Going Broke With Greece

When you poke a pig, it squeals.

Last week, The Wall Street Journal poked the largest money market funds in the country for loading up on European bank debt. The Investment Company Institute (ICI) started squealing immediately.

In a June 27 editorial entitled, “Money-Market Mayhem,” the Journal accused the money market fund industry of “[piling] into European bank debt, even as everyone knew those banks had stocked up on bad European sovereign paper. The US Treasury is even saying privately that the US needs to support the European bailout of Greece lest European banks fail, US funds take big losses, and we get another flight from money funds.”

Two days later, The Daily Reckoning kicked in its two cents in our essay “Money Market Funds No Longer the World’s Safest Investments” by observing, “Somewhere along the way, the money market funds lost their way… The fund managers started taking bigger and bigger risks for smaller and smaller rewards… Less than three years after nearly dooming the US financial system by buying American asset-backed garbage, the money funds are at it again, buying European PIIGS-backed garbage.”

The very next day, June 30, the ICI’s President and CEO, Paul Schott Stevens, fired back at the Journal (and by extension, The Daily Reckoning). “Your editorial ‘Money-Market Mayhem’ vastly overstates the risks to US money-market funds in the Greek debt crisis,” Stevens argued. “Yes, these funds hold the debt of European banks…[But] of the banks in prime money-market funds portfolios, in every case the bank’s direct exposure to Greek government debt is less than 1% of the bank’s total assets…”

While Stevens’ observation is factually correct, it is functionally irrelevant. No bank ever went bankrupt based on the percentage of assets it had devoted to a given investment. A bank’s equity, not its assets, is the only number that really counts. But you don’t have to take our word for it. Let’s let the numbers do the talking. In fact, let’s let the exact numbers to which Stevens refers do the talking.

It is true that Greek sovereign debt represents less than one percent of the assets “of the banks in prime money-market funds portfolios.” But Greek sovereign debt, by itself, is not the main risk to the European banking system, and therefore, to US money market funds. The main risk is a contagion that might begin in Greece, but end who knows where and who knows how badly.

A default in Greece would almost certainly trigger a contagion effect throughout the weakest economies of the Eurozone – potentially causing a wave of defaults in the “PIIGS” countries of Portugal, Italy, Ireland, Greece and Spain.

To quantify money market fund risks honestly, therefore, investors must consider total exposures to PIIGS debt, not just exposure to Greek debt. Furthermore, and of even greater significance, investors must consider these exposures in relation to each bank’s equity, not its assets. BNP Paribas is one particularly illuminating example:

BNP’s direct exposure to Greek government debt is a mere 0.21% of the bank’s assets…just like Stevens said. As a percentage of BNP’s equity, however, that seemingly insignificant 0.21% jumps to 5.6%. In other words, Greek debt accounts for more than 1/20th of BNP’s net worth.

That number, while large, doesn’t seem too worrisome until you add in BNP’s exposure to the other PIIGS governments. The chart below tells the tale. Loans to PIIGS government debt represent nearly half of BNP’s net worth. And this figure does not include any of BNP’s loans to corporate borrowers in those nations.

Direct Lending to PIIGS Governments as a Percentage of Each Bank's Equity

In short, BNP is carrying one very large, concentrated bet on its books.

Simultaneously, America’s largest money market funds are carrying one very large, concentrated bet on their books. As the table we featured in the June 29 edition of The Daily Reckoning shows very clearly, the largest American money market funds have allocated an average of about 40% of their assets to European debt securities, most of which are issued by European banks.

Allocation of European Debt Securities in the US's Largest Money Market Funds

Whether such concentrated risk-taking is reckless or prudent is for each investor to decide for himself. But when viewed from 30,000 feet, hogging into European bank commercial paper seems much more beneficial for the managers of the money market funds than for the clients of these funds.

According to the Fidelity Web site, the managers of the $67 billion Fidelity Institutional Prime Money Market Portfolio (FIPXX), for example, charge 14 basis points (0.14%) per year to oversee the fund. The holders of this particular money market fund receive only 12 basis points per year (0.12%). Obviously, if the managers of FIPXX did not load up on European bank debt, they would not be able to pay out 0.12% per year to the fund’s shareholders. But neither would they be able to pay themselves 0.14% per year for doing so. A fee of 0.14% in the case of FIPXX amounts to more than $93 million per year.

Perhaps the FIPXX fund managers are earning all 14 basis points of their fees by delivering 12 basis points per year in a zero-basis-point world. Or perhaps they are merely taking crazy risks for no good reason. Again, this question is for each investor to decide for himself. But while trying to decide, let each investor remember that 12 basis points per year is one basis point per month – a digit that might as well be zero. Who cares about one basis point per month, no matter what the risks may or may not be?

Let each investor also remember that the Investment Company Institute believes it’s well worth the risk (to your money) to allocate more than 40% of a money market fund’s assets to the debt securities of European banks which, in turn, have allocated more than 40% of their net equity to the debt securities of Europe’s most economically troubled nations.

Interestingly, the folks with the money in these funds are beginning to gauge risk differently than the ICI.

According to J.P. Morgan, investors withdrew about $85 billion from US prime money-market funds last month – that’s a sizable sum, equivalent to about 5.6% of total assets under management at such funds. Not surprisingly, Treasury-only money market funds enjoyed a massive $47 billion of inflows at the same time. The Treasury-only funds yield nothing, literally. But the risk of a Greek default and ensuing contagion would pose no immediate risk to these funds.

Here is a troubling thought: If investors continue withdrawing billions of dollars from prime money-market funds, these funds will be forced to withdraw billions of dollars of credit to European banks. If the European banks lose this valuable source of short-term credit, they might start to feel a very uncomfortable liquidity squeeze at the very same moment that the PIIGS loans on their balance sheets are tumbling in value.

Just yesterday, Portugal became the second of the five PIIGS nations to become a “junk” credit, according to Moody’s Investors Service. Greece was the first. Two data points do not make a trend, but they do make two data points that are pointing in a bad direction.

“In a zero-percent world,” we observed last week, “one would imagine that cash managers would resign themselves to earning nothing for clients when nothing – approximately – is what the market is offering. One would imagine that cash managers would be busy improving their golf games. But one would be wrong. Instead of playing golf, the cash managers are busy ‘groping for yield.’… Money market funds [have become] much more exciting than they ought to be.”

Eric Fry
for The Daily Reckoning