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  1. 1. Stress in Credit Markets: Implications for Short Term Investing FOR USE WITH FINANCIAL PROFESSIONALS ONLY. NOT FOR USE WITH THE GENERAL PUBLIC. AFP of Atlanta Education Day --- August 19, 2009 Kevin H. Brown, CIMA Senior Vice President, Dreyfus Investments A Division of BNY Mellon Asset Management
  2. 2. Outline <ul><ul><li>I. Credit Crisis: Genesis and Unraveling </li></ul></ul><ul><ul><ul><li>What is “credit” </li></ul></ul></ul><ul><ul><ul><li>Cause vs. effect </li></ul></ul></ul><ul><ul><ul><li>Timeline </li></ul></ul></ul><ul><ul><li>II. Short Term Investing: Participants’ Reactions </li></ul></ul><ul><ul><ul><li>Federal Government </li></ul></ul></ul><ul><ul><ul><li>Issuers </li></ul></ul></ul><ul><ul><ul><li>Investors </li></ul></ul></ul><ul><ul><ul><li>Asset Managers & Securities Dealers </li></ul></ul></ul><ul><ul><ul><li>Industry Assets </li></ul></ul></ul><ul><ul><li>III. What’s Changed: Implications for Short Term Investing </li></ul></ul><ul><ul><ul><li>Treasury Due Diligence </li></ul></ul></ul><ul><ul><ul><li>Risk factors Redefined </li></ul></ul></ul><ul><ul><ul><li>Regulatory Proposals </li></ul></ul></ul>
  3. 3. I. Credit Crisis: Genesis and Unraveling
  4. 4. Genesis of Credit Crisis <ul><li>What does “credit” mean? </li></ul><ul><ul><li>Barron’s Financial Guides, 2007 edition: </li></ul></ul><ul><ul><ul><li>“ At its loftiest, it is defined in Dun & Bradstreet’s motto: </li></ul></ul></ul><ul><ul><ul><li>‘ Credit: Man’s Confidence in Man’” </li></ul></ul></ul><ul><ul><li>Quantitative vs. Qualitative </li></ul></ul><ul><ul><li>This crisis: significant qualitative factors </li></ul></ul>
  5. 5. Genesis of Credit Crisis CAUSE EFFECT Slow-motion collapse, recession Subprime borrower paying habits Exaggerated crisis amplitude Excessive investment bank leverage Buck-passing of risk Securitization Inaccurate ratings; risks remain unidentified Rating Agency Policies Improper issuance & risk calibration Lax mortgage issuer regulation Credit wrongly extended, risk escalation Borrower Behavior Credit wrongly extended Lowered Consumer Credit Standards Artificial price escalation of leveraged assets, exaggerated purchase capacity, artificial demand Low Interest Rates Credit forcibly extended to wrong obligors Community Reinvestment Act
  6. 6. Genesis of Credit Crisis <ul><li>Results: </li></ul><ul><ul><li>Created updraft of ever-escalating house prices </li></ul></ul><ul><ul><li>Housing development & construction rose to meet demand </li></ul></ul><ul><ul><li>Artificial and unsustainable support of both supply and demand </li></ul></ul><ul><ul><li>Many ignored what was to many an obvious bubble in real estate price/demand </li></ul></ul><ul><li>And then the bubble started to burst. </li></ul>
  7. 7. Unraveling and Unwinding
  8. 8. Unraveling and Unwinding <ul><ul><li>Phase 1: New Century June 2007 </li></ul></ul><ul><ul><ul><li>Investor flight to quality </li></ul></ul></ul><ul><ul><ul><li>Fed begins easing </li></ul></ul></ul><ul><ul><ul><li>Quick acceptance of lower yields </li></ul></ul></ul><ul><ul><li>Phase 2: Broader Collateralized Debt Obligation (CDO) & Collateralized Mortgage Obligation (CMO) problems (Quantitative vs Qualitative judgments) </li></ul></ul><ul><ul><li>Phase 3: Structured Investment Vehicle (SIV) * Commercial Paper issuers with heavy CDO & CMO holdings…October 2007 </li></ul></ul><ul><ul><li>Phase 4: State Pools, Common Fund </li></ul></ul>*A Structured Investment Vehicle is a triple A-rated leveraged investment vehicle that seeks to maximize spread income through proactive management of liabilities and assets.
