Federated Hermes Inc (FHI) 2013 Q2 法說會逐字稿

Greetings, and welcome to the Federated Investors third-quarter 2013 earnings call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation.

(Operator Instructions)

As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ray Hanley, President of Federated Investors Management Company. Mr. Hanley, you may begin.

Good morning, and welcome to our second-quarter results conference call.

And today, leading the call will be Chris Donahue, Federated CEO and President, and Thomas Donahue Chief Financial Officer. And we also have Debbie Cunningham joining us for some remarks on the money market condition. Let me say that during today's call, we may make forward-looking statements, and we want to note that Federated's actual results may be materially different than the results implied by such statements. We invite you to review the risk disclosures in our SEC filings. No assurance can be given as to future results, and Federated assumes no duty to update any of these forward-looking statements.

And with that, I will turn it over to Chris.

Thank you, Ray.

Good morning. I will begin today with a brief review of Federated's business performance, and Tom will then comment on our financial results. Looking first at cash management, average money market fund assets were down $13 billion from Q1, and period-end money fund assets decreased by $10 billion. The decrease included the seasonal effects of tax payments, and decreases by certain institutional investors against the backdrop of declining rates and yields over the quarter. Debbie will comment later on on market conditions and our outlook for rates.

Our market share for money funds decreased slightly in Q2 to approximately 9% from 9.2%. For historical purposes, recall that in '08 our share was about 8.5%, and back in 2000 it was about 5%. The impact of yield-related fee waivers increased in the second-quarter. The repo rates have been at very low levels since mid-May, which of course impacts the waivers. And Tom will comment on this in his remarks.

On the regulatory front, the SEC issued its 700-page money market fund reform proposal for public comment last month. We commend the SEC for taking a thorough and thoughtful approach, proper to preserving their jurisdiction for money market funds. We are working on a series of comment letters to address various aspects of the proposal. The main points of the proposal have been extensively reported, so I won't go through them. Our initial reaction to the proposal is that parts of it are workable, like gating, and would improve money funds. And other parts are unworkable, like floating the NAV, and unnecessarily detrimental to money funds with negative implications for investors, issuers, and the financial markets.

Our core beliefs remain consistent. We continue to advocate for sound policy that enhances the resiliency of money funds for our clients, who fully understand that money funds, like other investments have elements of risk. They aren't interested in radical, costly and unnecessary change like floating the NAV. The floating NAV would create market inefficiencies without providing meaningful benefits. In particular, as both the Fed and the SEC have acknowledged, the floating NAV would not eliminate the idea of runs. We know that many institutional money fund users have gone on record, to make it known that they cannot or will not use any floating NAV money funds due to a host of legal and/or investment policy restrictions, operational complexity and tax burdens.

Tax issues remain unsolved and significant. The cost to adapt systems to accommodate the floating NAV would be enormous. These and other issues will cause many users to move from the product, if subjected to a floating NAV. We believe that some of these money fund users will migrate from institutional prime to government agency money funds, creating dislocation in that part of the market. Others will increase deposits in banks, in particular among the largest banks making them even bigger. Still others will look to separate accounts, offshore products and other less regulated and less visible alternatives. This process is unnecessary, and will be very disruptive to investors and to the financial system. The cost will be significant and real, and the benefits will be minimal, if any.

The impact of the floating NAV, were it ultimately to be enacted, on the money fund asset levels of our clients is difficult to assess. We are hopeful that a significant portion of our $97 billion in prime money fund assets would be properly classified as retail under the proposal's definition, recognizing that the implementation of a retail exemption could be operationally difficult and involves added complexity because a large portion of our assets are held in omnibus accounts.

In contrast with the floating NAV, gating, that is giving the funds' Board of Directors the option on imposing a gate on redemptions in extremely rare periods of a dysfunctional market as experienced by money funds and other participants in '08, promotes the equal treatment of investors, and improves financial markets by potentially stopping a run dead in its tracks. It has proven to be effective in practice, avoids costly and unnecessary disruptions, and most importantly preserves the critical features and benefits of money funds for investors, issuers and the capital markets.

Following the meaningful reforms enacted by the SEC in 2010 and voluntary efforts by major industry participants which continue today, to further increase transparency by publishing daily shadow price NAVs, money funds are the safest and most transparent investment products, and would be further enhanced by adding the gating option. Radical change like floating the NAV, will unnecessarily cause the demise of the institutional prime money market fund, a high quality product that enhances our financial system on many levels.

Let's turn to equities. Flows for equity mutual funds in separate accounts were positive for the second-quarter, with solid results in a number of products. Combined Q2 net sales of equity funds and separate accounts was $383 million. Gross equity fund sales in the second-quarter were a little over $1.9 billion, one of our best quarterly totals ever, and net fund flows turned solidly positive. Our equity product line is very strong, with solid performance across a variety of products. We had 13 funds produce net positive sales in the second-quarter. Some familiar faces, strategic value dividend, capital income, international strategic value, Kaufman large, muni stock advantage, clover small, managed val, international leaders and others.

