Published: December 01, 2008
Money market funds have been providing high levels of liquidity and security, in addition to yield, for over three decades. JPMorgan Asset Management is a leading global money market fund provider in terms of market share and global assets under management. In light of the extraordinary recent market events, it is now invaluable more than ever to take a look at the evolution of money market funds and how it has affected the corporate treasury industry.
Money market funds were first introduced in both the United States and France in the 1970s at a time when interest rates were high on both sides of the Atlantic. Regulation had capped interest rates on bank deposits which gave way to the creation of money market funds which could address the need for overnight liquidity while providing competitive yields for cash investments.
The industry in both regions developed slightly differently however, with US money market funds developing the stable Net Asset Value (NAV) model (e.g. one dollar or one euro equalling one share of the fund), while French funds were typically priced using a variable NAV model with accumulating shares. With the introduction of Rule 2a-7 as part of the 1940 Company Act by the Securities and Exchange Commission, the US market created a common set of constraints that all fund managers had to adhere to. Meanwhile in France and the broader European industry, a wider array of funds were developed under the classification of money market funds, ranging from ultra conservative to riskier short term bond funds. This lack of unified definition led to the incorporation of the International Money Market Funds Association (IMMFA), an industry run body that provided guidance to managers.
All JPMorgan money market funds domiciled in Europe are members of IMMFA and Kathleen Hughes, European Head of Global Liquidity, is a board director. This trade association for providers of AAA-rated stable NAV money market funds domiciled in Europe exists primarily to represent and promote this product. IMMFA maintains a Code of Practice for the industry, provides generic information and performance data about funds, lobbies governments and regulatory bodies for appropriate treatment of institutional money market funds and supports the formal recognition of institutional money market funds in the UK, Europe and elsewhere. The IMMFA code of practice is based on Rule 2a-7 in the US and sets out best practices for managing stable NAV money market funds. In Europe there are now over 30 IMMFA member fund managers. Market size is over $554 billion in AUM (Source: IMMFA report dated 17 October 2008 using FX rates as of 17 October).
The cornerstone of the US money market, and something that has also profoundly influenced the international market, is Rule 2a-7 of the Investment Company Act of 1940, although this regulation was actually introduced at the start of the 1980s. Rule 2a-7 sets out the strict criteria which US domiciled funds must adhere to if they want to call themselves money market funds and use the ‘amortised cost’ method of accounting to maintain a stable NAV (instead of mark-to-market methodology).
Rule 2a-7 guidelines aim to limit managers to only buy high quality, low maturity securities with a high degree of overall portfolio diversification. This is because 2a-7 money market funds should aim to preserve principal at all times and maintain value day-after-day, and not simply seek to perform well over time. Specifically the securities themselves that are held within the funds must be ‘first tier’ while, in order to maintain a high degree of liquidity, the overall portfolio must have a Weighted Average Maturity (WAM) of less than 90 days with individual securities having a maturity of less than 397 days. Finally, to ensure diversity, a fund may only hold a maximum of 5% of its holdings with any one issuer.
Recent events in financial markets have had a large impact on the money market sector and individual funds. While the earlier events significantly stressed the financial system, more recent developments have been positive for money market funds.
The takeover of Fannie Mae and Freddie Mac by the US Government on 7 September was both a positive and a negative. It was positive for the many money market funds which had exposure to the mortgage giants’ securities in lieu of commercial paper, believing the mortgage giants to already be implicitly guaranteed by the US Government and thus proved correct. Up until this point most financials had managed to raise capital successfully, but the Fannie and Freddie rescue only highlighted to investors the risks of placing capital with companies that didn‘t have government backing and it added to the pressure on banks to raise capital.
This pressure was acutely felt by Lehman Brothers. The American investment bank had been talking with potential backers and had hoped for a merger or government bailout, but was forced to file for bankruptcy on 15 September. This had a direct knock-on effect on money market funds and was very damaging for those that held Lehman securities (JPMorgan Asset Management Global Liquidity Funds had no unsecured Lehman exposure on the date of their filing for bankruptcy). In particular, it contributed to the Reserve Fund, a US money market fund, ‘breaking the buck’ when its shares fell below their par value of $1 on 17 September after writing off Lehman-issued debt that it held. [[[PAGE]]]
The US money market industry was very shaken by the failure of the Reserve Fund, which was a large independent US-based money market fund. Unlike JPMorgan and our main competitors it was a privately held, family owned business which meant it did not have access to capital that a bank would have or the resources of a large institution behind it. It is important to note that several large firms have supported their money market funds in the past year after the market value of the funds had fallen below acceptable levels, most notably due to structured investment vehicles (SIVs), so that investors did not lose money. The Reserve Fund incident caused concern in the money market fund industry and led to significant outflows, although JPMorgan fared better than most given our dominant market position, structure and reputation.