  9. 9. Unraveling and Unwinding <ul><ul><li>Phase 5: Asset-Backed Commercial Paper: questions arise </li></ul></ul><ul><ul><li>sponsor? transparency? LOC? </li></ul></ul><ul><ul><li>Phase 6: Municipal securities: bank LOCs </li></ul></ul><ul><ul><li>Phase 7: Auction Rate Securities: Failed Auctions Jan 2008 </li></ul></ul><ul><ul><ul><li>Merrill, UBS, Citi: $18bb, $11bb, $8bb; sand bags relative to market </li></ul></ul></ul><ul><ul><ul><li>$330bb market </li></ul></ul></ul><ul><ul><ul><li>morphed into classic bank run </li></ul></ul></ul><ul><ul><li>Phase 8: Bear Stearns in Mar 2008; broader Repurchase Counterparty Questions </li></ul></ul><ul><ul><ul><li>term or overnight? </li></ul></ul></ul><ul><ul><ul><li>credit review of counterparty? </li></ul></ul></ul>
  10. 10. Unraveling and Unwinding <ul><ul><li>Phase 9: Contraction of Commercial Paper issuance </li></ul></ul><ul><ul><li>Phase 10: Long list of AAA’s fall to the axe </li></ul></ul><ul><ul><li>Phase 11: The crescendo (the latest) </li></ul></ul><ul><ul><ul><li>Lehman; September 15, 2008 </li></ul></ul></ul><ul><ul><ul><li>Obligor to many; Reserve Prime fund broke buck </li></ul></ul></ul><ul><ul><ul><li>1.2%; $785mm face value; flood of redemptions; then runs </li></ul></ul></ul><ul><ul><ul><li>Public perception of Bruce Bent; rhetoric </li></ul></ul></ul><ul><ul><ul><li>Huge fund; many institutional investors affected </li></ul></ul></ul><ul><ul><ul><li>Firm size: capital support not an option </li></ul></ul></ul>
  11. 11. Unraveling and Unwinding <ul><li>CORE ISSUES? </li></ul><ul><ul><li>People didn’t pay their bills </li></ul></ul><ul><ul><li>Violated D & B’s “essence of credit”: Man’s confidence in Man </li></ul></ul><ul><ul><li>Liquidity Problems, Valuation Problems </li></ul></ul><ul><ul><li>Will I get paid? </li></ul></ul>
  12. 12. Unraveling and Unwinding <ul><li>Phase 12: Era of the marriage of the titans & acronym proliferation; </li></ul><ul><li>heightened credit market dysfunction </li></ul><ul><ul><li>Private </li></ul></ul><ul><ul><ul><li>B of A & Merrill Lynch </li></ul></ul></ul><ul><ul><ul><li>JP Morgan & WaMu </li></ul></ul></ul><ul><ul><ul><li>Wells & Wachovia </li></ul></ul></ul><ul><ul><li>Public (selected) </li></ul></ul><ul><ul><ul><li>TARP </li></ul></ul></ul><ul><ul><ul><li>CPFF </li></ul></ul></ul><ul><ul><ul><li>SEC NO Action Letter </li></ul></ul></ul><ul><ul><ul><li>TLGP </li></ul></ul></ul><ul><ul><ul><li>MMIFF </li></ul></ul></ul><ul><ul><ul><li>Spending Stimulus </li></ul></ul></ul>
  13. 13. Unraveling and Unwinding <ul><li>Phase 13: </li></ul><ul><ul><li>Continued Fed tightening, persistently low yields </li></ul></ul><ul><ul><li>Money Market Fund Reaction: Trading restrictions, Fee waivers </li></ul></ul><ul><ul><li>Dec 2008: Treasurys trading at negative yields </li></ul></ul><ul><ul><ul><li>Sample investment opportunity </li></ul></ul></ul><ul><ul><ul><ul><li>You give me $1,000,000 </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>And 60 days later, I’ll give you $999,833.33 </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>- $166.67 HPR </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Negative 1 bp return (annualized) </li></ul></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Treasury fund balances peaked Nov 08 at $720bb; $550bb July 2009 </li></ul></ul></ul></ul></ul>
  14. 14. Unraveling and Unwinding <ul><ul><li>Issuing credit is a slow process </li></ul></ul><ul><ul><li>Unraveling is a slow process </li></ul></ul><ul><ul><li>Yet Confidence evaporated quickly </li></ul></ul><ul><ul><li>Confidence rebuilding is a slow process </li></ul></ul>
  15. 15. II. Short Term Investing Participants Who Did What?