Inflows were led by the strategic value dividend strategies in domestic and international I mentioned. We also saw solid increase in the sales of our capital income balanced allocation fund. This fund has a very strong investment performance record, and has gained sales momentum over the last several quarters. Another highlight is the Kaufman large cap fund, where sales have also increased substantially over the last couple of quarters. This fund is nearing $700 million in assets, up from $370 million at year-end, with very strong performance over the 1-, 3-, and 5-year time frames, this fund is positioned for substantial growth. Other fund strategies with net flows, I have already mentioned.

As we mentioned in April, in April our second-quarter flows in equity separate accounts were negatively impacted by model changes for two of the MDT fundamental quant strategies. And this added up to $200 million in all cap core and small cap core when combined. Our MDT strategies continue, however, to generate very solid investment results in the second-quarter. All seven managed account strategies outperformed the benchmark for the second-quarter and the trailing 1- and 3-year periods. All seven are ahead of benchmark since inception. We have begun to see heightened RFP interest in the MDT strategies.

A comment on early Q3 flows. Actively managed equity flows are solidly positive, a hair under $60 million led by domestic and international strategic value dividend strategies, Kaufman large capital income fund. Equity SMA flows are also positive here, early in the third-quarter. In our equity index funds, we had a client redeem $220 million from the mid cap index fund which uses an enhanced indexing strategy. And they did this due to a change in the investment process they made last year. As a result, our combined equity and SMA flows are slightly negative. Looking at equity performance at the end of the second-quarter, we had 12 equity strategies in a variety of styles, with top quartile three-year records, and eight in the top quartile for one year.

Turning now to fixed income. Federated and the industry experienced a rapid reversal in investor sentiment for bond funds in the second-quarter. After generating slightly positive bond fund flows in April and May, we saw net redemptions of about $1.7 billion in June. July has been much calmer. Our bond fund flows are slightly negative for the first three weeks of the quarter. In June, investors moved out of bond funds of nearly all types including corporates, govies, mortgage-backed, multi-sector, munis and international. High yield funds remained positive, though at a diminished rate. We also saw inflows into our floating rate fund which is building some momentum, and into other short duration projects as a reaction to higher rates on the longer part of the curve.

While the industry as a whole experienced significantly higher bond fund redemptions in June, our results were particularly impacted by a change made by one of our intermediary clients, which led to an $800 million redemption from our total return bond fund. This fund has been just about or just below its category median on a 1-, 3-, and 5-year basis, and yet is top quartile on the 10-year basis.

This fund has had a retirement-based portfolio manager change in mid April. Its performance since then has been improving. The fund's pure ranking in the second-quarter was in the top half, and the fund is in the top quartile for the first three weeks of the third-quarter. At quarter-end, we had 10 fixed income strategies with top quartile 3-year records, and 12 strategies in the top quartile on a 1-year basis.

Our 3-year performance stars, include Fed bond fund, our high yield products, emerging market debt products, and ultra short bond funds among others. Fixed income separate accounts were slightly negative. New fundings were offset by a sizable redemption from a client as a result of their company being purchased, and by a series of smaller redemptions due to reallocations and use of cash. The disruption in the fixed income markets was a factor in some of these redemptions.

Turning to overall fund performance, and looking at Morningstar-rated funds, 53% of rated equity fund assets are in 4- and 5-star product as of quarter-end, and 79% are in 3-, 4-, and 5-star products. For bond funds, the comparable percentages are 45%, 4- and 5-star, and 85%, 3-, 4-, and 5-star.

As of July 24, managed assets were approximately $364 billion, including $267 billion in money markets, $40 billion in equities, $57 billion in fixed income which includes the liquidation portfolios. Included in these figures, of course, money market mutual fund assets stand at about $233 billion. And so far in July, our money market fund assets have ranged between $231 billion and $236 billion, averaging where they stand at $233 billion.

Looking at distribution, equity fund gross sales grew by 9% in the second-quarter compared to quarter one, and increased 25% compared to quarter two of 2012. We saw the strongest absolute growth in the broker dealer channel, where we continue to leverage our investment in additional distribution capacity.

We are steadily expanding the number of advisors doing business with us, and growing the product set used by these advisors. We are also considering further modest growth in sales personnel in this channel as the year proceeds. Interestingly, the number of advisors doing business with us is approximately 39,000, up from 36,000 in '011 and 29,000 in '08. In the institutional channel at quarter-end, we had about $600 million in equity and fixed income account additions expected by year-end, roughly $325 million in equities, and $275 million in fixed income.

Turning to our offshore business and acquisitions, we continue to develop our Asia Pac operation based in Australia. We are in the process of adding our first sales personnel, with a position planned to be head of sales in Hong Kong and another in Singapore. In Europe, we had our first trades booked in Q2, from our expanded distribution efforts with Bury Street. We are making progress in Germany with the LVM family of funds which had positive flows during the quarter. We continue to actively seek alliances and acquisitions to advance our business in Asia, in Europe, as well as in the United States.

Now I would turn it over to Tom to discuss our financials.

Thank you, Chris.

