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Fund Industry Leaders Want Money Market Reform

Plus, layoffs loom at American Funds, and Oppenheimer retools its bond team.

Morningstar Analysts, 03/23/2009

Morningstar's fund analysts cover 2,000 mutual funds. Their full analyst reports, including Stewardship Grades, are available in Morningstar Principia Mutual Funds Advanced and Morningstar Advisor Workstation Office Edition.

A group of fund industry leaders is advocating immediate reform to bolster money market fund regulation, including new liquidity and credit quality standards and better disclosure. The Money Market Working Group, led by Vanguard chairman John Brennan, was formed in November, shortly after the Reserve Primary Fund's NAV dropped below $1 per share. As only the second fund to ever "break the buck," this anomaly shook investors' confidence in money market funds, leading to $210 billion in outflows in the next two days. The rush of redemptions added to the market's woes because money market funds provide low-cost financing to businesses, banks, and the government. With investors pulling out of money market funds, liquidity dried up, and lending came to a halt. To slow redemptions, the government was forced to temporarily guarantee money market funds that applied to its Treasury Temporary Guarantee Program for Money Market Funds.

The Money Market Working Group set out to examine the current challenges facing money market funds and develop regulatory reforms so that they will continue functioning effectively in any economic climate. In a report submitted to the Investment Company Institute board, they propose several new standards they would like all money market funds to voluntarily implement by Sept. 18.

Many of the recommendations are sound and could help money market funds better cope with redemption pressures like those that occurred in late 2008. The group proposes minimum daily and weekly liquidity requirements for all money market funds along with regular portfolio stress testing to gauge whether they're able to deal with sudden changes in shareholder redemptions, interest rates, and credit risk. They also suggest shortening portfolio maturity levels.

The group also wants to raise credit quality standards and guard against trendy funds. They recommend that Tier 2 securities--those with the second-highest short-term rating--be eliminated from money market eligibility. While that's a good idea, it's somewhat limited by the fact that there's no assurance that Tier 1 securities, as currently defined, are actually safer. The group also proposes all money market funds establish "new product" committees to protect investors against the dangers of untested products. Finally, the group suggests all money market advisers monitor credit quality by using at least three rating agencies. The group believes this would drive competition among rating agencies and presumably improve credit analysis across the industry. However, it's not clear whether this would have any noticeable effect on ratings quality, and one could imagine firms cherry-picking agencies with reputations for looser standards as a way to allow higher-yielding securities into their portfolios to boost yields.

Finally, the report calls for funds to better understand their client base. Many investors consider money market funds completely safe and don't understand the potential risks, which can backfire for investors and funds alike if trouble arises and redemptions peak. Monthly disclosure of portfolio holdings is one easy way to keep investors informed. It will likely be harder for funds to truly understand the risk tolerances of all of their investors, but better investor education can help.

Encouraging money market funds to follow the recommendations listed in the report is a great first step. Hopefully these regulatory standards will eventually be required for all money market funds rather than simply followed on a voluntary basis.

Looming Layoffs
Cost-cutting is still in full force at investment firms that are reeling from the market downturn and a drop in assets. Capital Group, the parent company of American Funds, has seen assets plunge to $637 billion, down from $1.1 trillion a year ago. The firm, which is the second largest in terms of assets under management, recently froze all pay raises and indicated that another round of layoffs could happen within the next few months. The first round affected roughly 500 employees worldwide.

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