January 9, 2015 / 6:18 AM / in 3 years

Big banks park beat-up energy sector bonds in U.S. money funds

The skyline of the banking district is pictured in Frankfurt, October 21, 2014. REUTERS/Ralph Orlowski

BOSTON (Reuters) - Big European and American banks have found a productive place to park the energy sector’s most distressed debt: the $2.7 trillion U.S. money market industry.

Barclays Bank plc, Credit Suisse and Wells Fargo and others get overnight and short-term loans from companies that run money market mutual funds such as Fidelity Investments, BlackRock Inc, American Beacon and others. The banks use the money to fund long positions in securities or to cover short positions. For collateral, the funds are accepting the junk-rated bonds of beat-up energy companies.

Even though the value of the bonds are in free fall as oil prices plummet, the money funds readily accept the debt, because it’s a way to generate above-market yields in an industry hurt by near-zero interest rates. In 2014, the average yield for taxable money fund investors was a paltry 0.01 percent. Banks currently have about $90 billion outstanding in short-term and overnight loans backed by riskier assets that include corporate debt and equities.

The exact amount of junk-rated energy debt used as collateral was not available. But more than a dozen of the sector’s mostly highly distressed issuers, including QuickSilver Resources, Black Elk Energy, Halcon Resources, Samson Investment and Sidewinder Drilling Inc, have had their bonds used as collateral, according to recent fund disclosures.

These so-called “other repurchase agreements” generate above-market yields for the funds, ranging anywhere from 20 basis points to 50 basis points. In contrast, repo loans backed by safe U.S. Treasuries can generate yields of about 10 basis points and less, according to recent fund disclosures.

Most money fund assets are in Treasuries, certificates of deposit and government agency debt. But some jarring discoveries in the types of collateral money funds accept on short-term loans to big banks can be found by investors who dig through industry disclosures.

A money fund run by Morgan Stanley recently disclosed, for example, an $8.25 million repurchase agreement with Credit Suisse, which used bonds issued by Sidewinder Drilling as most of the collateral. As oil prices have tumbled, so has the value of Sidewinder’s 2019 bonds, falling about 44 percent since early October.

Credit Suisse declined to comment.

Money funds downplay the risk in the repo transactions backed by the junk-rated collateral. They say their ultimate backstop is the bank on the other side of the deal. Fidelity, the largest money fund operator in the industry, declined to comment on any specific transaction. In a statement, the company said, “We make an independent assessment on the counter-party credit quality in all repurchase agreements to ensure the counter-party represents minimal credit risk.”

By contrast, No. 1 U.S. mutual fund company Vanguard Group plays it safe. The $133 billion Vanguard Prime Money Market Fund and the company’s other money funds only accept U.S. government securities as collateral, company spokesman David Hoffman said.

“In times of stress, governments are far more liquid than other asset classes,” Hoffman said. “This is especially true with U.S. Treasuries, which are likely to rally during times of stress.”

Federal Reserve Bank policymakers say they are worried that some banks rely too much on repo loans as a source of wholesale funding. They also point out how money funds make loans secured by assets they would quickly unload if the bank on the other side of the deal defaulted.

“What always worries you about wholesale funding is the run risk,” John Williams, president of the Federal Reserve Bank of San Francisco, told reporters this week at an economic conference in Boston. “... Heavy reliance on wholesale funding, which is still there for certain institutions, is an important issue that we need to address and make sure our financial system is resilient to things going wrong.”

Despite a host of new regulations for money funds and banks, some of the same elements of risk that led to a redemption run in the money fund industry and the failure of Lehman Brothers in 2008 remain intact. Treasury and Federal Reserve officials say more work needs to be done to address the risks of asset fire sales and redemption runs.

A redemption run on the Reserve Primary Fund in 2008 has been a rallying cry for reform after its exposure to Lehman Brothers debt prompted panicked investors to withdraw their money in droves. That run led the fund to “break the buck,” a rare event in the money market fund industry that refers to a fund’s net asset value falling below $1 per share.

In recent presentations, Boston Fed President Eric Rosengren has said there should be more disclosure about the composition of the collateral used in repo agreements. He said it would allow investors an opportunity to observe changes in financing patterns and might prevent risk taking that investors may consider excessive.

And this summer, before oil prices began their descent, bonds issued by Black Elk Energy Offshore Operations LLC were used as collateral in repo agreements with funds run by Fidelity, BlackRock Inc and Goldman Sachs’ investment management arm, fund disclosures show.

But in recent months, Black Elk debt maturing later this year is not turning up as collateral in the latest round of money fund disclosures. The yield on its bonds has spiked as high as 75 percent in the past month, an indication of the bond market’s dimming view the company can avoid default.

Writing By Tim McLaughlin; Additional reporting by Michael Flaherty; Editing by Richard Valdmanis and John Pickering

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