NEW YORK--()--Money market funds' (MMF) proportion of secured exposure in the form of repurchase agreements (repos) has been on a secular rise for almost a decade. Fitch Ratings attributes this trend to a number of factors, including a shift in demand for secured assets, broadening collateral practices, and the general evolution of the credit markets. In addition, amended rule 2a-7 has contributed to demand for repos by requiring taxable MMFs to hold at least 10% of their assets in daily liquid instruments (such as overnight repos).
“Repos: A Deep Dive in the Collateral Pool”
MMFs are focused on the counterparty credit quality first and foremost as the primary source of repayment. We believe regulatory requirements to maintain high quality short duration portfolios make it problematic for MMFs to take a possession of the long-term collateral securities in the event of dealer insolvency.
For example, a great majority of repos are collateralized by instruments with remaining maturities of greater than one year. If the fund were required to accept the collateral underlying the repo, these instruments would have to be taken into account in calculating the fund's weighted average maturity (WAM). The fund would then have to dispose of the collateral as soon as possible if the instruments constituting the collateral caused WAM to exceed 60 days or did not satisfy other regulatory and rating agency criteria.
Given this general limitation of the collateral acceptance, the levels of the collateral haircut have only secondary significance for MMFs and, therefore, historically these levels have not been dynamically adjusted to market conditions. With that said, we believe collateral could still serve as another source of repayment in the event of a counterparty default.
When rating MMFs, we assume funds will be able to liquidate available U.S. government collateral without material loss of value. However, other types of collateral could become illiquid and cause funds to incur mark-to-market losses. Due to their greater volatility and lower liquidity especially at the times of market stress, nongovernment collateral securities are assigned greater haircuts, albeit not actively managed. In addition, our rating criteria limit rated MMF investments in repos backed by nongovernment securities to a maximum of 5% of the fund's assets, at par with other unsecured exposures. In essence, we attribute no value to such collateral.
Given the described limitations for MMFs in accepting repo collateral, in practice, MMFs are primarily focused on the quality of counterparty. We believe that transactions solely with counterparties rated at least 'A/F1' are consistent with 'AAAmmf' ratings.
Lastly, we explain the lack of active haircut management on the part of MMFs by the prevailing short duration of the repo transactions which are generally unwound on daily basis. Thus MMFs constantly re-evaluate eligibility of the counterparty for the next-day trade and may opt out of transacting with a counterparty whose credit quality deteriorates.
For a broader review of U.S. MMFs collateral management practices, see Fitch's recent report "Repos: A Deep Dive in the Collateral Pool," dated Aug. 1, 2012, at www.fitchratings.com.
Additional information is available on www.fitchratings.com.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.