Greece is in the soup. Are we about to get scalded with the spillover?
The odds say no, thanks to official support for Greece and the European banks that look most apt to suffer in a default. Yet it's clear that the U.S. financial system remains vulnerable to trans-Atlantic aftershocks.
One pathway that could wash Greek problems onto these shores is Europe’s wholesale bank funding market, which relies in large part on U.S. money market funds. A Fitch Ratings survey this spring estimated that the top 10 U.S. prime money market funds had 44% of their assets in European bank debt of one sort or another, ranging from certificates of deposits to short-term loans known as commercial paper and repurchase agreements.
With Moody’s having downgraded three French banks Wednesday for their exposure to Greek debt, and the 2008 crisis having been amplified by problems at a money fund that took big losses on Lehman Brothers notes, that number looks ominous.
The money funds’ European exposure “is potentially important,” says Viral Acharya, a finance professor at New York University’s Stern School of Business. “The risk is that if you have any upset in the money funds again, the people who have put their money there could flee.”
A flight out of money funds could start the same cycle we saw after Lehman’s failure, in which funds facing losses could be forced to sell assets to meet redemption requests, starting a disruptive cycle of fire sales. That could mean another brush with economic catastrophe, rather than a simple stock market pullback.
But the good news is that there is no sign it will come to that. Though stocks and commodity markets have sold off this week as default fears rose, measures of interbank stress remain muted. The Libor-OIS spread, which tracks the risk of bank default, has been falling this month, and the cost of insuring U.S. bank debt against default hasn't risen much.
As long as European authorities are able to prevent a major bank from failing in the wake of a Greek default, another run on the money funds looks unlikely. The good news is that compared with their overextended stance headed into the 2008 crisis, banks “are reasonably well capitalized” now, Acharya says, and dollar liquidity remains ample.
Another hopeful sign is that scarred by the break-the-buck episode, the money funds may be acting more prudently. The Fitch report notes that U.S. money funds had next to exposure to the banks of troubled countries like Greece, Ireland, Portugal and Spain as of February.
Banks in France and Germany are certain to take hits if Greek debt goes bad – but as long as the losses aren’t catastrophic, the money funds should hold up.
Of course, it’s impossible to say for sure how vulnerable funds are without looking at what each one holds. Investors in money funds should check out their holdings to make sure they’re not taking any more risk than they’d like.
Acharya adds that the Securities and Exchange Commission could further put investors at ease by stress-testing the biggest funds for their exposure to European debt and other risks. You would expect the biggest funds to have been steering clear of risky asset concentrations, but saying that doesn’t make it so, as we learned a few years ago.
“Some regular, credible tests of these funds would be very helpful,” says Acharya. “This is just the sort of issue we could use more disclosure of.”