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Funding Agreement Update Part II

In the last, issue I reported on the impact of General American's technical default on the short-term variable rate funding agreement market. Short-term variable rate funding agreements are purchased by money market funds and other institutional investors and offer an indexed rate reset periodically. In this issue, I'll briefly discuss the benefits of such funding agreements to the buyers and sellers, as well as why another General American situation is highly unlikely.

One of the greatest advantages of funding agreements to buyers is that they can easily be customized to fit the customer's needs. Short-term variable rate funding agreements are available in a variety of different forms with regards to index, interest reset period, maturity and redemption notification period. This allows the buyer to make the trade-off between spread and features that best fits their particular portfolio needs and desires.

Another benefit to buyers is the competitive yields available. Money market funds, for instance, hold a variety of short-term securities, including U.S. Treasury bills, bank Certificates of Deposit and commercial paper. Commercial paper is issued in the open market and represents the obligation of the issuing corporation. Since 1988, there have been some years in which the size of the commercial paper market has exceeded that of the Treasury bill market. Money market funds purchase roughly one-third of all commercial paper issued⁽¹⁾ . Commercial paper also tends to offer higher yields than Treasury bills and Certificates of Deposit due to greater credit risk and illiquidity.

The following graph illustrates the difference between the yield on 1 month Libor versus dealer-placed top-tier one-month commercial paper. Top-tier commercial paper has a short-term financial strength rating of either A-1 (S&P), P-1 (Moody's) or F-1 (Fitch). Over the last three years, Libor has yielded an average of 17 bps more than commercial paper. Funding agreements typically add a spread of 5 to 10 bps over Libor to this yield advantage. Thus, over the last three years, funding agreements have provided a yield spread of about 25 basis points over commercial paper and an even greater spread over other alternative money market fund investments. This yield spread is largely due to the relative illiquidity and non-standard documentation of funding agreements.

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A third benefit that funding agreements offer buyers is diversification, both through exposure to additional issuers and through exposure to the insurance industry. This diversification provides stability to the supply of money market investments available in the market.

Funding agreements are attractive to issuers for many of the same reasons. Customization allows issuers to establish liabilities that best fit available investments or meet asset/liability management needs. They also offer issuers the ability to diversify their customer base. This has allowed funding agreements, including European Medium Term Note (EMTN) programs, Global Medium Term Note (GMTN) programs and Municipal Reinvestment GICs, to supplement the traditional pension GIC market.

Short-term funding agreements also provide issuers with diversification through exposure to the short end of the yield curve. This is a good compliment to other institutional investment products such as traditional GICs in the 3 to 5 year maturity range, EMTN/Global notes in the 5-10 year range and Structured Settlement and Terminal Funding contracts in the 10+ year range.

The key to successfully managing any insurance company business is in understanding and managing the risks on both the liability and the asset side of the balance sheet. In addition to the usual institutional investment product risks, such as asset default risk, interest rate risk, and spread risk, the disintermediation risk on putable funding agreements sold to money market funds requires special attention given how quickly very large amounts of money can leave, as occurred with General American. Moody's has referred to the cause of the disintermediation in General American's case as "rating spiral risk"⁽²⁾.

Rule 2a-7 of the Investment Act of 1940 permits money market funds to use valuation methods that maintain stable share prices only if certain requirements regarding investments are met. These requirements are designed to minimize the deviation between the fund's stabilized share price and the market value of the portfolio. Rule 2a-7 does this by attempting to control the fund's exposure to credit and interest rate risk through specific quality, maturity and diversification requirements. With regards to quality, an "Eligible Security" under 2a-7 is a short- term security that has received a short-term rating in one of the two highest rating classes by requisite NRSROs (Nationally Recognized Statistical Rating Organizations), such as Moody's and Standard & Poors. An unrated short-term security may be deemed an eligible security if the money market fund's Board of Directors determines that it is of comparable quality to a rated eligible security and meets certain other requirements⁽³⁾.

Moody's placed General American's A-1 financial strength rating on review for possible downgrade on December 18, 1998. On March 5, 1999, the rating was downgraded to A-2. On July 30, 1999, the day after ARM announced the planned recapture by General American of $3.4 billion of its funding agreement reinsurance portfolio, Moody's lowered General American's rating to A-3. From July 30 to Aug 2, 1999, many investors exercised their 7-day and 30-day puts. On August 9, 1999, General American defaulted on its obligations recognizing that it could not make payments on the remaining agreements, which had also been put.

Issuers have addressed this risk in several ways. First of all, General American's exposure to 7-day puts was unique in the industry. Moody's estimates that the company had $5 billion in 7-day contracts outstanding, amounting to 60% of the entire 7-day put short-term funding agreement market⁽⁴⁾. While some issuers also sold 7-day puts, their exposure was much more limited, recognizing that 7 days is too short a period of time to raise a large amount of cash if problems developed. In addition, some issuers have significantly reduced their exposure to 7-day and 30-day puts, pushing put provisions to 90 days or more. Buyers have also begun questioning the validity of a 7-day put from all but the strongest issuers.

Regulators are also addressing the monitoring of asset liquidity relative to possible liquidity demands. The NAIC's Life Liquidity Risk Working Group is currently looking at ways that regulators can better measure a company's liquidity risk. The N.Y. Insurance Department has issued Circular Letter No. 35, which requires N.Y. licensed insurers to disclose short-term cash requirements and available liquid assets. It has also encouraged companies to adopt formal crisis liquidity plans, if they have not already done so. These plans should include not only liquid assets, but all sources of liquidity such as company surplus and standby lines of credit.

With the General American situation behind us, and with issuers, regulators and rating agencies refining liquidity monitoring and management, the short-term variable rate funding agreement should continue to provide benefits to both buyers and sellers.

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