Regulatory Proposals for Money Market Funds and Current Topics Affecting the Short-Term Investment Marketplace Presentation To: Presentation By: Joe Ulrey Chief Executive Officer
Today s Topics Regulatory Proposals for Money Market Funds and Current Topics Affecting the Short Term Investment Marketplace A brief history of money market funds and significant challenges faced Overview 1992-1994 derivative security issues 2007-2009 financial crisis Intervention following the 2008 Crisis Government intervention Sponsor support 2010 money market fund reform Current money market fund proposals Current market Environment Strategy
A Brief History of Money Market Funds and Significant Challenges Faced
Overview Money market mutual funds have a 40-year history The first money market mutual fund was established in 1971 Money market instruments, such as market-rate CDs and commercial paper, generally offered yields significantly higher than the rates banks were legally allowed to pay under Federal Reserve Regulation Q, which placed a ceiling on bank deposit rates Money market funds were established to give retail investors access to money market instrument rates of return, which were much higher than the rates set by banks Money market funds are investment products and not guaranteed or insured by the federal government or the fund sponsors As of September 12, 2012, over $2.5 trillion were invested in money market funds Only two funds have broken the buck or returned less than $1.00 per share to investors Source: Investment Company Institute 4
1992-1994 Issues related to derivative securities During a 60-day period in 1994, the Federal Reserve spiked the federal funds rate 125 basis points to ward off inflation Adjustable rate derivative securities held in some money market funds were impacted by the sharp rise in rates, including: Government agency floaters Range floaters Dual Index floaters Constant Maturity Treasury (CMT) floaters Inverse floaters Source: Federal Deposit Insurance Corporation 5
1994 Community Bankers U.S. Government Fund The first money market mutual fund breaks the buck In 1994, Community Banker s U.S. Government Money Market Fund broke the buck Institutional money market fund 27.5% of its portfolio was invested in adjustable rate derivative securities Value of these notes declined sharply with the rapid rise in interest rates The fund liquidated in September 1994 at 96 cents per share Source: Federal Deposit Insurance Corporation 6
2007-2009 Financial crisis sets in Difficulties in the subprime mortgage market began to spill over into money and credit markets in mid-2007 Securitized subprime and other mortgage derivatives were broadly held in the financial markets Defaults on subprime mortgage payments set off a liquidity crisis in the system Several significant events occurred in rapid succession, beginning in 2007 Auction rate securities market froze Collateralized Debt Obligation market collapsed Companies from numerous sectors failed, required assistance or merged: Mortgage: American Home Mortgage Corp, Countrywide GSEs: Freddie Mac, Fannie Mae Insurance: AIG, Ambac Financial group and other monoline insurers Financial: Wachovia, Washington Mutual Source: Investment Company Institute 7
2007-2009 Crisis affects major broker dealers Investor confidence in the financial institutions faltered as balance sheets began to show the effects of distressed holdings Weakening conditions at several major broker dealers caused distressed sales or structural changes during the height of the crisis Bear Stearns was bought out by JP Morgan the weekend of March 15-16, 2008 Merrill Lynch was bought by Bank of America the weekend of September 13-14, 2008 Lehman Brothers declared bankruptcy on September 15, 2008 when no buyer or government assistance was available Goldman Sachs and Morgan Stanley were approved by the Federal Reserve to become bank holding companies on September 21, 2008 Source: Investment Company Institute 8
2008 The Reserve Primary Fund The second money market mutual fund breaks the buck In 2008, the Reserve Primary Fund broke the buck On September 15, 2008, Lehman declared bankruptcy Reserve Primary Fund had 1.2% of its portfolio invested in Lehman Brothers commercial paper On September 16, 2008, Reserve Primary Fund announced it had broken the buck Investors ultimately received approximately 99 cents per share Source: Investment Company Institute 9
Intervention Following the 2008 Crisis
Government Intervention Programs Money Market Mutual Fund Programs In September 2008, the U.S. Treasury Department and Federal Reserve announced two programs for money market funds aimed at preventing runs and maintaining liquidity Temporary Guarantee Program Voluntary program for funds regulated under Rule 2a-7 Funds paid an upfront fee to participate Treasury guaranteed shareholder money market fund balances Funds to support the program were allocated from the Exchange Stabilization Fund, which was established under the Gold Reserve Act of 1934. The program collected an estimated $1.2B in fees No claims were paid Asset-Backed Commercial Paper Money Market Fund Liquidity Facility (AMLF) Federal Reserve Program to facilitate liquidity in the asset-backed commercial paper market Sources: U.S. Department of the Treasury, FINRA, Investment Company Institute, Federal Reserve 11
