Charts like this — of the London Interbank Offered Rate better known as Libor — are enough to make those who remember the 2008 financial crisis shudder with apprehension.
Back then, bank borrowing costs ticked up as investors fretted over the soundness of lending unsecured short-term money to potentially troubled financial institutions. Nowadays, though there's plenty of handwringing about the state of some European banks — Libor's recent move upwards has little to do with financial institutions and yet a lot to do with the 2008 financial crisis.
At issue is massive reform of money market funds due to come into effect on October 14 and which will see such funds be required to float their net asset values (NAVs), adopt liquidity fees, and install redemption gates. The measures are an attempt to prevent a repeat of part of the crisis, which saw one prominent money market fund — The Reserve Primary — "break the buck" when its NAV dropped below $1 a share.
Such a thing is never supposed to happen in the world of money market funds, which were often pitched to investors as deposit-like places to safely store cash while generating returns. Prime money market funds invest in short-term floating-rate debt and commercial paper sold by companies, as well as some U.S. government securities.
As of last week, when three-month dollar Libor hit a post-crisis high of 72 basis points — the October 14 deadline was precisely 90 days away — a timeframe that comes with added import in money market world. As the deadline loomed, banks were forced to sweeten their rates on offer in order to borrow.
"Institutional prime money fund[s] anticipating volatility of investor redemptions around that date are avoiding short-term investment out to that maturity, or at least requiring higher yields to compensate for the liquidity," explains Deutsche Bank AG Analyst Steve Zeng. "Prime funds invest roughly 60 percent of their assets in commercial paper and certificates of deposit. For issuers relying on those instruments for funding, reduced participation from money funds means that their unsecured borrowing costs — which Libor is supposed to represent — have gone up."
You can see the dynamic in the below chart from Societe Generale SA. It shows $133 billion of assets leaving prime funds and some $135 billion worth of assets entering government money market funds that invest only in government-related securities since the start of June alone.
It's worth noting here that even before the October 14 date loomed into the 90-day window, some funds were prepping for reform, the most notable being Fidelity Investments' $111.5 billion Fidelity Cash Reserves fund, which changed its investment mandate to include only government and collateralized securities earlier this year. Short-term corporate borrowing costs have also already been on the rise — feeding into an effective tightening of financial conditions — as demand for commercial paper shrunk.
All of which raises the question of whether the shift has now been completed or if there's more to come.
Deutsche's Zeng reckons we're about halfway to as much as two thirds through the transition. He expects the spread between Libor and the Overnight Borrowing Rate (OIS) — a traditional measure of bank funding stress — to rise from its current 30bps to settle somewhere in the region of 35-40bps. But, he cautions, "if there is any large sudden outflow from prime funds, compounded by further banking sector stress, the spread could easily shoot above our forecast."
That means that while money market funds should be rendered safer thanks to October's reform efforts, banks will likely be losing a key funding source just as worries over some lenders are heating up.