  16. 16. Short Term Investing: Participants’ Reactions <ul><ul><li>Federal Government </li></ul></ul><ul><ul><li>Issuers </li></ul></ul><ul><ul><li>Investors </li></ul></ul><ul><ul><li>Asset Managers, Securities Dealers, Capital Markets </li></ul></ul><ul><ul><li>Industry Assets </li></ul></ul>
  17. 17. Short Term Investing: Participants’ Reactions <ul><li>1. Federal Government </li></ul><ul><ul><li>TARP </li></ul></ul><ul><ul><li>Treasury Guarantee Program for mmfs </li></ul></ul><ul><ul><li>CPFF </li></ul></ul><ul><ul><li>SEC NO Action Letter </li></ul></ul><ul><ul><li>TLGP </li></ul></ul><ul><ul><li>MMIFF </li></ul></ul>
  18. 18. Short Term Investing: Participants’ Reactions <ul><li>2. Issuers of Short Term Investments </li></ul><ul><ul><li>Some had to pay more as rates spiked </li></ul></ul><ul><ul><li>Some lost financing altogether (CP contraction from $2.5 to $1.6 trillion in 5 months) </li></ul></ul><ul><ul><li>Bank lines reduced </li></ul></ul><ul><ul><li>Typical short-term financing vehicles became suddenly more expensive </li></ul></ul><ul><ul><li>Cut growth, shed costs </li></ul></ul>
  19. 19. Short Term Investing: Participants’ Reactions <ul><li>3. Investors </li></ul><ul><ul><li>From Sept 2008 onward, steep risk retrenchment; abated in 2009 </li></ul></ul><ul><ul><li>Treasury rally in 2009 </li></ul></ul><ul><ul><li>Due Diligence Process Changes (details to come) </li></ul></ul><ul><ul><li>Piled into money market funds (certain funds; certain families) </li></ul></ul>
  20. 20. Short Term Investing: Participants’ Reactions <ul><li>4. Asset Managers, Securities Dealers, Capital Markets </li></ul><ul><ul><li>Winners and losers among firms </li></ul></ul><ul><ul><li>Industry asset explosion </li></ul></ul><ul><ul><li>Despite bank deposit growth & very competitive CD rates </li></ul></ul>
  21. 21. Short Term Investing: Participants’ Reactions Money Market Funds Net New Cash Flow – ($ Billions) Source: Investment Company Institute & Crane Data’s “Money Fund Intelligence Reports,” various dates
  22. 22. Short Term Investing: Participants’ Reactions 1,351 2,271 2,285 1,845 1,613 2,048 1913 2,052 3,074 3830 3,701 2,358 Assets in Taxable and Tax-Exempt Money Funds (Year-End; $ Billions) Source:’s “Money Market Insight,” multiple issues from 2009
  23. 23. Short Term Investing: Participants’ Reactions U.S. Taxable MMF Assets and Annual Returns
  24. 24. Short Term Investing: Participants’ Reactions U.S. Tax-Exempt MMF Assets and Annual Returns
  25. 25. Short Term Investing: Participants’ Reactions Source: Federal Reserve’s “Flow of Funds” Tables, Q1 2009 Percentage of Businesses’ cash held in money market funds
  26. 26. Short Term Investing: Participants’ Reactions Organizations’ Short-Term Investments Source: AFP 2009 Liquidity Survey Allocation Permitted Use
