January 19, 2011

By Peter Ortiz

Moody’s Tuesday issued revisions to a controversial proposal that called for changing the way it rates money funds, acknowledging broad industry concerns.

The changes make major revisions to some of the thorniest issues that cropped up in the original proposal, including a new ratings system and a measure that would have placed greater weight in the ratings on a money fund sponsor’s strength.

Moody’s issued its original proposal in September to address problems money market funds encountered during the credit crisis. The proposal sought to reassure investors by adding greater transparency of a fund’s characteristics as well as its market and liquidity risks.

But while Moody’s acknowledged in a release Tuesday widespread support for the original proposal’s main intent, it nevertheless made significant concessions.

One clarification is that fund sponsorship will not enhance a fund’s rating above its stand-alone rating, although sponsor quality remains a factor in the analysis, says Yaron Ernst, managing director of the Managed Investments Group at Moody’s. He adds there was a misperception that under the original proposal “a fund with a lower-quality portfolio could achieve a higher rating because of its sponsor.”

“Well, that is not going to happen,” Ernst says. “If the fund itself has a low standard of investment and low-quality portfolio, it will not get a lift by the sponsor.”

Some critics “argued that despite a long history of sponsor support as a critical factor in preserving money market funds['] stability, future support is less certain, assessment of sponsors involves judgment, and our considering sponsorship could cause investors to over-rely on sponsors’ implicit support for their funds,” Moody announced in its release.

Another major concern expressed in the comments was the proposed creation of a new set of symbols to distinguish between money market fund and bond ratings. The proposal called for a new range of rating symbols, from MF1+ to MF4 (MF stands for managed fund), for money funds while keeping the Aaa-to-C terminology for bond ratings. This was prompted by a Dodd-Frank provision that prohibits credit rating agencies from having multiple definitions for the same symbol.

In its place, Moody’s is tweaking its system for money funds so the ratings will be symbolized as Aaa-mf, Baa-mf, B-mf, C-mf (mf standing for managed fund). This is expected to quell concerns over market disruptions and investor confusion while holding true to the Dodd-Frank requirement, Moody’s states.

“Moody’s clearly caved in and did an about-face on their proposal,” says Peter Crane, CEO and publisher of Crane Data, who questioned what firms would pay for an MF4 rating. “The proposal got the stuffing beaten out of it.”

But Ernst says Moody’s is still achieving its two objectives: providing the market with more information, particularly on portfolio credit, liquidity and market risk; and using new symbols to distinguish between money market fund ratings and bond ratings.

Moody’s says its expectations are that the revisions to the fund sponsor provision will have little impact on incremental risk to funds due to a sponsor’s operational, market or funding challenges and that top-rated funds would still be backed by sponsors with investment-grade profiles.

The revisions won over one of the proposal’s most vocal critics.

“They won’t look at the quality of the parent in terms of being a positive for the fund,” says Anthony J. Carfang, partner at consulting firm Treasury Strategies. “The rating will be based on the qualifications of the fund itself, how well it is managed, how well it does credit research and its track record, as opposed to who owns it.”

Moody’s anticipates releasing and using the revised ratings methodology sometime in the next three months. It plans to publish the new ratings in the second quarter. The firm had heard from investors, sponsors, consultants, trade groups and regulators on its original proposal, but declined to identify any by name. It rates about 300 money market funds.

Carfang, who last month received a letter from Federal Reserve chairman Ben Bernanke acknowledging his firm’s concern about money fund parental support, says that the original proposal could have resulted in “serious downstream consequences.”

“For example, if a bank were to affirm it was supporting its funds, in effect the bank would have to consolidate its funds into its balance sheet because it has created a contingent liability, and obviously that would have capital consequences,” Carfang says, noting that such a move could ultimately force that bank to exit the money fund business.

Under the old proposal, institutions and corporate investors that are permitted to invest only in top-rated funds might have had to forgo those funds if they lacked deep-pocketed parents, Carfang says.

“Moody’s will be shining a brighter light on funds and penalize funds for financially unstable parents, which is a good thing,” he says. “But it will not put investors in the position of gambling on whether a strong parent will bail out a fund.”

Joan Ohlbaum Swirsky, of counsel at Stradley Ronon, notes that reliance on parental support could have raised some thorny issues for Moody’s, money funds and their sponsors.

“For various reasons, sponsors likely would need to disavow that there is an implicit agreement to support,” Swirsky writes in an e-mail response to questions. “Would that mean that Moody’s would need to downgrade a fund that disavows an intention to support? On the other hand, it may not be desirable for a fund to be rewarded with a higher rating for taking on more risk because it can count on sponsor support.”