US cash managers struggling with weak supply of high grade product

The amount of cash in circulation in the US is growing at over 10% per year, and with it the need for short term fixed income product outside of bank deposits.

At the same time, treasury bills outstanding hit a new multi-year low this month.

Recently issued floating rate treasury notes (see discussion) provide an alternative for bills, but the amount hitting the market is immaterial to make a dent at this stage. Money market funds also jumped into the Fed's RRP program (see discussion), but the supply of that experimental product is also limited for now.

Private repo, one of the most common places for parking short-term cash outside of bank deposits, has been somewhat problematic as well. The supply of treasury collateral, large portions of which remain trapped on Fed's balance sheet, has often been insufficient. The recent rise in treasury settlement fails (failure to deliver) is an indication of such shortage.

Source: Barclays Research

Investors looking to park cash outside of bank deposits can also buy bank commercial paper (CP), which is what most "prime" money markets have been doing. But banks do not like to rely on commercial paper for funding because many found themselves unable to roll it during the financial crisis. The volumes of bank CP therefore remain subdued (with rates declining as well).

Bank commercial paper outstanding

The only place where we can see substantial growth in short-term product volumes is corporate commercial paper.

Corporate commercial paper outstanding

Highly rated investment grade corporations can borrow money for a month at as little as 5-7 basis points (annualized). With the CP market often cheaper than bank revolvers, a number of companies are using it to finance working capital.

Source: FRB

However, given the limited number of firms with ratings high enough to satisfy money market funds' requirements, the increased corporate CP volumes are insufficient to meet the rising cash management needs in the US.


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From our sponsor:

FRFA may provide relief to product-starved US money markets

Expectations of future shortages in quality liquid bonds in US debt markets continue to persist (see story). These shortages however are likely to be more acute for short-term paper. As a percentage of total government debt for example, treasury bills outstanding continue to decline.

Source; Barclays Research

Similarly, commercial paper volumes remain subdued relative to historical levels, as banks and corporations no longer want to rely on money-markets-based funding to finance their operations.

At the same time the US broad money supply has almost doubled in the past 10 years. Savers are looking for more relatively safe short-term product that can compete with bank deposits. That is why the Fed's reverse repo facility (FRFA - see post) is going to be so critical in the next few years. The Fed now holds nearly $4 trillion in securities, which the central bank can "sterilize" by taking in short-term deposits. These deposits in turn will be a good alternative to treasury bills and bank deposits, providing some relief to product-starved US money markets.

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From our sponsor:

Banks don't want to pay for funding when they can get it for free

As US banks continue to grow their deposit base, they are reducing reliance on commercial paper (CP). Why pay for funding when depositors are willing to provide capital for free and in increasingly larger amounts? On the other hand foreign-owned banks, a number of whom don't have a large retail presence in the US, have recently increased their issuance of CP. The chart below shows the divergence in CP outstanding between the two groups.

Source: FRB

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From our sponsor:

Corporate commercial paper outstanding is at record high

Consistent with the growth in corporate bonds (discussed here), corporate commercial paper outstanding hit a new record recently - exceeding the pre-crisis highs on a seasonally adjusted basis. These of course are the largest and the highest rated corporations who use the CP market to manage cash flows. The mid-sized and smaller firms do not have access to this market. Also it's important to note that corporate CP constitutes just over a quarter of bank CP, which still dominates the market.

Non-financial commercial paper outstanding (SA, source: FRB)

Who is buying this paper? Interestingly enough the purchasers (other than the usual suspects such as money market funds) often tend to be other corporations who have massive amounts of cash on their balance sheets. They buy CP (as well as other short-term instruments) as a substitute for bank deposits to boost yields.

WSJ: - Commercial paper accounted for 11.06% of corporate cash assets at the end of January, an increase of 1.19 percentage points from a month earlier, representing the biggest jump among all assets categories, according to data from Clearwater Analytics...

.

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From our sponsor:

Too early to celebrate ECB's balance sheet reduction

The ECB has been receiving praise for shrinking the Eurosystem balance sheet since last summer.

MarketWatch: - The euro notched an 11-month high versus the dollar Friday, as European banks prepared to pay back a larger-than-expected chunk of cheap, three-year loans provided by the European Central Bank.

