Wells Fargo Advantage Funds' Dave Sylvester writes in the latest "Portfolio Manager Commentary: Overview, strategy, and outlook," "As everyone focuses on the current situation in Europe, much has been written about money funds' exposure to foreign banks or, more specifically, European banks. Yet if one really wanted to focus on the core issue, it would be banks in the eurozone or, even more appropriately, a few banks in the eurozone. How did a problem that began in Greece, a relatively small country on the edge of Europe, become a topic that brought money funds back into the spotlight? What are the real concerns, and is there any reason to be at all optimistic?"
He says, "So what does this have to do with money market funds? As part of their diversified portfolios, money market funds hold obligations of banks, including foreign banks. Despite protestations from the editorial boards at leading financial publications that they are shocked -- shocked! -- to find foreign bank debt in U.S. money funds, we are not in Kansas anymore. We have had an interconnected and global financial system for many, many years, and money funds lend to high quality issuers across the developed world. Some speculate that money funds' exposure to foreign banks has increased as yields have declined, but that's simply not the case. In fact ... U.S. money funds' exposure to foreign banks has remained fairly constant for the past five years, at 40% to 50% of money fund assets."
Sylvester continues, "Why have money funds invested in foreign banks? In part, it is simply a supply issue. While the total supply of U.S. dollar denominated investments that are eligible to be purchased by prime money market funds exceeds $9 trillion, when U.S. government securities and repurchase agreements (repos) are excluded, that number drops to a level closer to $2 trillion. Of that $2 trillion, we estimate that foreign banks and their affiliates issue about 40%. Therefore, money fund exposure to foreign banks is not outsized but in line with the composition of the money markets themselves. It has been no secret that supply in the money markets is very constrained; we have addressed the topic here on a number of occasions."
He explains, "To us, it is not surprising that money funds have continued to keep a fairly high level of exposure to foreign banks. U.S.-based issuers have been dropping out of the domestic money markets for a couple of years now. As the economic woes have taken a toll in the financials sector, a number of banking institutions were absorbed or purchased by stronger entities. Other firms just no longer meet money funds' requirement that issuers present minimal credit risk. Both of these factors reduced the number of available issuing entities. In addition, as interest rates have plummeted, the remaining high-quality issuers have been taking advantage of these favorable rates by issuing long-term debt. However, foreign banks remained key issuers in the short end. Most have continued to improve their fundamental credit profiles and issue into the money markets."
The latest Wells commentary comments, "What have foreign banks been doing with the money raised by all of this issuance? To a great extent, they've been using it to build their cash reserves. Data from the Federal Reserve (the Fed) shows that the cash balances at foreign-related institutions have more than doubled in the past year to approximately $1 trillion. Much of the increase has come in the last several months, as foreign banks' cash reserves have increased from $500 billion at the end of February. Some market observers estimate that of the $1.5 trillion in excess reserves held at the Fed, more than $850 billion is held by the U.S. branches of foreign banks."
It says, "Now, we are back to Greece. What happens to the European banks if Greece defaults, or even if the bondholders have to take a large haircut? Clearly, the exposure to Greece varies among banks, as does the amount of capital that each bank holds. But we do not underestimate the contagion risk, and we suspect that this would lead to further problems for Portugal and Ireland. In our assessment of whether or not an issuer presents minimal credit risk, we believe that one relevant measure is to examine the level of capital of each bank in relation to its exposure to the peripheral nations. We believe that the efforts to shore up bank capital over the past several years have put many of the large eurozone banks in a position where they have sufficient capital to absorb significant losses on their holdings of the sovereign debt of the peripheral nations, should such a loss be necessary."
Sylvester writes, "We also do not underestimate the risk of a credit freeze. In the past, market participants have shut off credit availability to all issuers in a sector when trouble strikes, no matter what the underlying credit fundamentals might be. However, the fact that foreign banks have such large cash balances and excess reserves held at the Fed gives us a very different set of circumstances in the current environment. In previous episodes, borrowers were financing long-term illiquid assets with short-term funding. When the funding was cut off, those borrowers struggled to replace the funding as the price of the assets declined. In the case of foreign banks today, the assets are largely demand deposits at the Federal Reserve. Quality, liquidity, and price stability of these deposits are beyond question. If money funds and other market participants choose to not roll over their maturing commercial paper (CP) and certificates of deposit (CDs), those banks could simply draw down their reserves at the Fed. Additionally, European banks have access to liquidity provided by the ECB, which, along with other central banks around the world, has in place swap lines with our own Federal Reserve. As such, it appears that there is plenty of liquidity to back up near-term maturities. The fact that in mid-June we saw a sharp drop of $123 billion in cash held by foreign banks in the U.S. may indicate that this unwinding process is already under way."
Finally, he writes, "Does this mean that we are totally complacent? Absolutely not! The widening of credit spreads and the attendant price risk is still a concern, as is the potential for another shift out of prime funds. This is why, for some time now, we have been in favor of short and highly liquid portfolios, sometimes at the expense of yield. We believe that these steps will help to minimize the effects of any short-term price volatility caused by these events. Finally, it is notable that one of the reasons for the heightened focus on money funds during this episode is increased levels of transparency. Unlike almost every other segment of the financial services industry, people can look through money funds and see exactly what they hold. Data is reported regularly and in a standardized format."
