An August 5, 2014 article in Reuters, “Unlikely booster for money market funds: beat-up Puerto Rico bonds” by Tim McLaughlin caught our attention. But it seems to be missing some details.
The article says:
“…The funds have accepted the U.S. territory’s debt as collateral on their short-term loans to Wall Street banks, and in exchange for that added risk are receiving a higher interest rate, according to public filings.
As a result, American Beacon’s $767 million fund has one of the best one-year returns in the industry, while Fidelity this year used at least one loan backed by Puerto Rico bonds to generate a yield about 20 basis points higher than U.S. Treasuries or bank certificates of deposit…”
and
“…The American Beacon Money Market Select Fund, for example, has nearly a third of its repurchase agreements backed by riskier collateral. As payoff, the fund’s one-year total return of 0.08 percent through the end of July is better than 91 percent of peers, according to data from Lipper Inc, a unit of Thomson Reuters…”
“…In recent months, the American Beacon fund has used a $39 million repurchase agreement with RBC Capital Markets LLC to generate a yield of 18 basis points. In April, the collateral in the deal contained about $6 million worth of Puerto Rico bonds, including ones issued by the island’s electric authority…”
So what details are missing? The article makes is sound as if the funds own the Puerto Rican bonds outright. Repo is a contingent risk. In the case of the American Beacon repo with RBC, their counterpart (RBC) has to default before American Beacon ends up owning the Puerto Rican bonds. That doesn’t mean the collateral should be ignored – we have often argued that collateral isn’t paid nearly enough attention – but the article could have been clearer. Nevertheless, American Beacon seems to be pushing the envelope.
The Fidelity repo position wording seems odd. “…Fidelity this year used at least one loan backed by Puerto Rico bonds…” That sounds like Fidelity took in collateral that may have been some sort of structured securitization that has PR paper in the pool. It is impossible to know how much Puerto Rican exposure there was or what tranche Fidelity ended up with. There was just enough detail to raise eyebrows but not enough to figure out if it was important.
We remember that some legal departments questioned if a securities financing on a tax-free bond didn’t cause problems for the beneficial owner claiming the income from the paper was tax-free. In repo, the owner of the paper ends up with any coupon payments from the underlying bond, but it can be interpreted as being manufactured by the repo dealer and not coming from the issuer. That raises the question as to whether it is free of tax. Some repo dealers were ok with this when structured via tri-party (since it is really just a lien that moves around — unless there is a default — and not the actual bonds), others are not. We are not sure if this is an issue or a matter of legal interpretation. Anyone know for sure?
The article mentioned the fire sale issue that the Fed is working on.
“…The risk around counterparty banks is partly why U.S. regulators have had concerns about repurchase agreement collateral since the financial crisis. The possibility of collateral fire sales still poses “significant risks” for the U.S. financial system, according to the Financial Stability Oversight Council’s 2014 annual report released in May…
Without question, if there is a repo dealer default then the money market funds will end up selling the Puerto Rican paper as fast as they can, creating a fire sale. Given the stress that the paper is already under, that liquidation won’t be pretty. It begs the question: can the funds own the paper outright and if not, why are they allowed to take it in as collateral anyway? Sifting through collateral, typically executed via tri-party, is very difficult. Can the tri-party agents facilitate the kind of granularity that would allow Fidelity not accept the structure that held the PR paper, if they so chose? And is there the will to really get into the weeds on what collateral is accepted?
We would be remiss not to mention that the article quoted Finadium’s Josh Galper, talking about the impact of the money market fund reforms.
At the end of the day, this is probably a tempest in a teapot. Hopefully.