Most of the reduction is from the MRO and LTRO loan repayments by EMU periphery banks. These were funds borrowed by banks to replace lost sources of funding, including massive losses of deposits.

Source: Credit Suisse

But before congratulating Mr. Draghi on this achievement, it is important to note that the ECB has simply swapped a portion of its on-balance sheet exposure for an unlimited off-balance sheet commitment via the Outright Monetary Transactions program.

Consider Spain for example. Fundamentals of the stretched financial system, collapsing property values, and record unemployment have hardly changed. There is certainly no fundamental justification for the spectacular collapse in sovereign yields (chart below), except for the fact that the ECB is committed to buy unlimited amounts of this paper should Spain request it.

Spain: government 2-year bond yield (source: Investing.com)

Just because off-balance sheet exposure is not visible doesn't make it any less real. As a reminder of how off-balance sheet exposures can quickly appear on balance sheets, just take a look at the start of the financial crisis in 2007. Large U.S. and European financial institutions had significant off-balance sheet exposures by providing backstop guarantees to their commercial paper vehicles prior to the financial crisis. When that commercial paper could no longer be rolled, banks, particularly Citi, RBS, and Wachovia, were forced to take assets - mostly mortgage securities - onto their balance sheets. The chart below shows mortgage securities on the balance sheets of large US commercial banks. This is not a "buying spree" in late 2007 to early 2008 - it's a forced balance sheet expansion driven by commercial paper backstops.

Large US banks' holdings of mortgage securities (source: FRB)

Now the ECB has this type of unlimited backstop to periphery Eurozone governments. And the recent stabilization of the EMU sovereign paper markets is driven entirely by the off-balance sheet commitment - which could easily turn into on-balance sheet exposure. Furthermore, any attempt by the ECB to exit this commitment will result in a complete reversal of these gains - and another Eurozone crisis.

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From our sponsor:

TAGP expiration will put downward pressure on short-term yields

In 2008 many businesses in the US became concerned that the various transaction accounts they use to conduct business could be at risk due to banks failing. This was especially true for accounts that held more than $250K, which is the maximum FDIC-guaranteed deposit. In particular companies worried about moving large amounts through banks for payrolls, lease payments, purchases of goods, etc. In order to reassure frightened corporate America, the FDIC implemented the Transaction Account Guarantee Program (TAGP), which provided unlimited government guarantees for non-interest-bearing transaction accounts such as deposits earmarked for payroll. This was all part of the Temporary Liquidity Guarantee Program (TLGP) meant to restore confidence in the shaky financial system.

Unlike the FDIC insurance on regular deposits, the government did not charge a fee for guaranteeing these TAGP accounts. And as rates went lower, many TAGP depositors left their money in these accounts that gave firms and individuals unlimited liquidity with full government backing. And earning zero on a guaranteed account vs. earning 10-20bp on an unprotected account made sense for many businesses.

At the end of 2012 however, this unlimited FDIC guarantee program is set to expire, affecting some $1.4 trillion of deposits. According to a recent survey (see attached paper from Western Asset Management), two out of five depositors in these accounts will reallocate cash elsewhere once the accounts are no longer guaranteed. The money will go into either interest bearing accounts, short term securities such as CP or short-term treasuries, or money market funds (and money market funds will be forced to buy short term securities). Given an already significant shortage of money market products out there - a problem that has been worsening since the financial crisis (see this post from 2009) - this will put downward pressure on rates (including short-term IG corporate paper). Even in a normal year demand for short-term securities increases at year-end (see discussion), but with TAGP expiration we may see more negative yields in short-term treasuries and incredibly tight CP spreads.


Pending Expiration of Unlimited Deposit Insurance Coverage

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Eurozone banks are pulling out of the US

Back in December we discussed how lack of access to dollar funding will push Eurozone banks out of the US. That's not because these banks don't like US lending. It's simply due to the fact that European banks generally rely on domestic euro deposits for funding (exacerbated by increased capital requirements). To obtain dollar funding however they used to issue commercial paper and sell it to US money market funds. But US money market funds walked away from this CP last year to avoid exposure to the Eurozone. This left Eurozone banks with no access to dollars except via the Fed Liquidity Swap (or converting euros into dollars and hedging the position via currency basis swap, which became extremely expensive). Here are a couple of posts on the topic: Post 1, Post 2.

