August 5, 2011 / 4:40 PM / 8 years ago

US downgrade to hit repo agreements most

LONDON, Aug 5 (IFR) - Certain Asian and European investors may have to turn to alternative Triple A rated assets while repo agreements might be hurt if S&P cuts the US’s rating.

US politicians finally agreed to raise the debt ceiling earlier this week. However, there is still a possibility that the country’s Triple A rating could be downgraded by S&P which has yet to opine.

Moody’s this week confirmed the US Triple A rating but put it on negative outlook, while Fitch has yet to conclude its review. It is expected to do so by the end of the month and has not ruled out changing the outlook to negative.

According to JP Morgan the biggest impact of a US downgrade will be on tri-party agreements in Europe and the US repo market.

Certain tri-party agreements have strict ratings requirements which would result in US Treasuries no longer being accepted as collateral.

“This would affect around EUR90bn of repos with US collateral in place in Europe,” said Nikolaos Panigirtzoglou, an analyst at JP Morgan.

Although there is no mention of ratings restrictions in tri-party agreements in the US, in Europe tri-party agreements are classified first by rating, then by issuer and then by country.

“If the US sovereign were no longer rated Triple A, US Treasuries would not be eligible anymore. This would affect around EUR90bn of repos currently in place in Europe (or 3.1% of the EUR3trn European repo universe).

The JP Morgan did add however that while a downgrade would not affect the eligibility of US Treasuries as collateral in US repo agreements, there was a risk for a haircut increase.

“If the haircut had to increase from 2% to 3%, repo borrowers would have to fund an additional USD30bn via other sources,” Panigirtzoglou wrote. “This is a rather small amount. But it can become more problematic if haircuts rise by more or if volumes start shrinking as money market funds or repo investors retrench.”


Meanwhile, market analysts believe that there would be very limited forced selling by domestic investors as a result of a downgrade.

US pension funds and companies have a certain amount of flexibility regarding the sale of downgraded debt and would likely be reluctant sellers of their own sovereign.

The number of investors that are restricted to by Triple A mandates is minimal. Expectations are that around USD40bn could be pulled from US Treasuries as a result of force selling.

“An upper bound of around USD40bn of possible forced selling is minute compared to the USD10trn of tradable US government bond,” said Panigirtzoglou.

“At the moment US pension funds and insurance companies seem to have flexibility regarding the sale of downgraded debt so they are likely be loyal and patriotic about investing in their own sovereign,” said a commercial paper trader.


However, while the impact on many investors is thought minimal, the past week has seen a total of USD30bn being pulled from the US Treasury market and more is expected in the coming months as investors take out their holdings.

According to the JP Morgan research note, “US money market funds would not be required to sell US Treasury Securities in the event of a US downgrade, it is investor redemptions that pose most risk. Government money market funds are mostly at risk of losing their Triple A rating in the event of a US downgrade as they have no other investment alternatives.”

Meanwhile, a European CP trader said that a downgrade of the US would have a profound effect on money managers that focus on the US. According to him and other CP traders, investors that have Triple A ratings restrictions include European pension funds, asset managers, private banks, bank treasuries and Asian central banks.

“Many US investors will remain loyal and patriotic to Treasuries but for European and Asian investors they will be looking for alternatives,” he said.

As it stands 26% of the USD1.7trn US Treasury market comes from money market funds that typically look for ultra safe investments. Meanwhile, foreign central banks who hold around USD3.5trn of US Treasury securities are already seeking alternatives to US Treasuries.

So what are they? According to commercial paper traders, Treasury investors have already begun to look at Australia, Denmark and other European sovereigns that have their Triple A status intact.

“In the current market, Australian paper can offer a pick-up of 10bp-12bp over US Treasuries for one-month paper, German paper 10bp, Austrian 10bp-12bp and Danish paper 8bp,” said a banker.

“That will be very attractive to a minority of investors that are restricted to Triple A rated debt products.”

Reporting by Aimee Donnellan, Editing by Helene Durand

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