Monday, November 30, 2009

Cost Basis Reporting: impact on TA systems, if any

The Emergency Economic Stabilizaton Act of 2008 consists of a tax provision which requires brokers to report extensive cost basis information to the IRS and investors. Investors who received past gain/loss statements from their brokers should realize that these statements were not reported directly to the IRS. As a result, this provision brings cost basis reporting for tax purposes to an entirely new level.

In just over two years, starting on January 1, 2012, brokers and their transfer agents will be required to track and report gains/losses for mutual fund transactions in much greater detail than currently required. The deadline for stock transactions is actually one year earlier: January 1, 2011. Experts in the industry are saying that any brokerage which has not started planning for the systems impact is already behind schedule.

There is no shortage of articles highlighting the need to take action and vendors touting potential solutions. One major class of solutions aims to import data from existing transaction processing systems and compute the required cost basis information for investors and the IRS. Approaching the problem as only a reporting challenge has its appeals, probably foremost for cost and expediency. Recoding a transfer agency system during a recessionary period (or anytime, for that matter) ranks up there with persuading Americans to agree on healthcare reform.

With respect to mutual funds, transfer agency shareholder recording systems ("TA systems"), from vendors such as DST, PNC, SunGard, and Envision, generally follow fundamental rules when tracking sharelots. (For those wondering, assume a sharelot to represent the most basic level of tracking an investment in a stock, ETF, mutual fund, bond, etc. on a TA system.) The following such rules apply to a single account ("account-level processing").

1. When an investor purchases shares in a mutual fund, a sharelot is created on the trade date of the investment. If for some reason multiple purchase orders for the same fund occur on the same trade date, the TA system might consolidate those orders under one sharelot.
2. When an investor sells/redeems shares in a mutual fund, the balance of an existing sharelot is reduced by the size of the sell order as of trade date. The choice of which existing sharelot to reduce depends on various rules, usually chosen by the mutual fund (hopefully disclosed in the corresponding Prospectus or Statement of Additional Information.)
3. When an investor reinvests a dividend into a mutual fund (not necessarily the same fund which paid the dividend), the balance of a sharelot created specifically for reinvested dividends is increased. Generally, every reinvestment trade does not create a new sharelot (but, as with everything related to transaction processing, exceptions may exist).
4. The purchase or sale of mutual fund shares as part of an exchange (selling one fund and using proceeds to purchase another) is handled no differently. Sharelots are reduced and created accordingly. However, other rules may take into account special redemption fees, front-end loads, or commissions, for which additional sharelots might be required in order to facilitate computations.
5. Moving shares from one account to another (i.e. changing brokers) generally has no impact on the sharelots, should not result in a taxable event, and should not change the cost basis. However, brokers need to be certain to transfer the sharelot data properly across systems. A surprising portion of account transfers require human intervention, such as sending/receiving faxes and manual data entry.

What might the new cost basis reporting requirements mean for mutual fund transactions and share balances recorded on TA systems, and their users? Here are a few potential repercussions to consider.

1. Systems which follow certain rules for processing sell orders might need to accommodate other rules required under the tax provision.
Simple FIFO or LIFO no longer suffices. Investors will have the option to select which rules to
follow, even change selections over time.

2. The reinvestment of dividends may require the creation of more sharelots in order to track each individual reinvestment transaction. The IRS will require brokers to compute the gain/loss for each set of shares purchased, regardless of whether an investor used cash or dividend distributions to fund the purchase.
3. Wash sales occur when identical shares (the true meaning of which may be pending clarification) are purchased within 30 days before or after being sold. If a taxable loss is realized when shares are sold, the corresponding purchase would require an adjustment to the sharelot cost basis. Not all TA systems may handle this adjustment automatically.

These are only a few considerations, and future postings on this blog may introduce more. Keep in mind that the impact on TA systems might be minimal if adopting the new cost basis reporting requirements is defined as a reporting challenge. As brokers plan various solutions in coordination with technology vendors, will the underlying data architecture and trade processing code in TA systems remain largely insulated?

Check future postings for an ongoing assessment of operational considerations and hopefully some quantitative simulations of the potential tax impact.

Friday, November 20, 2009

Treasury TGP = Sticky Situation

In the last two postings, I discussed how the Treasury's Temporary Guarantee Program (TGP) for supporting money market funds favored shareholders who held positions on or prior to September 19, 2008 (the "Cut-Off Date"). The TGP served to preserve the perceived safety of participating money market funds for existing covered investors and possibly new uninsured investors.

More specifically, the TGP offered money market funds a few key competitive advantages.

