Liquidity Management February 9th, 2010 Liquidity Risk Liquidity refers in essence to cash or a means of payment that is immediate. You can think of liquidity in terms of “no checks-in the-mail story” or “IOU’s”, we want cash now! Liquidity risk is important for FI’s because: (1) the FI may need to return money to a person/company to whom they owe much sooner than expected or (2) they may need to give unexpectedly to a person/company cash due to a contractual obligation do so. Liquidity Risk at Depository Institutions Liquidity Risk at Depository Institutions is the highest among FI’s due to the shorter term nature of both their assets and liabilities. Liquidity Problems in theory should not lead to insolvency risk but at times can. This is because liquidity problems require immediate emergency action which may require very high costs which can quickly erode an FI’s capital. Causes of Liquidity Risk The most common cause of liquidity risk at a depository institution is a loss of confidence in the FI by depositors and other purchasers of an FI’s liabilities. Lack of confidence at other types of FI’s can also cause problems but the threat is usually less immediate. Other causes are simply mismanagement whereby the FI has not structured its assets and liabilities in an organized enough fashion to meet in an efficient way the liquidity needs. Liability-Side Liquidity Risk Due to laws of large numbers, large financial institutions can predict with relative ease the amount of new deposits (insurance premiums) and deposit withdrawals (policy cancellations/pay outs) that will occur over short to medium term horizon. In fact, there is usually a very stable source of “Core Deposits” which varies very little over this horizon i.e. most people don’t see wide swings in their deposit accounts and what swings there are, tend to average out over all depositors unless some unusual event occurs. If the bank sees a declining trend in its Core Deposits or knows that its Core Deposits will not grow fast enough to keep up with its lending activities, a bank can “purchase” (borrow) funds such as Fed Funds, issue CD’s or enter into repurchase agreements (“repos”) to meet its liquidity needs. We call this response “Liability Management” or “purchased liquidity management”. However, large “lenders” to financial institutions do not benefit from FDIC insurance. Therefore, their decision to take any particular bank’s credit risk can become an issue. In a financial crisis, we are seeing that the reliability of all sources of deposits become questionable. Asset Side Liquidity Risk Banks have lots of unfunded commitments to lend to corporations that they do not expect ever to be drawn. They also provide unfunded commitments to Special Purpose Corporations or Vehicles (“SPC”s or SPV”s) that buy up pools of mortgages, auto loans, or credit card receivables. We typically call these asset backed securities and they are funded through commercial paper markets. Because these SPV’s are complex, the market doesn’t want to do too much analysis - typically just relying on a Moody’s and S&P rating and a “CP back-up line” to redeem the commercial paper in case of disruptions in the CP market. Disruptions are a real risk if there are some high profile bankruptcies or significant economic turmoil which would cause investors to leave CP markets and buy lower yielding US government securities. Such turmoil could also cause corporations to draw down on their unfunded commitments. Conclusion: Banks have lots of unfunded lending commitments that they do not expect to be drawn in normal times but could become a problem in rough economic times. If they do get drawn then banks need to go out and raise the funds which creates Asset Side Liquidity Risk. Stored Liquidity Management A Depository Institution can take a different approach from purchasing liquidity by “storing liquidity” on the asset side of the balance sheet. They simply keep a lot of cash or cash equivalents (interest baring deposits/instruments that can be turned into cash in a day but not more than a few days). A bank is already forced by regulators to maintain some of the “stored” cash reserves at the Federal Reserve. If the bank uses “stored” assets to generate cash, it in effect shrinks the balance sheet i.e. it liquidates an asset position to meet the obligations of its deposit or debt holder. However, since it is often difficult to generate a return from cash and cash equivalents, there is an opportunity cost to storing cash at a bank. Of course the bank has many stored sources of wealth in its assets. However if a bank tries to dispose of longer term assets quickly, it may have to do so at a “fire sale” price. It is, therefore, these “fire sales” that can lead to massive losses and eventual insolvency at banks. A Bank’s Liquidity Risk Exposure Given that a bank can adjust its asset side over a short to medium term horizon, good analysis and management of both sides of the balance sheet usually addresses Liquidity Risk. To measure a Bank’s liquidity risk exposure, a bank can create a Net Liquidity Statement by analyzing its available “sources” and how much of those sources it has used – “uses” to determine its excess liquidity. Another way of measuring a bank’s liquidity position is by comparing certain key ratios to its peers. For example, Total loans/Deposits or Purchased (borrowed) Funds to Total Assets are good indications of how much a bank