The Big Idea

Proving liquidity in bank securities portfolios

Tom O'Hara, CFA | May 5, 2023

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. This material does not constitute research.

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.

Financing terms

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

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.

Tom O'Hara, CFA
thomas.ohara@santander.us
1 (646) 776-7955

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.