The Big Idea
Proving liquidity in bank securities portfolios
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.
Bank failures and deposit outflows have helped make liquidity the most important focus of bank portfolio managers, and regulators are likely to require more concrete evidence of liquidity going forward. Defining a framework to measure liquidity is more important now than ever, with several factors coming into play. Financing terms and trading volumes supply the most extensive and reliable information and help to frame an informed view.
One way to measure liquidity for a given security type is to look at the capital markets financing available and the terms of that financing. The additional collateral that a lender requires above the value of the asset is known as the haircut. The lower the haircut, the more liquid that asset is perceived to be (Exhibit 1). Should the lender need to seize and liquidate the collateral, the lender wants a cushion above the market value of the bond to account for market uncertainty and potential additional volatility at the time of liquidation. Lower haircuts indicate lenders’ greater confidence in their ability to liquidate without incurring a loss. Treasuries and agency MBS have haircuts that reflect the relative trading volume, bid-ask and ability of these markets to absorb large flows, with haircuts increasing for less liquid assets, particularly non-investment grade. It is also interesting to note the increase in haircuts for some of these asset types over the past 12 months as the Fed embarked on their massive rate hike program, creating a great deal of market volatility.
Exhibit 1: Haircuts generally increase as perceived liquidity declines
Source: NY Fed, Santander US Capital Markets
While liquidity is likely the main determinant in deriving the financing haircuts, there are clearly some other factors in play as well. One of the most glaring anomalies is when looking at muni bonds compared to agency debentures. Muni’s have three times the daily trading volume of agency debt but require more than three times the amount of haircut.
A look at a snapshot of repo outstanding compared to average daily trading volumes says interesting things about how long it would take a repo lender to liquidate specific collateral. In the case of muni bonds, the total repo outstanding is less than one day of average trading volume, whereas agency debentures and strips have repo volumes that closer to seven days of average trading volume.
Exhibit 2: Trading volumes compared to repo balances, $ billion, March 2023
Source: NY Fed, SIFMA Research, Santander US Capital Markets
In general, the more liquid collateral types have daily trading volumes that would allow for a full liquidation of repo balances in about a week or less, whereas less liquid collateral types such as non-agency MBS and ABS could take more than a month to liquidate.
Trading volumes are also a quick way to gauge liquidity for any given security type (Exhibit 3). Larger average trading volumes usually indicate a market with a greater number of investors. Securities with higher trading volumes are generally more likely to be sold at an attractive price, whereas securities with low volumes attract fewer buyers, making it more difficult to sell at a desirable price and perhaps more difficult to sell at all. Of course, the markets with the largest amounts of debt outstanding, namely US Treasuries, MBS and corporates, naturally have the largest daily trading volumes.
Exhibit 3: Daily trading volumes, $ billion
Note: SIFMA combined MBS and CMBS into agency MBS, although agency MBS makes up the vast majority of daily trading.
Source: SIFMA Research 3/7/23, Santander US Capital Markets
In addition to looking at the daily trading volumes, we can also look a trading volume as a percentage of total bonds outstanding for each sector (Exhibit 4). This shows that the U.S. Treasury and Agency MBS trading activity, each by itself, to be two to three times greater than the activity for all of the other collateral types combined as a percentage of total outstanding issuance.
Exhibit 4: Daily trading volumes as a percentage of bonds outstanding
Source: SIFMA Research 3/7/23, Santander US Capital Markets
As for some of the other gauges of liquidity such as bid-ask spreads and the price impact of large trade flows, as my colleague Steven Abrahams has noted (The evolution of liquidity and its fair value, 8/13/21), those metrics are more difficult to measure and are often based on estimated or anecdotal information.
Of course, the ultimate market-based measure of liquidity would be securities sales. However, in the wake of 500 bp of rate hikes in the past 14 months, sales of those positions at market value would trigger losses that flow to bank earnings and capital and are therefore impractical and unlikely tests of liquidity.
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