A Relevant Liquidity Lesson For Complex Structures

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Includes: EGF, FTT, GOVT, PLW, TAPR
by: Alhambra Investment Partners

In the third quarter 10-Q from Capital One (NYSE:COF), the bank notes a rather large change in funding. At the start of the year, Capital One had drawn $17.72 billion in advances from the Federal Home Loans Banks (which of the twelve isn't stated and it is likely there were funding agreements with several). The FHLB system allows banks to pledge collateral in order to receive these advances as one subsidized method of funding bank assets, primarily residential or commercial mortgage loans. That balance was safely less than the overall standby borrowing capacity for Capital One of $29.5 billion.

By the end of Q3, however, the bank had repaid some $13 billion of the advances. Some of that gap was funded by a net increase of $3 billion in longer-term debt. The bulk was transitioned by interest-bearing deposits which rose by $7 billion, leaving the rest funded when the bank issued another $4 billion securitized debt obligations. The latter are securitization tranches of various forms likely on the bank's credit card trusts that were consolidated years ago under FAS 166/167 (post-crisis).

In Table 30 of Capital One's SEC filing, the bank suggests the reasons for the rejiggered accounting as perhaps relating to the current phase-in of Basel III's Liquidity Coverage Ratio (LCR). We are not privy to the calculations, but a major part of the numerator is FHLB drawing capacity. Again, at $29.5 billion in what could be secured (after generous haircuts) at FHLB, Capital One had "only" $11.8 billion available potential liquidity to start the year. The LCR phased effect was to be 80% effective on January 1, 2015, but 90% of the final rule by January 2016 (and 100% January 2017). Reducing the outstanding advances allowed the bank increase its liquidity potential, satisfying a larger LCR standard, via untapped FHLB advances of $23.6 billion (the difference remaining being a lower advance ceiling by September 30).

It also required the shift in overall funding mix as noted above, which included a healthy increase in potential interest cost via those interest-bearing deposits (which had not impacted the bank's profits by the end of Q3) and a real increase in interest expense due to "other borrowings." The first nine months of 2015 cost the bank $241 million in interest on "other borrowings" compared to $226 million in the same period of 2014 ($82 million in Q3 2015 alone vs. $71 million in Q3 2014).

What was interesting was that the moves by Capital One were opposite the general trend in FHLB activity overall. Total advances made by the consolidated FHLB system actually grew by about $21 billion from the start of 2015 to the end of Q3; from $570.7 billion to $591.5 billion. The FHLB system gets its funding for these advances by issuing its own debt, one form of the agency class. There was a reported $858 billion in FHLB debt outstanding at the end of Q3, up about $10 billion from $848 billion at the start of 2015. The rest of that increase in advances was made up through FHLB's asset side, with held-to-maturity securities declining by $10 billion to $95 billion (bonds in the portfolio that matured and were not rolled into new bond positions) and a reduction in cash and deposit balances with banks of a further $9 billion. Between the increase in debt liabilities and the decreases in the bond portfolio and cash and equivalents, that left more than enough to fund the $21 billion uptick in outstanding advances. Whatever was remaining after all that was placed in the money markets; about $4.1 billion.

ABOOK Feb 2016 FHLB Balance Sheet

That makes the FHLB a significant conduit for risk and maturity transformation in terms of funding asset positions at the banks. The remainder is left available for both money markets as well as FHLB's own portfolio; but those are remainders subject to the primary mission of advances.

In August 2007 alone (as the eurodollar market broke down), the FHLB was hit with a $110 billion increase in bank draws on standing collateral for advances. Instead of taking the Discount Window approach with the Federal Reserve (there was practically no increase in Primary Credit), liquidity shifted mightily to the FHLB. For the whole third quarter of 2007, FHLB advances increased by an enormous $184 billion to $824 billion total. By the end of Q3 2008, FHLB advances had ballooned to $1.011 trillion. To fund that huge liquidity draw, the FHLB floated almost $300 billion new discount notes and $100 billion in bonds.

