greece' and '​German Banks' Exposure to Greece'. For example, investments in BNP Paribas ('​AA-/​F1+') accounted for 5.​3% of Fitch-​rated prime MMFs' total assets. French banks Societe Generale ('​A+/​F1+') and Credit Agricole ('​AA-/​F1+') accounted for 4.​5% and 3.​9% of the funds' total assets, respectively. Amongst the UK issuers, the largest allocation of 5.​5% of total assets was to Barclays Bank ('​AA-/​F1+') followed by 3.​6% of the funds' assets invested in Royal Bank of Scotland ('​AA-/​F1+') and 3.​5% in Lloyds TSB Bank ('​AA-/​F1+'). German Deutsche Bank ('​AA-/​F1+'), Commertzbank ('​A+/​F1+') and Landesbank Hessen-​Thueringen ('​A+/​F1+') accounted for 3.​8%, 0.​8% and 0.​4% of the Fitch-​rated MMFs' assets, respectively."

The update adds, "Fitch notes that these MMFs have taken proactive credit and liquidity risk management actions in response to the ongoing market volatility. As of the end of May 2011, rated MMFs maintained an average weighted-​average maturity to reset date of 37 days and an average weighted-​average maturity to final maturity date of 54 days indicating relatively low interest rate and liquidity risk. Moreover, these MMFs generally restrict the final maturity of any European exposures to 90 days or less. A shorter investment horizon, absent excessive redemption activity, should allow MMFs to exit specific '​at risk' credits in an orderly fashion via natural runoff rather than a forced sale of the security."

Finally, Fitch comments, "The data presented in this commentary is based on portfolio holdings provided to Fitch as part of its regular surveillance process for rated MMFs. The data represents reported portfolio holdings as of end of May 2011 and, as such, may not reflect funds' more recent (​or future) portfolio composition or allocation.... Fitch will continue to monitor MMF exposures to sovereigns or financial institutions in Europe as well as shareholder redemption activities. While exposures seem manageable at present given the high credit quality overall, an abrupt deterioration could challenge MMFs' ability to exit at risk exposures and maintain preservation of capital. Fitch will comment further as warranted, including in the agency'​s quarterly money market fund special report."

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The July issue of Crane Data'​s Money Fund Intelligence newsletter went out to subscribers this morning along with June 30 performance data, rankings and indexes. Our latest flagship publication includes the articles, "Concerns Over European Holdings Latest Hit to MFs," which discusses the recent outflows and worries over Greece; "State Street Global'​s Meier & Smith on MMFs," which interviews the two SSgA veterans; and, "NAV Buffer Takes Center Stage at MF Symposium," which reveals that the money fund industry and others are now seeing Fidelity'​s "​reserve" plan as the most likely path forward for new regulation.

The lead article reveals that Prime money funds saw inflows of $​4.​1 billion on Wednesday (​the first increase in almost a month) and inflows of $​7.​5 billion yesterday. It says, "Concerns about money funds' heavy European holdings, triggered by a Moody'​s warning on French banks and a speech by Boston Federal Reserve President Eric Rosengren saying money funds may be vulnerable, dominated the headlines in June. While these worries were likely overblown and money funds remain several steps away from troubles at the edges of Europe, the heavy press coverage did trigger moderate outflows in Prime Institutional money funds in the second half of June."

It continues, "Prime money fund assets declined by $​81.​7 billion in June and another $​13 billion in the first five days of July, according to our Money Fund Intelligence Daily. But the outflows remain modest and have slowed since peaking June 24. Prime and overall assets have even begun rebounding the past two days. (​They were up by $​4 billion on Wednesday, July 6, Prime'​s first solid increase since June 8.)"

The July issue also says, "In our latest fund manager '​profile,' MFI interviews State Street Global Advisors' Steve Meier, Chief Investment Officer for Global Cash, and Barry Smith, Global Head of SSgA'​s Cash Business. Money fund veterans Meier and Smith discuss the Boston-​based manager'​s history with cash, recent challenges in the short-​term markets including concerns about Europe, and the regulatory outlook for money funds." (​Look for excerpts in coming weeks, or contact us to request the story.)