relies on core deposits or purchased funds. Other ways to measure Liquidity Risk Liquidity Index – a model that looks at the type of assets on a DI’s balance sheet and assigns a fire-sale value to it and then divides those assets by what would have been the fair market value of those assets. Financing Gap = Average Loans - Average Deposits or Borrowed Funds - Liquid Funds. Financing Requirement or simply Borrowed Funds = Financing Gap + Liquid Funds. What an analyst needs to think about when looking at a large Financing Requirement is whether it is due to an unusually large Financing Gap or an unusually large amount of Liquid Funds. Financing Gaps are, from a liquidity perspective, more dangerous than holding large amounts of liquid securities. However, keeping too much liquidity is not good for the efficient running of the FI. Maturity Ladder/Scenario Analysis is a more complete analysis of all the banks accounts and different scenarios that the bank could face while in distress (“What if scenarios”). Liquidity Pressure In a financial crisis, individuals, various categories of FI’s and corporations will behave differently. Individuals in high risk funds will often try to withdraw funds quickly while individuals in low risk deposits at commercial banks will usually remain calm. Highly leveraged corporations are more exposed to liquidity pressure than obviously those with low leverage and/or high cash positions with longer term liabilities. Life Insurers have more long-term assets and long-term liabilities and are hence less exposed. Covenants on liabilities such as loans and bonds can turn long-term instruments into immediately maturing instruments e.g. the MAC clause (Material Adverse Change) and leverage covenants such as minimum BIS ratio for a bank and Debt to EBITDA, EBITDA/Interest for corporations. Liquidity can be costly! The cost of obtaining cash can be very high. If a firm goes to borrow at the last minute because it doesn’t have much cash, even if its credit quality is high, it may face very high cost of funding e.g. year end financing is usually very expensive due to “window dressing” at FI’s. If a firm decides to sell “marketable securities”, it may incur short-term capital gains taxes and lose the benefit of the long-term capital gain break. Or it may find that the demand for such securities is very low hence the bid/ask spread is very wide i.e. this means whoever buys the security will take a huge “liquidity” premium to hold the security until more normal market conditions prevail and the bid/ask moves closer to the asset’s true economic value. In a bid ask spread such as 98/99, a broker bids (or is willing to buy) at the bid or first price and asks or offers to sell at the second price (remember “buy low, sell high!”). When FI’s go to sell securities, many counterparties may be wary of just taking the settlement risk (the time to receive the money for the security and the risk the security goes up/down in value during that time) for fear that the distressed counterparty might not be able to follow through on the sale. This may result in a larger bid ask spread or a delivery vs. payment i.e. when I get your bond, I will pay you so you will need to wait a couple days for the cash. Ultimately, if a bank (or individual or corporation) cannot come up with cash, its business becomes disrupted and its ability to operate normally becomes severely impaired. This can lead to large losses which in turn can lead to insolvency. Bank Runs In any collection scenario, “he who collects first may collect all and he who is second may get none”. It is this fear that can create panic and a herd mentality which then produces a run on a bank. This same panic and fear can cause banks and suppliers to behave the same way with corporations resulting in credit lines being shut off by banks and raw materials and other supplies being held up by suppliers. In both cases, the bank or corporation may have sufficient economic resources overtime to repay their debts. However, it is the unexpected rush to pay that causes the entities to face a liquidity crisis. The most common cause of bankruptcy is liquidity not insolvency. Deposit Insurance and Discount Windows Deposit Insurance will usually keep depositors calm enough to leave their deposits in a financial institution if they believe they are 100% covered. In addition, as lender of last resort, the Fed will provide “discount window loans” to help banks that are having liquidity issues. Such loans were made available during 9/11. However, there is a moral hazard issue here in that the government does not want to be seen bailing out sophisticated/uninsured investors (I.e. deposits greater than $100 K) who have lent to FI’s to take advantage of good credit spreads. Not Just Banks and Corporations Life Insurers can face early cancellations on policies if there is fear that they are near insolvency. Given that life insurers have long-term investments, the cost of liquidating those investments may be more than the penalty people pay to cash in their insurance policies leading to actual insolvency. Property and casualty insurers can also face liquidity risk when the insured cancels or fails to renew his policy due to concern over the P&C’s solvency or just due to competitive reasons. Of course, there may also be large unexpected claims that cause the P&C to raise additional funds at a much higher cost. Such claims also result in periods