Taking a look first at money fund fee waivers, the impact to pretax income in Q2 was $23.7 million, up from $21.7 million in the prior quarter. The increase was due mainly to lower rates for Treasury and mortgage-related securities. Based on current assets and assuming overnight repo rates for Treasuries and agency securities run at 3 to 8 basis points over the quarter, the impact of minimum yield waivers to pretax income in Q3 could increase to $28 million. Looking forward and holding all other variables constant, we estimate that gaining 10 basis points in gross yields would likely reduce the impact of minimum yield waivers by about 45%, and a 25 basis point increase would reduce the impact by about 70%. It is important to note that the variables impacting waivers can and do change frequently.

Revenues in Q2 decreased 2% from the prior quarter, due largely to minimum yield waivers and lower average money fund assets, partially offset by an extra day and by higher average assets for equities. Operating expenses decreased from Q1, due largely to lower distribution expense due to higher minimum yield waivers. Comp and related was up from Q1, which included a reversal of $3 million of incentive compensation expense that was accrued in 2012 but not paid.

Q2 comp and related had been estimated to be $69 million, came in at $67.9 million as incentive comp was less than expected. The Q2 effective tax rate was 37.4%. Most of the increase from Q1 was due to increased state tax -- taxes, resulting from a tax law change during the quarter. We estimate the effective going forward rate to be around 38%.

Looking at our balance sheet, cash and investments totaled $303 million at quarter-end, of which about $231 million is cash available to us. Our net debt was below $75 million. We announced a 4% increase in our quarterly dividend to $0.25. Based on the performance and financial strength of Federated, it is appropriate to further reward shareholders with the first increase in our quarterly dividend since 2008.

Looking forward, cash and investments combined with the expected additional cash flows from operations, and availability under present debt facilities provide us with significant liquidity to be able to take advantage of acquisitions, acquisition opportunities and related contingent payments, share repurchases, dividends, new products, fees and other investments, capital expenditures and debt repayments.

That completes my part of the presentation. And I would like to ask Debbie Cunningham to make a few comments on money markets. Debbie?

Thanks, Tom.

Just giving you some guidance, from an outlook perspective about the third-quarter, and where we stand from a rate perspective versus the second-quarter. Right now, we are currently on a 1-month LIBOR basis, right around 19 basis points. For most of the second-quarter, we were at 20. So down slightly, just 1 basis point. Similar for three months LIBOR, currently right around 27 basis points. For most of the quarter, it was right around 28. 6- and 12-month LIBOR were off a little bit more, 3 basis points lower from a 6-month LIBOR perspective, and 4 basis points lower from a 12-month LIBOR standpoint, ultimately giving us a flatter yield curve currently, than what we have been dealing with in the first half of the year.

Also, detrimental so far in the third-quarter as compared to the second, has been the overnight rate, repo rate. Basically single-digits and low single-digits have been prevalent in the third-quarter so far, as opposed to what were higher single-digits to lower double-digits for a portion of the second-quarter. Our expectation would be, however, that this improves for a couple different reasons, in the third-quarter as we enter into the mid-August time frame. Number one, would be from a supply and demand perspective, we expect to see Treasury will need some additional financing and will do so, in the form of cash management bills, which will essentially bring a little bit more supply into the marketplace, and as such improve rates in that process.

Secondly, with regard to quantitative easing, the $85 billion that is currently being purchased on a monthly basis by the New York Fed out of the marketplace, in both Treasury, and agency, and agency mortgage-backed securities, we do believe will be announced to be cut back or tapered, in the context of the market terminology, beginning in the -- at the September FOMC meeting. We should think that will be done sequentially, probably somewhere in the neighborhood of $15 billion to $20 billion cut back per month. But again, with that additional supply being now left in the marketplace, as opposed to being held on the books of the New York Fed, that should begin the improvement process for very short-term and overnight rates.

We also think that, although Bernanke has been very stressful in telling us that, the tapering of quantitative easing is still an easing process, it is just less in the form of easing, we do think that the market will interpret that to some degree, as a beginning of an unwind process which ultimately should have an impact that begins to even out the yield curve again, into the second half, the end of 2013, the beginning of 2014.

Thank you, Debbie. And we would like to open the call up for questions?

(Operator Instructions)

Our first question today is coming from Bill Katz from Citigroup. Please proceed with your question.

Thanks so much. Tom, a question for you. You mentioned that the fee waivers, if rates were in the single-digit basis point here would be about $28 million. How sensitive is it to Debbie's forecast, to the extent that rates were to move up into August, how quickly could that reset? And then the broader question is, be positive (inaudible) or short, the rates are actually higher from here, and this $28 million were to go away -- and hard to believe right now -- but could we envision that that would drop to the bottom line? Or is there some backed-up investment spend needed against that?

Okay. The first part, Bill, we have -- we are basically using Debbie's forecast for this quarter. So while we are saying 3 to 8, the first part of the quarter, and the end part of the quarter, that is why we are averaging it. So $28 million is our forecast. The -- the second part, or do we -- do we expect that to fall to the bottom line, if it goes away? Is that what your question was?

Yes.

If rates go up, do we expect that to fall the bottom line? So, of course, we have the distribution expenses that when our revenues go up, our distribution expenses will go up. And other than that, we would have slight, slight changes to our -- depending on how much it went away, would have slight changes to incentive comp, as overall if the Company does better we pay a little bit higher incentive comp. But fundamentally, the major portion of it would go to the bottom line.

