Dispelling Misinformation on Money Market Funds

By Brian Reid

The ongoing attention to U.S. prime money market funds’ exposure to the debt crisis in Greece has brought three questions to the fore:

• Are U.S. money market funds invested in the “periphery countries”—Greece, Italy, Spain, Portugal, and Ireland—that are seen at risk in a debt crisis?
• Why are U.S. money market funds investing in European banks?
• What risks do those investments pose for U.S. money market funds and their investors?

The answers to those questions can be summed up in four points:

• U.S. prime money market funds have no direct exposure to Greek, Portuguese, or Irish government or bank debt. Their holdings of Spanish and Italian bank debt are minimal and have fallen substantially since last autumn.
• U.S. money market funds have plenty of sound reasons to invest in large, well-capitalized banks with extensive U.S. and global operations—whether those banks are headquartered in the U.S. or Europe.
• It would take a rapid collapse of one or more large European banks to have any impact on U.S. money market funds and their investors. The market is not anticipating any such collapse.
• Regulators and money market funds themselves have put greater safeguards in place to strengthen these funds since the financial crisis.

Those are the facts. Unfortunately, there’s been a lot of misinformation and misunderstanding surrounding these matters. Let’s see if we can clear the air.

Are U.S. money market funds invested in the “periphery countries”?

For the past 12 months, ICI has surveyed a large sample of its money market fund members, covering 85 percent of the industry’s assets, on the portfolio holdings of their prime money market funds. (“Prime” funds—also known as taxable non-government funds—hold commercial paper and other corporate debt issues, in addition to Treasury and U.S. government agency securities.) And since November, funds have filed detailed portfolio information with the Securities and Exchange Commission. Taken together, these data show that:

• For more than a year, U.S. prime money market funds have had no direct holdings of Greek or Portuguese debt, whether sovereign (issued by the government) or private.
• U.S. prime money market funds’ holdings of debt in Spain, Ireland, and Italy were small as a share of the funds’ portfolio a year ago and have declined rapidly.
• U.S. prime money market funds now have no holdings of Irish sovereign or bank debt.
• The latest public data as of April 2011 shows that Italian and Spanish bank debt combined accounts for less than 2 percent of prime funds’ aggregate portfolios—down by about half since last fall.

There are good reasons why U.S. funds don’t hold foreign sovereign debt: U.S. funds buy dollar-denominated securities, and most countries issue debt in their own currency (the euro, in these cases). But the small share and rapid decline of private debt from the “periphery” in these portfolios is evidence of the careful credit analysis and monitoring that money market fund managers apply to every security in their portfolio.

Why are U.S. money market funds investing in European banks?

U.S. funds do have substantial holdings of global financial institutions that are headquartered in Europe, primarily in bank securities. As of April 2011, prime money market funds had 50 percent of their portfolios invested in short-term securities issued by highly rated banks or other issuers based in Europe, concentrated in banks headquartered in France (14 percent), the United Kingdom (11 percent), Germany (7 percent), and the Netherlands (5 percent).

With the month-end portfolio data that money market funds now post on their websites, investors can see exactly who issued the securities these funds hold. Alex Roever, an analyst for J.P. Morgan Chase & Co., studied the data and concluded: “Money funds’ investments in European banks are concentrated in a relatively few, very large, highly-rated institutions.”

Indeed, the European banks listed in those filings should be familiar to many Americans, because most of these banks have extensive U.S. operations. For example:

• BNP Paribas (headquartered in France) has a securities operation that serves as a “primary dealer,” one of 20 banks required to participate in all U.S. Treasury auctions and the Federal Reserve’s open market operations.
• So does Deutsche Bank (Germany). In fact, 12 of the 20 banks listed as primary dealers by the Federal Reserve Bank of New York have foreign-headquartered parents.
• Barclays PLC (UK) issues credit cards, operates a primary dealer.
• HSBC (UK) is a primary dealer, and has a major U.S. retail banking operation—as evidenced by its billboard in Times Square.
• ING (Netherlands) has built one of the largest online retail banking operations in America. (It is in the process of selling ING Direct USA to Capital One Bank.)

Other European banks listed in funds’ public portfolio filings lend heavily to U.S. businesses, or do investment banking in America.

So there’s no mystery why these banks and others need dollar-denominated funding: they have extensive U.S. operations to finance.

