MONEY MARKETS-Exposure to Europe could prove troublesome

Tue Jun 21, 2011 3:51pm EDT

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By Chris Reese and Ross Kerber

NEW YORK/BOSTON, June 21 (Reuters) - U.S. money market mutual funds' holdings of European bank securities could become a source of trouble if the region's debt problems keep spiraling, industry specialists say.

Top U.S. money market funds have stayed heavily invested in European financial institutions, Fitch Ratings said in a report that covered the three months to May 31 and released on Tuesday.

Though tensions have eased recently, a debt crisis leading to a default in a country like Greece or Portugal could hurt the banks and in turn pressure the U.S. funds that supply much of their credit.

The situation puts all parties in a quandary because the banks need access to dollars, while the U.S. funds need higher-yielding investments.

"Money funds are getting squeezed so badly domestically because there is just no yield in any kind of money-market instrument, so if they have the ability to invest internationally, Europe is kind of a good idea from a yield-grab perspective," said Thomas Simons, money market economist with Jefferies & Co in New York.

Fitch's report reviewed holdings of the 10 largest U.S. prime money market funds representing $755 billion in assets, about half of which it found could be exposed to European banks.

PRESSURES ON FUNDS

The questions come at a difficult period for the money market mutual fund industry, dominated by big asset managers like Fidelity Investments and Federated Investors (FII.N). Many have waived fees amid low interest rates and operate under new regulations after shocks during the financial crisis.

The companies now also have fewer places to invest, pushing them toward Europe. Fitch said total asset-backed commercial paper, once a mainstay security for money market funds, has dropped to $380 billion from $1.2 trillion at the start of 2007. U.S. money funds "have still had a lot of money to invest but they didn't have as many places to go," said Alex Roever, managing director for JPMorgan Chase & Co.

Meanwhile, rates on obligations from European banks such as BNP Paribas (BNPP.PA) and Credit Agricole SA (CAGR.PA) can run ten basis points or more than what U.S. banks pay, money fund specialists say.

One of the largest money funds is run by Vanguard Group Inc. of Pennsylvania. Spokespeople there said the $110.6 billion fund, Vanguard Prime, held 21 percent of its assets in certificates of deposit and commercial paper issued by European banks as of May 31, up from 17 percent at the end of last year, an increase driven by the shrinking pool of U.S. bank commercial paper.

The representatives added the fund holds no certificates of deposit or commercial paper from French banks, among the institutions facing the most scrutiny for their exposure to Greece.

LIKE JUNK BONDS

Simons compares the continued European money-market exposure to a rally in junk bonds in recent years, where "even though it is not a great investment it is one of the only places where you can earn any money in fixed income."

Fitch said the funds it analyzed represented 45 percent of the prime fund arena.

Exposure to French, German, and U.K. banks was constant over the three-month period at 30 percent of assets, Fitch said in the report. German bank exposure declined from 8.2 percent to 6.3 percent of money market fund assets. French bank exposure rose from 13.3 percent to 14.8 percent over the same period. U.K. bank exposure rose from 8.6 percent to 9.7 percent of money market fund assets.

However, money market funds' exposure to Italian and Spanish banks has decreased since peaking in 2009. Exposure to Italian banks dipped in the three-month period to 0.8 percent from 1.5 percent. Exposure to Spanish banks was steady at 0.2 percent of total assets.

On the other side of this relationship, of the top 15 money market fund exposures to global banks, money market funding accounts for at least three percent of total deposits, money market, and short-term funding for seven institutions, Fitch said.

That exposure level would be higher if the "full universe" of prime money market funds were included beyond the 10 largest funds, along with privately managed liquidity pools and European U.S. dollar-denominated money funds with similar investment profiles.

"While the overall funding reliance on money market funds might not appear significant, the potential withdrawal of money market funding could create negative perceptions about an institution's financial condition," Fitch said in the report.

NO SIGN OF A SQUEEZE

So far, money market funding has not shown evidence of fears of a squeeze.

Benchmark three-month dollar London Interbank Offered Rates (Libor) USD3MFSR= on Tuesday fixed at 0.2455 percent, down slightly from 0.2465 percent on Monday and not far above the record low of 0.2450 percent reached last week.

(Editing by Burton Frierson and Chizu Nomiyama)

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