Repo Rules May Pinch Money Funds

Fed restrictions on repo collateral could mean lower yields for funds, Fitch says.

U.S. prime money-market mutual funds may face lower yields and fewer investment choices in the market for borrowing and lending securities if the Federal Reserve restricts collateral options, according to Fitch Ratings.

A further reduction in short-term interest rates may make it even harder for the $2.6 trillion money-market fund industry to retain customer assets. Record low rates since late 2008 amid unprecedented central-bank monetary stimulus have put pressure on the industry, whose assets fell 31 percent in the past two years as of last month.

The Fed said on Feb. 15 it will boost its oversight of reform efforts in the $1.6 trillion tri-party repurchase agreement, or repo, market and will consider restrictions on the types of collateral that can be used. The 10 largest U.S. money funds eligible to purchase corporate debt, which account for more than 5 percent of the market, have raised over the past year their allocation to higher-risk collateral, such as corporate debt, stocks and structured finance, Fitch said.

“If certain types of collateral, specifically the lowest quality, are restricted, then there will be generally less collateral available and rates should fall,” Viktoria Baklanova, a New York-based senior director in Fitch’s fund and asset-management group, said yesterday in a telephone interview. “This would add to a generally very challenging environment for money-market funds both in terms of yield and credit. The overall direction the Fed is taking now is positive for containing systemic concerns, but there are always costs.”

Repos are transactions used by the Fed’s primary dealers for short-term funding. They typically involve the sale of U.S. government securities in exchange for cash, with the debt held as collateral for the loan. Dealers agree to repurchase the securities at a later date, and cash is sent back to the lender, which often are money-market funds.

In a tri-party arrangement, a third party, one of two clearing banks, functions as the agent for the transaction and holds the security as collateral. JPMorgan Chase & Co. and Bank of New York Mellon Corp. serve as the industry’s clearing banks.

The central bank has kept its rate for overnight loans between banks locked in a range of zero to 0.25 percent since December 2008 and said last month it will keep the benchmark low until at least late 2014. Money fund yields average 0.06 percent for the biggest 100 taxable funds, according to Crane Data, down from 0.61 percent three years ago.

The Fed has been seeking to strengthen the tri-party repo market, which neared collapse in 2008 amid the bankruptcy of Lehman Brothers Holdings Inc. and required assistance. The central bank intensified its effort after a private-sector Tri-Party Repo Infrastructure Reform Task Force that it sponsored issued a final report last month, saying more time and effort were needed.

Prime money-market funds’ investments include banks’ certificate of deposits, commercial paper, repurchase agreements and short-term notes and deposits.

At the end of 2011, Fitch-rated prime money funds allocated on average 6.5 percent of their total assets to repos backed by nongovernment collateral, marking a “big rise over the previous few years,” Baklanova said. The ratings company issued a report Feb. 3 on the repo market and posted a comment on its website last week on restricting collateral.

In Fitch’s sample of the 10 largest funds, encompassing about $90 billion in repo transactions, the average rate on repos backed by structured finance collateral yielded on average more than 50 basis points, or 0.50 percentage point, as of August 2011, while those backed by Treasuries yielded about five basis points and agency collateral repos yielded 15 basis points. Nearly 75 percent of the structured finance collateral consists of residential mortgage-backed securities, such as those backed by subprime and Alt-A loans, Fitch said.

“Restricting the tri-party repo market to what are judged to be liquid, marketable, transparent securities, obviously including Treasuries and agencies, is a good idea, at least until the market infrastructure is significantly more robust,” Darrell Duffie, a finance professor at Stanford University’s Graduate School of Business, said in a telephone interview yesterday. “We don’t want illiquid or hard-to-value-and-trade securities going through the tri-party repo market in a significant way.”

Antoine Martin, assistant vice president and function head of money and payments at the New York Fed, wrote today in his personal blog that “in aggregate the composition of collateral being financed in the tri-party repo market is not decreasing in quality.” He cited his analysis of public data previously released by the private-sector task force.

This suggests the Fitch report “may be more about how prime funds are reacting to a low-yield environment by reaching for yield and taking on riskier collateral,” Martin wrote. “This practice is problematic from a systemic risk perspective,” he wrote.


Bloomberg News


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