Government Intervention Programs Efforts to stabilize the economy On October 3, 2008, the Emergency Economic Stabilization Act of 2008 was enacted with the goals of stabilizing the financial system and restoring investor confidence in the financial markets Troubled Asset Relief Program (TARP) Capital Purchase Program (CPP) American International Group (AIG) Investments Targeted Investment Program (TIP) Automotive Industry Financing Program (AIFP) Housing programs, including Making Home Affordable (MHA) Temporary Liquidity Guarantee Program (TLGP) Federal Reserve s Commercial Paper Funding Facility Source: Office of Management and Budget, Federal Reserve 12
Sponsor Support Money market mutual funds Per the SEC, there have been 300 occasions when sponsors have voluntarily pledged or provided support to maintain a $1.00 NAV in their money market funds Trigger events included: 1989 default of Integrated Resources commercial paper 1990 default of Mortgage Realty & Trust and MNC Financial Corp commercial paper 1991 seizure of Mutual Benefit Life Insurance Company 1994 bankruptcy of Orange County, California 1999 downgrade and following supervisory changes of American General Life Insurance Co 2001 default of Pacific Gas & Electric and Southern California Edison Co. commercial paper 2007 to 2008 default, liquidation and valuation issues of Lehman Brothers, AIG, ABCP programs and other financial sector debt securities Source: SEC 13
2010 Money Market Fund Reform Liquidity and transparency enhancements Increased NAV transparency More timely holdings disclosure Introduction of weighted average life (WAL), limited to 120 days Reduction of allowable weighted average maturity (WAM) to 60 days Stress tests Introduction of liquidity requirements 10% minimum overnight liquidity 30% minimum weekly liquidity Source: SEC 14
Current Money Market Fund Proposals
Additional Reform Proposals Regulators and industry participants Securities and Exchange Commission Floating NAV Liquidity holdback on shareholder redemptions Capital buffer Financial Stability Oversight Council Systemically Important Nonbank Financial Institution (SIFI) designation for funds Direction to the SEC that they must take action Federal Reserve Banking capital requirements Industry participants No change Liquidity bank Building capital requirements Sources: SEC, Reuters 16
Current Market Environment
Current Market Environment Factors affecting short-term fixed income Slowed economic growth worldwide Domestic employment and economic numbers U.S. fiscal cliff could cause possible recession Global economic growth concerns China and Europe in recession Global political tension European concerns European sovereign and bank funding European Central Bank lowered deposit rate for banks to 0% Increases speculation around Interest on Excess Reserves (IOER) in U.S. Future Federal Reserve accommodation Effects of Operation Twist Implications for extending the language for 0-25 basis points fed funds target range Impact of Quantitative Easing 3 (QE3) on money markets Possibility of IOER rate cut 18
Current Market Environment Factors affecting short-term fixed income, continued Fate of Transaction Account Guarantee (TAG) Program Regulatory reform Schapiro proposal / committee rebuttal Diverging regulatory demands (money funds increase liquidity and shorten duration vs. banks encouraged to utilize longer-term funding) Implications of U.S. elections Direction of fiscal policy Composition of Federal Open Markets Committee Impact of Bernanke term expiration in January of 2014 19
Current Market Environment Factors affecting short-term fixed income, continued Changes to Fannie Mae & Freddie Mac credit support agreement Rating agency risk Possible downgrade of U.S. sovereign debt if fiscal issues are not resolved Volatility of NRSRO ratings and methodologies Declining issuance / product in 2a-7 universe Banks have reduced funding needs European Central Bank s Long Term Refinancing Operations Shrinking U.S. balance sheets Increased deposits Aversion to core European bank names 20
Strategy
Strategy Yield Curve and Duration Fed s stated intent is to keep federal funds rate exceptionally low through mid-2015 Risk remains skewed toward additional monetary easing despite the Fed s open-ended commitment to purchase $40 billion in mortgage-backed securities per month Reduction in IOER and QE3 are negatives for short-term yields Operation Twist is a positive for short-term yields, but is set to expire at the end of the year Short-Term Yield Curve is upward sloping although flatter in recent weeks 2-3 year bond prices are at less risk of a Fed-induced sell-off "Roll-down" opportunities persist but are muted by flatter yield curve Given the Fed's outlook, in the short end of the yield curve the risk of a significant rise in yields sparked by inflation concerns or a strengthening in economic growth is concentrated in bonds maturing in 2015 and beyond, arguing for a bullet portfolio strategy