There are over 100 Reserve Fund type small firms in the US that are registered 2a-7 fund managers but which do not have large banks standing behind them. This is not the case in Europe where there are only 30 IMMFA money market fund managers. This different landscape in the US was taken so seriously by the US government that it made allowances for money market funds, guaranteeing all assets that were in US money market funds at the close of business on 19 September and putting in place an insurance plan. JPMorgan participated in the insurance scheme to show support for the industry but does not anticipate needing to use it. The money market fund insurance scheme was introduced to ensure an orderly market but it is not a fix-all guarantee. It is designed to allow the orderly unwind of failing funds, particularly those small privately owned funds, but may be a poison pill because anyone who accesses the insurance must then unwind that fund.
The most recent events have been positive for money market funds. While central banks and governments were largely reacting to events as they arose before the failure of the Reserve Fund, they have since taken extraordinary actions to inject liquidity and make capital available to the global banking system. It now appears that most banks globally are deemed too important to fail, particularly the large global banks with diversified business models typical of the names that JPMorgan Asset Management Global Liquidity invests in for their stable NAV funds.
The US government made allowances for money market funds, guaranteeing all assets that were in US money market funds at the close of business on 19 September and putting in place an insurance plan.
Authorities in the UK injected capital directly into banks, and this strategy was then followed in the US, while authorities in the Eurozone made sure that unlimited US dollar funding was available for banks, and bank guarantees were also introduced in countries such as Ireland and Germany. Some banks in Europe were also fully nationalised, such as Fortis. Many of the securities held in our funds are now backed by support or a government guarantee.
This support from governments and central banks has been focused on avoiding systemic risk particularly at the short end of the curve, which is the life blood of the financial markets and where money market funds are invested. This has reassured many investors, who are now taking their money out of US treasury funds, which yield low returns, and putting it back into liquidity funds which can offer up to 200 basis points of excess yield over yields on US Treasury funds. Furthermore, although still at elevated levels, interbank lending rates are now resetting lower in response to all of the different governments’ programmes.
JPMorgan is in a strong position of leadership and has experienced significant growth, with $173 billion under management in our money market funds as of 10 October 2008, up from $83 billion on 30 June 2007. Year-to-date we have benefited from strong inflows that have exceeded those of our competitors, although the whole industry has benefited from the flight to quality. JPMorgan is also the leading euro money market fund provider, with a 32% market share of the total €82.781 billion market. (Source: iMoneyNet Offshore Analyser, 17 October 2008).
The portfolio positioning of our flagship JPMorgan Liquidity Funds - Euro Liquidity Fund (domiciled in Luxembourg with a fund size of over €14 billion), which has outperformed 7 day euro LIBID over the short, medium and long term, is currently (as of 13 October): 0% SIV exposure, 37.8% overnight maturities and 12.4% with maturities of less than one week. The tenors are currently much shorter than under normal circumstances, with WAM in the 20-30 day range, while our cash holdings are much higher. Normally our overnight cash holdings would represent about 10-15% of the portfolio, particularly in an environment where we expect interest rates to fall, but we think it is important to err on the side of caution in these unusual conditions and to focus on maintaining safety rather than yield. [[[PAGE]]]
Our credit team and credit process have served us extremely well. We started taking a much more conservative stance a year ago, holding overnight cash in the funds and reducing the weighted average maturity. SIVs were a particular concern so we removed our exposure to them, letting them all roll down, and we also stopped unsecured lending to Lehmans several months ago. In addition, we have been continuing to maintain higher than normal cash positions in our portfolios with less exposure to certain asset classes now than we had a year ago. Some of that is a reflection of the shrinking issuance market in asset backed commercial paper (ABCP), for example. Alternatively, we have increased our exposure to bank level corporate debt (CD) that we feel is very secure and we believe will be well supported by central banks.
Most recently, however, we have started to look at increasing WAM as the credit and bank risk has been removed. Libor yields are attractive and we will start looking at putting some of our excess liquidity to work further out in the curve to achieve more yield.
JPMorgan has also been innovative - our Treasury funds have seen strong growth in assets and we are market leaders in that space, having brought the first Euro Government Liquidity fund and a similar USD Treasury Liquidity Fund to the market. This fund has proved very popular since inception and experienced a substantial spike in growth over the last few weeks. It now has over €10 billion in assets under management (as of 15 October 2008).
Since the first money market funds were established in the early 1970s there has been an explosion in their popularity. AAA-rated funds have not only delivered liquidity, security and yield, but have also contributed to establishing market standards at the high-quality end of the money markets. Thanks to its experience, credit resources and rigorous risk management, JPMorgan has become the world leader in managing money market funds. In these times of crisis, these funds have made an important contribution in providing invaluable security and confidence for investors.
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