Further, there were other money market effects to consider. As the advances ballooned throughout 2008, that sucked up enormous resources that FHLB could not provide elsewhere including money markets. Total overall advances actually declined by the end of 2008 in Q4 to $928 billion, while the remaining resources that were offered into federal funds and repo markets dropped by about half, some $40 billion. The reduction in FHLB support to general liquidity through advances or remainder money market activity was due to impairment in even its once-invulnerable agency debt. From the 2008 FHLB Annual Report:

The FHLBanks experienced a deterioration in debt pricing as investor capital and dealer focus, including investment by the U.S. Treasury, was redirected toward those securities offered under the U.S. government's programs that carry an explicit guarantee of the U.S. government. Furthermore, international investors reduced their holdings of GSE debt securities in 2008, which adversely affected the FHLBanks' funding costs, liquidity and results of operations. During the second and third quarters of 2008, the FHLBanks' funding costs associated with issuing long-term consolidated bonds became more volatile and rose sharply compared to LIBOR and U.S. Treasury securities, reflecting dealers' reluctance to underwrite, and investors' current reluctance to buy longer-term GSE debt, coupled with strong investor demand for high-quality, short-term debt instruments, such as U.S. Treasury securities and FHLBank consolidated discount notes. [emphasis added]

Where does monetary policy enter this equation? The Fed believes it controls money markets, but it clearly does not, particularly in times of acute stress. The FHLB played a much larger role in money markets, as a secondary money market itself no less, than the Federal Reserve did. Further, this convoluted structure does not easily lend to monetary policy interjection should it have ever been ordered. The Fed could have, of course, bought outright agency FHLB debt to increase that floatation funding, but that still would have left the FHLB system with which to find its own means of distribution far removed from unrestricted flow.

The point of systemic liquidity is for the general order of securities and loan holdings to remain sustainable. Liquidity is not what you see today but what it might be under far worse conditions where bottlenecks and stress points are not easily determined ahead of time. In other words, what makes a bank hold an MBS position yesterday but want or need to sell it at any price today? In the case of MBS in 2007 and 2008, actual liquidity even in the form of an FHLB advance wasn't nearly enough, even though said advances were as good as cash.

Since this bypass liquidity turned on the perceived viability of the collateral itself, the idea of cash was nowhere near enough to forestall systemic retrenchment. The Fed could have bought FHLB debt which might have allowed more advances to be offered, but none of that would have changed the underlying nature of the problem with MBS collateral itself - it still had to be revalued compared to the overly optimistic (unrealistic) numbers that prevailed before August 2007.

The huge increase in FHLB advances from August 2007 on was due to past standby balances that had been approved but undrawn. But as banks drew upon those facilities in greater numbers and quantities, it only further impaired both banks' market standing (the unwanted stigma) and then the standing of the FHLB itself; again, the more liquidity provided by the FHLB under old assumptions, the riskier the FHLB appeared to outside investors (international) who were very much aware of collateral assignments and distributions under stressed volatility math. Thus, the very fact that the FHLB was acting as an emergency liquidity conduit meant that it would at some point be shut down by the "market" - as it was.

Nothing the Fed did or could have done, even through the FHLB, would have changed those systemic circumstances.

As noted not long ago, that is one reason why UST fails in repo surged to biblical proportions during the worst of the panic/liquidations. The Fed could have expanded its balance sheet as much as it wanted and it likely would not have made much difference because the distribution of liabilities or what is taken as "cash" periodically matters more than the quantity of "money supply" the Fed might create. Currency elasticity takes on an entirely different aura in the wholesale format. It just isn't as simple as commanding a lower federal funds rate or even "printing money" because there are chains of liabilities that produce negative feedbacks even when it seems to be the right course of action.

In this one instance, banks essentially offloaded their collateral risk onto the FHLB, which only had the effect of "buying" a little time before that strain was visited there - and then, of course, it only amplified where before individual banks were in trouble but now one of the mighty GSE's was. The problem wasn't cash or a shortage of it, but that you had the collateral and had only bad options for dealing with its revaluation - funding it in increasingly convoluted ways or dumping it on the market to take a huge loss. The latter seems the worst possibility, except that continued holding of the security only meant worse and worse funding conditions anyway.

Cash is only one perception of liability and it isn't even the most "liquid" at times, as difficult as that might be to process. The actual structures and plumbing matters, and that include changing circumstances of factors like collateral standing. And I haven't even addressed the further and perhaps greater complexity that much of these financial "resources" supporting both private money markets and the "market" for the FHLB took the form of eurodollars offshore, leaving even greater question as to how to untangle the illiquid mess as it dissolved further and further. The Fed never had a prayer of forestalling crisis even if it had actually realized that its "rate cuts" and "stimulus" were nothing to anything. It's a relevant lesson that should have been learned eight years ago, but it barely rated notice.

This is not to say that mortgage markets and banking irregularity are to be repeated, only that liquidity is never what you think it is - especially in reverse. The more complex the system, the less knowable and predictable its weaknesses.

Note: None of this commentary is intended or should be viewed as offering investment advice about Capital One or FHLB securities in any form. This is intended for illustrative purposes only about the nature of wholesale finance as clearly different than banking and money as it is commonly understood.