Livin’ On a Prayer: Why the Deficit Deal Falls Short

BY BRUCE FERNANDEZ, CFA

Although most of the recent media coverage has focused on the $14.3 trillion of national debt, the real issue is a measure known as the fiscal gap. The fiscal gap you ask? What is it and why is it so important? The easiest way to think about it is this: the national debt deals with the past while the fiscal gap looks at the future.

So what does our fiscal gap look like? Not good. In fact, the Congressional Budget Office (CBO) calls the fiscal gap outlook “daunting.” CBO projections[1]clearly show a sharp increase in federal spending for entitlement programs, primarily

CBO Budget Projections June 2011

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Medicare and Medicaid, in the decades ahead (see below).[2] The CBO concludes if policymakers want to close the fiscal gap and put the federal government on a sustainable budgetary path, they will need to increase revenues substantially, decrease spending significantly, or adopt some combination of those two approaches. The report of President Obama’s Commission on Fiscal Responsibility and Reform, aptly entitled “The Moment of Truth”, reached similar conclusions last December.[3]

While it is true the policymakers managed to avoid an immediate default, the debt deal comes nowhere close to getting us even “halfway there” in terms of closing the fiscal gap since it addresses neither entitlements nor tax reform. It is also unlikely the debt deal will do much to help the U.S. retain its “AAA” debt rating for the same reason. Nonetheless, our policymakers have taken an important first step.



[1] CBO’s 2011 Long-Term Budget Outlook, June 2011

[2] The alternative fiscal scenario incorporates several changes to current law that are widely expected to occur or that would modify some provisions that might be difficult to sustain for a long period.

[3] The National Commission on Fiscal Responsibility and Reform, “The Moment of Truth”, December 2010

 

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It’s Greek to Me: Understanding Money Funds’ Exposure to European Banks

BY BRUCE FERNANDEZ, CFA

What do the recent events in Greece have to do with you?  If you have money invested in a money market fund (MMF), the answer may surprise you.   According to a recent report by Fitch[1], MMF exposure to European banks on represents 50% of the total assets of the 10 largest prime MMFs as of May 31, 2011.  The WSJ[2] reports the biggest U.S. money-market funds hold roughly $1 trillion of debt issued by big European banks, causing concern for U.S. regulators and lawmakers.  Why the concern?  It turns out, European banks, in particular French banks, have large exposures to Greek debt.

It’s been almost three years since money market funds faced their most significant challenge to date when the Reserve Fund “broke the buck” in September 2008 and prompted investors – primary institutional investors – to withdraw about $210 billion from prime money market funds over the next two days.  Only when the US government announced the third day that they would temporarily guarantee money fund balances did the broad market panic subside.[3] Still, prime MMF aggregate assets dropped $450 billion (21 percent) in the four weeks beginning on September 10.[4] While several steps have been taken to minimize the credit and liquidity risk of MMFs since September 2008, MMFs still appear to be susceptible to a loss of investor confidence and another possible “run on the bank.”

So what is an investor to do?  The most important step is to be aware not all MMFs are the same.  While commoditization of the MMF industry has occurred over the years, there still are important differences in terms of what MMFs choose to invest in.  While it may take a trained eye to see these differences, differences do exist if one looks carefully enough.  However, there are some simple ways to glean important information about portfolio risk without digging into all the details.  One proxy for portfolio risk appears to be yield.  According to a Federal Reserve staff working paper[5], “empirical evidence suggests that gross yield, especially leading up to the run in 2008, was predominantly an indicator of portfolio risk.”  So it turns out that by avoiding MMFs with the highest yields may be a simple way to help investors steer clear of MMFs that have higher portfolio risk.  Basically, as a MMF fund investor, you should perform the same due diligence you would on any other investment.



[1]Fitch Ratings, U.S. Money Fund Exposure to European Banks Remains Significant, June 21, 2011

[2] Wall Street Journal, “Unease Rises Over Funds”, June 22, 2011

[4] Patrick E. McCab, “The Cross Section of Money Market Fund Risks and Financial Crises”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.

[5] Op. cit., McCab.

 

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