Deutsche Bank's William Prophet wrote in a commentary last week entitled, "This Won't Hurt a Bit," that "There are two distinct observations worth making about the May month-end holdings of the U.S. money fund industry. First, unsecured lending to Europe didn't really change all that much last month.... [A]mong this sample anyway, we would say that lending patterns have been remarkably stable so far this year (all things considered). And there can be no doubt that this is the main reason why the LIBOR setting has been stable as well."

He continues, "And lending to Europe appears to be even more stable when we take secured funding into account.... When both secured and unsecured loans are accounted for, lending to Europe fell for the first time in eight months during May, and even then it was a relatively small change. And we're sure that geographic dynamics are largely responsible for this stability.... [N]otice how not much has happened since then. The numbers have indeed fallen a bit further for a few of these countries. But it's pretty clear that the U.S. money fund industry has decided that no matter what happens to the EUR, the banks of certain countries will remain safe (or necessary?) places to invest."

Prophet explains, "And this brings us to our second observation. Perhaps an even more relevant topic at this point is how all these dynamics change in the event of a broad Moody's downgrade of U.S. banks.... [W]hereas [retail deposits] represented only about 55% of total bank liabilities back in 2008, they now represent over 75%. And at the same time there has been an equally sharp decline in what we would call "institutional" funding.... [T]he main takeaway here is that lending to U.S. banks represents a very small component of U.S. money fund balance sheets these days, with unsecured lending representing just 2% of total assets. And by the way, the levels here haven't really changed in over 2 years."

He writes, "In other words, given that U.S. banks are borrowing less within the "institutional" market, no one should be surprised to see data consistent with this among the U.S. money funds themselves. The overall numbers are a bit higher for the secured market (we estimate that 7% of money fund balance sheets are repo's with U.S. bank counter-parties) but it's entirely fair to say that U.S. banks are not doing a lot of business with U.S. money funds these days, which explains why the latter is lending to Europe."

Prophet tells us, "The broader point here is that we think a broad Moody's downgrade of the U.S. banking system would actually have a somewhat limited impact on short rates. There will of course be the knee-jerk reaction within euro-dollars which will depend upon how many banks actually see their ratings go down. But we just don't see the leverage among U.S. banks whereby a broad downgrade would be a truly critical event for funding markets."

He adds, "And there are a couple of other dynamics to keep in mind as well, although these are much broader in scale. First, there has been a radial decline in the overall demand for short-term funding within the U.S.... This has been offset by a decline in assets among money funds, but it's instructive to compare the total amount of funding supply to the level of demand.... In short, the gap between the supply of cash assets and the demand for short-term funding is wider than it's ever been. And so the bottom line is that credit ratings do matter, but it's hard to draw up a scenario where there is material, sustained upward pressure on funding rates as there appears to be some serious supply/demand imbalances here."

Finally, Prophet comments, "As a very final thought on this topic, it is indeed strange how high funding rates are given the low level of longer-maturity yields. Indeed judging from the front end of the U.S. curve, you would never guess that global financial markets are anywhere near a crisis. And this would seem to suggest that there is indeed a lack of funding supply. But we think the level of short-term rates is being kept high by some temporary factors and on a structural basis, there is plenty of downward pressure on short rates."

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