Our other lead story, "NAV Buffer Takes Center Stage at MF Symposium," says, "​We recently hosted approximately 400 money fund professionals in Philadelphia for our third annual Crane'​s Money Fund Symposium. While Europe was of course a hot topic, the regulatory outlook was also a major area of discussion. Presenters and participants seemed to think that the possible options for further money fund reform are narrowing, and that the NAV Buffer has become the most likely candidate for change."

Our monthly Money Fund Intelligence XLS, which contains a host of performance statistics on money funds, rankings and our Crane Indexes, has been uploaded to the website and will be e-​mailed to clients shortly, and our Money Fund Wisdom database has been updated with June 30, 2011 data. Note that our June 30 Money Fund Portfolio Holdings data set will be available to Wisdom subscribers next Friday, July 15.

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The Federal Reserve Bank of New York issued a press release entitled, "Tri-​Party Repo Infrastructure Reform Task Force Issues Progress Report on Direction of Reform" and its full "Progress Report" update. The statement says, "Today, the Tri-​Party Repo Infrastructure Reform Task Force, under the auspices of the Payments Risk Committee (​PRC), issued a Progress Report to update market participants and provide additional detail around the previously communicated reforms addressing key infrastructure weaknesses of U.​S. tri-​party repo transactions. The Task Force is largely on track with the schedule outlined in its May 2010 recommendations and reiterates that its key end-​state objective is the practical elimination of intraday credit. There are significant operational changes occurring this year which provide the necessary foundation for this objective and will require attention and action from all tri-​party repo market participants."

The Task Force explains, "The following are some highlights of these changes: Since June 27, 2011 all dealers have been using automated collateral substitution functionality provided by their Clearing Banks. This has facilitated moving the unwind for non maturing repos (​excluding rehypothecated collateral) to 3:​30pm NYT instead of early in the morning. Starting July 25, 2011 the unwind for maturing repos (​excluding rehypothecated collateral) will move to 10:​00am NYT. On August 22, 2011 the unwind for all tri-​party repo trades will move to 3:​30pm NYT (​excluding Interbank GCF collateral). Dealers and Cash Investors must have signed addendums by July 25, 2011 in preparation for August 29, 2011 when all tri-​party repo transactions must be confirmed by each party to the trade in order to settle."

Chairman Darryll Hendricks comments, "The Task Force has succeeded in designing and implementing important pre-​requisite steps toward the objective of the '​practical elimination' of intraday credit provided by the clearing banks. I encourage all market participants to take immediate action to ensure that they are fully prepared for the upcoming changes. These are, however, pre-​requisites and the Task Force is continuing to develop the remaining steps to achieve our objectives."

The report adds, "Although the original goal was to fully achieve this end-​state objective in 2011, it became apparent as the Task Force worked through the details that the current settlement process will not accommodate execution of a simultaneous '​unwind and rewind' of maturing and new trades early enough in the afternoon to be workable for market participants and a more substantial re-​engineering of tri-​party repo settlement mechanisms may be needed. The Task Force will continue to advance changes in this and other areas, and will release a revised timeline this fall which will include the following key milestones: Substantial reengineering of settlement processes to facilitate the ongoing lockup of collateral until maturity date, and to facilitate the return of maturing cash to lenders as early as possible in the afternoon. Requirement that clearing banks provide intraday credit on a committed line basis only and capped at 10% of the dealer'​s aggregate repo book."

Finally, the release says, "All of the Dealer firms on the Task Force, representing over 75% of the total tri-​party market, are in the process of communicating these imminent and important changes to the market directly with their clients and working closely to ensure they are prepared. Investors that have not begun to adapt their processes for these changes should contact their counterparties and clearing banks immediately to make sure they have adequate information and support to do so. The Task Force previously consulted with the industry and public on the upcoming changes by requesting comments in December 2010 and by holding extensive discussions with tri-​party repo participants. The Task Force plans to continue this consultative approach."