  27. 27. Short Term Investing: Participants’ Reactions <ul><ul><li>Top 80 US asset managers </li></ul></ul><ul><ul><ul><li>(any manager < $2bb in cash) </li></ul></ul></ul><ul><ul><li>$7.87 trillion AUM in cash & cash equivalents at 12-31-08* </li></ul></ul><ul><ul><li>Top 10 Assets under Mgmt: </li></ul></ul><ul><ul><ul><li>$3,619,522,000,000 </li></ul></ul></ul><ul><ul><li>Top 10 Firms’ Market Share: 46% </li></ul></ul><ul><ul><li>*Institutional Investor, July/August 2009 issue </li></ul></ul>209.7 Charles Schwab 10 227.9 Wells Fargo 9 241.0 Northern Trust 8 285.8 Goldman Sachs 7 338.4 BlackRock 6 356.7 Federated 5 386.0 BNY Mellon (Dreyfus) 4 468.5 State Street 3 592.6 Fidelity 2 612.8 JP Morgan 1 Cash & Equiv. AUM ($billion) Firm Rank
  28. 28. Short Term Investing: Participants’ Reactions <ul><ul><li>$3.690 trillion AUM in all domestic money market funds at 7-31-09* </li></ul></ul><ul><ul><li>Top 10 Firms’ AUM: </li></ul></ul><ul><ul><ul><li>$2,520,500,000,000 </li></ul></ul></ul><ul><ul><li>Top 10 Firms’ Market Share: 68% </li></ul></ul><ul><ul><li>*Imoneynet “Money Fund Analyzer as of 7-31-09 </li></ul></ul><ul><ul><li>**Excludes offshore money market fund balances, if any </li></ul></ul>120.3 Columbia (B of A) 10 121.7 Wells Fargo 9 186.5 Schwab 8 192.0 Vanguard 7 216.9 Goldman Sachs 6 240.8 BlackRock 5 246.0 Dreyfus (BNY) 4 294.2 Federated 3 390.6 JP Morgan 2 511.5 Fidelity 1 MMF AUM** Firm Rank
  29. 29. III. What’s Changed? Implications for Short Term Investing <ul><ul><li>Treasury Due Diligence Process </li></ul></ul><ul><ul><li>Risk Factors Redefined </li></ul></ul><ul><ul><li>Regulatory Proposals </li></ul></ul>
  30. 30. Treasury Due Diligence Process <ul><li>People, Process, Philosophy </li></ul><ul><ul><li>People: </li></ul></ul><ul><ul><ul><li>Tenure of staff </li></ul></ul></ul><ul><ul><ul><li>Professional background </li></ul></ul></ul><ul><ul><ul><li>Credit & Sector expertise </li></ul></ul></ul><ul><ul><ul><li>Compensation </li></ul></ul></ul><ul><ul><ul><li>Reporting structure </li></ul></ul></ul>
  31. 31. Treasury Due Diligence Process <ul><li>People, Process, Philosophy </li></ul><ul><ul><li>Process: </li></ul></ul><ul><ul><ul><li>Risk Management: identify all </li></ul></ul></ul><ul><ul><ul><li>Credit Criteria </li></ul></ul></ul><ul><ul><ul><li>Concentration rules </li></ul></ul></ul><ul><ul><ul><li>Creation of Buy List </li></ul></ul></ul><ul><ul><ul><li>Sector Focus </li></ul></ul></ul><ul><ul><ul><li>Team Decision Making </li></ul></ul></ul><ul><ul><ul><li>Capital Commitments Committee </li></ul></ul></ul><ul><ul><ul><li>Limits definitions: issuer, amount, tenor </li></ul></ul></ul>
  32. 32. Treasury Due Diligence Process <ul><li>People, Process, Philosophy </li></ul><ul><ul><li>Philosophy: </li></ul></ul><ul><ul><ul><li>Disciplined investment approach </li></ul></ul></ul><ul><ul><ul><li>Emphasis on fundamentals: liquidity, ratings, structure </li></ul></ul></ul><ul><ul><ul><li>2a-7 approved list should have large, liquid issuers with multiple dealer support </li></ul></ul></ul><ul><ul><ul><li>Risk Budgeting </li></ul></ul></ul>
  33. 33. Treasury Due Diligence Process <ul><li>Portfolio Construction : What to ask your asset manager </li></ul><ul><ul><li>Hierarchy: capital preservation, liquidity, yield </li></ul></ul><ul><ul><li>Investment strategy: global macro-economic indicators, Federal Reserve policy, current credit markets </li></ul></ul><ul><ul><li>Yield curve, Fed actions: cornerstones of WAM strategy </li></ul></ul><ul><ul><ul><li>Long and wrong </li></ul></ul></ul><ul><ul><ul><li>Short and under </li></ul></ul></ul><ul><ul><li>Pre-trade and post-trade compliance </li></ul></ul><ul><ul><li>Stress Tests </li></ul></ul><ul><ul><li>Active management of cash positions </li></ul></ul><ul><ul><li>Consistent sell discipline </li></ul></ul><ul><ul><li>Downgrade policy </li></ul></ul>
