From the October 2009 issue of Treasury & Risk magazine

Whacking the System Over Breaking the Buck?

If the Securities and Exchange Commission's proposed rules governing money market mutual funds see the light of day, corporate treasurers will have to dig deeper for their companies' short-term financing needs. The rules would, in effect, bar money market funds from investing in commercial paper issued by many of the country's largest and oldest companies. While the intent of the SEC is to strengthen the U.S. financial system by regulating money market funds more like banks, critics charge that the commission is wielding a bigger stick than is necessary to tame an industry that needs scolding, at most. They contend that many major American companies' ability to issue commercial paper will be severely impaired, forcing some to abandon this form of short-term debt issuance for more expensive alternative financing. "It's more than likely to drive up the cost of short-term debt for many companies," predicts Holly Koeppel, executive vice president at American Electric Power, a Columbus, Ohio-based utility that provides electricity to customers in 11 states.

AEP falls within the so-called second tier, or A2/P2 category, of commercial paper issuers that would be affected by the SEC's proposal, which is currently out for comment. A2/P2 is a rating of the risk of default of commercial paper. The SEC seeks to limit money market fund investments to the highest quality securities, a tier that would include high-flying A1/P1 issuers, but exclude companies rated A2/P2.

AEP is just one of hundreds of otherwise soundly managed and financially stable companies in the A2/P2 category. Others include such well-known corporate names as American Express, General Mills, Sara Lee, Kraft, Heinz, Philip Morris, Cigna, Lockheed Martin and Nissan, to name a few. "Some of the world's biggest and best companies will be adversely affected," says Anthony Carfang, a partner at Chicago-based consultancy Treasury Strategies.

Money market funds are the largest buyers of the commercial paper sold by corporate treasurers, state and local governments, and financial institutions. If the money fund industry is "ruined by regulation, a vital source of short-term capital will evaporate for these entities," Carfang says. "The SEC wants to regulate a $3.6 trillion industry because over the last 30 years someone lost a few million bucks."

He is referring to the SEC's impetus for strengthening the regulation of money market funds--the collapse of the $62.5 billion Reserve Primary Fund. On Sept. 16, 2008, the fund lowered its share price below $1 because of its exposure to the commercial paper of bankrupt Lehman Brothers. In industry parlance, the Reserve Primary Fund "broke the buck," meaning investors in the money market fund lost money, only the second time in history this had occurred. Normally, the net asset value of money market funds, considered among the least risky investments, is kept at $1.

The failure triggered a run by money market investors demanding that their money be returned, which had the effect of freezing the commercial paper market, potentially cutting thousands of borrowers from this routine source of short-term funding. Since then, Reserve Primary Fund has withheld a significant amount of money from investors pending the outcome of numerous lawsuits filed against it.

While many finance executives extol the intent of strengthening money market funds from an investment standpoint--they're widely considered a reliable, stable place for companies to invest short-term cash--the corollary impact on corporate short-term financing gives them pause. "We issue commercial paper, but for the most part it is purchased by insurance companies and not mutual funds, so the proposed rule, if it goes into effect, won't have much impact on us, even though we are categorized as A2/P2," says Linda Harty, executive vice president and treasurer of Cardinal Health, a Dublin, Ohio-based distributor of medical supplies and pharmaceuticals with $99.5 billion in 2009 revenue. "That said, for companies that sell their paper to mutual funds who would be shut out of this market, the rule would potentially push them into more costly forms of short-term debt, since the money funds provide funding at rates below conventional loans. Nevertheless, the extra expense may be worth it, given the SEC's objective of greater protections for investors."

Money market mutual funds have accumulated roughly $3.6 trillion in cash since their debut in 1971. The funds create a way for companies to tap short-term funding at low rates from a stable, low-risk, highly liquid pool of cash. To make good on this promise, the funds typically invest in low-risk securities like highly rated commercial paper, thus limiting their exposure to losses from credit, market and liquidity risks.

Money market funds are regulated by the SEC, rather than coming under the jurisdiction of banking regulators, something that Paul Volcker, the former Federal Reserve chairman and current adviser to President Obama, would like to see changed. As Volcker complained to the news agency Reuters in late August, "To the extent [that banks] have competitors [like money market funds] that have different ground rules--kind of free-riders in my view--weakens the financial system."

"Volcker has never been a fan of mutual funds. He's been vehemently opposed them since their inception, referring to them as a 'shadow banking system,'" says Carfang. "What he fails to recognize is that the funds remain a major source of cash for quality borrowers, who will be shut out of issuing commercial paper if the SEC's proposals see the light of day. These second-tier companies are among the largest, most stable companies in business today, with investment-grade long-term debt ratings. Why punish them by increasing the cost of capital?" Volcker could not be reached for comment.