And Bill, on the other thing you mentioned, there is no backed-up investment spend.

Okay. And second question is, Chris, as you have gone through this, as you see a document, it is a bit voluminous. Any sense on the time line, when we might start to get any further public comments or any extension, just given now the IRS has sort of come out with their own proposals on the, on the wash sale rule as well?

On the time line, Bill, overall, as it is currently listed, the comment period will go until about September 17. That, of course, could be extended. There have already been, I think 60 or 70 comments filed. We expect there will be thousands of comments filed. And as I had mentioned, we are working on various topics to file comments. The SEC on the time line, will have to go through those comments and spend a bunch of time on that. And we would expect therefore -- it would be very, very difficult for them to conclude anything before the turn of the calendar to 2014.

So I don't expect the SEC to make intervening comments, regardless of what the IRS has done on the wash sale rules. And although the wash sale rule thing is nice, if they -- as I mentioned in my comments, if they persist with their notion of the variable NAV, that doesn't solve the problem. Because the problem has to do with the compiling of capital gains and losses of minuscule amounts on every money market fund trade. And the information we had from before, was that that would be requiring a statutory move on the IRS, which has to do with Congress, tax law, and things like that, which would be highly problematic. And I don't have a time line for that.

The only thing I would add to that would be, that in the context of the proposal as they stand today, alternative one, should it be enacted, which would be the floating NAV for institutional prime, which we don't think is likely. But if it were to be enacted, it would be at least a [two] year time frame, from an implementation perspective. Alternative two, which would be the gating and fee idea, which is one that we are supportive of. That would be about a one-year transition time period. And then the other idea that they have put forth on a proposal basis, to strengthen some of the other types of diversification, stress testing and disclosure requirements would be somewhere in the neighborhood of about nine months.

Okay. And one last one from me. I am sorry, just focused on the money markets today. You mentioned that the vast majority of your institutional prime might sort of fall into this retail designation. How comfortable are you with that notion, now that you have been through the document relative to maybe some of the nuances of the categorizations?

Okay. Let's tear into the numbers a little bit, Bill, and you will see how we get to where we come out. So we are right now, we are at $97 billion in prime, $12 billion of that is from offshore product, okay? So that is not subject to the SEC. So that is over on the side. Another $5 billion is our leftover historical direct retail, along with our internal use of prime funds, where one fund is using another fund. So that is not an issue. Then we have $25 billion of the $97 billion that comes from broker dealer sweep accounts, where usually the underlying customers tend to be retail as defined. And retail as defined currently in the proposal is, they don't want to receive -- redeem more than $1 million a day. And so we think that, that would probably be okay.

Then we have $8 billion that comes from our institutional cash market, which tends to be large corporate customers who could not meet any $1 million a day type redemption. Okay. So then we have two other categories. We have $32 billion in trust and wealth management, which is our bank trust business basically, and another $15 billion in our capital markets. So this $47 billion, all these clients more or less come in through omnibus accounts, and they are very difficult to characterize. We do know from incidental comments with some clients, who are on their own going to comment to this extent, that some of them, the $1 million isn't going to work for them. And others say that, most of the time that works but sometimes it doesn't. And so they might be thinking about different numbers. So it is very difficult for us to characterize that $47 billion, because we don't see behind the curtain, as to what their redemption profile is.

Okay. All right. Thanks for taking my questions.

Thank you. Our next question is coming from Michael Kim from Sandler O'Neill. Please proceed with your question.

Good morning, First question, just in terms of the institutional channel, curious if you are seeing any signs of maybe some shifts in allocation trends, or a pickup in rebalancing? And then related to that, can you just give us an update on the pipeline and where you stand maybe versus last quarter?

Sure, Mike. On the institutional side, we have certainly seen a step-up in the equity activity. And so from an RFP standpoint, we have -- we had more than twice as many in the second-quarter than we did in the first-quarter. And it would be running at about a 50% higher rate based on Q2, than what we saw a year ago. So we have certainly seen heightened interest in equities, and in a variety of strategies. The clover, we mentioned the clover small cap. We did mention our $600 million yet to be funded, which is about $325 million of equity, a big piece of that is in the clover small cap value area.

That continues to show up in a lot of RFPs. The strategic value dividend strategy is probably the next one I would mention. And then some interest in our tail risk and managed volatility type of strategy. And we mentioned MDT. We are getting several RFP requests, and the performance there has been outstanding. So we have seen a shift to equities in the institutional channel, both from an RFP standpoint and from a pipeline standpoint.

Okay. That's helpful. And then maybe can you give us an update on what you are seeing in the M&A markets, in terms of opportunities, competition, pricing trends, what have you, particularly in light of sort of the recent step up in market volatility?

Uptick in market volatility never really seems to be a big factor with us, Michael. The people who, we are trying to do transactions with have to fit in with us culturally. And on the side where we are getting centers of excellence, we are interested in the people staying here and having a long-term view. So they aren't usually gone by -- or drawn by or controlled by, something has happened in the marketplace, and there is more volatility here or there. On the roll-ups, that does work on, its time to get out of the business, and so you do see some upticks in volatility there.

