New Ratings Scale For Money Funds Won't Come Easy

Investment ratings agency Moody's Corp. (MCO) plans to replace its AAA ratings for money-market mutual funds with a more-detailed grading system, but some in the fund industry give the idea low marks.

Officials at several leading funds sponsors expressed some discomfort with proposals to create a new ratings scale ranging from MF1 to MF4, in part because it goes against industry practice and changes what investors are used to--they say that many investment mandates, for example, require that an investment has to be rated AAA.

But Moody's said the change is intended to highlight the risks of money-market funds more clearly. Under the new system, Moody's would give greater importance to factors such as the capacity of the fund to meet unexpected redemptions and the ability and willingness of the parent company to bail out a fund should that become necessary.

Moody's said the changes would help investors understand not just credit risks of money-market funds, but also liquidity risks and broader market risks.

"There are risks that are unique to money-market funds and we're looking to provide additional information for investors," said Dan Serrao, senior vice president at Moody's global managed investments group, who helped devise the new system.

The changes come in the wake of the events of late 2008, when problems in the markets following the demise of Lehman Brothers Holdings caused panic among investors. One money-market fund, Reserve Primary Fund, which held Lehman debt, said it had "broken the buck"--the net asset value of each share had fallen below $1--a rarity in the money-market industry. The news triggered runs on many money-market funds as panicked investors withdrew their cash for fear of losing money. This in turn pressured the funds, which were forced to sell holdings into an already illiquid market.

While money-market funds don't promise to keep their net asset value at $1 a share, the vast majority of investors invest in the funds on the understanding that the fund's value will never fall below $1 a share.

Among the changes that Moody's hopes will provide guidance to investors: while it has always considered a fund's parent's ability to help out a troubled fund, that factor is given greater weight and the methodology has been tweaked to further quantify the parent's ability and willingness to support the fund.

Given that the risks of these funds go beyond credit risks, added Serrao, using a credit-rating system to grade the funds isn't the best approach.

"As we have seen, if one of a sponsor's liquidity funds experiences problems, it is very possible that other funds it manages will experience similar problems," said Moody's in a paper last week announcing the proposals. "Without sufficient liquidity, even a motivated sponsor may find it difficult to provide timely support in a stress scenario."

The harshest criticism of the Moody's plan came from Peter Crane, founder of Crane Data, which tracks money-market funds.

"These proposals are going down [among fund companies] like a lead zeppelin," said Peter Crane, founder of Crane Data. "Tweaking the ratings criteria is one thing, but moving away from AAA-ratings is sacrilege."

"It will take years or decades to condition people to this new system," he added.

None of the firms MarketWatch spoke to was willing to comment openly on the issue, though many of them planned to offer their critiques directly to Moody's this week. One money-market fund manager said he was "very much against" Moody's judging fund sponsors in such a way.

However, none of them opposed the proposal as strenuously as Crane, though some sympathized with his stance.

Crane said he believed there was industry objection to the range of ratings available, arguing that five tiers seem unnecessary--according to Crane Data just six taxable money-market funds are now rated A--two levels below AAA--and none have a rating below that. Crane questioned whether funds would pay to be given a lower rating.

Moody's defended its proposals.

"We've spent a lot of time thinking about this," said Serrao. "We believe there's a need for differentiation among funds."

"What we are proposing is a big change, but one that we think will ultimately be of benefit to investors and the industry," he said. "We expected to have a dialogue with the industry and we hope that it's a two-way dialogue."

Crane questioned how Moody's would determine whether a fund's parent company could or would step in and support it.

"You can't openly state that you'd support a fund since funds are technically their own companies, so how will they know?" he asked. "They'd only know from those companies that have provided support before, in which case you're rewarding the ones who have previously gotten into trouble."

Henry Shilling, senior vice president at the global managed investments group at Moody's, said Moody's would use its own judgment about a parent company's ability and willingness to support a fund. But, he said, "There's a long and established track record of parental support."

"Parent companies have been stepping in for as long as the money-market fund industry has existed," Shilling said.

Moody's said the proposals are open to public response until Nov. 5. Shilling and Serrao said they hope to hear from fund firms, regulators and investors.