Under "About the Task Force," the statement explains, "The Tri-​Party Repo Infrastructure Reform Task Force was formed in September 2009 under the auspices of the Payments Risk Committee, a private sector body sponsored by the Federal Reserve Bank of New York. The Task Force was formed at the request of the New York Fed to address weaknesses that became visible over the course of the recent financial crisis. Mr. Darryll Hendricks, of UBS Investment Bank, is chairman of the Task Force. On May 17, 2010, the Task Force published a report with recommendations for improving the infrastructure of the U.​S. tri-​party repo market.... For additional information about the Task Force and its work visit: http://​www.​newyorkfed.​org/​tripartyrepo."

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The Investment Company Institute'​s Chief Economist Brian Reid published a piece Friday entitled, "Dispelling Misinformation on Money Market Funds." It says, "The ongoing attention to U.​S. prime money market funds' exposure to the debt crisis in Greece has brought three questions to the fore: Are U.​S. money market funds invested in the '​periphery countries' -- Greece, Italy, Spain, Portugal, and Ireland -- that are seen at risk in a debt crisis? Why are U.​S. money market funds investing in European banks? What risks do those investments pose for U.​S. money market funds and their investors?"

Reid explains, "The answers to those questions can be summed up in four points: U.​S. prime money market funds have no direct exposure to Greek, Portuguese, or Irish government or bank debt. Their holdings of Spanish and Italian bank debt are minimal and have fallen substantially since last autumn. U.​S. money market funds have plenty of sound reasons to invest in large, well-​capitalized banks with extensive U.​S. and global operations -- whether those banks are headquartered in the U.​S. or Europe. It would take a rapid collapse of one or more large European banks to have any impact on U.​S. money market funds and their investors. The market is not anticipating any such collapse. Regulators and money market funds themselves have put greater safeguards in place to strengthen these funds since the financial crisis. Those are the facts. Unfortunately, there'​s been a lot of misinformation and misunderstanding surrounding these matters."

He writes, "For more than a year, U.​S. prime money market funds have had no direct holdings of Greek or Portuguese debt, whether sovereign (​issued by the government) or private. U.​S. prime money market funds' holdings of debt in Spain, Ireland, and Italy were small as a share of the funds' portfolio a year ago and have declined rapidly. U.​S. prime money market funds now have no holdings of Irish sovereign or bank debt. The latest public data as of April 2011 shows that Italian and Spanish bank debt combined accounts for less than 2 percent of prime funds' aggregate portfolios -- down by about half since last fall. There are good reasons why U.​S. funds don'​t hold foreign sovereign debt: U.​S. funds buy dollar-​denominated securities, and most countries issue debt in their own currency (​the euro, in these cases)."

The article asks, "What risks do those investments pose for U.​S. money market funds and their investors?" It answers, "It would take a rapid collapse of one or more large European banks to have any impact on U.​S. money market funds and their investors. What evidence is there that this could happen? Using the portfolio holding reports filed by money market funds, many analysts have looked at prime money market funds' exposure to Greece and the other '​periphery' countries through the funds' investments in debt issued by European-​headquartered banks. Among the European banks in prime money market funds' portfolios, in every case the bank'​s direct exposure to Greek government debt is less than 1 percent of the bank'​s total assets -- and for most of the banks, it'​s much less."

ICI'​s Reid continues, "The credit rater Moody'​s draws another distinction -- between the banks' short-​term debt, which money market funds hold, and their long-​term issues. While Moody'​s recently announced it is reviewing the long-​term ratings for three French banking groups, the same announcement reaffirmed Moody'​s highest rating on those banks' short-​term paper. Thus, any exposure that U.​S. money market funds have to these French banks is deemed of the highest short-​term credit quality."

