‘It’s regulation, stupid’

Brendalee Scott-Novak, Butterfield

The spike in LIBOR (London Interbank Offered Rate) for much of 2016 resurrected well-buried fears foreshadowing the 2008 financial crisis. Following the collapse of Lehman Brothers and the run on money market funds that left the prominent Reserve Primary Fund a distant memory, fears surrounding the insolvency of financial institutions came into fair play.

Far from the pandemonium surrounding 2008, the sharp rise in borrowing cost among financial institutions is enough to make investors stop and wonder! With no sign of distress in the financial system and policymakers’ hesitancy in moving rates higher, why does LIBOR continue to spike?

Some have pointed to changes in the calculation of LIBOR, growing expectations for rates to move higher, as well as increasing demand for U.S. dollar-denominated assets abroad as reasons for the move. Notwithstanding, the most significant driver of the recent spike appears to be the impending money market reforms effective Oct. 14.

In anticipation of these changes, prime money market funds that invest primarily in corporate debt securities are rapidly reducing their investments in floating rate debt and commercial paper. As broad-based selling intensifies, coupled with the frequent supply from banks and corporations operating in this very liquid market, LIBOR rates shot up.
So what are these new rules transforming the way banks borrow and institutions invest?

Post the collapse and near-death experience of many financial institutions in 2008, the U.S. Securities and Exchange Commission set out to create stability and resiliency around money market funds. The proposed amendments came in the form of liquidity fees and redemption gates, making them less susceptible to runs. One of the most significant changes to the new rules, however, is the requirement for prime money market funds to maintain a floating rate NAV (net asset value) vis-à-vis a fixed $1 price per share. This move will unquestionably expose invested principal to potential losses, a stark contrast to the primary objective of money market investors. The new rules also lend themselves to suspend redemptions up to 10 business days within a 90-day period with liquidity fees of 1 percent or 2 percent if liquid assets fall below certain thresholds.

While these changes do not directly impact retail money market funds per se (which can still maintain a fixed NAV), they have significant implications for institutional investors. Those investors must now reassess the role money market funds play in their portfolios and choose between increased risks (accepting the potential for principal impairment inherent within prime funds) or invest in lower yielding government money market funds. Another option for investors is to switch their exposure from prime funds to government funds, which are not subjected to the new reforms. Societe Generale SA reported that more than 133B were redeemed out of prime money market funds versus subscriptions of c. 135B into government money market funds for the month of June. This shift has undoubtedly reduced one of the seismic financing options available to banks and corporations that depend on commercial paper and private placements as their primary source of unsecured financing. Providers of prime funds must also decide on their own course of action to mitigate the flowing tide from their funds.

Impact on secured loan markets

A further corollary of rising LIBOR is the significant impact on the secured loans markets. Most mortgages and car loans are based on a variable rate tied to LIBOR and comprise a minimum floor rate plus a spread. With LIBOR shooting from 31 basis points in 2015 to a 12-month high of 86.5 basis points, floor levels are easily breached, converting these loans into higher floating rate obligations. In much the same way that these obligations move in line with LIBOR, the potential returns on investments in this segment will also increase.

While the impending money market reform led to an increase in borrowing cost for banks and retail consumers, and an investment dilemma for institutional investors and fund providers, it also poses a conundrum for policymakers. The rise in LIBOR resulted in tightening of financial conditions similar to that of a rate hike, tempering the actions of the Federal Reserve for any imminent increases. With the effective date of the reform mere days away, the question then arises, is this shifting dynamic finally over? The LOIS Index, which is the spread between LIBOR and OIS (Overnight Index Swap) still points to elevated levels of bank funding stress. This spread now stands at 43 basis points versus a mean of 21 basis points for the last 12 months. Consequently, if prime funds continue to face an exodus in redemptions post the effective time line coupled with any exoteric shocks to the banking sector, spreads could once again spike beyond levels not seen in almost five years.

Disclaimer: The views expressed are the opinions of the writer and while believed reliable may differ from the views of Butterfield Bank (Cayman) Ltd. This document is for illustrative purposes only. It neither constitutes investment advice nor is it an offer or an invitation to acquire or dispose of any securities and should not be relied upon as such. Prior to making any investment decision a financial adviser should be consulted.

The data sources for this document are listed below. It is believed to be accurate as of the date of publication and may be subject to change without notice. While every care has been taken in producing this commentary, neither the author nor Butterfield Bank (Cayman) Ltd. shall be liable for any errors, misprints or misinterpretation of any of the matters set out in it. Past performance is not necessarily a guide to future performance.