1. Normally, FDIC-insured bank deposits are the dominant means for saving cash under a federal guarantee program. The TGP placed money market funds on a more even playing field, which probably was merited given the alternative of having investors en masse pull out of money markets funds. In response, the American Bankers Association warned that investors would be encouraged to withdraw bank deposits to take advantage of the TGP. As a result of this concern, the Treasury decided to limit the guarantee to shares held as of the Cut-Off Date.
2. If investors wanted to transfer funds out of a money market fund after the Cut-Off Date, the guarantee would cease to apply to the transferred funds. However, it seems that an investor could transfer funds back into the same money market fund and continue to benefit from TGP coverage up to the eligible balance as of Cut-Off Date. Therefore, money market funds became a convenient place to park funds (a sort of "safe haven") any time investors became worried about systemic risk in other assets or markets.
3. The "safe haven" status might have also encouraged investors to stay in a specific fund family. In other words, an investor could hop around different mutual funds within the same fund family where the money market fund provided coverage under the TGP. A decision to switch to another fund family would most likely involve a choice to close an account and abandon the insurance, unless an investor was a shareholder in money market funds at multiple fund families. As long as an investor never closed an account which provided coverage under the TGP ("Covered Account"), he/she could have transferred funds in and out of that account without losing the applicable insurance.
Given the last item, fund sponsors probably benefited from the "non-portability" of TGP insurance. (Remember when cell phone numbers in the U.S. could not be transferred between different carriers?) In contrast, FDIC insurance was always "portable", because the FDIC would insure bank deposits regardless of when and from where the money arrived. Although the Treasury specified a Cut-Off Date to prevent investors from moving their funds out of seemingly weaker institutions into safer money market funds, the Cut-Off Date and customer service representatives probably encouraged investors to think twice before leaving a fund family.

Combined with numerous press releases announcing participation in the TGP, marketing departments at fund families were handed a powerful tool for mitigating customer attrition - and possibly attracting new customers and assets (see "Exposed Assets" in the November 13 posting).

Friday, November 13, 2009

Covered and Exposed, but by how much?

Did money market fund investors fully appreciate how the Treasury's Temporary Guarantee Program ("TGP") impacted the benefits and cost of coverage?

Firstly, the overall cost was not substantial as a percentage of assets in the money market funds. For the initial period of the program and its subsequent two extensions, participating funds paid 0.01%, 0.015%, and 0.015% of the "Covered Assets" (i.e. value of shares outstanding as of September 18, 2008) for each period. Hence, the total cost of participating for the full term was 0.04% of Covered Assets. Remember that Covered Assets never adjusted for any investments and redemptions which occurred after September 18, 2008 ("Cut-Off Date").

(We need to define one more term before pressing ahead: Shares purchased in excess of the account balance as of the Cut-Off Date would not be covered under the TGP; we shall refer to them as "Exposed Assets".)

Given that every share of a mutual fund (technically, within one class of shares) must be charged the same fees, every share must pay its share (no pun intended) of the cost of participating in TGP (for lack of a better term, "TGP Premiums"). Therefore, Exposed Assets paid part of the TGP Premiums even though the Treasury excluded coverage for losses on Exposed Assets if the fund NAV price dropped below $1.00 (or $0.995 to be accurate).

Was the amount of TGP Premiums paid a material sum to make it worthwhile to even further this discussion? That depends on whether you consider $1.2 billion to be "material". The Treasury indicated that they would keep the TGP Premiums in its Exchange Stabilization Fund. (By the way, $1.2 billion is approximately 0.04% of $3 trillion.)

A small study, including a simple simulation, can shed some light on how much investors might have paid for insurance with respect to Covered Assets and Exposed Assets.

All registered mutual funds publish their monthly sales and redemptions via the SEC's web site. Each fund must report individually for each month, albeit with a few months lag. By looking at sales and redemptions for every month and every fund, one can try to estimate how much Covered Assets stayed in the funds, with the remainder comprising Exposed Assets. At this point, these estimates cannot be validated with account-level data, which is not trivial to gather and otherwise non-public.

Given that the TGP ended on September 17, 2009, we don't have enough data to carry the analysis through the end of the program. However, as of October 2009, a sizable minority of funds have reported sales and redemptions through June 2009. Total assets range from approximately $550 billion to $700 billion. With time, as funds disclose their historical figures, more assets can be included in this analysis.

For now, the selected sample reflects data for 10 of the largest fund families, excluding money market funds which invested primarily in Treasurys. Midway through the TGP, a number of fund families chose for certain Treasury and Government funds to stop paying for the TGP given that their primary investments were in securities issued by the government. This exclusion simplifies the analysis and keeps samples consistent with each other.

Let's jump into the results. For now, we can assume that investors in Covered Assets end Exposed Assets purchased and redeemed shares in the same proportion as their corresponding balances. For example, given a balance of $400 for Covered Assets and $200 for Exposed Assets (i.e. split 67%/33%), one-month activity of $120 in purchases and $150 in redemptions would be allocated accordingly ($80/$40 for purchases and $100/$50 for redemptions).

(Note: Since the analysis covers the period ending June 30, the entire TGP Premiums are less than would be expected given the 0.04% rate. In other words, through June 30, the Treasury probably collected $1.2 billion of TGP Premiums, but not all of the premiums were fully earned. The resulting adjustment assumes that, as of June 30, the TGP had another 2.5 months until expiration on September 17.)

Treasury Temporary Guarantee Program for Money Market Funds - Scenario 1 (table)

In the table above, the split between Covered Assets and Exposed Assets is shown in the orange cells. The respective split in TGP Premiums is shown in the green cells. In this case, investors owning Exposed Assets paid only $19 million of premiums. On an average asset base of $159.3 billion, that comes to a rate of only 0.0117% (1.17 bps). Another way to measure their contribution: Exposed Assets covered 10.6% of the total TGP Premium. Not so bad considering that Exposed Assets represented 24% of average total balances. (Remember, all of these results are estimates based on a cash flow model.)

