CNAV: Emerging From the Crisis
Events in the financial markets during the last two years have been exceptional. Leading financial institutions on both sides of the Atlantic had to be rescued; major investment banks collapsed or had to be restructured; and lending between banks all but dried up. Key interbank rates – the rates banks charge each other to borrow – also rose to record levels. MMFs did not escape unscathed, as confidence evaporated and liquidity disappeared. So much so that, according to Fitch, some 12 MMFs in Europe alone were suspended or liquidated after their net asset values (NAVs) fell by around 20%.
But governments acted by pumping huge amounts of cash into the money markets and offering myriad banking and other guarantees. These actions have, to date, prevented a cataclysmic meltdown of the financial system. Indeed, we are now starting to see some green shoots of recovery in the financial sector. Confidence is slowly returning, with interbank borrowing rates coming down; there are also tentative signs that some credit funding is starting to flow once more.
While some trust is returning to the money markets, we are not out of the woods yet. Fundamental changes will have to be made before the industry can fully regain its footing. Now is an opportune moment to look at what originally attracted investors to constant net asset value (CNAV) MMFs, what went wrong and how best to address these problems – both from an industry and a regulatory standpoint – so that the industry is better prepared for any future storms.
Prior to the credit crunch, we witnessed a revolution in cash management in Europe, with an explosion in the use of CNAV MMFs. Investors from across the spectrum embraced them, and came to see them as an attractive alternative to traditional bank deposits.
The benefits of CNAV MMFs are numerous. First, they offer a simple, efficient product that is actively managed within rigid and transparent guidelines. Second, their conservative investment objective of providing an enhanced yield over traditional bank deposits is highly desirable. Third, their structure makes them extremely liquid, thus allowing same-day withdrawal of money. Lastly, they are triple A-rated, meaning they are perceived as being extremely low risk, with security of capital, a priority in their investment strategies.
So how do they achieve these objectives? Same-day access is achieved by ensuring a percentage of the fund matures each day. This is accomplished via a mixture of overnight deposits and a range of assets that naturally mature each day. The overall numbers and types of investments used vary from day-to-day, but generally managers will hold a higher percentage at month and quarter-ends when investors have a higher tendency to withdraw cash. In addition, funds also carry a range of short-dated liquid assets that can be quickly sold to meet any unexpected redemptions.
To ensure security of capital, each manager will employ a rigorous credit process that will result in a list of approved counterparties and asset types. The portfolio itself will be invested in a highly diversified range of counterparties and asset types, thereby reducing the risk from a failure of a particular counterparty or asset type. The manager will also have to adhere to strict credit rating restrictions imposed by the agency that rates the fund. This will limit the ability of managers to buy too many longer-dated and/or lower-rated assets.
With managers ensuring they know as much as possible about anticipated cash flows, they will know that not all the fund will be liquidated on any one day. Thus, to a limited degree, they will be able to buy slightly longer-dated assets, if they believe that to be appropriate – although the scope to do this is limited by the fact that the maximum weighted average maturity (WAM) is limited to 60 days. With appropriate and prudent management, managers will be able to maximise the return of the fund, thus ensuring that the fund is a competitive product when compared to traditional bank deposits.
So why did some managers get into so much trouble? During the period of easy credit and abundant liquidity, the prospect of a yield above bank deposits that is relatively risk-free proved tantalising to investors looking to eke out as much from their cash as possible. However, the period of prosperity and easy access to money masked the dangers that were lurking in some of the assets. Historically low price volatility hid what proved to be the riskier nature of some of the assets that were being invested in, notably structured investment vehicles (SIVs), asset backed securities (ABS), floating rate notes (FRNs) and, to a lesser degree, asset backed commercial paper (ABCP).
But once the US subprime crisis arose, the true risks began to emerge. This was exacerbated by the global economy slumping into recession. Questions started to emerge about the true credit quality of even top-rated repackaged securities, whilst the impact and danger of gearing increased. The result was a dramatic drop in price and liquidity in these assets. SIVs, which raised short-term debt to fund a geared portfolio of longer-dated assets, found they could no longer finance themselves. ABS structures were downgraded by the rating agencies, which appeared to be late in re-assessing the risks, and sharp price falls were seen as the expected pay down schedules extended. FRNs saw discount margins widen massively, while the ABCP market effectively closed as buyers withdrew from the market.
As the financial crisis cast its shadow over the economy, MMF managers had fewer counterparties to deal with. Falling credit ratings also resulted in many names dropping outside their credit matrices, thus becoming ineligible for funds. Investment banks, forced to scale back their operations by the crisis, had smaller balance sheets and could therefore not hold as much inventory. All these factors blocked the arteries of the financial system, and liquidity stopped flowing though the system completely. This lack of liquidity drove bid-offer spreads much wider, thus making trading or forced sales very expensive. The upshot of this was that the majority of MMF managers resorted to keeping the lion’s share of their asset in overnight deposits and shorter-dated assets – investments beyond three months became almost non-existent.
