The likelihood that Moody’s will downgrade bank debt in the coming weeks and months is bad news for the banks themselves. But we would like to look at the other side of the equation: what will the Bank’s customers do in response?
What appears to have been missed so far however is the impact to the buy-side from the bank downgrades. We mentioned in yesterday’s SFM post “The coming Moody’s bank downgrades: funding and collateral will feel the heat” that counterparties may also want/need to close out derivatives contracts altogether if ratings fall too low. But the elephant in the room is the ability of money market funds to buy commercial paper and repo from banks that have lowered credit ratings. Paper issued by a bank with a credit rating less than two notches below whatever is deemed best (today its the top rating) would be ineligible. Any issuer that ends up with a short term rating of P3 will be out. The 2a-7 rules also require money market funds to sell investments that are downgraded into the second tier or ineligible security category.
The next question is: what about those downgraded banks as repo counterparties? It might be a hard sell to a board to do repo with a counterparty when the fund couldn’t otherwise buy their debt. Fund managers can look through to the underlying repo collateral for purposes of 2a-7’s diversification provisions, but “only if the fund’s board of directors or its delegate evaluates the counterparty’s creditworthiness.” (SEC Amended rule 2a-7(c)(4)(ii)(A))
The SEC wrote in their Final Rule on Money Market Reform, effective May 5, 2010 about repo counterparties,
“The effect…is to require a fund adviser to determine that the counterparty is a creditworthy institution, separate and apart from the value of the collateral supporting the counterparty’s obligation under the repurchase agreement.”
“…in the midst of a market disruption caused by the default of a counterparty, a money market fund may find it difficult to protect fully its collateral without incurring losses.”
Repo is contingent risk — first the counterparty, then the collateral. But to rely on the collateral only has, historically, been asking for trouble.
So repo bought by 2a-7 funds from (what morphs into) a P3 counterparty may disappear unless the SEC makes a speedy revision to the rules.
Depending on how severe and broad the downgrades are, our estimate is as much as US$1 trillion of the US$10 trillion global repo industry could be returned overnight. Literally. Since 85% to 90% of repo is overnight, money market funds just wouldn’t buy them the next day. The seriousness of this shock to the global financial system must not be underestimated, and a sudden loss of repo funding is what killed more than one Wall Street firm.
Concurrently, non-affected repo and other financial products that meet 2a-7 eligible security requirements would see a spike in asset prices. Anyone holding this paper already will be in great shape. Banks and broker/dealers who dodge the Moody’s bullet will be in huge demand as a counterparty. This is a major market dislocation waiting to happen.
Like many regulations and trends that affect banks (Basel III anyone?), a downgrade of bank debt will have a cascading effect onto the buy-side — including some unintended consequences. Money market funds will feel the first effect but anyone with an OTC derivative transaction with a downgraded effect will be impacted as well. This will certainly also influence the decision of big investors buying asset-backed securities and even trading equities and options. There will some winners (the US Treasury and banks outside of Moody’s hit list comes to mind), but mostly losers.
A link to the SEC Final Rule on Money Market Reform is here.