It adds, "Could those banks collapse? The Wall Street Journal'​s editorial page, which has fanned the flames by criticizing money market funds, says they won'​t: '​Neither France nor Germany can defend this plan [​to roll over Greek debt] on grounds that a Greek default would destroy their banks.... [​E]​ven a 50% write-​down would not destroy these banks. BNP Paribas is the largest private holder of Greek debt outside of Greece, and ... a 30% write-​down of its Greek holdings would reduce its earnings per share by only 3%. The market agrees. The default-​insurance premiums, or CDS spreads, on individual European banks indicate that the markets are not anticipating a sudden collapse of any bank that could pose a threat to prime money market fund portfolios."

Reid comments, "​It'​s also important to note that neither money market funds nor their regulators have been standing still since the financial crisis. Money market funds operate with tighter regulation and greater resiliency now than they did in September 2008. Six months after the Reserve Primary Fund broke the dollar, the fund industry voluntarily adopted higher credit standards, shorter portfolio maturities, greater portfolio transparency, and explicit liquidity requirements for fund portfolios. In January 2010 -- six months before the Dodd-​Frank Act passed -- the Securities and Exchange Commission adopted regulations based largely on those standards. These measures have made money market funds considerably more resilient: prime funds, for example, today hold $​660 billion in assets that are liquid within one week, far more than the $​310 billion outflow experienced in the week of Lehman Brothers' failure."

Finally, ICI writes, "No one can say with certainty how a European financial crisis would play out. But the Eurozone has been experiencing debt and financial concerns for more than a year now. Throughout this period, prime money market funds and other investors have reacted to changing developments. As fiduciaries to their shareholders, money market funds are constantly examining the quality of their portfolio and the creditworthiness of investments -- going above and beyond any credit rating agency ratings. Through this careful analysis and active monitoring, prime money market funds have already reduced the risk to their shareholders—​and they continue to do so."

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Last month, Money Fund Intelligence interviewed Tom Nelson, Chief Strategist for Reich & Tang, manager of the Daily Income Funds, the new RNT Natixis Liquid Prime Portfolio, and Reich & Tang Insured Deposits, an FDIC-​insured sweep program. Excerpts from the Q&​A, which appeared in our June issue, follow. Q: How long has Reich & Tang been involved in running money funds? Reich & Tang has been managing money funds since 1974. It is one of the largest firms in the nation focused solely on liquidity and cash management services. From the beginning we have focused within the retail channel and were at the forefront of the brokerage sweep business, which continues to grow nicely today.

Through some natural synergies with our parent company, Natixis, we have executed on a logical business model to further penetrate the institutional market, which is growing at a strong pace. Natixis is one of the largest asset managers in the world, which is based in Paris and has its U.​S. headquarters in Boston. We work closely with Natixis' U.​S. investment banking group, which provides banking services to institutional clients throughout the country.

Q: Tell us about the new fund. Why launch an ultra-​short money fund? To be blunt, it just makes sense. Since 1974, we have maintained a conservative strategy built on the foundation of careful and extensive credit research, a function that we maintain in-​house. Our ultra-​short money market fund, the RNT Natixis Liquid Prime Portfolio, is an extension of that philosophy -- but takes money funds to a level that is more current with the times. The fund is targeted to investors that have any concerns about their money fund liquidity, and is designed to withstand all types of market events, such as those witnessed in 2008. Essentially, we looked all the major issues that investors and regulators associate with money funds -- ability to provide liquidity, credit quality, inclusion of questionable investments, and transparency -- and from that built a fund that addresses all of these concerns.

