The Importance of Credit Research and NRSRO Ratings
by Mark Stockley, Managing Director and Head of International Cash Sales, BlackRock
Following the worst financial crisis in recent history, the global money market funds industry has come under heightened scrutiny. The events of 2008, including the historic ‘breaking of the buck’ by the Reserve Primary Fund in September of that year, brought to light both idiosyncratic (fund-specific) and systemic (industry-wide) risks associated with money market funds, and gave rise to several reform measures designed to enhance the stability of the industry. For example, in the US the Securities and Exchange Commission (SEC) Rule 2a-7 reforms for money market funds, which took effect in May 2010, enhanced oversight and transparency in the US money market funds industry by expanding disclosure requirements and imposing tighter restrictions on the portfolio maturity, credit quality and liquidity guidelines of money market funds. Similar changes have been made to the industry framework for European money market funds through the Institutional Money Markets Fund Association (IMMFA), the European Federation of Asset Management Associations (EFAMA), and the Commission of European Securities Regulators (CESR – now ESMA).
In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act signed into law in July 2010, subsequently instructed the SEC to make certain additional changes to money market fund regulations. One recent proposal resulting from this mandate addresses the use of Nationally Recognized Statistical Rating Organizations (NRSRO) ratings by fund advisors.
While no specific regulation regarding credit rating agencies has been enacted in the European Union, the European Commission conducted a public consultation earlier in 2011 which sought input from investors, market participants, regulators and other stakeholders around the “potential risks from over-reliance on credit rating by financial markets participants”. At the time of writing, the Commission is still considering what actions, if any, will be taken with regard to the use of credit rating agencies references in financial markets.
As such, we believe that this subject is an important topic for international investors to be aware of, given the global nature of the constant net asset value (CNAV) money market funds industry and the fact that European-based CNAV money market funds often seek to hold credit ratings reflecting their conservative investment policies. In fact IMMFA specifically states its objective in issuing its Code of Practice as “…promoting best practice in the management and operation of triple-A rated money market funds”.
We think that ratings provide useful screen for advirsors and enable comparisons across funds by investors.
In this note we focus on the SEC proposal and while we agree that all money market fund advisors must conduct independent credit research, we do not support the proposed elimination of NRSRO references. In our view, ratings provide a useful screen for advisors performing their own credit assessments and enable investors to compare different money market fund products.
We also take the opportunity to outline a framework for fundamental credit analysis and the key principles which we think should govern an approach to credit evaluation. In our belief, a strong risk framework is created through independent research but augmented through use of external information such as ratings.
Section 939A of the Dodd-Frank Act directs the SEC, along with other US federal agencies, to review regulations that rely on credit ratings as a standard of measurement. The legislation further requires them to eliminate references to ratings as a standard of creditworthiness and to substitute alternate standards of creditworthiness.
Although BlackRock agrees that all money market fund advisors must conduct independent credit research, we do not support the proposed elimination of NRSRO references in these rules and disclosure forms. As stated above, we think that ratings provide a useful screen for advisors and enable comparisons across funds by investors. We believe Rule 2a-7 should continue to permit money market fund boards or their delegates to consider NRSRO ratings along with other factors as a minimum credit quality standard. BlackRock supports the assumption embedded in Section 939 of the Dodd-Frank Act that NRSRO ratings should not be the sole determinant of whether a particular security should be included in a money market fund portfolio.
Under current Rule 2a-7, a fund is required to limit its investments to those securities that its board or its delegate determines present minimal credit risks. This determination must be based on factors in addition to NRSRO ratings. We believe it is essential that a board or its delegate make an informed and independent assessment of the creditworthiness of each issuer and security – not only prior to purchase, but on an ongoing basis for those securities held in the portfolio. In our view, a NRSRO rating provides a useful preliminary filter.