Strategy Asset Sectors U.S. Treasuries Current yields are at low end of our trading band Threat of additional QE or a reduction on IOER is driving decline in yields U.S. Agencies Agency spreads have tightened on both stronger demand and lower supply Agency callable spreads are tighter but still represent selective value relative to their bullet counter-parts Fannie Mae and Freddie Mac continue to enjoy strong demand for their debt U.S. Agency MBS Agency MBS represent the best yield opportunities in the market Pre-pay speeds have increased on low mortgage interest rates and HARP program Shorter-dated CMOs require extensive analysis to determine appropriateness of investment
Strategy Asset Sectors Corporates Industrial issuers have strengthened balance sheets and cash positions U.S. banks have increased capital and liquidity positions Current credit spreads are relatively tight but still represent value vs. other asset classes Foreign issuers represent value while avoiding eurozone banks Asset-backed Securities (ABS) Auto, equipment lease and credit card-backed ABS are favored Tighter ABS spreads make sector more valuable as a portfolio diversifier than a yield enhancement strategy Municipals Greater opportunities with dramatic increase in new issuance in 2012 Increased headline risk with recent municipal bankruptcy filings
Questions
Sources and Speaker Bio
Sources Investment Company Institute, Money Market Funds in 2012, History of Money Market Funds, February 13, 2012 Investment Company Institute, Money Market Funds in 2012, SEC s 2010 Money Market Reforms are Working, July 17, 2012 Federal Deposit Insurance Corporation, Effects of Interest Rates on Money Market Mutual Funds, May 19, 2004 Investment Company Institute, Money Market Funds in 2012, Money Markets Funds: What Really Happened in the 2008 Financial Crisis, February 14, 2012 SIFMA, Federal Government Support Programs Resource Center (http://www.sifma.org/issues/regulatory-reform/federal-government-supportprograms/overview/) Office of Management and Budget, OMB Report under the Emergency Economic Stabilization Act, Section 202, August 31, 2012 U.S. Department of the Treasury Press Release, Treasury Announces Temporary Guarantee Program for Money Market Funds, September 29, 2008 FINRA, Treasury s Guarantee Program for Money Market Mutual Funds: What You Should Know, July 9, 2010 Investment Company Institute, Money Market Funds in 2012: Money Market Funds Are Not Guaranteed, February 27, 2012 27
Sources Continued Federal Reserve, Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility, updated February 5, 2010 Securities and Exchange Commission, Mary Schapiro s testimony on Perspectives on Money Market Reforms, June 21, 2012 Securities and Exchange Commission, 17 CFR Parts 270 and 274,RIN 3235- AK33, Money Market Reform, February 23. 2010 Reuter s, U.S. Treasury Weighs Money Market Reforms, Faces Hurdles, August 23, 2012 28
Joseph M. Ulrey III Chief Executive Officer Joe serves as Chief Executive Officer and President of U.S. Bancorp Asset Management and President of First American Funds. Prior to his appointment as Chief Executive Officer and President in January 2011, Joe served as the Chief Financial Officer and Head of Technology and Operations, overseeing finance, mutual fund treasury, securities lending, technology and investment operations. He is a member of the Investment Practices Committee and the Internal Compliance Controls Committee. Joe began his financial industry career in 1981 for U.S. Bancorp. He joined U.S. Bancorp Asset Management in 1991. He previously oversaw credit research, money market mutual funds, quantitative products and risk management. Prior to working at U.S. Bancorp Asset Management, Joe headed asset/liability management, planning and analysis and strategic. Joe received a B.A. from Macalester College and an M.B.A. from the University of Chicago. Joe serves on the finance committee of the YMCA of the Twin Cities. 29
Disclosure U.S. Bancorp Asset Management, Inc. is a registered investment advisor and subsidiary of U.S. Bank National Association. This information represents the opinion of U.S. Bancorp Asset Management, Inc. and is not intended to be a forecast of future events, a guarantee of future results, or investment advice. It is not intended to provide specific advice or to be construed as an offering of securities or a recommendation to invest. The factual information has been obtained from sources believed to be reliable but is not guaranteed as to accuracy or completeness. Past performance does not guarantee future results. U.S. Bank is not responsible for and does not guarantee the products, services, or performance of its affiliates and third parties. 09/2012 30