ab Strategic Insights Portfolio Advisory Group

Greece, European & U.S. Money Market Funds July 2011

Introduction Recognizing the systemic risks presented by a possible Although its economy makes up only 2% of total euro member-country default, policymakers in the euro area area Gross Domestic Product (GDP), has been a and at the IMF responded in 2010 by providing sizeable major source of risk to world financial markets for the loans to Greece's government. The aid packages were past two years. As a result of its credit difficulties, the conditional on the Greek government making necessary Greek government is currently only able to borrow at fiscal reforms to put the country on firmer footing. The extremely high interest rates, a practice it cannot sustain scale of the austerity measures required to achieve these while continuing to honor its current debt obligations. fiscal targets will almost certainly result in a significant The Greek government has therefore become almost deterioration of Greek private sector wealth and overall entirely dependent upon continuing aid packages and standard of living. other support facilities administered by the International Monetary Fund (IMF) and European Union (EU) to Figure 1: Greek debt as % of GDP prevent an outright default on its debt obligations. 160 Public Debt % of GDP As the last few weeks have shown, Europe's debt problems are not limited to Greece alone. In fact, at 140 numerous times during the past two years, ratings agencies and financial markets have called into question 120 the debt problems of Portugal, Ireland, Spain and Italy. 100 The purpose of this paper is to explain how Europe's debt difficulties, centering on the prospect of a Greek 80 default, are indirectly connected to U.S. money market 60 funds (MMFs). While MMFs are prohibited from holding Greek assets directly, they are permitted to maintain 40 exposure to financial institutions, which in turn may have exposure to Greek and other peripheral euro sovereign 20 Greece Eurozone debt. We believe that many of the recent alarmist headlines in the financial press overstate the near-term 0 risk to these funds. However, we also acknowledge that 1995 1997 1999 2001 2003 2005 2007 2009 an unexpected worsening of the situation in Greece, which could cause wider problems for other euro area Source: Eurostat, as of Dec. 31, 2010 nations, is a notable risk for the European banking system, and therefore for U.S. money funds. UBS Research Americas (WMR) believes that some form of Greek default is inevitable. The risks are not spread evenly across all banks, or even However, it appears that European officials want to delay all European banks. Therefore, we will also identify such an event for as long as possible to allow banks to which of the largest global banks appear to be at recapitalize and other nations to get their fiscal houses in greatest risk of contagion and to provide information on order. Any default, which it's called a rescheduling or a the holdings of several money market fund families restructuring of debt, will be negotiated with an eye currently offered on the UBS platform. toward limiting the potential ripple effect through the banking system. This accounts for the global financial Greece & The European Debt Problem markets' focus on Greek budget negotiations. Indeed, the recent passage of the Greek austerity measures Greece's current predicament stems from a rapid rise in unlocks more IMF relief, which should help assuage fears public debt in the mid- to late-2000s, much of which of an immediate default. However, we believe the was not accurately reported at the time. This lack of reprieve will prove temporary, and our baseline scenario transparency was compounded by the global recession in remains a Greek restructuring sometime next year in 2008, which caused the gap between Greece's which holders of Greek debt should expect to recover government spending and tax revenues to widen further. only thirty to forty percent of what they have been Greece's total debt outstanding relative to GDP has promised. grown rapidly while its ability to service this debt has diminished (Figure 1).

Strategic Insights: Greece, European Banks & U.S. Money Market Funds Portfolio Advisory Group

European Banks' Sovereign Credit Risk government, which owns 25% of the , should help prevent a run In coming to the aid of Greece with loans in the • Group – massive exposure to sovereign hundreds of billions of euros, Europe's political leaders debt of Greece and other peripheral euro area have not acted selflessly. A large proportion of Greece's countries; however, it has a higher capital base debt is held by foreign investors, particularly large than most of its peers, which would help it European banks. In fact, the ability of certain banks to weather a write-down on Greek debt remain sufficiently capitalized hinges on Greece fully repaying its debt. As that scenario becomes less and less In addition, the Moody's rating agency announced in likely, markets and the financial press are turning their June that it was reviewing three French banks for a attention to the health of these banks. potential downgrade stemming from their Greek debt exposure. It expressed concern over the level of exposure WMR performed an analysis of Greek debt exposure on that Credit Agricole, Societe Generale and BNP Paribas the balance sheet of the largest European banks. For have to the Greek economy, which includes private some of these banks, Greek debt comprises up to 20 or sector loans as well as government holdings. 30% of core capital, meaning a payout of significantly Consequently, both Credit Agricole and BNP may be less than 100% on this debt could materially impact their downgraded by one notch and Soc Gen by two notches capital ratios (ratio of the bank's capital to its risk- in the near future. weighted assets). As Figure 2 shows, Greek banks (National and ) are in by far We view this possible action as relatively benign. the greatest peril. Moody's downgrade of these banks merely brings their ratings into line with the existing ratings of Standard & Figure 2: Euro area bank exposure to Greek government Poor's. While a lower rating could mean an unwelcome debt rise in funding costs, short of a catastrophic contagion effect on the broader French economy, a combination of € blns % of Tier 1 capital 14 350% Greek default and lower credit ratings, in isolation, does Greek assets (euro blns) LHS not present a serious risk to the health of these three 12 300% French banks. Greek asset % of Tier 1 capital RHS 10 250% European Bank Exposure in U.S. Money Market 8 200% Funds