By prospectus the fund must maintain a weighted average maturity of 9 days or fewer. As you know, the SEC requires money funds to maintain at least 10% of assets in overnight paper, our fund averages approximately 60%. While liquidity and return of capital is paramount, the fund is inherently designed to perform well in a rising interest rate environment. The fund is positioned to be a '​first responder' in being able to reinvest in higher yielding paper when the Fed eventually and inevitably moves to a tightening posture. Credit quality -- all investments in the fund are A1/​P1, it does not invest in second tier paper. We have seen a flight to conservatism with many of our clients' investment guidelines, which has no tolerance for ABCP, ABS, collateralized loan agreements, and loan participations -- all of these are non-​permissible investments in our fund.

Transparency -- the fund is arguably the most transparent fund in the business. We post fund holdings on a daily basis and even post our approved credit list for up to three days prior to inclusion in the portfolio. This is clearly an outlier in the industry, but one we are proud of because it enables clients and shareholders to know exactly what they are buying, and it epitomizes the concept of full disclosure. Debate about money market funds continues -- the talk of credit facilities, debate about floating NAVs, the President'​s Working Group on Financial Markets -- all of which have thus far failed to inspire the confidence of the majority. So while existing and new proposals are meticulously dissected, debated, and eventually woven into some type of legislation to address liquidity, credit quality, questionable investments for money funds, and transparency concerns, we will continue to offer clients and shareholders a product that addresses each of these areas. Clearly there is a market for investors concerned about what is in their portfolio and how it will behave if/​when an adverse market event takes place.

Q: Can you talk about your recent acquisition and expansion into "​bankerage"? Sure. One of Reich & Tang'​s core services is providing sweep solutions to broker-​dealers and banks. It is clear that the appetite for FDIC insurance is growing and will play an increasingly important role in many firm'​s long-​term product strategies. The expansion in ... January of this year [​R&​T purchased Double Rock Corporation'​s Liquid Insured Deposits] adds to our already significant presence in the FDIC sweep space and has strategically positioned us to further penetrate the expanded FDIC-​insured market.

As customer demand for FDIC insurance continues to grow, we are very well-​positioned to help both BDs and bankers attract new business, better compete, and provide a valuable service to their customers. The ability for a community bank or a broker-​dealer to offer each of their customers millions of dollars in FDIC insurance through one account is a distinct competitive advantage -- one that attracts coveted HNW customers, business accounts, and municipal accounts, to name a few. Beyond that, it gives investors choice. We are pleased to be able to provide both FDIC-​insured solutions as well as money market fund options to all investors.

Q: Can money funds coexist with FDIC-​insured sweep products? They can and they do right now. The cash space is not unlike many other asset classes -- investors will go where they perceive the value to be, or where it meets their particular needs. Some will say the value is in FDIC insurance, others will say it is in active fund management of multiple disciplines, while others still will chase rates. None of these will ever go away, and the combination of money funds and FDIC insurance will ensure that investors have a choice. The smarter providers and sponsor firms will offer both. No one product meets the needs of all investors. While Reich & Tang Insured Deposits meets the needs of investors seeking a means to protect their cash up to $​2.​5 million of FDIC insurance, it doesn'​t meet their need for tax-​free income that a money fund easily provides.

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On Wednesday, we noted that the Association for Financial Professionals, formerly known as the Treasury Management Association, published its "2011 AFP Liquidity Survey," which "provides CFOs, treasurers and other financial professionals data to benchmark their companies' short-​term investment strategies." We excerpted from its "Key Findings," which showed that companies continue to build cash and that "companies continue to hold nearly four-​fifths of their cash and short-​term investment holdings in three historically ultra-​safe investment vehicles: bank deposits, money market mutual funds and Treasury securities." Today, we excerpt from AFP'​s survey sections on Money Market Funds and Multi-​Family Trading Portals."

AFP writes, "In January 2009, the Securities and Exchange Commission (​SEC) voted to adopt new rules to strengthen money market funds. The new rules focus on limiting risks associated with money market funds, increasing protection of investors, improving fund operations, and enhancing fund disclosures. The amendments were designed to increase the resilience of money market funds to economic stresses, reduce the risks of runs on funds, facilitate the orderly liquidation of a money market fund (​MMF) that breaks, or is about to break, the buck, and improve the SEC'​s oversight of money market funds."

