How can money-market funds holding the securities that General American Life Insurance defaulted on still be selling for $1 a share?
OK, I wrote that one.
And I had a pretty good idea of what the answer was before I started looking into it.
But I thought that in light of widespread exposure to the company's problems through money-market funds, a full explanation would be a good idea. Even though it seems unlikely that any money fund investor will lose money.
As most of you probably know, a money-market fund is a species of fixed-income mutual fund. The lowest-risk species, they are managed to maintain a $1 share price, and they pay an interest rate that tracks short-term rates like the fed funds rate and Treasury bill yields. As part of an investment portfolio, they are not bonds, but cash, since the value of the principal doesn't fluctuate.
fluctuate, I should say. Money-market funds intend, but don't guarantee, that they will maintain a net asset value of $1 a share. However only one money-market fund has ever "broken the buck," and it was an institutional fund that eventually repaid its investors 96 cents on the dollar. "No retail investor has ever lost money in a money-market fund," says Peter Crane, vice president and managing editor at Ashland, Mass., money fund tracker
IBC Financial Data
How do money-market funds maintain a constant share price? By investing only in the safest, least-volatile (in the grand scheme of things) securities available. And that's not just by choice. An entire section of the Investment Company Act of 1940, which regulates mutual funds, sets the credit quality, maturity and diversification standards for money-market funds. It's called Rule 2a-7, and it and its amendments drone on for more than100 pages.
Broadly, Rule 2a-7 requires money-market funds to have 95% of their assets in the securities that carry the highest ratings from credit rating agencies like
Moody's Investors Service
Standard & Poor's
. It caps the amount of assets that can be invested with any one issuer at 5% for highest-rated securities, and 1% for other securities. It caps the amount of illiquid securities a fund can hold at 10%. Maturity-wise, a money fund can invest only in securities due in less than 13 months and must maintain an average maturity of no more than 90 days.
What types of securities do money-market funds invest in? Talking just about taxable funds (municipal money-market funds obviously invest in short-term or floating-rate munis), a typical money-market fund holds some combination of Treasury bills and notes; fixed- and floating-rate federal government agency notes, taxable municipal obligations and corporate notes and bonds; corporate commercial paper, asset-backed securities and bank deposits.
The higher a yield a money-market fund carries, the likelier it is that the fund is forswearing Treasury securities, whose yields are lowest because there's no credit risk involved, in favor of higher-yielding corporate obligations.
Which leads us to the problem that nearly 40 money-market funds now have with $6.8 billion of funding agreements -- a species of corporate note -- they purchased from General American Life Insurance. This Missouri company last week came under administrative supervision by the state insurance department after finding itself unable to make payment on the funding agreements. Here's a chart showing some of the biggest holders, according to their latest semiannual SEC filings. If you own one, don't panic. Just read on.
Funding Agreements Defined
Funding agreements? If you recall the recent
column on stable value funds, you'll know that many life insurance companies sell an investment that is essentially comparable to a bank CD. Unfortunately named GICs (stands for guaranteed investment contracts), the product takes an investor's money for a fixed period of time and pays a fixed interest rate on it. Simple as that. GICs are commonly used by issuers of bonds and notes as a place to park the proceeds of an offering until they are needed.
Funding agreements aren't GICs, but they are typically also sold out of a life insurance company's stable value operation. They differ from GICs in two key respects: Their interest rates are floating, rather than fixed, and they may come with an early redemption option for the investor.
Funding agreements pay an interest rate typically linked to Libor, the London interbank offered rate. The insurance company's long-term rating determines how much more than Libor its agreements pay. A company with a high rating, say double-A (on a scale where triple-A is highest), may be able to sell funding agreements that pay anywhere from 5 to 15 basis points over Libor. Until last month, General American was rated A2 by Moody's and double-A-minus by Standard & Poor's. I haven't been able to find out from the company what kind of spread over Libor it was paying on its funding agreements, but market participants have said it ranged between 20 and 30 basis points, even though the funding agreements (until recently) carried the highest short-term ratings.