This unwind of US assets is in fact now taking place and US banks are the beneficiaries.

FT: - France and Germany, led by BNP Paribas and Deutsche Bank, still have some of the biggest foreign operations in the US. But French financial groups including BNP, Crédit Agricole and Société Générale have announced plans to shrink their balance sheets.

US assets owned by German banks have fallen from their $427bn peak in 2007, to $267bn as of March. Assets held in the US by French bank-owned offices have fallen from $420bn in December 2007 to $373bn, according to the latest Fed data.

The pullback by banks from smaller eurozone countries is even more stark, as their banking systems come under severe pressure. US assets owned by Irish banks plunged from $130bn in September 2008 to $3.6bn as of March.

Wells has been one of the more active US banks in buying assets from European competitors. The company recently snapped up a $6bn loan portfolio from WestLB, the troubled German Landesbank, as well as the North American energy business of France’s BNP.

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Recent trends in US money market funds

Today we got the highly anticipated Fitch report on US money market funds. There are two key items in the report worth discussing:

1. European bank exposure continues to decrease (which is not surprising) but there is also quite a bit of rotation going on.

Fitch: MMF exposure to French banks, which declined by 63% over the past month, was partially offset by increases in exposure to Dutch, Swiss, U.K., and Nordic banks. European bank exposure currently represents 33.4% of total holdings of $645 billion within Fitch’s sample of the 10 largest MMFs, a decrease from 34.9% of fund assets at the end of October. The current exposure level is the lowest in percentage terms for European banks, which was as high as 51.5% as of month-end May 2011

Funds rotated significantly out of France into Canada and somewhat into Japan. Exposure to French banks is now only 3%.

2. The biggest development in US money markets continues to be a shift from unsecured commercial paper and into collateralized instruments, namely repo (as is the case with eurozone banks lending to each other.) The next chart shows the increase in usage of secured lending.

This trend will certainly keep US money market funds from major redemptions as we saw in 2008 (particularly with the Reserve fund), but as the earlier post shows, Eurepo rates have collapsed.  Lack of product that meets the strict new criteria and near zero rates makes the money markets business  unprofitable - it's difficult to charge fees on something that earns close to zero. Money markets funds will continue to be an "asset gathering" mechanism used to lure investors into more profitable asset classes.

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Severe dollar funding constraints will push EU banks out of US markets

The tightness in dollar funding continues to be a major problem for a number of EU banks. Much of it is driven by US money market funds not rolling their commercial paper (CP) holdings issued by eurozone banks. As CP matures, European banks have to find alternate sources, which is proving to be difficult.

Yahoo Finance: "It is utter madness ... When we see big names paying 300 basis points over overnight rates for dollars you know something is wrong," said the head of money markets at a bank in London, who asked not to be named.

The non-US financial institutions' commercial paper outstanding continues to dwindle:

This demand for term dollar funding keeps putting upward pressure on interbank lending rates as banks want to charge increasingly more to part with dollars for longer than overnight:

3M USD LIBOR

The ECB has responded by tapping the Fed Liquidity Swap Facility this week in the amount not seen since 2009 in order to provide dollars to numerous eurozone banks.

Many European banks will be forced to change their business models.  This inability to raise dollars will severely constrain their activities in the US, making it increasingly difficult for them to lend to US corporations or buy illiquid US assets.  Even if the situation in the eurozone improves, these banks will be loathe to add dollar assets to their balance sheets because of potential funding risks in the future.

In many instances they will also be constrained from lending in Asia and the Middle East, where dollars are often preferred to euros because of trade with the US.  Without access to dollar funding, European banks will shift their focus to Europe, creating new opportunities for US (and in some instances UK) and Asian banks. Banks like JPMorgan and HSBC will be clear winners and increase market share because of their access to dollars.

