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Fitch: Repo could be ‘serious’ threat to money market funds if U.S. defaults

If the U.S. defaults on its debt payments, a key danger to U.S. money market funds lies on the repurchase market, Fitch Ratings said in a special report July 18.

Fitch said it continues to believe an agreement will be reached to raise the debt ceiling, but if the U.S. does default, money market funds – which hold $1.3 trillion in government securities or in repo loans they’ve made with government securities as collateral – are vulnerable in three key ways.

The biggest threat in a U.S. default is that frightened investors might pull their money out of the funds, repeating the run on money market funds that occurred in 2008. From the report:

The lesson from 2008 is that money market funds can be vulnerable to confidence-driven runs.

 When investors clamor to get their money back, money market funds must be able to raise cash quickly. In finance jargon, this is called having liquidity. Since 2008, a financial institution’s liquidity has been a prime concern of regulators.

Money market funds rely on repos and to a lesser extent ownership of very short-term U.S. Treasury securities as their primary sources of liquidity, according to Fitch.

A second threat in a U.S. default is that the U.S. government might not give the money market funds their cash back when their short-term Treasury securities mature. From the report:

If money market funds were facing net outflows, a failure by the U.S. government to rollover maturing U.S. Treasury securities could have an immediate liquidity impact for money market funds.

The third threat in a U.S. default is disruption on the repo market. From the report:

Money market funds’ reliance on repos as the primary source of overnight liquidity is potentially more problematic. Overnight repos collateralized by U.S. Treasury and agency securities accounted for all daily liquidity for government money market funds and over 80 percent of daily liquidity for the U.S. prime* money market funds. Any material disruption of the repo markets could be serious.

Declines in the value and liquidity of U.S. Treasury and agency collateral could result in increased margin haircuts and margin calls*, at the very least, potentially pressuring the overall repo availability and liquidity. Liquidity in the form of repo also would depend on the strength of the counterparties … and their ability to make two-way markets, given the repo market’s interconnectedness.

If money market funds can’t pay their investors on time, Fitch would likely have to downgrade fund ratings, Fitch said. That could intensify the run on the funds. From the report:

A failure to meet timely redemptions and maintain preservation of capital, consistent with Fitch distinct rating scale and criteria for money market funds, would have negative rating implications.

Since the financial crisis of 2007-2008, regulators have required money market funds to shorten the maturities of their investments so they can get cash fast in an emergency. Ironically, this has driven money market funds more deeply into the unstable repurchase market, especially overnight repos. From the report:

Since 2008, money market funds have substantially strengthened their liquidity profiles through holdings of daily and weekly liquid assets. The chart on page 3 shows U.S. government money market funds operating with close to 60 percent of the assets under management in repos and assets maturing in one week or less. However, much of this liquidity is in the form of U.S. Treasury and government agency securities and repos backed by such securities. Likewise, U.S. prime money market funds held approximately 32 percent of assets under management in assets maturing in one week or less, although over 80 percent of the repos are backed by U.S. government securities.

In spite of potential problems for money market funds if the U.S. defaults, the Fitch report said investors don’t seem to be concerned. From the report:

So far, the apparent political impasse over raising the statutory debt limit by early August and the extraordinary measures taken by the U.S. Treasury to avoid hitting the debt ceiling have not caused dramatic outflows from government money market funds this year. In fact, government money market funds have experienced net inflows of late, as shown in the chart on page 4. The market’s sanguine view may reflect the widely held belief that the possibility of a U.S. default is remote (consistent with Fitch’s current view) or it may mean that money market fund investors are willing to look through a default since it would likely be temporary and U.S. Treasury securities still serve as one of the least risky liquidity management options among short-term instruments such as bank deposits and direct corporate investments.

_____

* A prime money market fund is one that invests in corporate as well as government securities.
* Margin haircuts and margin calls means lenders would demand more collateral to cover the repo loan.

 Further reading:
Thinking the Unthinkable — What if the Debt Ceiling Was Not Increased and the US Defaulted? Fitch Ratings, June 8, 2011
The Domino Effect of a US Treasury Technical Default, JP Morgan, April 19, 2011

 

 

 

 

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