Thomas Murray was formed in 1994. The firm issues ratings on custodians, capital market infrastructures and central securities depositories and helps pension funds and other beneficial owners select and monitor their global custodian bank including the risks, operational performance and costs associated with their custody arrangements. Thomas Murray currently monitors assets under custody of over $1 trillion on behalf of its clients in Asia / Pacific, Europe and North America. The writer is a Director at Thomas Murray and is head of the Custodian Monitoring unit. Prior to joining Thomas Murray, he was a Managing Director at Standard & Poor's where, from 1993 to 2000, he was head of the European Managed Funds ratings team that analysed the safety and quality of European bond and money market funds.

How Safe is Your Scheme's Cash?

Market Turmoil and the Implications for Pension Schemes' Cash

A number of Thomas Murray's clients who transfer surplus cash to their custodian banks' money funds, or who use their custodian banks' cash collateral investment pools as part of their securities lending programmes, have approached us with questions about the impact that the current market turmoil is having on these funds, particularly in respect of losses. Some clients are also concerned about the safety of cash left on deposit with their bank.

Whilst we are unable to comment on specific funds or banks, we hope that this short note provides some context to the current problems and is helpful guidance for those that are concerned about these issues.

Background

Until the 1990s, pension schemes typically left surplus cash on deposit with their custodian bank or a separate cash concentration bank. However, increasingly mindful of the risks of this approach (as cash, unlike securities, is fungible and cannot be segregated from a custodian’s assets and liabilities in the event of its bankruptcy), schemes increasingly turned to other alternatives including money market funds or other short term investment funds.

These arrangements have a number of benefits:

The funds' returns may be higher than those offered by the custodian bank
Some funds are rated by the major credit rating agencies and the rating on the fund may be higher than that of the custodian bank
The use of a money fund ensures that assets are segregated should a custodian default
Money funds enable deposits to be invested across a wide range of securities thereby providing diversification of risk
Some money market funds are rated as money market funds by the credit rating agencies. Unlike credit ratings, which focus on the default probability of the fund and its securities, a money fund rating addresses credit, liquidity and interest rate risks. Funds with these specialist ratings invest only in high quality short term instruments and, in theory at least, are designed to maintain a constant net asset value.

In the US and in Europe, many money funds have suffered substantial redemptions as investors, worried about the impact of the Lehman default, and "fire sales" of other assets, on funds' net asset values, have withdrawn their funds en masse. Also, many pension schemes have recalled loans from securities lending programmes putting further pressure on the liquidity of money funds as cash collateral is returned to the borrowers. This has also had a "knock on" effect on asset safety as many of these cash funds have residual holdings in more illiquid securities which may be trading below par value.

In the US, a number of funds have closed down, have suspended withdrawals and redemptions or have suffered impairments to net asset values as liquidity issues have forced them to sell securities at a loss. Some cash collateral pools linked to securities lending programmes have experienced similar issues. In Europe, the money market fund industry as a whole has experienced substantial redemptions and liquidity issues, although we understand specialist AAA money market funds have held up better than most, as investors seek the reassurance of conservatively structured funds.

So what should pension schemes do if they have cash in these funds?

Whilst not able to comment or advise on specific cases, as Thomas Murray is neither a credit rating agency nor does it have access to the details of individual cases, we have suggested that schemes request portfolio details from their custodians and ask the following questions:

Is cash swept into the custodian's own money market fund, another institutional money fund or a cash collateral pool?
Who manages the cash pool or fund? Is it the custodian or a third party manager?
Irrespective of which of the funds above are used, has the fund experienced substantial redemptions in recent months and, more importantly, in recent weeks and days?
If there have been large redemptions, have the most liquid assets been sold first to meet redemption requirements? Has this placed additional liquidity stress on the fund?
Have higher quality assets been sold to meet earlier redemptions? Has this had a negative impact on overall credit quality of the fund?
Does the fund have exposure to Lehmans or other defaulted issuers and, if it has, what is this exposure as a percentage of the overall fund?
Does the fund invest exclusively in short term instruments or are there longer dated instruments in the portfolio which may create greater interest rate sensitivity or liquidity issues?
Is the fund or pool exposed to illiquid instruments e.g. asset backed securities or other securitised debt obligations?
Have liquidity or credit issues impacted the net asset value of the fund? What is the fund doing to ameliorate those issues?
What is the custodian's policy if there are losses in the fund or pool? Will it make good those losses?
Is the fund rated AAA? Is this a credit rating or a rating that addresses credit, liquidity and interest rate risks?

A final comment for those clients that leave cash on deposit with their custodian - it is not always the case that the legal entity that takes the deposit benefits from a credit rating specifically assigned to it. In those cases where it may not be, we suggest that schemes seek confirmation that the deposit taking entity is rated and, if it is not, ask for explicit support from the rated entity to the deposit taking entity.

For further information contact Nick Bradley: nbradley@thomasmurray.com

Disclaimer: Thomas Murray makes no representations or warranties, express or implied, as to the accuracy, adequacy or completeness of its analysis or commentary including without limitation, any warranties of merchantability or fitness for any particular purpose or use. Neither Thomas Murray nor is affiliates shall be liable to any user or anyone else for any inaccuracy, error or omission, regardless of cause.