But on the -- I would say we have more activity going on, as we have focused on the Asia Pac and in Europe, and there is lots of meetings. And it has taken us a significant amount of time to develop relationships over there, spending time. And actually with our, with our team in Australia of people down there with Craig Bingham and his contacts, we are developing, and starting to have some pretty decent discussions. And the same thing in Europe, we have met people for two and three years now, and can see our way to having pretty decent discussions. And that is what I have to say about that.

Okay. Maybe just one more for you, Tom, in terms of the adjustment in the bonus accrual in the second-quarter, can you quantify that? And then any color in terms of how you are thinking about the comp line, as you look out to the back half of the year?

Yes. We thought we were going to have $69 million, and we basically had $68 million. So if you -- the way the bonuses work, we have to accrue what we think it is going to be for the full year. So that if we were about a $1 million off, that means that we had -- since it is half a year, that means we had $2 million less for the whole year than we thought we were going to have. And in terms of a run rate into the future, it is -- for the next quarter, we would expect it to be in the $68 million range.

Got it. Thanks for taking my question.

Thank you. Our next question is coming from Robert Lee from KBW. Please proceed.

Hi, good morning.

Hi.

I apologize. I got on a little late, so maybe you did touch on this. But could you, maybe just -- I think Chris, you had mentioned -- well, you did mention this. You talked about the outflows from the -- I guess, the total return product, and the change in manager there. Should we be expecting that with the change due to retirement that -- are you aware, or there could be some other flows related -- outflows related to that? Or you are not concerned about that at this point?

Well, at this point, we are not aware of any other big lumps like that coming out.

Okay. And then maybe looking at it -- and this goes for both the fixed income and the equity business on the fund side. I mean, you have always kind of run with higher redemption rates in both those product lines, at least relative to the industry. And I understand it is somewhat driven by distribution and probably a decent proportion of short duration products. But as you look out, is there anything, is there anything as you think about, just kind of running the business that you think could cause that redemption rate be -- I am thinking about this over time -- to kind of moderate, maybe shifting distribution patterns or anything related to the shifting product mix? Because it does require you to kind of produce a lot of gross sales every quarter just to kind of stay in place?

Well, there is a lot of red queen involved in the mutual fund industry in general. And in this product in particular as you have noted. By red queen, I mean you have to run twice as fast just to stay in one place. And what we have seen, even with the turnover that occurred in June, from what was going on in April and May, there is still a lot of interest in these types of products as standard issue inside our client base. So even though at the top of the -- of the pipe on the chart so to speak, you are getting increased volatility, the core demand for the product remains strong.

And Don Ellenberger and his team have done an excellent job in these kinds of circumstances. And the watch word that this fund has had with its clients, has been consistency over time. And that is why I mentioned the 10-year record, because that's what this fund is all about. So with that, I don't think we are going to see the kinds of fundamental changes that you are talking about. Ray?

Rob, to your point on the fixed income side, I think you would look at the shorter duration products which are a significant part of our product set. And so we would have higher than industry redemptions there. However, on the equity side I think our redemption rate, I mean this quarter, if you annualized it would be something in the 24% range I think. And I think that is probably a bit more consistent with the industry.

Okay. Great. And just one last question. Just curious, as you look to -- expand in Asia Pac, can you maybe update us on just, what do you kind of think of as your kind of lead strategy that will help kind of -- kind of get -- maybe hit the ground running and probably -- and gain some traction quicker? If there is a couple of specific ones, or maybe even some new ones you have there, designed specifically for that market?

Well, it has to be answered in two parts, Rob. One is Tom mentioned that we are having some discussions and interesting things, and they have done time with it. That they are -- that one of the things we have in mind is doing acquisitions of some investment managers that already have product out there. So that would be one thing. And I am not going to characterize it, because then that gets you too close to who we might be talking to. And then internally, what we have looked at is our high yield, our total return bar and fund, our emerging market debt, as kind of the triumvirate of lead type products. And there are a couple others that we think would work as well.

Yes, I would throw into that the dividend strategy, the strategic value dividend. As one that we have had some indications of interest in, as we have done our due diligence in those areas.

Great. That was it. Thanks for taking my questions.

Thank you. Our next question is coming from Cynthia Mayer from Bank of America Merrill Lynch. Please proceed with your question.

Hi, good morning.

Good morning.

So maybe just circling back to the math that you were doing on the money market funds, and which might qualify for retail and which might not. It sounds like you think you have $8 billion that is definitely institutional, $47 billion which is hard to characterize. So of that, call it $55 billion, have you surveyed the clients? Do you have a sense of what proportion of those would leave if the NAV floats? What proportion would leave if there are gates? And also is there -- of the money that might leave, is there any offset in expenses?

We have not done that as of yet, and it is very difficult to do. There are others, outside firms that are working on doing those kinds of things exactly, as part of comment process. Incidentally, when you are talking to people, you find out that they go through the list of things that we mentioned, that I mentioned in my remarks. They will look at govie funds. They will look at bank deposits, primarily the too-big-to-fail banks. And some will be willing to look at other types of things, separate accounts, individual separate accounts if they are really big, team separate accounts on private type offerings, and maybe even some of them can squish money offshore. So I really can't give you a chapter and verse like I would like to on where that money could possibly end up, because we haven't asked them exactly where they think they would go.

