New MMF Rules Are Driving Money Away, But Making The Financial System Safer

by: Martin Lowy

Summary

Institutions and corporations are taking their money out of prime MMFs because of the new rules.

That seems to be causing funding costs for banks and others to increase.

Net net, that is better for the financial system.

Short-term funding costs at banks and other institutions appear to have risen in recent months. One might be tempted to say the Fed must be tightening monetary conditions without announcing a rise in interest rates. The following chart from Goldman Sachs shows the increase in funding costs and the fact that the increase continues after the Fed's December 2015 rate rise should have been digested.

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There are other factors that indicate that the funding cost increase may not be over, and that it may not be temporary.

A major event on the funding horizon is the October 14, 2016, deadline for prime money market funds to comply with the SEC's new rules. You may recall that it was Reserve Primary Fund's need to "break the buck" (because it owned Lehman commercial paper, which became worthless overnight) that caused much of the financial turmoil following the Lehman Brothers bankruptcy. Eventually, that event triggered major changes in the way that money market funds are regulated.

Previously (since 1972), money market funds were permitted to price their stock at a constant $1 per share, so long as they followed certain rules. In practice, for over 20 years, MMFs invested only in government securities and bank deposits. Came the late 1990s, and another innovation, the "Prime" (it should have been called the "Not-So-Prime") money market fund was invented, to be used as an investment for corporate treasurers and the like to park assets at a slightly better rate than the traditional money market funds. And these institutional money market funds invested not only in traditional MMF assets, but also in short-term corporate debt (commercial paper).

The new SEC rules were adopted on July 23, 2014. The adopting release explained the basics of the new rules as follows:

"The new rules require a floating net asset value (NAV) for institutional prime money market funds, which allows the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets and provide non-government money market fund boards new tools - liquidity fees and redemption gates - to address runs."

The new rules do not significantly affect consumer MMFs.

The reaction of corporate treasurers and similar institutional investors has been to sell down their prime MMF positions significantly or to eliminate them entirely. They do not see prime MMFs as being sound, safe investments under the new rules. We can see that process in the next set of graphs from Goldman Sachs:

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The assets of prime MMFs (left panel) have declined by about $450 billion since November 2015, and there still are over two months to go before the new rules take effect. At the same time, OIS spreads (right panel) have increased by 25 basis points, of which about ten basis points appear to correspond to the Fed's long-anticipated interest rate rise in December 2015. The correlation suggested by the graph may or may not be meaningful, but the idea that removal of $450 billion of funding from certain short-term capital markets has an impact is not far-fetched.

Even for those still holding prime MMFs, the new liquidity rules are making durations of portfolio assets shorter. Here is a chart of the changes in WAM:

What is going to take the place of that prime MMF funding? The institutional investors still have the assets and the need for safe, short-term investments. Maybe the assets are going directly into banks. Maybe they will go into Federal Reserve RRPs (reverse repos), though the most recent data from the Fed do not suggest that is happening. My research to date has not told me where the money is going. Wherever it is going, it probably is seeking higher rates for what its owners probably perceive as higher risk.

There is, I think, a bigger picture here. For many years, regulation in general favored enabling issuers of short-term debt to make their debt look safer than it was. The trend now is reversing. Such trends probably are cyclical, as each last war is different from the next one, but for the time being, short-term borrowers probably will be paying up by a few basis points as compared with what they would have had to pay a few years ago.

Is that good or bad? I come down on the side of good. The various governmentally sanctioned flimflams made the financial system more fragile, because when investors discovered they had been scammed, they fled in droves.

Will, say, 10 or 15 bp of additional cost for short-term borrowings make a difference to the economy? Frankly, I doubt it. Recent experience suggests that it takes much bigger moves to have any discernible impact.

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.