  34. 34. Risk Factors Redefined <ul><li>… .For Investors in Money Market Funds & Separate Accounts </li></ul>
  35. 35. Risk Factors Redefined <ul><li>Investment Manager Analysis </li></ul><ul><ul><li>Performance History </li></ul></ul><ul><ul><li>Security Selection Track Record </li></ul></ul><ul><ul><li>Fund Closings, large trade warnings & acceptance </li></ul></ul><ul><ul><li>Credit Analyst/Portfolio Manager Accessibility </li></ul></ul><ul><ul><li>Holdings Transparency </li></ul></ul><ul><ul><li>Business structure of Sponsor </li></ul></ul><ul><ul><li>Size of asset management in relation to firm </li></ul></ul><ul><ul><li>Length of participation in asset management </li></ul></ul><ul><li>Fund Analysis </li></ul><ul><ul><li>WAM strategy & results </li></ul></ul><ul><ul><li>Quality of credit research </li></ul></ul><ul><ul><li>Tolerance for fringe asset classes </li></ul></ul><ul><ul><li>Counterparty evaluation </li></ul></ul>
  36. 36. Risk Factors Redefined <ul><li>Shareholder Base </li></ul><ul><ul><li>Retail vs institutional client base </li></ul></ul><ul><ul><li>Access vehicle: portals, intermediaries, direct </li></ul></ul><ul><li>Systemic Factors </li></ul><ul><ul><li>Participation in government insurance & liquidity programs </li></ul></ul><ul><ul><li>Evolving regulation structure (proposed 2a-7 amendments) </li></ul></ul><ul><ul><li>Investor perception </li></ul></ul><ul><ul><li>Rumors and innuendo </li></ul></ul>
  37. 37. Risk Factors Redefined <ul><ul><li>Bottom line: How is the Treasury’s process changing? </li></ul></ul><ul><ul><li> Implementing Increased Due Diligence </li></ul></ul><ul><ul><li>Limits by fund, fund family, ratings, bank-owned funds </li></ul></ul><ul><ul><li>Scrubbing Holdings </li></ul></ul><ul><ul><li>Holding Aggregation </li></ul></ul><ul><ul><li>Portal Migration ($200bb; 8% of institutional mmf AUM)* </li></ul></ul>*Crane Data’s “Money Fund Intelligence,” March 2009
  38. 38. Risk Factors Redefined <ul><li>Implementing Increased Due Diligence </li></ul><ul><ul><li>Manager Research </li></ul></ul><ul><ul><ul><li>Statistics, performance </li></ul></ul></ul><ul><ul><ul><ul><li>Crane Data </li></ul></ul></ul></ul><ul><ul><ul><ul><li> </li></ul></ul></ul></ul><ul><ul><ul><li>News & Reporting </li></ul></ul></ul><ul><ul><ul><ul><li> </li></ul></ul></ul></ul><ul><ul><ul><ul><li> </li></ul></ul></ul></ul><ul><ul><ul><li>Consultants & Financial Advisors </li></ul></ul></ul>
  39. 39. Regulatory Changes <ul><li>Investment Company Institute (ICI) </li></ul><ul><ul><li>Report of the Money Market Working Group (MWWG) released March 17, 2009 </li></ul></ul><ul><li>Obama Administration: June 17, 2009 </li></ul><ul><ul><li>Report on Financial Regulatory Reform </li></ul></ul><ul><li>SEC on June 24, 2009: proposed 2a-7 amendments </li></ul><ul><ul><li>Goal: “significantly strengthen the regulatory framework for money market funds to increase their resilience to economic stresses and reduce the risks of runs on the funds.” </li></ul></ul>
