Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

US fondness for ratings continues

Last week, I blogged
about the US being an outlier in terms of its excessive use of ratings
in its regulations. This fondness for credit ratings (particularly the
highest rating) continues. Yesterday, the US SEC announced
proposals for reforms of money market mutual funds. Reforms are
clearly needed here – among the most scary consequences of the
Lehman bankruptcy last September were the problems at the Reserve
Primary Fund which saw its Net Asset Value drop below par.

SEC is eliminating the ability of the money market funds to hold 5%
of their assets in “Second Tier” securities that have the
second highest credit rating instead of the highest rating. This was
of course one of the recommendations of the industry body (ICI) in its
report of March
this year. But even that report admitted that investment in second
tier securities had nothing to do with the post Lehman crisis. Lehman
had a Prime-1/A-1/F-1 short term credit rating (making it a first tier
security) right up to its bankruptcy.

To my mind, this reform is indicative of regulatory capture. This
is the kind of tiny change that has propaganda value for the fund
management industry (“money market funds are safer than ever
before”) while changing nothing substantive. If the SEC
genuinely wanted to use ratings to make funds safer, it could have
said that the issuer must also have a AAA/AA long term rating –
Lehman was rated A long before its bankruptcy.

Actually, having something like 5% in second tier securities is not
entirely a bad thing in that it reduces the skewness of the
distribution. A portfolio of top rated securities can only experience
downgrades and this produces a skewness towards the left. A small
proportion of securities that can experience upgrades could make the
distribution more symmetric.

The weighted average credit rating of a portfolio is more important
than the minimum rating as a measure of credit risk. The current SEC
rule does not distinguish between gradations within the highest rating
category. A money market fund with a small amount of second tier
securities and a lot of A1+/F1+ securities in its portfolio can have a
higher weighted average credit rating than a fund which has no second
tier securities at all. In the run up to its bankruptcy, Lehman had
an A1/F1 rating and not an A1+/F1+ rating.

Finally, the best reform (something that a regulator captured by
the industry would never dream of doing) is simply to prohibit stable
(amortized) value completely. All funds should be required to operate
a proper net asset value (based on market prices) that would fluctuate
up and down so that investors do not get a false sense of


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