A Standard & Poor’s plan to change the way it rates the credit risk of counterparties in repurchase agreements will boost costs for broker-dealers who draw cash through the arrangements and shrink the pool of liquid assets for money funds, according to industry participants.
Today is the final day in a one-month public comment period on S&P’s proposal to view unrated broker-dealers serving as counterparties in repos to rated money funds as having “high credit risk.” S&P now assigns to an unrated counterparty that’s at least half-owned by a rated entity the parent company’s risk level.
“This would be disruptive not only to the dealer community, whose funding costs will go up, but also to the money funds who will need to find some replacement for that overnight liquidity,” said Joseph Abate, a money-market strategist at Barclays Plc in New York. “The changes are unnecessary because the overwhelming majority of repos held by money market funds are against government securities which are liquid and the transactions are typically overnight.”
Money-market mutual funds have come under scrutiny since September 2008, when credit markets nearly froze after the $62.5 billion Reserve Primary Fund collapsed on losses related to bankrupt Lehman Brothers Holdings Inc. Lehman failed partly because lenders lost confidence in the firm’s ability to pay repo loans or post adequate collateral.
S&P is proposing to modify criteria for assessing counterparty credit risk in funds with principal stability fund ratings and fund credit quality ratings. These counterparty transactions include repos, reverse repurchase agreements, swaps, forward purchases, foreign-exchange contracts and other hedging positions.
“There are a lot of issues that go on if something goes wrong with the counterparty,” said Peter Rizzo, senior director of fund services at S&P in New York, in an interview. “That is not a risk we want to see in our rated funds. While we are not ignorant to the fact that our criteria may change behavior, we need to apply and develop criteria that we feel is best suited for AAA standard.”
Rating companies and regulators have increased scrutiny of derivatives and short-term funding tools, which proved vulnerable during the financial crisis. U.S. regulators have increased the amount that money-market mutual funds hold in the form of cash and easy-to-sell securities.
Funds must be able to sell 10 percent of their assets in one day and 30 percent within a week under rules approved in January by the Securities and Exchange Commission to reduce investor runs.
As of late September, taxable money funds had a total of $570 billion in outstanding repo transactions, the majority with unrated broker-dealer counterparties, according to Barclays. If the S&P plan is adopted, dealers without their own explicit rating will effectively be blocked from doing repo transactions with rated money funds, Barclays said in a report last week.
“There is definitely risk of the S&P proposed changes affecting money funds’ use of repos,” said Deborah Cunningham, chief investment officer in Pittsburgh for taxable money markets at Federated Investors Inc., which manages more than $336 billion in money-market investments. “It would change the marketplace if it comes through. If this becomes required, then it’s a question of will the counterparties go down the path of paying for this additional rating. That remains to be seen.”
Assets in Repos
The more than $4 trillion-a-day repo market is used by dealers to finance their holdings of securities in inventory. Rates are typically below unsecured borrowing costs because the loans are backed by collateral.
In a repo arrangement, a lender sends cash to a borrower in return for collateral, often Treasury bills or notes, which the borrower agrees to repurchase as soon as the next day for the face value of the securities plus interest.
As of Aug. 31, U.S. prime money market funds held 17 percent, or $281.5 billion, of their assets under management in repos, up from a long-term average of 11 percent, according a Fitch Ratings report published Oct. 4. Prime money funds typically invest in commercial paper, bank certificates of deposit and floating-rate notes issued by private firms.
“The surprising part of the S&P proposal is that loans by money-market funds to broker-dealers would get a low credit rating even when they are backed by U.S. Treasuries,” said Darrell Duffie, a finance professor at Stanford University and president of the American Finance Association. “The broker-dealers that now depend on those loans for a substantial amount of their financing would probably go elsewhere, at a slightly higher average interest rate.”
Repos undertaken by U.S. money market funds are almost entirely done on a tri-party basis to help reduce the risks associated with a counterparty default, analysts led by Viktoria Baklanova wrote in the Fitch Ratings report.
The Federal Reserve has been working to strengthen the tri-party repo market after its near-collapse in 2008 and 2009. In a tri-party arrangement, a third party functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. are the only banks that serve in a trade-clearing capacity in the market.
A tri-party repo reform task force, formed in September 2009 by the private industry group sponsored by the New York Fed called the Payments Risk Committee, recommended cash investors focus on the collateral underlying repo agreements.
In a May statement of proposals, the task force called for investors, such as money funds, to secure “liquidation plans” for repo collateral in the case of a dealer default. In many cases, “cash investors were unprepared to cope with the consequences of a dealer default” and at times had “financed assets that they would not normally hold outright,” during the financial crisis, the task force statement said.