They say, "Changes are now in place with the goals of tightening liquidity requirements, imposing higher credit-​quality requirements, shortening portfolio maturity limits addressing reliance on rating agencies, enhancing disclosure of portfolio holdings, and addressing issues that arise when money market funds experience market challenges. Still on the table is the issue of the Floating NAV (​net asset value). Money market funds now post their shadow NAV on a 60-​day delay basis so that investors can see the true value. If the floating NAV for money market funds were mandated it would surely be a deal breaker for treasury departments.... Nearly seven out of ten respondents report that the changes in 2a-​7 money fund rules have had no impact on their organizations' investment decisions (​69 percent)."

The Survey continues, "With the substantial percentage of cash and short-​term investment holdings in money market funds, organizations must be able to evaluate the counterparty risk of these funds. Organizations may draw upon analysis conducted by internal staff and/​or by third-​parties to conduct this crucial work. Just over half of organizations rely on the credit ratings issued by a nationally registered statistical rating organization (​NRSRO) when it analyzes and monitors counterparty risk of its money market funds. Larger organizations are more likely than smaller ones to use credit ratings to analyze counterparty risk. Other techniques used include: Reviewing fund holdings on a more frequent basis (​41 percent); Reviewing the parent company and/​or the fund sponsor ownership (​32 percent); Increased use of technology, portals and/​or additional reporting validations (​17 percent); and, Outsourcing investments and utilizing the services of the third-​party'​s credit team (​13 percent)."

On "Multi-​Family Trading Portals," AFP'​s Liquidity Survey comments, "Organizations have the option of using an electronic, multi-​family trading portal to execute short-​term investment transactions. These portals provide organizations an opportunity to more easily facilitate transactions and compare investment choices. In addition, trading portals can lower the costs associated with managing and administering an organization'​s short-​term investments. Thirty-​one percent of organizations use an electronic, multi-​family trading portal to execute at least a portion of their short-​term investment transactions.... The use of multi-​family trading portals increased over that reported last year."

It adds, "While organizations can use electronic trading portals to trade a number of investment vehicles, they use them primarily to trade prime money market funds (​79 percent) and direct holdings in treasury/​government securities (​59 percent). Nearly one out of five organizations that uses an electronic trading portal does so to manage bank time deposits, while eight percent use such portals for transactions involving treasury/​government money market funds and their holdings of commercial paper."

AFP continues, "There are a number of benefits to using electronic, multi-​family trading portals. Seven out of eight organizations that use electronic portals agree that they provide all the needed information in a single platform. Users of electronic trading platforms also note that these portals provide for better transparency and reporting (​55 percent), allow the ability to tie funds back to an organization’​s bank relationships (​thus allowing for better tracking) (​41 percent) and allow for better pricing and more competitive offerings (​32 percent)."

The Survey comments, "The most important criteria when choosing an electronic, multi-​family trading portal is the functionality of the platform (​58 percent). Users of portals also consider whether the platform is offered by their organizations' banking partners (​45 percent), breadth of the money market funds offered (​36 percent), its integration with organization'​s treasury management systems (​31 percent), fees (​31 percent) and the portal'​s reporting capabilities (​30 percent)."

Finally, AFP writes, "Organizations examine a number of criteria when selecting the money market funds to include in their short-​term investment portfolio. The only criterion used by more than half of organizations that include MMFs in their short-​term investment portfolios is the credit ratings of the funds, used by 64 percent of organizations.... For both smaller organizations and those that are privately held, the top consideration is the current yield offered by the fund. Other criteria considered include: Current yield (​49 percent); The underlying investments are permitted funds (​38 percent); Allowable credit ratings of permitted underlying investment vehicles of fund (​23 percent); Assets under management (​AUM) (​22 percent); and, The fund'​s sponsor (​22 percent)."

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