A question of funding
The recent turmoil in the financial markets has highlighted the importance of liquidity risk management. For structured product providers, it could mean the end of cheap overnight funding for long-term assets and the erosion of profit margins. By Duncan Wood
On March 12, five months before the liquidity crisis hit fever pitch and a swath of the fixed-income markets virtually shut down, the Institute for International Finance (IIF) issued a report that advised the banking industry to sharpen up its liquidity management practices. Buried in its appendices was a section drafted by experts from Barclays, Commerzbank, Credit Suisse, Deutsche Bank, HSBC and Merrill Lynch, which outlined a series of common shortcomings in structured product funding practices and recommended a set of fixes.
Before banks had time to digest the recommendations, what had started as a problem in a relatively small part of the US mortgage market had spread to the wider financial market, causing investors to pull cash off the table and liquidity to dry up. "There's been an ongoing effort to rationalise funding policy across the industry, but the liquidity crisis that many feared arrived quickly and in a pretty dramatic way. I think most banks knew what they needed to do and had probably got some elements of that implemented, but it's hard to imagine that everyone was in a position where they could be sure that every single desk was pricing liquidity risk correctly," says Olivier Vigneron, head of structured credit risk management at BNP Paribas in London.
One of the reasons why the problems were allowed to persist is the fact that structured products desks can, in effect, boost the profits they make on certain types of transaction by ignoring prudent funding policies. "Sometimes it's easier to arbitrage your controlling system than to arbitrage the markets. Traders will get away with whatever they can," says Robert Fiedler, head of strategic product management at risk software vendor Fernbach in Frankfurt. The weaknesses identified by the IIF report are widespread - but if industry practices were brought up to scratch, the volume and the profitability of some products would suffer, he says.
In general terms, the industry's problems boil down to the overuse of short-term funding for long-term assets, but the IIF report gets far more specific, pointing at total return swaps and negative basis trades as particular problem areas. In a typical total return swap, where a bank is receiving a spread over an interest rate benchmark and paying the return on an asset, the dealer will usually acquire that underlying asset to act as a hedge. Often, bank funding desks or treasury teams will assume that a highly rated asset is liquid and will fund it overnight. But the report warns that such assets may not be liquid. More to the point, even if the asset can be sold quickly, the bank would be leaving itself open on the total return swap, which may not be easy to unwind.
In a negative basis trade, a bank tries to capture the differential in the pricing of credit risk between the cash and derivatives markets by buying a bond and hedging it with a less expensive credit default swap. The negative basis package achieved in these trades requires the bank treasury desk to provide funding for the bond and, as with total return swaps, dealers often assume the asset side of the transaction is liquid and forget that selling it would leave them with an open derivatives position. In both cases, the report warns that banks could be building up "potentially unrecognised liquidity mismatches".
Less risk
The head of structured repo at one large US bank says the risks in these mismatches are not so great if the asset remains liquid and can therefore be sold. "But the negative basis packages that people are more focused on often involve much more structured assets, like tranches of collateralised loan obligations, for example. That can create a very juicy trade, but the problem is that the liquidity of your collateral is way less." An absence of liquidity on the asset side of the package is compounded by a potential lack of liquidity in the associated credit default swap - usually, pay-as-you-go swaps are used, where volumes are lower and trades harder to unwind.
As a result, banks typically expect these packages to be on the books for years, says the US bank's head of structured repo. "You can't have the view that you're going to exit the package in 12 months because both legs are relatively illiquid. It's almost a buy-and-hold trade, so these packages really necessitate long-term funding. If you're funding them overnight, you may believe you're making money from your view on the credit, but much of the profit is coming from your willingness to take liquidity risk."
Some practitioners argue there's no justification for this kind of liquidity arbitrage. "I think it makes no sense to fund an arbitrage-type position in the overnight market. These trades have a term view on them. No-one expects to unwind them in a day or two, so I don't see why you wouldn't at least put funding on for a week or a month," says Moorad Choudhry, a visiting professor at London Metropolitan University (LMU).
The temptation to ignore this kind of advice is strong, says Brian Ranson, head of the credit strategies group at Moody's KMV in San Francisco: "The cheapest way to fund is to do it short term and then roll. It's also the riskiest way to fund. However, banks can be reluctant to significantly extend the funding because it would wipe out the small margins they're making. If they were forced to extend it, some of these trades either wouldn't get done or the client would have to pay a wider spread."
While ignoring the liquidity mismatch may seem reckless, Fernbach's Fiedler stresses that it has a rational basis. There are two options for funding, with the simplest being a strict policy that insists that the funding maturity must be matched to the tenor of the asset - so, a five-year bond would be matched with five-year funding. This approach ignores the fact that a liquid bond could theoretically be sold in a matter of minutes, making long-term financing unnecessary, he says. As a result, many institutions classify their assets according to their perceived liquidity and fund them accordingly: "You end up with a system of synthetic maturities where liquidity determines funding. You might even decide that a portion of one bond ends up in a two-day funding bucket, while the rest of the bond should go into three days," explains Fiedler.
The problem with this approach is that even liquid assets may not actually be available for sale or repo. For instance, they might be held as collateral in an exchange account or - as in the IIF's examples - locked in a hedging relationship with another position, making it difficult or undesirable to sell. The correct way to navigate this minefield, says Fiedler, is to keep tabs of the current market value and the liquidity of each asset so it can be funded appropriately - what's known as counter-balancing capacity. This capacity then helps determine how much funding is required in aggregate in different term buckets.
