The Euro as Neutron Initiator?

By Marla Singer and Geoffrey Batt

In September of 2008 the Reserve Primary Fund, loaded with exposure to Lehman Brothers debt, faced massive withdrawals and promptly "broke the buck."  (Slipped below $1.00/share NAV).  The result was a cascade of credit crunches for major corporations dependent on commercial paper for not just their near term financing, but their day to day operations.  Firms like Honeywell, General Electric, 3M, Boeing and WalMart were gripped in what might even be called a destructive co-dependent relationship with the short term cash available in the commercial paper market.  Particularly in an environment of low interest rates, money market funds desperate for yield are ravenous lenders to these large cap firms that divert their cash elsewhere and use the commercial paper market to make up the difference.  The constant "roll risk" means that any seizing up of the commercial paper market could deliver sudden and unexpected defaults by the country's largest and most respected firms.

In May [2008], about $530 million of the Lehman debt in the Reserve Primary fund was commercial paper. Another $250 million was in medium-term notes. The fund also had $150 million in medium-term notes tied to AIG and $100 million in AIG-related floating-rate notes.

 

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The Lehman debt, whose face value was $785 million, had to be written down to zero for the flagship fund of New York's Reserve Management Corp. That pushed the fund's per-share price down to $0.97, a bracing signal to investors and a jolt to money-market investors world-wide.

The resulting, panicked cash exodus from money market funds meant many firms couldn't roll their debt over.[fn]"Breaking Buck," The Wall Street Journal, September 18, 2008.[/fn]

That, however, is only half the story.  Most large money market funds also make extensive use of repurchase agreements, effectively short term loans made by the money market fund, generally to financial institutions and collateralized by securities of one kind or another.  Since repos are generally subject to daily mark-to-market margin requirements, the deterioration of collateral can quickly become an expensive proposition for the borrower.  Should the borrower default, or fail to meet a margin call the money market may end up selling the collateral into an already distressed market, compounding the problem.  Bond yields spike.  Equity tanks.  Cash constrained large caps start to lose the ability to raise capital through the sale of common stock as it quickly becomes prohibitively dilutive to do so.  Those that do further erode the value of collateral.

Lather.  Rinse.  Repeat.

The combination of both of these drains, a cash exodus from money market funds and the deterioration of collateral, can prove ruinous and the resulting credit crunch can quickly balloon to the broader market, as it did in 2008.

Given this background, it is less than comforting to examine the holdings of the larger money market funds in the context of a crashing Euro.

Fidelity's Institutional Money Market Fund's March 31, 2010 holdings disclosure shows that 16.3% of the funds assets were tied up in repurchase agreements, many with European banks and collateralized with corporate obligations.

Similarly, JP Morgan's Prime Money Market Fund's April 30th, 2010 disclosure bristles with exposure to European financial institutions and firms.

It is impossible to know exactly what sort of exposure to a weakening Euro either fund actually has, or if large caps continue to be addicted to the commercial paper gambit, but it will certainly be entertaining (provided you aren't in them) to find out if money market funds prove, once again, to be the neutron initiator to a plutonium laced market.