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US Money Market Funds Shift Away from Europe

There is further evidence that US money market funds continue to reduce their exposure to Europe. Contrary to popular belief the funds are generally not selling paper.  Typically they hold commercial paper (short-term loans) to maturity and they are simply not rolling the maturing debt. From the NY Times:

American institutions are pulling back on loans to even the sturdiest banks in Europe. When a $300 million certificate of deposit held by Vanguard’s $114 billion Prime Money Market Fund from Rabobank in the Netherlands came due on Nov. 9, Vanguard decided to let the loan expire and move the money out of Europe. Rabobank enjoys a AAA-credit rating and is considered one of the strongest banks in the world.

“There’s a real sensitivity to being in Europe,” said David Glocke, head of money market funds at Vanguard. “When the noise gets loud it’s better to watch from the sidelines rather than stay in the game. Even highly rated banks, such as Rabobank, I’m letting mature.”

Rabobank's dollar funding constitutes about 14% of it's overall funding needs (below). However this does demonstrate that even the strongest banks in Europe are having to change their funding strategy.

So where are these firms going to obtain dollar funding? The stronger banks will obtain it in the interbank market - borrowing from other banks (JPM or HSBC for example). The weaker ones will have to rely on the Fed via the ECB. As discussed earlier the Fed's Liquidity Swap is expected to grow to accommodate this shift.

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Only the strongest survive (and thrive) in the CP markets

Money market funds continue to struggle to put cash to work , searching for product that would comply with pending new regulation, yet provide returns that are above treasury bills. The returns on money market funds continue to be pathetic - about 15-25 basis points annualized.

The better rated banking firms have taken notice of this demand. They now have a choice of funding themselves by borrowing from other banks or via the CP market. (Neither was really available on anything but the overnight basis in the second half of 08).


With the 3 month LIBOR hovering above 25 bp, CP funding is cheaper for banks that can get AA rating on the paper (see the CP yield curve below).





And banks are indeed taking advantage of it, issuing CP and selling it to guys like the Fidelity MM fund. That gives the larger/stronger banks a real advantage over the smaller ones. Community banks have to pay depositors 60 bp on checking accounts and over 105 bp on money market acccounts - and that's their key source of funds. The larger banks can fund themselves with CP at 20 bp. That's a significant competitive advantage.

The new issuance of CP has caused the amount of financials-issued commercial paper outstanding to spike,



source: FRB



driving up the overall CP notional.



source: Bloomberg


This new supply is easily absorbed by money market funds. The CP market has simply bifurcated into those who have the credit quality to issue paper and those who don't - there's little in between. With new regulation, money markets won't be able to buy much "tier-2" CP and there aren't other buyers out there. You are either "tier-1" or you are basically out of the market (some stronger "tier-2" can still place paper, but in limited amounts - maybe 5% of the total). For a while the Fed was buying CP via the CPFF program, but that's winding down:



source: FRB


The survivors in the CP market are some of the strongest institutions or institutionally sponsored ABCP programs. Everyone else has to look for other sources of funds.

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Fed's CPFF winding down due to pricing

One of the reasons the declines in the commercial paper markets have been gradual rather than falling off the cliff in October of 08, was the Fed's program called Commercial Paper Funding Facility (CPFF).

Here is part of the announcement form the Fed at the time of the CPFF launch:

The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

For those who were unable to sell commercial paper in the market could go to the Fed and place the paper with CPFF. Even GE Capital ended up using the facility last fall, as it became clear it would have trouble rolling it's paper. The stronger issuers like GE stopped using the program as soon as they could find private buyers. Many weaker issuers however continued to rely on CPFF.

At the time of it's creation, the costs to use the program were reasonable. Here are the terms:



These costs dropped somewhat a month after the program was launched, but remained almost constant since then.

CPFF historical rates:


Given that the assets financed with commercial paper tend to have a floating coupon, CPFF created a mismatch between assets that are yielding increasingly less and the financing that's almost fixed.

The market based commercial paper rate however, continued to fall (with LIBOR). Those who are able to issue paper privately are getting increasing cheaper financing.

90-day (A1/P1) CP rates for corporate CP as well as ABCP:


Thus on a relative basis CPFF is becoming increasingly expensive, and participants are desperately trying to find other sources of funds (including getting out of the CP market altogether). That's why the volume on CPFF continues to fall:



Overall the program kept corporations (including GE) and bank facilities from a complete liquidity crisis, creating gradual wind-downs or a migration to private sources. Ironically the Fed has made a bundle on the program. There haven't been any defaults and with the 300 bp spread on ABCP and 100 bp upfront for unsecured CP, it's has been a good deal for the Fed.