And Cynthia on the expenses, it is just the simple thing that the, revenue would go away like you are talking about, and the distribution expense would go away. So a lot of the big dollar expenses are answered. And then, we would have to go through and say, did we get the money in the other places like Chris mentioned, a possibility? And see what effects it would have on our margin, and how we wanted to manage it for growth and for investment. Just like you would expect we would do.

Okay. For stuff that is truly institutional, is there much in distribution expense?

It would be lower Cynthia than the retail. If you look at, in normal yield environments where we don't have the extremely low rates like we have now, the distribution expense is effectively about half of the money market revenue, but that that varies, and across the channels.

Okay. And so if a lot of money goes into government money market funds, could that potentially push the yields negative? And can you just remind us of what your policy is when yields get negative or close to negative?

I will let Debbie discuss how much movement of money into governments could go to into -- cause them to go negative, which I don't think would happen. But nonetheless, Debbie will handle that. And then I will talk to you after that about the second part of your question.

Cynthia, we really feel as though negative yields aren't much of a threat at this point, even if there were a substantial movement of client assets out of prime assets from an industry perspective and into the govie side. Having said that, we are getting a little bit of positive momentum, in the context of supply that we expect to be better from a performance perspective for the rest of the year. And if we continue to chug along from an economic standpoint, the improvement for that should continue to be pretty good. We do think, however, that it is just locating if you will, in the context of too much going into the government space, it can driving yields even closer towards that zero number.

Negative yields should be something that, although it can be handled by the Treasury at this point, it is certainly not something that they feel is in the normal and sort of ordinary operating procedures. And we would expect that even on certain instances where special T-bills or Treasury securities might trade negative for a short period of time in the secondary, the expectation would be that Treasury would work very hard to make sure that at auction, there would be no such negative yields which ultimately would be sort of the precedence that would be set from a market perspective.

And then in answer to the second part, Cynthia, in terms of what our attitude about negative yields in the funds would be, if it is a short-term type thing, then it would be handled in an analysis related to waivers. But if it is a long-term negative yield on a money fund, then we soon discover the Federated Investors Inc. is not a charity. And that, if the marketplace says that this kind of product is no longer viable, then that is the result that the marketplace has cried for. But we don't think that is what is going to happen. So on the short-term it would just fall into our regular waiver-type analysis, and we would see what that meant to us.

Great. Thanks. And then just on expenses, it looks like apart from distribution which was lower due to waivers and systems, there were a bunch of other small item, expense items, and they all rose. If you combine them, it was like those expenses were up 2.4% versus the previous quarter, comp travel, advertising, other. So is that seasonal or are there some expenses there which have to do with the responding to regulatory stuff? Is there -- is that a new good run rate?

You captured with, the way you phrased it, as basically stuff happens. We did -- we have increased the advertising a little bit, and we do -- are going to expect some more expenses with the money market dealings. And we are picking up a little bit in office and occupancy, as we opened up our Australian office and things move up. I don't know if I have a forecast on exactly the next quarter for the other expenses like you are looking for. Maybe we could talk to you after the call?

I would say Cynthia, that travel is seasonal. We have seen that kind of a step up from Q1 to Q2. And so trending that over a longer-term would be the way to model that. But we can certainly go through that with --

Okay. Great. Thanks a lot.

Thank you. Our next question is coming from Eric Berg from RBC Capital Markets. Please proceed with your question.

Thanks so much. Chris, acknowledging that the municipal market is one of many, many businesses in which you compete, I would nonetheless like to get your views on sort of what is happening right now. By that I mean the following, Detroit broke, Chicago downgraded, Illinois in very bad shape, and many other examples. Two part question, first what do you consider to be the threshold issues, the most important issues that need to be resolved in the Detroit matter? And what would you consider to be for the municipal market in general, given all these difficulties to be sort of the best case and worst case outcome? Just how could this story end, either favorably and unfavorably?

Let's first cleanse the table by saying that in none of these circumstances do we have any money market assets. So that nobody gets the idea, that because we are discussing this, that somehow this has -- has gotten into any of the money market funds. Because -- and this gets into the answer to your questions. The first thing is, that these things are very slow trains coming down the track that every analyst who does his homework sees. And that was especially true with New York. It was true in Harrisburg, in our home state of Pennsylvania. It was true in Birmingham. It is true in Illinois, and the other instances that you mentioned. It was also true in New York, back in the day during those times.

So that is one thing that supports having a financial advisor and going through the advice routine, when you are dealing with municipal securities. That it isn't just a buy and throw it into a bucket, and then everything works out. And so, the way that we look at it is, that this is an endorsement of the importance of doing real credit work and real analysis on the whole thing. Now one of the most important issues, the most important issues are to stop the bleeding, and get things reorganized. And I don't know all of the facts about Detroit, but I do know that they are spending and making promises, a lot more than they can handle. And one of the issues is the underlying efficacy of what a pension promise really is.