While treasurers can sell commercial paper to insurance company investors, Carfang says the cost is higher. "Besides, if the SEC rule survives, you can bet that insurance companies and other buyers of commercial paper will follow suit and also make A2/P2-issued paper unacceptable," he says. "Imagine a board meeting of an insurance company where the board says to the CFO, 'If this isn't good enough for some of the most sophisticated investors in the world, why are we investing in it?'"

Carfang is not alone in lambasting the SEC proposal. The U.S. Chamber of Commerce says the rule could "have a negative impact on money market funds and unnecessarily limit their important role." The chamber agrees that the SEC's proposal would constrict the market for second-tier securities, driving companies "to draw down their credit facilities, which would have a negative impact on the ability of banks to lend to other parts of the economy," the chamber states, noting that the proposed prohibition could "elevate borrowing costs for companies that issue A2/P2 securities, thereby restricting their ability to meet their short-term cash needs, increasing their cost of capital and driving up consumer costs." The chamber also expresses concerns that the proposal could cause other investors not to buy second-tier commercial paper.

Others share this view. Bill Mekrut, treasurer and vice president at large commercial insurer FM Global, says that if A2/P2-rated firms are shut out of issuing commercial paper to money funds, "the only recourse will be drawing down lines of credit or seeking other sources of financing, which could be pricey these days." FM Global does not issue commercial paper, though it does invest in money market mutual funds.

"There's no question that it will drive A2/P2 issuers out of the market for their short-term financing," says David O'Brien, former director of treasury operations at Fidelity Investments and president of Enlightened Enterprises, a Dallas-based consulting firm specializing in treasury management. "There are many aspects of the financial marketplace that require attention. This isn't one of them. Like a lot of regulations it will lead to unintended consequences, driving general corporate investors to the banks to borrow bank lines of credit. This doesn't fix the problem, which can be traced to the quality, or lack thereof, of the agencies rating commercial paper."

David Stowe, director and head of the financial risk management practice at consulting firm Strategic Treasurer, offers a similar perspective. "If the SEC proposal becomes rule, it will limit the demand for lower-tier debt and thus restrict the options that companies have for raising funds, which is not a good thing," Stowe says. "If the stability of money market funds is the premise for the proposed regulation of requiring higher-rated commercial paper in the funds, then basing the criteria off of the debt rating agencies' level doesn't eliminate all risk. As we've learned from the subprime mortgage bonds debacle, no one should depend solely on the rating agencies as a single source of information." Stowe favors more transparent disclosure of what money market funds are buying, as opposed to tighter restrictions.

Companies like Fidelity that offer a range of money market mutual funds to corporate and other investors favor a similar splitting-the-hair approach, endorsing the enhancement of investor confidence by improving market transparency and discipline, but finding unwarranted the restrictions on second-tier commercial paper. Fidelity's comment letter urges the SEC to "consider the possible unintended consequences" of its proposals "for government and corporate issuers who benefit from financing provided by money market mutual funds." Fidelity declined to elaborate in an interview.

The chamber, on the other hand, takes a firmer stance, disputing the purported safety enhancements for investors in money market funds. "The inability to diversify a money market fund portfolio could exacerbate the negative effects of another major default by an issuer of A1/P1 securities," the chamber states.

Fitch Ratings, which has rated money market funds since the early 1990s, has a different view. "We just feel it is more prudent for funds to invest in tier-one issuers," says Roger Merritt, a managing partner in Fitch's New York office. "We did not rate the Reserve Fund, which was rated by Standard & Poor's and Moody's, but as it shows even one small credit event in a fund can be pretty material, having the potential to create a panic or a run on other funds, which is why the government stepped in."

But are second-tier issuers all that much riskier than first-tier issuers? Data from Moody's indicates that from 1972 to 2006, the 180-day default rate for P2 commercial paper issued by corporations was 0.03%, versus 0.01% for P1 issuers, a negligible difference indicating that second-tier issuers are only marginally riskier than first-tier issuers. "These companies carry investment grade credit ratings, span across nearly every industry, and represent a major sector of our economy," the chamber states.

Carfang, who has discussed the proposed SEC rules at several recent symposia, says the Lehman Brothers-Reserve Fund fiasco that incited the SEC's proposed rules was a virtual blip on the radar screen. "Really, when you consider the safety of investing in mutual funds, it doesn't amount to a hill of beans," he charges. "There are literally hundreds of funds out there with assets of $3.6 trillion combined, and here's the Reserve Fund with $800 million in [Lehman] assets causing all this fuss."

Instead of unnecessary regulations, Carfang says, "Let's just take time out and catch our collective breath."

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