Yields on funds subsequently suffered, meaning MMF managers were finding it increasingly difficult to generate excess returns anywhere near the levels they had in the past. This was exacerbated by the actions of global central banks, which, in attempting to arrest the global economic slowdown, cut rates to historic lows, driving yields even lower. There was also a huge dispersion of rates being quoted by various counterparties, making it difficult to compare fund yields to those of bank deposits. Investors would look at the yields quoted on the broker screens, which appeared to suggest that fund yields were below traditional bank deposits.
The dispersion of yields being quoted, coupled with the lack of liquidity in markets, also made it difficult for managers to accurately assess the true market value of the assets they held. Managers needed to become more conservative to ensure that any risk of a mismatch between the amortised prices and the mark-to-market was limited. However, as prices of certain assets had fallen sharply, some MMFs experienced sharp falls in yields and sizeable losses – something that was not expected from this sector.
However, thanks to a number of huge government interventions, and sponsor support, widespread failure of MMFs was avoided. As a result of these measures, coupled with funds being run more conservatively, the market has started to stabilise, albeit slowly. There is no doubt, though, that the industry has been left bruised and battered. A period of reassessment is currently underway, but the question now is: ‘‘How will MMFs adapt to the new landscape?”
One thing is certain: CNAV funds will be less risky and more liquid. Most managers will see their credit teams become more aggressive in driving their approved counterparty and asset-type lists. The WAM of funds is also likely to be lower – particularly in the short term – with the need for more liquidity resulting in a higher percentage of funds being held in overnight deposits and short-dated assets. The range of asset types that can be invested in will also be reduced. SIVs, which have all but disappeared, will no longer play a part; ABS will almost certainly be off approved lists; FRNs, if permitted at all, will be limited in maturity; and the number and types of approved ABCP programmes will fall. In fact, the latest statistics show that the ABCP market has halved in outstandings over the last two years, with the current level now consistent with that seen at the turn of the century.
The independent board of directors that scrutinise funds will also have their own stipulations. This will focus primarily on the need for more stress-testing analysis, incorporating factors such as redemptions, rising yields and falling ratings. They may also want managers to place a greater emphasis on capital preservation and liquidity at the expensive of higher yields. Addressing the latter, with less risk in the portfolio, the scope for funds to outperform short-dated deposits will be curbed, but that in no way means that the asset class should be abandoned: with efficient management, funds will still be able to offer a viable alternative to deposits. Investors will be reminded of the original pitch – that funds are highly diversified by counterparty, are extremely liquid and have stringent risk controls, all of which are designed to ensure that they remain a stable product.
Of course, after such upheaval in the market, regulations will inevitably change. Market participants will do what they believe to be necessary to prevent a repeat of events of the last two years.
First, the Institutional MMFs Association (IMMFA) has proposed a new code of conduct to improve the robustness of their members’ funds. They are also keen to harmonise the industry across Europe and even with the US 2a7 market. Under these new guidelines, all funds will have to have a liquidity policy that ensures that a certain percentage of a portfolio matures within one week. Furthermore, there will be a tighter maximum maturity limit on all assets, and any new asset types that funds invest in will have to be approved by IMMFA. Lastly, all portfolios will be required to have a formalised policy in place to deal with any potential losses.
Building on this – and focusing more on protecting the consumer – the Association of British Insurers (ABI) is consulting with its members about the creation of a new money market sector out with the existing one. The goal is to help investors identify MMFs that have a greater focus on capital stability. To quote:
‘‘[If this is implemented], funds in this sector may not be ‘no risk’, as funds will still be exposed to credit risk and a degree of liquidity risk, and in a very low-interest rate environment it is possible that the returns may not exceed the charges levied for some funds within the sector. But funds in this sector will be lower risk than those funds that invest in other money market instruments with higher yields.’’ (ABI Money Market Sector Review – March 2009)
In addition, the Group of 30 (G30) – an international body of leading financiers and academics – has also tabled a number of proposals for the money market industry. The stand- out proposition is that only banks will be able to run CNAV funds. This is because they are the only bodies with sufficient capital to bail out funds that run into difficulties. To quote:
‘‘Those institutions remaining as money market mutual funds should only offer a conservative investment option with modest upside potential at relatively low risk. The vehicles should be clearly differentiated from federally insured instruments offered by banks, such as money market deposit funds, with no explicit or implicit assurances to investors that funds can be withdrawn on demand at a stable NAV. Money market mutual funds should not be permitted to use amortised cost pricing, with the implication that they carry a fluctuating NAV rather than one that is pegged at US$1.00 per share.’’ (G30 ‘ ‘A Framework for Financial Stability’ – January 2009).
Although these measures have still to be finalised and put into practice, it is clear that the money market industry will look markedly different going forward. The emphasis of funds will surely shift away from chasing yield, towards greater capital preservation and higher levels of liquidity. Controls governing the market will undoubtedly be tighter and overall levels of risk within funds will reduce.
While some of us have benefitted from holding to the original conservative mission, confidence in the market and trust across the industry has been damaged and this needs to be rebuilt. But the latest regulatory proposals show that the industry is serious about addressing the challenges it now faces; and despite the tempest that has recently swept through the sector, MMFs will not only have an important role to play in the world of finance – but will emerge from the crisis stronger.