June 15, 2010

The SEC has addressed some technical questions about the amended money market fund rule in areas including stress testing, credit rating agencies and whether funds should be concerned about “breaking the buck” on the upside.

The Q&A is intended to clarify the nuances of money market fund rules, but one expert says the real guidance that will assist directors is yet to come. “Staff Responses to Questions About Money Market Fund Reform” is expected to be periodically updated.

Several topics in the May 25 guidance address issues with nationally recognized statistical rating organizations (NRSROs), including one concerning whether money funds that invest only in government securities need to designate NRSROs. A government security is already defined as a first-tier security.

The SEC’s amended rule requires that directors designate by Dec. 31 four or more NRSROs whose short-term credit ratings the fund would use to determine whether a security is eligible.

“So why should you have to designate an NRSRO if, by definition, you only invest in government securities that are defined to be first-tier?... It’s just part of the definition,” says Joan Ohlbaum Swirsky, of counsel at Stradley Ronon.

The SEC said a fund does not need to designate an NRSRO in this case.

Another question concerned board NRSRO designation for municipal funds. “Muni funds had questions because there’s not a lot of rating agencies that rate muni funds. And the question was, can you designate one of the NRSROs that doesn’t rate your securities?” Swirsky says.

The SEC responded affirmatively. “As long as a Designated NRSRO rates at least one type or class of securities in which the fund invests, the Designated NRSRO will count toward the required four,” the Q&A stated.

Jamie Baxter, independent vice-chair of the Putnam funds board, which oversees a number of small money market funds, says much of the SEC attention on NRSROs in the adopting release and the Q&A guidance has been aimed at weeding out unreliable rating agencies with help from boards.

“I think the SEC was trying to say to trustees, ‘You have to have some measure of oversight in the selection of rating agencies so that you don’t get some upstart in Tokyo,’” says Baxter, who is also chair of the Mutual Fund Directors Forum.

The commission also answered a question on whether it’s necessary to stress test a portfolio for vulnerabilities to “breaking the buck” on the upside — or exceeding a $1.005 net asset value (NAV). The commission said it wasn’t.

“If you’re going to break the dollar on the upside, it’s really not too much of an issue because you can just dividend out the gain, most likely; you can deal with it. It’s not like when you have a loss and you’ve got to somehow find a way to make it up,” Swirsky says.

Another question asked how to stress test defaults of holdings within money market funds. Money funds are limited to high-quality securities, so a downgrade of or default on portfolio securities would be very unexpected.

“Downgrades and defaults are likely to be limited to an individual security or to a few specific securities. This test should therefore be designed to assist the board of directors in assessing the effect of isolated stresses on a fund’s shadow net asset value ('NAV'),” the SEC responded.

“If a downgrade or default of a portfolio holding is likely to have a significant effect on the fund’s shadow NAV, so that the shadow NAV would deviate by more than one-half cent per share, the test should indicate the full extent of the loss a fund might be expected to incur as a result.”

Here, Swirsky says, the SEC expects that the adviser will identify securities in the fund, perhaps the largest or most risky, and make a determination of what the fund would get for that security if it defaulted. Then, the effect on the NAV would be calculated.

“Let’s say you had a $100 bond. If it defaulted, you might think, ‘Well, maybe I’ll get 50 cents on the dollar; maybe I’d get half of that,'” she says.

“They want you to do the math, and put in the number and say, OK, if you took either your largest holding or your most risky holding… and it defaulted, or it was downgraded, and you were only going to get 50 cents on the dollar or 75 cents on the dollar, or 25 cents on the dollar, you have to make a guess as to what you would get. Then do a calculation. What would be the effect on your NAV?”

Peter Crane, president and publisher of Crane Data LLC, says many of the questions addressed are stating the obvious and that the real work on money fund reform is yet to come.

“A lot of this guidance and a lot of the new rules needs a beta test to see what works and to see what’s expected, and what’s feasible. That Q&A coming so close on the heels of the [SEC money fund reform adopting] release just meant they wanted to clear up a lot of these tiny issues just to get them out of the way,” he says.

He points to one area that addresses “know your customer” evaluations. One of the questions in the guidance asks how a money market fund should go about incorporating those evaluations in stress testing procedures.

The SEC said a fund should incorporate an evaluation of the liquidity needs of its shareholders into its stress testing. Redemption activity likely to occur in the following year also should be considered.

But Crane says that because many of the new mandates are “so soft,” the real risk lies in funds going overboard.

“When the SEC says ‘know your customer,’ I joke to people, ‘Are you kidding me?’ They know what time these people get up in the morning, what time they go to bed. During September '08, they were getting e-mails from them in the middle of the night,” he says.

“And of course large customers, which are the ones that the mandate is directed at, any salesperson worth their salt probably knows when the kids’ birthdays are, what sport they play.…You don’t need any incentive to learn when your customer intends to take back $1 billion from you. That’s something that you want to know anyway.”