where the insurance company is taking a large loss hence lenders will often reevaluate its credit risk and at the very least charge the client more. Of course policy holders are getting nervous too about the P&C’s credit worthiness. Mutual Funds can also be at risk. Closed end funds sell a limited number of shares so anyone who exits the fund must find a buyer for their shares. I.e. Closed End funds may solicit $100,000,000 in funds at $1 per share and thus have 100,000,000 shares. They then purchase securities with those proceeds. The success or failure of their investments will be translated directly into the share price so holders of the shares who don’t like the result will need to find a new buyer of the share. Hence the shareholder generallybears the liquidity risk. Open end funds on the other hand, simply calculate Net Asset Value (Asset Value – Liabilities = NAV or really the “equity of the fund”. Not Just Banks and Corporations (continued) Closed end funds thus are less risky unless they borrow funds to increase their returns. In such a case, they would find that the lenders of those funds may change their attitude in periods of high market volatility or if there is something they see in the investment fund’s strategy that they don’t like. Mutual Funds that are classified as open end funds can face a double threat if investors and lenders suddenly withdraw funds. One of the issues that faces all the funds is that he who gets out first may get out more than he who gets out last if the assets are extremely illiquid. Market prices for a small block of assets in a normal functioning market may have a tight bid ask spread. However, in a distressed market, the bid ask spread on even normally liquid securities can widen hugely. Thus due to supply and demand, if a fund has to sell large blocks of securities, the price may fall dramatically hence those who got out because there was still available cash, may not have been affected by the liquidity premium that was sacrificed by the Open end fund. Countries can also face liquidity crisis – South Korea during the Asia Crisis in the late nineties saw a run on its domestic banks by large international FI’s who had leant them 10’s of billions of dollars in short term debt. The Korean banks had then leant them to their Chaebols (e.g. Samsung, Hyundai, LG, and Daewoo) who used them for long term projects. Korea quickly ran out of dollars and had to go to the IMF for the world’s largest bail out. Long Term Capital Management Trades Convergeance and Relative Value Strategies Both require taking long and offsetting short positions. If the strategy is to hold the two positions to maturity then we see that as a Relative Value trade. If on the other hand we anticipate some event occurring prior to maturity, e.g. within a foreseeable time frame, which causes the two assets to be more closely priced then that would be a Convergeance trade. On-the-run Off-the-run Example Example off-the-run treasuries and on-the run treasuries. The government issues regularly 2 year treasuries and 3 year treasuries. If the government had issued a 3 year treasury bond 1 year ago it would have still 2 years remaining on its maturity (now an "off the run treasury“) In theory, the 2 year off- the-run treasury should have the same yield as a 2 year on-the-run treasury (new issue of two year Treasury Bond). However, due to factors such as institutional demand, off-the-run treasuries tend to yield slightly more than the comparable on-the-run or newly issued security. Example Continued To make money, LTCM would have to go long the higher yielding asset (i.e. purchase) while going short the lower yielding asset (i.e. sell). The short-selling of the Treasury would probably be achieved by borrowing the on-the-run treasuries from an institution with the promise to return those securities at maturity or just pay the full amount to the lender at maturity. However, since LTCM actually expected the gap to last only a short while since once on-the-run securities have been issued the next sale will occur in the secondary market. They thus become off the run securities and hence decline in value as the yield requirement increases. Hence LTCM can now buy the newly issued securities in the secondary market at a lower price than the originally issued securities and return those securities to the entity that lent them. Since they don’t hold to maturity this becomes a convergeance strategy. Other Strategies and Concepts Directional Trades Swap Spread Examples (contractual obligations that are tied to actual instruments vs holding the actual instruments or short-selling them). Fixed Rate Mortgages and Prepayments Notional Value vs Value at Risk LTCM Hits the Wall Due to changes in liquidity premiums and other factors unforeseen by LTCM, LTCM almost failed on its commitments to other financial institutions. Given that they were a hedge fund, they were taking enormous leveraged positions in the form of derivatives, short positions and borrowed funds. This meant that they were often the largest holder of certain securities. The threat of them unwinding their having to unwind their positions created further turmoil in the markets since the liquidation of significant percentages of certain categories of assets was creating huge liquidity pressures on the market. The US government got major financial institutions to bail out LTCM to avert a potential financial market meltdown.