Largest European Bank Holdings by U.S. Prime Money Market Funds

Bank	Headquarters	Fund Holdings* (% of funds' total assets)	U.S. Banking Operations
			Retail	Primary Dealer	Corporate / Investment
BNP Paribas	France	4.0
Deutsche Bank	Germany	3.9
Barclays PLC	UK	3.8
Societe Generale	France	2.9
Credit Agricole	France	2.8
Groupe BPCE	France	2.4
Rabobank Nederland	Netherlands	2.2
ING	Netherlands	2.1
Lloyds Group	UK	2.0
Royal Bank of Scotland	UK	2.0
Credit Suisse	Switzerland	1.9
UBS	Switzerland	1.8
Svenska Handelsbanken	Sweden	1.5
DnB NOR	Norway	1.5
Nordea Bank	Sweden	1.4
HSBC	UK	1.2

*Data from Form N-MFP as of April 29, 2011
Source: Investment Company Institute, FDIC, corporate websites, Federal Reserve Bank of New York

European-based banks are woven into the financial fabric of America. Given the size of these banks and their importance to the U.S. and global financial system, U.S. prime money market funds have plenty of sound reasons to hold significant investments in these well-capitalized global financial firms. As J.P. Morgan Chase’s Roever concluded: “European banks provide a plentiful supply of short-dated investment grade debt.” At the same time, U.S.-headquartered banks are flush with cash, holding nearly $1.9 trillion in vault cash and balances at Federal Reserve banks.

Are money market funds taking on bigger risks by investing in Europe? The short answer: No. There’s an active private market in “credit default swaps” (CDS) that allows holders of bank debt to hedge against banks’ default—providing, in essence, bond insurance. This market is pricing the default risk of both U.S. and European banks in prime money market fund portfolios at the same average premium—in other words, essentially the same risk.

Wherever a bank (or other issuer) is located, money market funds can only invest in its short-term securities; must subject those securities to rigorous credit analysis; and must limit its concentration in any one issuer to 5 percent of its portfolio. Finance today is global. Whether they’re investing in the dollar securities of a large, highly capitalized, strictly regulated, highly rated global bank headquartered in Paris, or those of a similar bank headquartered in New York, money market funds are still providing financing for businesses, consumers, and local governments in the U.S. market.

What risks do those investments pose for U.S. money market funds and their investors?

It would take a rapid collapse of one or more large European banks to have any impact on U.S. money market funds and their investors. What evidence is there that this could happen?

Using the portfolio holding reports filed by money market funds, many analysts have looked at prime money market funds’ exposure to Greece and the other “periphery” countries through the funds’ investments in debt issued by European-headquartered banks.

Among the European banks in prime money market funds’ portfolios, in every case the bank’s direct exposure to Greek government debt is less than 1 percent of the bank’s total assets—and for most of the banks, it’s much less.

The credit rater Moody’s draws another distinction—between the banks’ short-term debt, which money market funds hold, and their long-term issues. While Moody’s recently announced it is reviewing the long-term ratings for three French banking groups, the same announcement reaffirmed Moody’s highest rating on those banks’ short-term paper. Thus, any exposure that U.S. money market funds have to these French banks is deemed of the highest short-term credit quality.

Could those banks collapse? The Wall Street Journal’s editorial page, which has fanned the flames by criticizing money market funds, says they won’t: “Neither France nor Germany can defend this plan [to roll over Greek debt] on grounds that a Greek default would destroy their banks.…[E]ven a 50% write-down would not destroy these banks. BNP Paribas is the largest private holder of Greek debt outside of Greece, and…a 30% write-down of its Greek holdings would reduce its earnings per share by only 3%.”

The market agrees. The default-insurance premiums, or CDS spreads, on individual European banks indicate that the markets are not anticipating a sudden collapse of any bank that could pose a threat to prime money market fund portfolios.

It’s also important to note that neither money market funds nor their regulators have been standing still since the financial crisis. Money market funds operate with tighter regulation and greater resiliency now than they did in September 2008. Six months after the Reserve Primary Fund broke the dollar, the fund industry voluntarily adopted higher credit standards, shorter portfolio maturities, greater portfolio transparency, and explicit liquidity requirements for fund portfolios. In January 2010—six months before the Dodd-Frank Act passed—the Securities and Exchange Commission adopted regulations based largely on those standards. These measures have made money market funds considerably more resilient: prime funds, for example, today hold $660 billion in assets that are liquid within one week, far more than the $310 billion outflow experienced in the week of Lehman Brothers’ failure.

No one can say with certainty how a European financial crisis would play out. But the Eurozone has been experiencing debt and financial concerns for more than a year now. Throughout this period, prime money market funds and other investors have reacted to changing developments. As fiduciaries to their shareholders, money market funds are constantly examining the quality of their portfolio and the creditworthiness of investments—going above and beyond any credit rating agency ratings. Through this careful analysis and active monitoring, prime money market funds have already reduced the risk to their shareholders—and they continue to do so.

Brian Reid is ICI’s Chief Economist.