Did FRFA crowd out EU banks?

Based on the latest report from Fitch, US money market funds' exposure to European banks - dollar denominated commercial paper and repo loans to EU banks - declined by some 10% (in dollar terms) from the previous month (h/t Kostas Kalevras - @kkalev).

Source: Fitch

Fitch had a possible (and somewhat surprising) explanation. Could the Fed's reverse repo program called FRFA that is currently being tested (see post) be crowding out European commercial paper?

Fitch: - The December decline in MMF allocations to European banks was largely offset by repo exposure to the Federal Reserve Bank of New York (FRBNY). The FRBNY has been periodically conducting overnight reverse repurchase agreement (RRP) exercises with market participants, including MMFs, to test how these operations might function as a policy tool for managing short-term interest rates. This technical exercise, in which FRBNY serves as the fund’s repo counterparty, accounted for 3.7% of all MMF assets within Fitch’s sample at end-December. By comparison, the MMF’s allocation to European banks declined by 3.8% (i.e. expressed as a percentage of MMF assets) in the course of December. It is unclear whether the FRBNY exercise might have crowded out some of the MMF allocations to European banks or whether the European reduction reflects a new equilibrium taking hold.

Another explanation is window dressing for year-end. Many investors review their money markets allocations once a year, often paying attention just to the year-end report. Showing a lower EU bank allocation number on that report could provide a marketing benefit.

Nevertheless this is something banks, both in the US and abroad, will need to consider going forward. As the FRFA's scope increases, banks' commercial paper and repo rates will need to rise in order to compete with the Fed for money market funds' dollars. That of course is the purpose of the program - using the broad money market investor base to manage short-term interest rates.

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From our sponsor:

Wishing for US debt ceiling train wreck

How long will it take for the US Treasury to run out of funds if the October 17th deadline comes and goes without an increase in the debt ceiling? The answer is - less than a couple of weeks.

Source: Barclays Research

Fitch Ratings: - A formal review of the rating with potentially negative implications would be triggered if the US government has not raised the federal debt ceiling in a timely manner prior to when the Treasury will have exhausted extraordinary measures and cash reserves. According to official comments by the US Treasury secretary, extraordinary measures could be exhausted by 17 October.

In such a scenario, the Treasury would be forced to dramatically cut back on current spending with adverse implications for the economic recovery. Even if it were to prioritise debt service - something the Treasury has repeatedly stated it has neither the legal authority nor logistical capability to do - it would likely incur arrears on a range of payment obligations and thus continue to incur debt, but in a disorderly and disruptive manner.

Amazingly, there seem to be countless Americans who are rooting for this to happen. Emails are pouring in arguing that a US default in fact is a good thing. They really believe this will magically solve the US fiscal deficit problem and/or somehow "punish" the Obama administration. They don't seem to realize that this is akin to wishing for another 2008, while US government deficit would only worsen as a result (with tax revenue collapsing while entitlement liabilities growing just as fast). Alternatively these people just don't seem to value their jobs, homes, pensions, and bank accounts - all of which will be at risk should the US government fail on its obligations.

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From our sponsor:

The spike in ratings downgrades is driven by banks

Fitch has been on a downgrade "war path" recently. The latest downgrade vs upgrade statistics are showing a "mini spike" in the number of downgrades. It's not nearly as bad as the 2008/2009 cycle, but is clearly visible. This spike is coming entirely from rating actions in the developed markets.

Drilling down further reveals what is actually driving the downgrades. The chart below compares the rating actions for industrials versus financials. Clearly Fitch has been aggressive in downgrading banks.

Source: Fitch; click to enlarge

The equity market seems to agree with this assessment. Financials have underperformed considerably over the past year (covering the period of these downgrades).

Financials (white) vs. the SP500 (green) performance over the past year

The other rating agencies have also been active in downgrading financials - particularly last year. At this rate it is only a matter of time before many banking institutions will lose their investment grade standing. It will be interesting to see how the high yield and the crossover markets handle this inflow of new names.

SoberLook.com

Bank ratings migration is an attempt to fix old errors

Here is a recent chart from Fitch that shows ratings migrations for US banks between 2007 and 2011. The trend makes sense in terms of what has transpired during this period as the whole ratings distribution was shifted down.

Banks ratings migration (Fitch)

But take a second look at these results. Ratings are supposed to represent credit risk. Therefore this is telling us is that there is more risk in the US banking system now than there was in 2007. Really?

The chart below shows the core capital ratio for all FDIC insured institutions. It represents tier-1 capital as a percent of average total assets (with some adjustments per FDIC). This is telling us that bank capitalization in the US has improved significantly since 2007.

US bank capital ratio (FDIC, Bloomberg)

The weaker banks - 417 of them - have been closed since 2007.  So how is it that according to Fitch US banks are more risky now? Maybe it has to do with bank ratings being incorrect to begin with - possibly off by several notches. And maybe this "rating migration" is simply an attempt to correct that error.

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Could the "wisdom of crowds" be wrong on France downgrade?

Intrade generally represents an efficient market with thousands of participants placing bets on various events - what is sometimes referred to as "wisdom of crowds". That is why it is quite surprising that Intrade has the probability of France being downgraded by June 30th, 2012 at only 67%. This probability should be in the 90s.

The rules are clear - it takes only one rating agency to pull the trigger before next summer and the contract settles at par.

Intrade.com:

• This market will settle at $10.00 if either Moodys, Standard and Poors or Fitch announce they have downgraded the long term credit rating of France below AAA.

• This market will settle at $0.00 if neither Moodys, Standard and Poors or Fitch announce they have downgraded the long term credit rating of France below AAA.

• This market will be settled using official statements from Moodys, Standard and Poors or Fitch regarding the downgrading of France's credit rating, as reported by three independent and reliable media sources. Please note that only one of the rating agencies needs to announce a downgrade for this market to be settled at $10.00.

But the rating agencies all but told us the downgrade is coming. Here are the two warnings.

Warning #1:

Standard and Poor's: 

France (Republic of) Sovereign Credit Rating AAA/Watch Neg

Depending on the score changes, if any, that our rating committees agree are appropriate for each sovereign, we believe that ratings could be lowered by up to one notch for Austria, Belgium, Finland, Germany, Netherlands, and Luxembourg, and by up to two notches for the other governments.

Warning #2:

Fitch: Fitch has also revised France's Rating Outlook to Negative from Stable. While France's 'AAA' status is underpinned by its wealthy and diversified economy and financing flexibility, the Negative Outlook reflects heightened risk of contingent liabilities to the French state arising from the worsening economic and financial situation across the Eurozone.

At 67% odds, it looks like easy money - there is very little doubt France is getting downgraded.  But back to the "wisdom of crowds" and the predictive markets. What this is telling us is there is (highly surprising) a significant portion of the market - a third to be precise - that is holding out hope that France will not get downgraded in spite of the rating agencies' open warnings. They will be thoroughly disappointed.


Note:  With regard to US citizens trading contracts on Intrade, the internet gambling prohibition makes it illegal to operate a gambling website in the U.S. but it has no restrictions/penalties on clients.

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