6 150% It may surprise some to learn that close to half of the assets held in U.S. money market funds (MMFs) 4 100% represent liabilities of non-U.S. banks. The supply of 2 50% (CP) and Certificates of Deposit (CDs) from U.S. banks is insufficient to satisfy U.S. investor 0 0% demand, so fund managers turn to non-U.S. banks. A significant fraction of non-U.S. assets held by MMFs ribas roup erale bank ece Bank ciete Bank originates in the euro zone, although not all euro zone So Gen assets are equally exposed to Greece. While many money BNP Pa BNP of Gre Dexia G Piraeus

National market funds have deliberately trimmed their exposure Commerz Source: UBS Wealth Management Research, The Economist, as of Dec. to euro area banks in the past year, by some estimates, 31, 2010 U.S. MMFs still hold close to $500 billion of euro area bank obligations out of approximately $1.7 trillion in According to WMR, the most endangered non-Greek total MMF assets. banks are: Ironically, U.S. MMFs hold exposure to many non-U.S. • Postbank – part of that continues banks precisely because they are among the few entities to operate under its own brand; largest deemed of sufficient creditworthiness to include. Money exposure to Greece as a percentage of capital market funds are governed by strict rules meant to but Deutsche integration should help buffer any prevent market losses based on either interest rate or losses credit risk. As Figure 3 shows below, even after the • – not well-capitalized as is, and Moody's downgrades, most of the French banks we refer WMR estimates its Tier 1 ratio, an important to above still carry ratings that are at least as strong as measure of a bank's financial strength, would their U.S. counterparts. fall to around 5% in the event of a partial Greek default; the implicit backing of the German

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Strategic Insights: Greece, European Banks & U.S. Money Market Funds Portfolio Advisory Group

U.S. Banks Also Exhibit Credit Risk We assign a low probability to a MMF "breaking the U.S. banks have encountered their own set of difficulties buck", a term for a drawdown in a MMF's net asset with the major ratings agencies of late. Separate from value (NAV) to below $1.00 per share, due to a Greek the European situation, credit analysts are concerned default. As a secondary consideration, a further increase that continued political support for large financial in headline risk surrounding euro zone banks or MMFs institutions, in the U.S. and globally, is not assured going could lead to a withdrawal of assets, which might forward. Moody's explicitly cited the reduced willingness present a liquidity challenge to the funds. However, rules or ability of governments to provide support to banks as for money market funds written after 2008 ensure that reasons for putting both Citigroup and funds maintain a minimum level of liquidity to on negative watch in June. Both banks' short-term credit accommodate redemptions. We believe this should help ratings are also on negative watch. Were Moody's to allay concerns about a run on these funds, even if one or downgrade one or both short-term ratings, under more funds did run into trouble. current rules MMFs would be forced to significantly limit their exposure to these banks. So while U.S. financial The Effect of a Wider European Contagion institutions generally have far less direct exposure to Greek sovereign debt than do many of their European In the worst-case scenario, a disorderly Greek default or counterparts, they carry their own sets of risks. some other exogenous event could cause borrowing costs to rise for several other European states including Figure 3: Credit ratings of European & U.S. banks Ireland, Portugal, Spain and Italy, and threaten the ability of these countries to finance their debt. While we do not Moody's Moody's S&P expect any of these four countries to be forced into a Short-term Long-term Long-term near-term default or restructuring, our continued BNP Paribas P-1 Aa2* AA** confidence in this view hinges on whether Greece's situation is resolved, and if so, how. Because A Greek Credit Agricole P-1 Aa1* A+ failure to meet a scheduled payment would constitute Societe Generale P-1 Aa2* A+ the first default of a country within the European Commerzbank P-1 A2 A** currency union, the exact size and nature of the Dexia P-1 A1* A** "domino effect" is unknowable.