The early redemption option is also known as a put option. Investors in General American's funding agreements -- i.e., the money-market funds -- in many cases had the right to "put" their funding agreements back to the company and receive their money back within a fixed number of days. In exchange for that option, they received a lower interest rate than they would have on a nonputable agreement. (The rates discussed in the last paragraph are for nonputable agreements.)
There are four basic types of funding agreements, almost all of which mature in one year: Nonputables, 90-day putables, 30-year putables and seven-day putables. Much of General American's business was in seven-day putables. IBC's Crane says the company was "far and away" the biggest issuer of seven-day putables.
Without a put option, funding agreements have to be counted among the illiquid securities that can make up only 10% of a money-market funds assets. With the option, they are considered liquid.
Events Triggered by Downgrade
General American ran into trouble at the end of July when
downgraded its credit rating. (
Standard & Poor's
followed several days later.) General American had been selling funding agreements jointly with
ARM Financial Group
. Earlier in July, General American agreed to take over ARM's half of the business.
That recapture of assets and liabilities from ARM triggered the Moody's downgrade. The agency's concern was that with the recapture of assets from ARM, General America no longer had enough liquidity on the asset side of its business -- in the securities it owned -- to meet the volume of redemption demands it might receive in the event that holders of its funding agreements decided en masse to exercise their puts.
Which they did following the Moody's downgrade. Moody's doesn't have a short-term rating on General American, but its downgrade of the company's long-term rating to A3 from A2 was enough to make hearts pound at the money-market funds that held the funding agreements. They exercised their puts en masse, and on the seventh day, Aug. 10, General American couldn't pay.
"This appears to be a classic example," writes Kathy Shanley of
, a corporate debt newsletter, "of a mismatched funding book, with short-term liabilities (given the 7-day put option) used to fund a longer-term, less-liquid investment portfolio."
In other words, General American either shouldn't have owned so many illiquid securities, or it shouldn't have made so many of its funding agreements putable in 7 days. IBC's Crane says General American's predicament appears to be an isolated case. The other big issuers of funding agreements --
-- have better credit ratings than General America had, and much less exposure to seven-day puts.
Maintaining the Buck
What now? The money-market funds holding the General American agreements are watching and waiting for the company to figure out how it is going to come up with the money to at least return investors' principal when the funding agreements reach final maturity, perhaps through some sort of partnership.
In the meantime, it's crucial for the money-market funds not to break the buck. The problem is, the funds have to put a value on the General American agreements when they calculate their net asset values every day, and at the moment, the securities arguably have no value.
A fund with a small enough position in the securities as a percentage of its assets could value them at zero without breaking the buck. For example, a fund that valued 0.5% of its assets at zero would still be worth 99.5 cents a share, which rounds to a dollar. ("It happens every day that the $1 NAV is just smoke and illusion anyway," Crane says, meaning that actual NAVs merely round to a dollar, with most of the differences appearing in the third decimal place.)
But a fund with a 5% position in a security would be worth 95 cents a share if it valued the position at zero. Needless to say, funds with large positions in General American funding agreements aren't valuing the agreements at zero. And no one's saying they should; the fund companies say they expect to be repaid in full, and perhaps they will. And even if they don't, they're likely to do whatever's necessary, including reimbursing the funds for the securities, to avoid the stigma of breaking the buck.
Few fund companies are willing to discuss how they are valuing the General American agreements.
Alliance Capital Management
, which holds a total of $570 million of the agreements in four money-market funds, has announced that it has obtained letters of credit that will prevent the funds' NAVs from dropping below $1 in the event General America fails to pay. On that basis, it continues to value the securities at face value. Alliance yesterday received a 10% repayment from General America.
A spokesman for
Chase Asset Management
, evidently the second-largest money-market fund holder of the securities with $549 million (Chase isn't confirming the amount) would only say: "Our valuation of the security is such that the valuation of the fund is not impaired."
While it's unlikely at this stage that any money-market fund investor will ever feel any of the fallout from the General American debacle, you can be sure that the valuation of the security is going to keep a great many people involved in money-market fund management very busy for a very long time.
Send your questions and comments, along with your full name, to
TSC Fixed-Income Forum aims to provide general bond information. Under no circumstances does the information in this column represent a recommendation to buy or sell bonds, funds or other securities.
As originally published, this story contained errors. Please see
Corrections and Clarifications.