Here is a graph showing the trend in Covered Assets and Exposed Assets during the simulated period.

Treasury Temporary Guarantee Program for Money Market Funds - Scenario 1 (chart)

So what happens if, after September 18, 2008, purchases into these money market funds came more so from investors who had very few, if any, shares in money market funds before the Cut-Off Date? Let's assume that, all else equal, purchases only are split 50/50, where as above the split was 67/33. This might be a more realistic scenario because few investors expected Lehman to go bankrupt, starting a cascade of events which resulted in the TGP, and resulting in a rapid growth rate of Exposed Assets.

Treasury Temporary Guarantee Program for Money Market Funds - Scenario 2 (table)

Now Exposed Assets comprise, on average, 32% of the total assets. Investors owning Exposed Assets paid only $48 million of premium. On an average asset base of $211.5 billion, that is a rate of only 0.0228% (2.28 bps). Another way to measure their contribution: Exposed Assets covered 27% of the total TGP Premium. Exposed Assets and Covered Assets are charged more comparable rates (2.28 bps versus 2.91 bps, respectively) for insurance, even though only investors in Covered Assets can receive a payout if a money market fund's NAV price falls below $1.00.

Here is the graph corresponding to this second scenario.

Treasury Temporary Guarantee Program for Money Market Funds - Scenario 2 (chart)

Finally, we can take this analysis one notch further (for academic purposes). Let's assume that, all else equal, purchases only are split 33/67 (inverse of the split used in the first scenario).

Treasury Temporary Guarantee Program for Money Market Funds - Scenario 3 (table)
The trend should be self-evident. Exposed Assets comprise, on average, 47% of the total assets. Investors owning Exposed Assets paid only $77 million of premium, resulting in a rate of 0.0250% (2.5 bps). Although the rate is only marginally higher than in the previous scenario, Exposed Assets covered almost 44% of the total TGP Premium. Interesting, for an academic example.

Here is the graph corresponding to this third scenario.

Treasury Temporary Guarantee Program for Money Market Funds - Scenario 3 (chart)

The critical question: how much did investors add to their existing money market fund balances after September 18, 2008? The money market funds, with help from their transfer agents, have access to data to answer this question. The accurate way to quantify Covered Assets and Exposed Assets would be to look at account level activity, while not complicated would be extensive given the number of accounts held in retail money market funds. Although an industry-wide analysis may be burdensome, specific fund sponsors can perform the analysis individually.

In the meantime, the above scenarios simulated by a cash flow model can only demonstrate the general impact. Check back later for future updates of the numbers and further commentary.

Friday, November 6, 2009

Money Market Guarantee Program: the Finer Print

The Treasury Temporary Guarantee Program ("TGP") for money market funds has received ample publicity since its inception after the Lehman Brothers bankruptcy. According to a FAQ from the Treasury's web site, the guarantee is subject to certain limitations.

1) If an investor owned 100 shares in a specific fund as of close of business September 19, 2008, subsequently sold the 100 shares, and then repurchased 100 shares in the same specific fund prior to a Guarantee Event, the investor would be covered for 100 shares.

2) If an investor owned 100 shares in a specific fund as of close of business September 19, 2008, subsequently sold the 100 shares, and then repurchased 125 shares in the same specific fund prior to a Guarantee Event, the investor would be covered for only 100 shares.

3) If an investor owned 100 shares in a specific fund as of close of business September 19, 2008, subsequently sold the 100 shares, and then repurchased 100 shares in another fund that is participating in the program, the investor would not be covered.

Let's run through a slightly different example (not from the Treasury's web site) which essentially reflects what the FAQ explains.

On September 12, 2008, an investor owns 100 shares in a money market fund which later participates in the TGP. Lehman Brothers files for bankruptcy on September 15. Fearing that stocks will plummet and bonds will become riskier, the investor reacts over the next few days by liquidating risky assets and purchases another 400 shares in the money market fund. Now the he/she has 500 shares of the money market fund. On September 29, the Treasury opens the TGP for money market funds. However, he/she has no luck in getting the guarantee to cover any of the proceeds generated from selling securities after the Lehman bankruptcy. The investor would have had to foreseen the meltdown in the credit markets (i.e. Lehman bankruptcy) in order to get full coverage (500 shares) under the TGP. Out of the 500 shares of the money market fund, only 100 are covered under the TGP.

This example does not discredit the mission or benefits of the TGP. The money market fund does participate in the TGP in order to stabilize its investor base, thus mitigating the changes of a "run on the fund" which would subsequently hurt all investors.

Rather, only the "finer" print is being highlighted here. After the Lehman bankruptcy, many investors reallocated their investments into money market funds and other relatively safer investments. Hence, it was important for money market funds to receive some form of government support to comfort investors. However, did investors fully appreciate the impact of the September 18, 2008 cut-off?

More posts on this topic should be forthcoming.