Kroll Bond Rating Agency published a new paper entitled, "Money Market Funds Brace for Regulatory Launch." Written by Barry Weiss, Marjan Riggi and Christopher Whalen, it says, "As summer draws to a close, the money market fund industry is bracing itself for the October deadline for implementation of new rules for money market funds, rules that could reshape the short duration marketplace. In July 2014, the Securities and Exchange Commission (SEC) voted to adopt amendments to the rules that govern money market funds, Rule 2a-7. The amendments, which followed earlier attempts at regulatory reform, were meant to address risks of investor runs in money market funds. However, like many regulatory changes put in place since the 2008 crisis, it seems the new SEC amendments to Rule 2a-7 may be causing unintended ripples that threaten to disrupt the liquidity of the very industry they were meant to stabilize."
The update tells us, "The new rules include the requirement for institutional prime money market funds (MMFs) to 1) no longer maintain a stable value $1 per share net asset value (NAV), 2) to have the ability to drop "gates" to limit redemptions, and 3) to assign liquidity fees to redeeming shares under certain guidelines so as to mitigate the risk that the remaining shareholders will be redeemed at less than a dollar per share. Additionally, the reforms detail enhanced reporting requirements, as well as updated diversification requirements and stress testing. Lastly, the amendments to Rule 2a-7 focus on the removal of references to and a reliance on credit ratings for the underlying portfolio investments (not ratings on the funds themselves)."
It continues, "[D]espite such forward planning and testing, recent anecdotal evidence and AUM movements have pushed the topic back into the headlines, causing market participants and those on the periphery much concern. It isn't just a drop in institutional prime money market funds AUM, however, that is the sole cause of anxiousness among investors. Prime funds have credit exposure, lending to borrowers in the short duration market on an unsecured and secured basis.... As AUM moves out of these funds, there are ramifications for those borrowers who have come to rely on this funding, as well as an impact on those funds to which the AUM is flowing, government and treasury money market funds."
The update comments, "KBRA notes that fund managers and internal risk management teams have spent the past few years planning for the October deadline. Previous regulatory amendments had brought forth liquidity rules, (10% daily and 30% weekly liquidity requirements) for funds in the prime institutional space to have a ready level of liquid assets in place to serve as a preventive measure against redemption runs on the fund.... Managers have also attempted to lower weighted-average maturities (WAMs) and weighted average lives (WALs) of their prime portfolios as a preventative measure against redemptions runs. This coincided with AUM flowing out of prime funds with broader strategies and into government and treasury-only money market funds.... [This] has led to the divergence between government and prime funds.... WAMs and WALs of prime portfolios continue to be brought in, while government and treasury MMF portfolios' WAMs and WALs extend."
The Kroll piece also says, "[T]he outflow from prime MMFs or credit funds has been significant during the past 10 months and for some funds larger than previously anticipated, even being two months away from MMF reform implementation. Revised expectations by market participants now anticipate further AUM outflows from prime funds; thus, some of the more dire predictions about the impact of the MMF rule changes are no longer considered so farfetched.... [P]lunging AUM for prime funds is almost counter to the rise of 1 month Libor, as credit is becoming more and more expensive to finance. Less demand for the short duration funds has meant that even those who are willing to pay the punitive end of the capital charges must also pay up to attract the dwindling short duration demand."
It continues, "For the past few years, banks and other financial institutions which tapped the short-duration market had found that there was ample demand for their obligations in the overall bond market and that the structure of credit spreads was very accommodating. Many issuers, including nearly 100 banks rated by KBRA, chose to take the opportunity to term debt out that previously they might have financed via the short duration MMF or Federal Home Loan Bank markets. However, with one rate hike under its belt and the FOMC debating further hikes, short term rates are rising (as illustrated by the movement of 1 month Libor ...), and demand on the short end is ebbing. Thus, even in this still low-rate environment, issuers are facing the fact that the cost of financing with short duration paper is up to 5 times higher than even 6 months ago and market conditions are indicating this could get even worse."
Weiss, Riggi and Whalen write, "Over the past two years, the spread between prime funds and government funds has been around 16 basis points (bps). Recently, however, this spread has even reached levels around 20 bps. Last month, in July 2016, according to Crane Data, spreads again closed to around 17 bps, while at the same time the outflows and liquid assets requirements meant fund managers of prime funds had to keep maturities short. As a result, prime MMF managers could not take advantage of the widening spreads borrowers, such as banks and other financial institutions, who were now being forced to offer to capture the short-duration financing they have come to rely on."
They state, "For investors, the question is: how much farther do spreads need to widen before the outflows from prime funds slow and perhaps even reverse? Expectations are that as we approach the October implementation date outflows will continue and maybe even pick up velocity. And as they do so, the cost of short-duration funding for credit will continue to widen. However, at a certain point, perhaps shortly after implementation of the SEC MMF reforms, outflows may slow, and prime MMF managers may then see more clearly what their base AUM will be going forward, and upon this event, returns on the prime MMF funds should grow. This is expected to occur at the same time the now heavy-AUM government and treasury funds MMF may see their returns continue to contract."
They add, "KBRA believes that in the short term prime funds must weather the outflows, but at some point, expectations are that the higher-yield prime funds will once again attract shareholders in search of yield. At present, consensus among fund managers point to spreads of nearly 30 bps between prime and government and treasury funds. However, given current market dynamics, it could very well be much higher. Nevertheless, KBRA expects the spread to be wide enough at some point as to attract AUM back into prime MMFs. This scenario implies that while short-term funding might be higher and demand lower for credit borrowers, prime funds should survive and be able to provide some semblance of funding in the short-term market for those borrowers who need it."
The paper adds, "KBRA expects prime funds will continue to see noteworthy outflows as we approach the October implementation of MMF reforms. However, KBRA anticipates post the implementation date, as shareholders become more comfortable with the floating NAV nature of the prime funds, and are further enticed by a widening of spread between the returns of treasury and government funds versus that witnessed in prime funds, that we should see outflows slow and ultimately reverse. While a full recapturing of the AUM lost in prime funds is not expected, a return of up to 25% of the amount lost seems plausible based on what we see and hear today."
Finally, it comments, "Nevertheless, over the next year and more, the short-duration market for corporate borrowers will change dramatically. Furthermore, depending on what we witness over the next few months and issuer responses to this changed market, there could very well be rating implications based on changes in demand for short duration funds and the widening of liability costs. In terms of the big picture, KBRA continues to believe that regulators and policymakers need to tread carefully in the market for short-duration liabilities, lest we create another liquidity crisis even as we take measures to prevent such an eventuality."
