Differences in leverage and liquidity

| November 13, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

The financial system has stood up well so far through pandemic, thanks in large part to the Fed. But improving prospects for managing Covid also improve the chance for an eventual shift in QE and other market support. That raises the question of the private balance sheets that normally sponsor different parts of the market. The biggest sponsors of the MBS market show low leverage and high liquidity, while sponsors in credit show higher leverage and weaker liquidity. When the time comes for the Fed to signal an exit, credit may throw the biggest tantrum.

Low leverage at banks and brokers, higher at insurers and hedge funds

Banks and broker-dealers are running at or near their lowest levels of leverage in at least 20 years, according to the Fed’s latest Financial Stability Report. The largest US banks at the end of the second quarter showed a ratio of tangible equity to total assets of around 8%, or $1 of equity for every $12.50 in assets. At the end of 2008, that ratio stood close to 4%, or $1 of equity for every $25 in assets. Broker-dealers at the end of the second quarter this year held $1 of equity for roughly every $16 in assets. Going into 2008, $1 of broker-dealer equity supported an average of roughly $47 in assets.

The lower leverage gives banks and broker-dealers much higher tolerance for volatility, limiting the risk of distressed sales and disorderly markets driven by those balance sheets. Broker-dealers did have trouble absorbing heavy flows in Treasury debt and MBS in March before the Fed expanded QE, opened the Primary Dealer Credit Facility and began buying MBS for settlement only a few days later, allowing broker-dealers to clear their balance sheet. With banks as the largest holder of MBS behind the Fed and with broker-dealers carrying material exposure, that bodes well for their ability to absorb volatility in MBS.

Life insurers and hedge funds are running relatively high leverage, which could limit their flexibility. Each dollar of life insurer equity now supports an average of around $11 in assets, roughly the amount supported in 2008. P&C insurers support $3 in assets, half the amount of 2008. Gross hedge fund leverage has climbed to an average of between $7 and $8 of assets for every dollar of equity. Records of hedge fund leverage do not go back to 2008, but current leverage is above the $6 level recorded in 2014. Hedge funds invest across a wide range of assets, so it is difficult to say where any limits to their flexibility might show up.

The relatively high leverage at life insurers and hedge funds could limit their ability to absorb flows in markets where they concentrate. Life insurers are the dominant investor in investment grade corporate and structured credit and hold a sizable share of private CMBS and commercial real estate loans, so distress in those markets could persist longer than in markets where banks play the biggest role, such as agency MBS and agency CMBS. However, life insurers and hedge funds hold only 26% of the assets held by major types of financial institutions, so they should have limited impact on broader market flexibility (Exhibit 1)

Exhibit 1: The distribution of assets across major financial balance sheets

Source: Federal Reserve

Strong liquidity at banks and brokers, less at insurers and mutual funds

As for liquidity, banks have historically high levels of liquid assets and historically low levels of volatile wholesale funding. Systemically important banks now hold between 22% and 28% of assets in highly liquid investments. In 2008, that stood at 8%. Short-term wholesale funding lately has dropped below 15% of assets, compared to 2008 levels of nearly 35%. Banks should be in extraordinarily good position to generate cash, although strains in repo markets in September 2019 showed banks may not always be prepared to efficiently redeploy cash.

Broker-dealers most often rely on the repo markets, and those continue to function well. Median tri-party haircuts have remained unchanged and financing levels for general collateral Treasury repo has fluctuated in a narrow range around 12 bp with MBS repo in a narrow range around 13 bp. Broker-dealers also can rely on the Primary Dealer Credit Facility.

Liquidity for insurers has generally weakened for most of the last decade. Less liquid investments across commercial real estate loans, certain corporate debt and investments in private equity and hedge funds have edged up to 35% of general account assets. Life insurers could see liquidity tested if they had to meet an unusual surge in claims or if premium streams began to drop, neither a very likely event.

Exhibit 2: Nearly 35% of life insurer portfolio investments sit in illiquid assets

Source: Federal Reserve

Mutual funds saw some liquidity stress in March when record outflows made many mutual funds forced sellers of corporate bonds and other assets with relatively thin secondary markets. However, the announcement of Fed QE and plans to buy corporate bonds reversed fund outflows and dramatically improved liquidity and spreads in corporate bond markets. With the Fed on standby for liquidity in those markets, mutual funds’ clearest liquidity risk is covered.

Looking through leverage and liquidity to asset markets

The Fed is supporting historic levels of liquidity across debt capital markets, but private portfolios in the financial system still have a role to play. Any shift in Fed policy looks likely to have its most disruptive impact on credit, both corporate and structured. The insurance investment portfolios and mutual funds that have become the biggest private sponsors of credit also have a combination of leverage and liquidity that limits their ability to intermediate the credit markets. In MBS, where banks play the biggest role, leverage is low and liquidity is high. Banks or broker-dealers could absorb sizable volatility from a shift in Fed stance. We are a long way from the point where the Fed might signal a pullback from QE and other forms of market support, but the improving prospects of recovery from Covid in the next year or so also improve the chances that the signal will come. If there is a taper tantrum this time around, it looks like it will come more in credit than in other markets.

* * *

The view in rates

A combination of factors argues for a steadily steeper curve through 2021 including, at the top of the list, steadily better management of the Covid pandemic and a corresponding return of normal levels of GDP and GDP growth. Beyond that, a new Biden administration stands to bring a pandemic stimulus package along with initiatives in trade, housing, immigration, education and infrastructure that could win Republican support. At the same time, the Fed looks likely to hold shorter rates down until it sees steady inflation above 2%, and that could take surprisingly long.

Despite a strong case for a steeper curve, longer rates should nevertheless be capped by continuing low productivity and economic growth below historic averages. The pandemic will likely leave a residue of concern about high density work and living, and lower density in a wide range of businesses hurts productivity.

The view in spreads

Improved management of the pandemic in the next year looks likely to add fundamental support to a bid for risk. Risk premiums should also decline. With the Fed also pumping cash into the economy and banks and insurers trying to find yield, spreads on corporate and household debt should keep tightening.

The view in credit

Improving prospects for growth should lift all credit boats. Although small companies and the most leveraged balance sheets remain at risk, the market has largely figured out who they are at this point. Risk-reward in those names is largely priced appropriately. Leverage does need to keep coming down on corporate balance sheets. That is the key risk to watch.

john.killian@santander.us 1 (646) 776-7714

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