Money market funds - running out of product

One lesson the financial crisis taught banks, corporations, and institutional investors is to match the term of their assets and liabilities. Reliance on short-term financing, whether it be repo or commercial paper, to fund longer term, potentially illiquid assets is deadly. Lehman and Bear were unable to roll their repo financing, while Citi, RBS, and numerous others couldn't roll asset backed commercial paper on their CP conduits. Even GE had to get the Fed to purchase their commercial paper. Surviving institutions said "never again". Those who can issue longer term financing, even if it is more expensive have been doing so. Corporate treasurers do not want to wake up to find that they can not roll their short-term financing and will be forced to sell assets.

The top rated issuers have been reducing their issuance of commercial paper as they roll into longer term liabilities. The graph below shows Tier-1 commercial paper issuance continues to decline.


source: the Fed

On the other hand buyers of short-term instruments are also under pressure. The typical buyers, money market funds, now have to increase liquidity, improve credit quality, and diversify even more. After the Reserve Fund fiasco, the SEC is on a war path to shorten average maturity of prime money markets' assets. At the same time top money market funds only buy Tier-1 credit assets, which becoming more scarce as the higher rated firms like GE push their liabilities further out (beyond the new duration restrictions of money market funds).

The resulting rift between issuers and investors is becoming even more exacerbated as cash positions of retail and institutional investors swell.



The lack of quality sort-term product is pushing prime money markets to buy more treasury bills or enter into treasury and agency repo, putting downward pressure on yields. Treasury repo yields are 10-20 basis points annualized. That's why if you look at your latest returns on a money market fund, they are pathetic. Some firms increasingly rely on foreign banks for quality short-term product - see Fidelity's institutional money market fund below:



In addition, the latest SEC proposal for money market regulation forces funds to include treasury notes in their average duration calculation, effectively restricting the proportion of treasury notes (anything longer than bills) in the portfolio. The business of running prime funds will only become more challenging going forward, limiting investor choices only to the larger mutual fund managers and banks like JPMorgan. These firms will effectively use money funds as a loss leader (or just low profitability business) to push investors into their more profitable mutual funds or banking products.

The contraction of the US commercial paper markets

The commercial paper market volumes are continuing to drop. The decrease in paper outstanding has in fact accelerated. A large portion of the change is coming from the Asset Backed Commercial Paper market (ABCP).

Source: the Fed


This is the market that used to support the various types of ABS financing, including the sub-prime markets. In fact when a sub-prime borrower asks where the funds for her mortgage came from, a big chunk of that money came from ABCP investors. ABCP funded the senior tranche of the pool of mortgages bought from the originators. ABCP investors were generally money market funds.

The ABCP market size took it's first hit in 2007 when investors got uneasy about the collateral. What remained after 07 was ABCP sponsored by banks, who in many cases were (or started) providing full credit support to the CP programs. Non-bank supported programs such as SIVs had to be unwound (liquidated).

The problem with commercial paper in general is that every week, month, or quarter (mostly every day during the crisis) some paper matures. The borrower has to borrow again, i.e. roll the paper. Until recently we've had decades of rolling commercial paper with practically no issues. If it was rated by the rating agencies, it could be refinanced. 2007 changed all that, and banks could no longer rely on the market to be there for them.

The banks are now reducing ABCP conduits (the off-balance-sheet entities that issue bank supported paper) and are using other, more stable forms of funding. Whether it's the FDIC guaranteed notes, longer term bonds, or the interbank funding, these sources are replacing commercial paper. Some of the financing is accomplished via TALF, which was specifically designed to replace the lost ABCP.

The type of ABCP programs that remain are now dominated by "multi-seller" bank supported financing. These programs involve multiple originators of credit card or auto loans tapping the commercial paper markets. The SIVs and the securities arbitrage programs are disappearing (see chart).

Source: Moody's


The overall decline in the commercial paper markets (to nearly half the peak levels) is another sign that the recovery will be extremely bumpy, and the GDP growth is unlikely to return to pre-recession levels. The shrinking ABCP markets powered a great deal of the consumer spending that contributed to that growth.