I want to talk about money market reform.
I'll admit it, starting a piece off with that sentence is pretty risky.
It almost guarantees that at least a quarter of the people who started reading have now stopped and moved on to something with a title like "Here's What To Expect From The iPhone 7."
And you know what? That's the problem with the world. That's the reason obfuscation is such an effective tool when it comes to keeping the general public completely in the dark about financial markets.
Have you seen "The Big Short"? You know how they have Margot Robbie naked in a bubble bath explaining MBS? Yeah, that should actually offend you. It's basically the filmmaker saying "even though moviegoers are ostensibly interested in trying to understand what happened in 2008, or they wouldn't have bought the ticket, the public is so obtuse that they'll quickly forget that the whole purpose of being in the theater is to learn about this stuff; so the only way to keep their attention for two hours is to put a naked Margot Robbie in a bubble bath halfway through."
By the way, I can tell you what to expect from the iPhone 7: it will be a lot like the iPhone 6. That said, it will still be way awesome and hugely profitable for the company, but won't be nearly as cool as whatever Steve Jobs would have come up with by now had he not died. And yes, he'll still be dead come the next Apple unveil. It's the same story every time.
Why anyone bothers to worry about that when the scaffolding of the financial system is what really counts is completely beyond me.
So without further ado, let's get to that scaffolding. A few days ago I wrote a bit about money market funds and dollar funding. It all sounds complicated - one reader complained of "brain freeze" - but it's all just a matter of understanding it as an interconnected system.
Think of the entire financial universe - stocks (NYSEARCA:SPY), bonds, FX, CDS, whatever - as one giant living organism and liquidity is the lifeblood that courses through its veins. When one limb runs short on liquidity, it goes to sleep and, if liquidity isn't restored at some point, it dies.
Now think about what money market funds do for the system. A money market fund is supposed to be a vehicle that's akin to a savings account, only with a higher rate of interest for the investor. But there's no such thing as a free lunch. You can't get a higher rate of interest without taking more risk, so money market funds have to find places to squeeze out some semblance of yield. (Although I would note that in reality, just about the riskiest proposition imaginable is borrowing short to lend long, which is exactly what banks do with your deposits, so thank God for the FDIC),
Prime money market funds (as opposed to funds that invest in government debt) invest in commercial paper and CDs to squeeze out that yield. Commercial paper is just unsecured, short-term corporate debt. Money market funds are thus liquidity providers to the system. Your cash is the liquidity. Contrary to popular belief, the money you dump into a money market fund isn't just sitting idly by in an inert account. What you're in fact doing is providing liquidity to companies like, say, Pfizer or Nestle (those are examples of issuers you can find in Vanguard's Prime Money Market Fund).
That being said, you should be asking yourself a simple question: "well if that's the case, then how can the NAV of a prime money market fund always be 1?" That's just it - it can't. Which is why starting in October, prime funds are going to have to start reporting a floating NAV. I'm sure you can imagine what that means for flows:
Here's an excellent (and balanced) take from RBC's Michael Cloherty (emphasis mine):
This is not a credit story or an inability to find financing story. The issue is that the largest investor for products that feed into the ICE LIBOR setting needs to hoard liquidity, as they cannot be sure how many of their investors will pull their cash as the new regulations approach. So they need to keep their maturities extremely short - buying 3m paper is far too long today, and buying 1m paper is likely to be too long by mid-August.
We expect the stress to peak around quarter end. Once we get past October 14th, money funds will no longer need to worry about redemptions, so they will be able to quickly extend their WAMs by buying 3m and 6m paper. This money market curve flattening should pull down the 3m sector.
LIBOR spreads will remain wider than they were before the money fund outflows began because there are fewer buyers for CP and CDs. But they should be much tighter than what is currently priced into 2017 because the remaining cash in Prime money funds will be able to be deployed out the curve.
That's actually pretty clear cut, but let me simplify it even further. If you're a prime fund manager, you have no idea how bad it's going to get between now and October in terms of outflows, so you can't buy any paper with a maturity date longer than a month. If you screw up and deploy too much capital out the curve relative to the incoming redemption requests, you're in trouble. Here's a bit more color on this from Deutsche Bank:
Why did LIBOR suddenly move higher?
This week the October 14th SEC Money Market Reform deadline finally rolled inside the 90-day window. Institutional prime money funds 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. Prime funds invest roughly 60% 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.
Is the move in LIBOR mostly over, and if not how much more is there to go?
It depends on how many more assets prime money funds will lose to government funds in the next three months. Our best guess is that the rate move is now somewhere between half and two-thirds complete. We expect LIBOR-OIS to settle into a 35-40 bps range. For context, the spread peaked at 50 bps during fall 2011 when European banks faced extreme funding stress, and long-dated FRA/OIS currently peg the spread at around 40 bps. But if there is any large sudden outflow from prime funds, compounded by further banking sector stress, the spread could easily shoot above our forecast.
And finally, here's what Credit Suisse had to say earlier this year:
Nearly 60% of prime fund investments are in financial CP or CDs (and Eurodollar deposits). A halving of prime funds AUM means ~$250bn less unsecured financing for financials. This means Libor will face upward pressure as banks need to identify new sources of unsecured wholesale financing (or deal with fewer reserves).
Now I know what you're thinking: "Ok Heisenberg, I get it, but why in the world should I care about that more than the specs on the new iPhone?" And you're probably also thinking something along these lines: "This seems esoteric and completely irrelevant for me."
Well guess what? That kind of thinking is what allows "accidents" to happen. As RBC notes, this is probably not going to be that big of a deal because everyone who wants out of prime funds will be out by the October deadline. Then managers will be free to move out the curve again and a sense of normalcy will return (although, as Credit Suisse notes, they'll still be less available unsecured funding so some folks will have to source liquidity elsewhere).
But here's the thing; let's say some unfortunate manager misjudges the amount of liquidity he/she needs to hoard to meet the incoming redemption requests. That's when you get headlines like the ones you saw in the UK earlier this month with respect to the gated property funds.
Clearly, the paper held by prime funds is a lot more liquid than a UK office building but it's the same concept - if you misjudge the pace of redemptions, you'll need to sell. And what have I said time and time again about dealers and their willingness to lend you their balance sheet in a pinch? As RBC puts it, "any money fund that had larger outflows than anticipated would have to get a cash bid from a dealer to meet its redemption requests, and in this environment assuming that there will be spare dealer balance sheet when you need it is a bad idea."
A bad idea indeed. Coming full circle, the issue is that if you didn't understand all of this and you saw a headline about a money market fund being in trouble because of soaring redemption requests, you might get spooked. And you wouldn't be alone. Of course if you understood that once October 14 comes and goes, everything will probably be fine (i.e. if you knew the context) you might cringe, but you'd know that the move up in LIBOR "is not a credit story or an inability to find financing story," as RBC puts it.
Of course the idea that the vast majority of investors will bother to understand any of this is far-fetched to say the least and that's why "accidents" happen; because people don't understand how the market actually works. They'd rather spend their time reading about whether or not the next iPhone will have a better camera or a larger screen.
Well I've got news for you: if Tim Cook botches the next unveil, the market's infrastructure won't notice. If, on the other hand, the market's infrastructure creaks because someone screwed up and got caught without enough liquidity to meet redemption requests, Apple's stock (and every other stock for that matter) will hear that creak loud and clear.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.