  40. 40. <ul><li>Investment Company Act of 1940: Rule 2a-7 </li></ul><ul><li>Sets Standards for: </li></ul><ul><ul><li>a. Credit Quality </li></ul></ul><ul><ul><li>Maturity </li></ul></ul><ul><ul><li>Diversification </li></ul></ul><ul><ul><li>Defines Board of Director Responsibilities </li></ul></ul>Regulatory Changes
  41. 41. Proposed 2a-7 Amendments <ul><li>Portfolio Risk </li></ul><ul><ul><li>Shorter Average Maturity </li></ul></ul><ul><ul><li>New Weighted Average Life </li></ul></ul><ul><ul><li>Credit Quality Strengthened </li></ul></ul><ul><ul><li>Periodic Stress Tests </li></ul></ul><ul><li>Liquidity </li></ul><ul><ul><li>No illiquid </li></ul></ul><ul><ul><li>Retail vs. Institutional </li></ul></ul><ul><ul><li>Daily and Weekly Standards ; General Liquidity Standard </li></ul></ul>
  42. 42. Proposed 2a-7 Amendments <ul><li>Holdings Disclosures </li></ul><ul><li>Special Operations </li></ul><ul><ul><li>Processing orders at other than $1/share </li></ul></ul><ul><ul><li>Suspension of Redemptions </li></ul></ul><ul><ul><li>Affiliate Purchases </li></ul></ul>
  43. 43. Wisdom & Insight: A Dialectic <ul><li>Wisdom from Tom Bell, former CEO of Cousins Properties* </li></ul><ul><ul><li>July 20, 2009 speech to Rotary Club of Atlanta: </li></ul></ul><ul><ul><ul><li>1st priority: get Fed government to stop changing rules </li></ul></ul></ul><ul><ul><ul><li>Markets frightened by unpredictable government rule-making </li></ul></ul></ul><ul><ul><ul><li>Can’t underwrite risk without rules </li></ul></ul></ul><ul><ul><ul><li>No markets without rules </li></ul></ul></ul><ul><ul><ul><li>Can’t make investments without rules </li></ul></ul></ul><ul><ul><ul><li>Can’t buy or sell without rules </li></ul></ul></ul><ul><ul><ul><li>If you can’t trade, there is no market </li></ul></ul></ul><ul><ul><ul><li>No market, can’t set a price </li></ul></ul></ul><ul><ul><ul><li>No price, nothing sells </li></ul></ul></ul><ul><ul><ul><li>Nothing sells, nothing grows </li></ul></ul></ul><ul><ul><ul><li>Jobs aren’t created, taxes aren’t paid </li></ul></ul></ul><ul><ul><ul><li>So, without free markets, without risk and reward, wealth creation and job creation stops </li></ul></ul></ul>*Atlanta Business Chronicle, Aug 7-13, 2009, page 29A
  44. 44. © 2009 MBSC Securities Corporation, Distributor for The Dreyfus Family of Funds. Dreyfus Cash Investment Services is a division of MBSC Securities Corporation Not FDIC-insured. Not bank-guaranteed. May lose value. An investment in any money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other governmental agency. Although a money market fund seeks to preserve the value of your investment at $1.00 per share, it is possible to lose money by investing in a money market fund. Yield fluctuates. Past performance is no guarantee of future results. Short-term corporate and asset-backed securities, while rated in the highest rating category by one or more NRSRO (or if an unrated municipal, deemed of comparable quality by Dreyfus), involve credit and liquidity risks and risk of principal loss.