"As you calculate the counterbalancing capacity, you have to sort every bond out to see if it's eligible or not, and you take away the bonds that are in a hedging relationship or that are already being used as collateral," says Fiedler. That sounds simple enough, but it's complicated by the fact that eligibility is, to some extent, scenario-dependent. In other words, while a bank might not want to break up a negative basis package if it was facing a mild liquidity squeeze, it wouldn't hesitate to do so in the event of a life-threatening solvency crisis. So, a certain amount of flexibility is required. But Fiedler insists that a system based on counter-balancing and clear eligibility criteria makes it far more difficult for traders to engage in liquidity arbitrage and expose the bank to unrecognised risks.
The US bank's head of structured repo says that prior to joining his current employer earlier this year, he had worked at two other major dealers, which paid much less attention to liquidity exposure: "By and large, a lot of people would ignore it. A few would say it was important but would be defeated by trying to put a precise price on it."
Liquidity risk is taken much more seriously in his new workplace, he says. The structured repo desk specialises in pricing and providing funding for structured transactions. Any trader that wants to put on a trade requiring funding can check the repo desk's funding curve to see how much it is going to cost at a range of different maturities: "Liquidity risk is a risk that's best managed by dedicated people who are in the tri-party repo market all the time, who know all the vehicles that the bank has set up to do long-term funding and how much is available. If there's a squeeze, we will reprice the funding curve to make it more expensive."
Traders can still choose to go for the cheapest funding option, he says - but the trade itself will be marked-to-market using term funding costs. As an example, he sketches out a situation in which a trader wants to fund a negative basis trade containing a five-year bond, for which five-year funding costs Libor plus 15 basis points. The trade as a whole is expected to earn Libor plus 30bp over its duration, leaving a margin of 15bp: "The temptation is to say, 'right, I'm not funding at five years, I'll fund at the overnight rate and maybe I'll make the full Libor plus 30bp'. And a trader can do that - but the trade is still marked against five-year funding on the curve." In other words, rather than declaring a 30bp mark-to-market profit upfront, the trader only declares 15bp. Over time, if the overnight rate remains lower than five-year rates, extra profit may accrue, he says.
Wake up
Belatedly, structured products desks have woken up to some of these issues. The crisis ought to have been a paradise for negative basis traders, with the basis between corporate bonds and credit default swaps widening dramatically in some cases. However, the simultaneous blowing-out of funding costs choked off this business, says the structured repo head: "In some cases, a basis that had been trading at 10-15bp suddenly widened to 25-30bp, but you couldn't monetise that because of the funding costs involved." There has been a big slump in the volume of such trades being transacted, he adds.
Communication between traders and the funding desk is key, remarks LMU's Choudhry: "You need to be talking all the time - you need to insist that the traders tell the funding desk what's happening. It's just the sensible thing to do, but you'd be surprised how often that doesn't happen in banks."
If there's a silver lining to the crisis, it's that banks will now start to take these kinds of issues more seriously, says Fernbach's Fiedler: "I was talking to one liquidity manager recently who was thanking God that the crisis had come along because it had been so hard for him to justify his existence within the bank. Banks were thinking 'we're liquid - why do we need liquidity management?'. Now they understand that being liquid is good, but it's not everything. You have to be able to prove it too."
A GREATER FOCUS ON RATINGS
It's not just banks that are starting to take a fresh look at funding and liquidity risk - investors and distributors are doing the same. As a result, institutions with lower credit ratings are finding it harder to sell structured credit products. "It's a reputational issue," explains David Long, head of equity derivatives for the Americas at JP Morgan in New York. "If distributors are seen to pass on a piece of paper and things go wrong, it's not acceptable for them to shrug their shoulders and blame the arranging bank. The arranger will suffer of course, but the distributor will also be held accountable by their clients."
As a result, some private banks have abandoned the assumption that the arranging bank will always be around to pick up the pieces in the event of a surge in defaults. Instead, they're beginning to pay more attention to the credit rating of the issuer. When that issuer is an off-balance-sheet entity belonging to a bank, investors are starting to scrutinise the precise nature of the support provided by the firm.
In some cases, this process is underpinned by strict criteria. Some private banks, for instance, have taken the decision to no longer deal with any arrangers rated lower than AA. In the current environment, that's great news for arrangers with a strong retail deposit base - their funding source is seen as stable and reliable, and their ratings are generally more resilient. Banks that rely more heavily on wholesale funding are more susceptible to liquidity doubt and downgrades.
But it's not just about the rating of the arranger. Investors are also taking a closer look at the relationship between arranger and issuer, and the way the issuing entity is structured. "Investors are becoming a little more discerning about the type of paper they want and they're increasingly aware that they'll get what they pay for," says Long.
In other words, while banks used to be able to set up vehicles that were collateralised with relatively risky assets - and could therefore issue paper very cheaply - it's becoming harder to do that now, says one dealer. "It's not a big hurdle, but it means that issuers need to be backed explicitly by a bank or collateralised with something totally reliable, like Treasury bonds. That's not hard to do, but it's more expensive."
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