This will get way beyond the scope of an earnings call on Federated. But at some point, when these pension promises get made, they are really made to save money today, in order to burden the future. And this kind of thought -- thinking doesn't always work out. And how can it end? Well, it ends in unfortunate ways for those whose pensions get cut because of the bankruptcy, which is indeed most unfortunate. And -- but because you see these trains coming down the track in a municipal area, careful investment managers can work it out. And all it does is tell you, that yes, this is a marketplace. There is risk in this area, and you have to be attentive to it. So I don't look at it in any draconian terms, because the marketplace is well-informed on -- on the numbers, and on the trains that may be coming down the track. And by the way, I am not a muni manager. (Laughter).

Right.

The other thing that I would add to that -- this is Debbie -- that in the sense of the possibility or the discussion about whether [GO] type financing would be included in the bankruptcy filing, which obviously wasn't the case. I think the discussion of that was enough of a scare of the muni market to really go back and rethink, in the sense of what Chris is saying, from start of due diligence and analysis perspective, AAA rated issuers even if GO's were put into subjectivity with regard to their contractual nature, and the ability for tax collection for repayment wouldn't be subjective or problematic. But when you are talking about A issuers they would be. And people would think twice and do a little bit more due diligence on what I would call, sort of the lower of the investment grade products that would be out there, from a municipality standpoint.

Certainly that can't be healthy overall from a country financing point. So we, as well as others in the muni marketplace, will continue to work with the industry in making sure that in fact those pledges, though those GO pledges and the taxation behind those types of bonds from a security perspective are not compromised.

Well, that was really what my ultimate question was, that was implicit in my question. In other words, I will finish up real quickly. But if it turns out that the very nature, the very -- the very nature of general obligation bonds changes, so that either courts rule that municipalities are not required to raise taxes in order to meet those obligations, why wouldn't this affect all of the municipal issuers? Why would this be particularly harmful to the A marketplace?

Well, I think it would affect all the municipal issuers, but it would affect the higher -- highest rated ones less. So certainly, you are going to see a spread. Right now munis finance themselves not as cheap as the US government, but certainly not as expensive as corporations. And I think that gap would narrow, and they would finance much of more like a corporation that doesn't have such a pledge or security lying behind it than they do today.

Thank you. Our next question is coming from Greggory Warren from Morningstar. Please proceed.

Yes, good morning. Thank you for taking my call. I just have a thought about the money market industry going forward. It was easier to make a case for consolidation, when there were proposals put on the table for capital buffers, which would have made it a much more expensive business to run. Based on where the proposals are now, and based on kind of what the feedback you are hearing out in the industry, do you think there is going to be a larger level of consolidation going forward? And then I guess the question is, are you interested in being a major participant in that? Or is your acquisition-related activity more going to be focused on the fixed income and equity side?

We -- to answer the second question first. We would be open to discussing with others who choose to get out of the money fund business at any time. So we would be open to doing that, and we have been doing that, and for many years. Okay. On the idea of consolidation, remember that, I guess it was about in '07, there were over 200 people doing money market funds. Today if you look at the list, they list about 80 people doing money funds. And I think the bottom 10 or 15 of those have $10 million or $20 million in it. So you barely have 60 people, 60 firm doing money market funds. And if you look at the names of the firms, you can very quickly decide, well, how many of those will actually be consolidation candidates, and how many wouldn't. And I think there are consolidation candidates there. But there has already been a consolidation going on here. Or looked at the other way, an oligopolization of this business. And that is encouraged each time you put on more rules, regulations and challenges. And so that will just continue.

Yes, that was -- sort of the thinking I was going at there. Because we have seen a lot of consolidation just because of the impact of fee waivers and interest rates over the last five years. But I was just curious if that was something that you would continue to focus on going forward? I mean, I know it is a big piece of your business, but looking at equity and fixed income, higher fee rates and better contributors to the top line going forward?

Well, owner operators like revenues and business, even if it may not be the best. It would be best if we could just do acquisitions of equity. That would help the ratios, the PEs and all of that. But if we think we can make a good trade on money funds, we are happy to do it.

Okay. Great. Great. Thanks for taking my questions.

Thank you. Our next question is coming from Roger Freeman from Barclays. Please proceed with your question.

Hi, good morning. I just have one question. I wanted to ask about another area of reg development. I am curious about your thoughts on the Feds Basel III rule proposals for the banking industry? With its focus on leverage now, and this current proposal doesn't provide offsets for low-risk liquidities, [high-qual] assets, and could reduce repo activity further. And I am just wondering if you thought about what impact that could have on your business? I guess, on the one hand yields could be higher, but on the other hand it could reduce the total size of repo-backed funds?

I will let Debbie address that directly. And then I have a comment, that is slightly related to that when that concludes. Okay. Thanks.

Certainly when you look at the impact of the banking industry reform and Basel III in particular, there are implications most clearly felt from a repo market standpoint, at least as far as money markets are concerned. We have been going through gut-wrenching changes already over the course of the last five years, in the sense of repo marketplace has been cut back by two-thirds. From a size perspective, on where it was in the financial crisis of '07 and '08. Having said that, the types of collateral that are being financed can be institutions that are doing that finance are a much higher and more credit-worthy level today than they ever were historically. So I think despite the facts that these regulations will make it a little more costly from a business perspective, the institutions that are currently in that business that remain, that have been able to weather the storm if you will over the last five years, will continue to go down the path of financing in that particular way.

