Proposals announced last week by the US Department of the Treasury regarding money market fund credit and liquidity risk are consistent with risks highlighted by Fitch Ratings in its January exposure draft on money market fund criteria, says the ratings agency. Fitch is considering whether ‘AAA/V1+’ ratings for ‘prime’ money market funds will be achievable over the longer term, absent fundamental changes.

Importantly, money market funds currently benefit from various forms of governmental intervention that have cushioned the impact of the current financial crisis. Removal of this support could negatively impact ratings if the credit and liquidity issues are not addressed at the same time, says Fitch.

The money market fund industry and its various regulators are considering changes to address credit and liquidity risk in ‘prime’ money market funds to improve their safety and soundness, while lowering their potential systemic risk. The timing and magnitude of these changes will determine whether ratings will be maintained at their current levels or if negative ratings actions will be necessary. Fitch will be monitoring the discussions between the Securities and Exchange Commission (SEC), the President’s Working Group on Financial Markets and other industry-led groups that could result in fundamental changes that provide for greater protections against and credit liquidity risk.

Fitch’s 26 January exposure draft proposed significant changes to the rating criteria for global money market funds in response to the adverse market events in 2008, which placed significant credit and liquidity pressures on money market funds. Fitch assigns ratings to Rule 2a-7 money market funds registered with the SEC, as well as offshore money market funds that offer a stable net asset value (NAV) and closely mirror 2a-7 funds. Fitch rates a total of 63 ‘AAA/V1+’ rated prime money market funds with approximately US$1 trillion of assets under management.

Fitch’s exposure draft proposed a series of changes that were deemed necessary to continue rating money market funds ‘AAA/V1+’. These changes included an evaluation of the fund’s institutional sponsor and that sponsor’s willingness and ability to provide support to the fund during times of credit or liquidity stress. They also included: updated guidelines on shareholder concentrations and redemption risk; updated diversification guidelines and a risk budgeting matrix that considers risk on two dimensions - credit quality and time to maturity; and the introduction of new weighted average days to final (WAMF) metric that captures the risk from credit spread widening and complements the existing weighted average days to reset (WAMR) metric.

Since the publication of the exposure draft, Fitch has received extensive feedback from various market participants globally. In most cases, market participants have been supportive of the proposed criteria changes, which dovetail closely with recommendations published by the industry in March 2009. However, additional analysis of the fund sponsors ability and willingness to provide financial support to the fund, if needed, is required particularly in light of the discussions mentioned above.

While money market funds have enjoyed a long and successful track record of stability up until last year, a critical element behind their stability has been sponsor support during times of stress. Historically, there have been numerous instances of money market sponsors providing some level of support to their funds. Absent this support, it is likely that more funds would have failed to offer same day liquidity and/or a stable NAV, particularly during the credit and liquidity stresses experienced in 2008. Without fundamental structural changes, money market funds will continue to rely on sponsor support, which may not always be forthcoming.

The financial crisis revealed structural shortcomings that, given their size and importance to the credit markets, have highlighted the systemic risks posed by money market funds. Despite holding diversified portfolios of assets that are subject to credit and market risks, money market funds do not maintain any equity or credit enhancement to absorb losses (beyond a threshold for NAV to decline by 50 basis points before ‘breaking the buck’).

These investment vehicles also have proven to be confidence sensitive and exposed to contagion risk by offering same day liquidity to shareholders, which can lead to ‘runs’ as a result of industry or sponsor concerns. Fitch believes that more can be done to better match the liquidity profile of fund assets to shareholder redemptions. However, the level of intrinsic asset liquidity that funds could reasonably be expected to maintain on a standalone basis would be insufficient to meet the level of redemptions witnessed last year, without having access to committed sources of back-up liquidity.

Fitch notes that today’s comment and its earlier exposure draft only pertains to ‘prime’ money market funds that invest in short term debt instruments issued by banks, financial and non-financial corporations, and asset backed commercial paper issuers. This comment does not apply to money market funds that invest in government, agency and tax exempt municipal obligations. Fitch will provide updated comment on these funds at a later date.