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Fitch: Shortage of risk-free repo collateral hits prime money market funds

Prime money market funds, which invest in both corporate and government securities, are increasingly accepting nongovernment securities as collateral for repo loans, according to an August 4 Fitch Ratings survey of the 17 money market funds it rates.

The survey did not say what kinds of nongovernment securities the funds are accepting, but the leading choices typically include corporate bonds, stocks, asset-backed securities, and private label collateralized mortgage obligations, according to the Federal Reserve Bank of New York.

Fitch said money market funds chose more nongovernment securities as collateral in the second quarter of 2011, and also grew their overnight repo holdings, because:

– They sought alternatives to European sovereign debt,

– There is a shortage of U.S. government securities, and

– Interest rates are so low that it isn’t worthwhile to invest longer term.

The Fitch-rated prime money market funds, which manage $446 billion, have about 16 percent of their total assets in repurchase agreements, Fitch Ratings reported.

The money market funds’ difficulty in finding enough super-safe collateral for their repo loans illustrates a wider problem in the credit markets.

As the economy improves, there may develop a shortgage of repo collateral. That could restrict credit or drive lenders to accept riskier, second-rate collateral, as they did when they accepted subprime mortgage-backed securities as collateral during the housing boom. That ended in disaster, when housing tanked and repo lenders panicked, sharply limiting credit and sending the Federal Reserve into bailout mode.

Money market funds do their repo lending through the tri-party market, where the borrowers are a handful of global money center banks and their subsidiaries, according to Fitch. The transactions are cleared by JP Morgan Chase or Bank of New York Mellon. The run on the tri-party market in 2008 – that is, the withdrawal of tri-party repo lenders – was one of the Federal Reserve’s greatest concerns during the financial crisis.

The top five companies that Fitch-rated money market funds made repo loans to in May 2011 were, in declining order: Barclay’s Bank, Deutsche Bank, BNP Paribus bank, Bank of America Merrill Lynch, and Royal Bank of Scotland, Fitch said.

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