It may become a little less lucrative. So currently, if you look at the structure of any type of a government money market fund, whether it be Treasury or Treasury and agency, a predominant portion of the assets within that product are generally repo, repo-backed, so indirect ownership through the repo marketplace of those Treasury, the government agency securities. Perhaps that construct will change to some degree, if in fact the financing side of the equation for repo becomes a little bit more expensive, and trends more towards the direct ownership of those particular -- of those particular types of securities. But again, lots to be sort of viewed and undertaken, as the implementation time period for a lot of these things is further down the road from a timing perspective, and the potential likelihood of additional change is still pretty high.

The comment I would make, it relates to the liquidity coverage ratio, which is arguably related to the questions you have asked. But when the Fed representative testified in front of the Senate about 10 days or so ago, he made the comment that while they were going to get to that, and it would probably be by year-end. And this is a way that the Fed has the ability to regulate how the banks utilize money market funds on a short-term basis, what they are now calling, of course, the short-term wholesale funding market. And so we would applaud their efforts to continue to do the regulation they think appropriate on the liquidity coverage ratio for the banks, because we think it is a much more efficacious way to regulate bank use of money funds, than by trying to clobber the money fund on the other side. So that it is not an available alternative, especially on the prime side.

Okay. Thanks.

Thank you. Our final question today is coming from Ken Worthington with JPMorgan. Please proceed with your question.

Hi, thank you for letting me squeeze in. A couple questions, maybe first for Debbie. Debbie, what are the risks to your near-term rate forecast? In other words, if you were going to be wrong, what would be the likely cause? And if, hopefully you can frame this, if rates were to stay as low as they were today and not rebound in August, what does that do to fee waivers, does it increase them a little bit? Does it increase them a lot? Like I know that it is very sensitive around rates when they get especially low, but just framing the magnitude would be helpful there on the waivers?

Hi, Ken, it's Ray. I will take the second part of that. And then Debbie can comment on her forecast. If you look at where we are trending now in July, we would be roughly heading toward a $9.5 million month of July. So if you took -- if we had three months of July, you would be at $28.5 million. But as we have said, we expect to see some improvement around the middle of the quarter.

Thanks.

Ken, I think from a risk perspective, it would be towards the lower end, and not the optimism that we are looking for the at this point of a few basis points of improvement. Having said that, it is a few basis points that we are looking for in this quarter. So I don't think it's -- it is clearly impactful in the context of the overall product. Why do I think it is more potential for downside risk? And that just has to do with a couple things, number one, the supply side of the equation. Certainly, we were surprised with the strength in the supply, or the strength in the receipts the Treasury was able to take in during the second-quarter, and the tax implications for that. If that -- if those surprise again in the third-quarter, that has some negative implications from a financing needs standpoint.

Also at the end of the second-quarter, Fannie Mae paid out on a dividend basis back to the Treasury $60 billion, because as we know that the housing market is now improving. They are able to start repaying some of their debt. Freddie is going to be doing something similar at the end of the third-quarter, although much smaller in magnitude, only $15 billion. So again, that has -- we are taking that into account. But it potentially it has a little more impact on the supply side of the equation.

And then I think the other part, that we are continue to be wary about, is the economic growth in the marketplace. Certainly, we seem to have more positive steps forward than negative steps backward at this point. Nonetheless, I don't think that we are completely convinced that we are on firm, firm footing for ultimately good growth going forward. So I think that would be, sort of again the impetus to the forecast being a little bit more on the negative side, than what we originally would say.

Thank you. Moving on to Kaufman, how much institutional or quasi-institutional money is run by Kaufman these days? And as we think about Lawrence and Hans, how much of assets are really at risk if they depart or retire? And are there any contingency plans in place? Or is there a plan in place to kind of transition the management of these products, just based on their being well into retirement age?

As regards the institutional participation, it is negligible. As regards, Hans and Larry, they remain strong at the ship of state, and working hard. I might add as a footnote to that, one of our founding fathers Dick Fisher is in here. He had his 90th birthday in May. And he is in here working everyday, traveling, talking to broker dealers and things like that. So these guys are turned on, and tuned in to their portfolios and got some good things going.

Next point would be, that they have a gang of analysts/sub portfolio managers that are outstanding, and have been together for a long time. When we bought the enterprise years ago, one of our fellows went up there by the name of [Aash Shah], and he remains a part of that team. And the individuals in that team run sections of those portfolios, which would -- which would continue. So the succession plan is that you have Mr. Lerner in there, who has been with them for many, many years. And you have a strong portfolio management team that has segmented that portfolio for a long time. And I have not heard from any of them, nor do I expect it to be true that either Hans or Larry have any idea of retirement. They, like Dick Fisher, love it, and have to have it, and we are happy to have them.

Great. Thank you very much.

Thank you. That does conclude our question and answer session. I will turn the call back over to management for any further or closing comments.

Well, we will also conclude the call, and we thank you for your time today.

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time, and have a wonderful day. We thank you for your participation today.