Citigroup P-1* A3* A** Figure 4: Select euro area bank exposure to sovereign JPMorgan Chase P-1 Aa3 A+ debt Bank of America P-1* A2* A**

Dexia Group * Possible Downgrade ** Negative Outlook Source: Moody's, Standard & Poor's, as of July 7, 2011 Commerzbank

Impact of Possible Greek Default on MMFs BNP Paribas

Regulatory rules dictate that funds provide detailed disclosures of their holdings on a regular basis. The Credit Agricole short-term maturity profile of the assets held in these funds allows the fund managers to exit positions Societe Generale relatively quickly by simply letting assets mature without rolling them over. This means that even MMFs with relatively large exposure to troubled banks are able to 0 30 60 90 120 150 unwind that exposure quickly. % of tier-1 core capital

Greece Ireland & Portugal Italy & Spain It is difficult to quantify the connection between the Greece-related threat to euro area banks and the risk to Source: UBS Wealth Management Research, The Economist, as of Dec. holders of U.S. MMFs. Nearly all of the CDs and CP in 31, 2010 MMFs mature within three months, and banks' short- term credit ratings are judged independently of their The largest European banks' exposure to "peripheral" long-term ratings. The ratings agencies have thus far not sovereign debt is much larger than their exposure to questioned the European banks' short-term credit Greek debt alone (Figure 4). In the absence of ratings. In fact, at the same time Moody's announced it government aid, a severe continent-wide contagion was reviewing several large French banks' credit ratings, could seriously threaten the health of many of Europe's it reaffirmed all three banks' short-term ratings. banks. The sizes of both Italy's and Spain's economies 3

Strategic Insights: Greece, European Banks & U.S. Money Market Funds Portfolio Advisory Group

(and total debt outstanding) are many multiples of determine their own level of comfort with the situation Greece's. Although we believe this scenario to be and to reallocate accordingly if necessary. unlikely, we cannot exclude the possibility that a worst- case contagion could impact the liquidity and even the In addition, UBS Global (GAM) net asset value of U.S. MMFs. maintains a public website that provides a breakdown of the holdings of all GAM funds on a monthly basis. The Conclusion: European Bank Exposure in MMFs two other MMF families on our platform are Dreyfus and Offered at UBS Federated. On balance, these funds hold a level of exposure to euro area bank debt that is in line with the Although we do not consider exposure to euro area rest of the industry. The table below details the exposure banks to be a significant near-term source of risk for U.S. to the troubled European banks identified earlier for MMF investors, we believe it is still important to provide select funds in all three families. The links for each fund detail to our clients on the underlying holdings of the go to the fund families' public websites, which contain funds on our platform. This will allow clients to information on the broader array of their offerings.

Figure 5: Exposure of Select Money Market Funds on UBS Platform to banks with largest Greece exposure BNP Credit Societe Paribas Agricole General Commerzbank Dexia UBS Select Prime Institutional Fund* 2.43% 0.79% 2.71% 0.00% 2.96% UBS RMA Money Market Portfolio* 1.46% 1.95% 2.85% 0.00% 0.00% UBS Retirement Money Fund* 1.88% 0.00% 2.78% 0.00% 0.00% Federated Prime Value Obligations** 4.87% 4.57% 4.34% 0.00% 0.00% Dreyfus Cash Management*** 5.33% 4.47% 5.32% 4.62% 0.00% Source: UBS Wealth Management, * as of 5/31/11; ** as of 6/15/11; *** as of 7/6/11

July, 2011 Figure 6: Credit Ratings Guide Moody's Moody's S&P UBS Wealth Management Americas ST LT LT Portfolio Advisory Group Prime Aaa AAA Aa1 AA+ High grade Aa2 AA P-1 Aa3 AA- A1 A+ Upper medium grade A2 A A3 A- P-2 Baa1 BBB+ Lower medium grade Baa2 BBB P-3 Baa3 BBB- Ba1 BB+ Non-investment grade Ba2 BB speculative Ba3 BB-

B1 B+

Highly speculative B2 B B3 B- Substantial risks Caa1 CCC+ Not prime Extremely speculative Caa2 CCC Caa3 CCC- In default with little CC prospect for recovery Ca C C In default / D /

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Strategic Insights: Greece, European Banks & U.S. Money Market Funds Portfolio Advisory Group

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