Sweeping US finance reform is on the verge of being enacted into law, after Senate approval of a final bill. Which means further curbs on too-big-to-fail banks…
…and that is likely to mean ratings danger for large US financial institutions.
As Moody’s er, somewhat vaguely announced on Friday:
Though it is unclear what provisions will be included in the final legislation, Moody’s expects that there will be elements that are both positive and negative to banks’ stand-alone credit profiles…
Currently, seventeen banks in the US receive some ratings ‘lift’ from Moody’s based on indications of systemic support. Moody’s will be assessing if the future law effectively diminishes the likelihood of
support. If this appears to be the case, Moody’s will announce a formal rating review process to explore this in detail prior to downgrading any supported bank rating.
But how much lift has there been, and what might happen if this is removed?
According to a note by Joseph Abate of Barclays Capital on Friday, possessing TBTF status has lifted banks’ debt by three to four notches more than their balance sheets would suggest.
So losing that status could give a bank’s access to short-term money markets a bit of a nasty squeeze, as the note explains (emphasis and link FT Alphaville’s):
Money market funds currently hold $2.5trn in short-dated assets and are one of the dominant, cash long investors in the front end. More than half of these balances are held in commercial paper and repo. Most of their repo is held against liquid collateral: Treasuries, agencies, and MBS. Since 2007, all but a negligible amount of money fund CP is A1, or Tier 1 paper. Governed by newly tightened 2a7 rules, the money funds are severely limited in their ability to purchase non-A1 assets or engage non-A1 counterparties. Under these new rules, they can invest only 3% of their overall assets in Tier 2 securities, and the maturities on these holdings are limited to less than 45 days. Similarly, they face counterparty limits of just 0.05% to any one A2 issuer.
Which might pose a problem for Goldman Sachs, Citigroup, Bank of America and Morgan Stanley, which are most at risk of downgrade, according to Abate.
Nor is there an easy workaround. Funds are allowed some leeway to lend to Tier 2 counterparties by ‘looking through’ to the underlying collateral posted, but they’ve their own AAA ratings to safeguard — and rating agencies are strict in their review when it comes to this practice.
In that case, as Abate writes:
Leaving aside the likely increase in bank funding costs and what is likely to become further upward pressure on Libor, we believe the ratings adjustments could substantially distort the repo market. These four banks have total repo outstanding of $850bn, of which the portion of cash raised from money funds and the asset composition of the collateral are unknown. [See chart; click to enlarge:]
The bulk of cash raised likely comes from money funds. Based on the asset composition of the repo at other large institutions, we suspect that 60-80% of the $850bn is against liquid collateral – or collateral that could be looked through. Loosely, this accounts for over one-third of the liquid collateral posted by dealers in the repo market at the end of March. The remaining $260bn is probably composed of private label mortgages, ABS, and non-investment grade corporates.
Which is quite a hefty amount of assets to suddenly drop from the secured funding markets, giving funds a dilemma — wait for the Fed to offer reverse repos when it starts its liquidity exit strategy, or relinquish their AAA ratings.
Rather tricky. As Abate concludes:
Ultimately, there are so many moving parts to this based on the interconnection between money funds and banks that it is difficult to determine what the repo market reaction might be… In short, the relationship between banks, ratings, and money funds is complicated.
Reform could lead to an even more complicated repo market. Great.
Related links:
Beware, repo rates are on the rise – FT Alphaville
F-crting about with the repo market – FT Alphaville
Major Parts of the Financial Regulation Overhaul – NYT