By Frank Lugo, Senior Investment Officer
Liquidity management is especially important when faced with uncertain economic conditions.
In these scenarios, historical events and trends are often the best teachers. The 2008 financial crisis might be one of the most studied financial events in history, and it continues to be a cautionary tale to reflect on.
Considering the current economic environment, taking a closer look at the financial crisis will show some insights into prudent liquidity management that may be needed now.
2008: how the financial crisis events unfolded
Entering 2008, the Fed funds rate was 3.50%. By March, the overnight rate had
been cut twice to 2.25%, and the economy was showing signs of trouble. On March 16, Bear Stearns was the first institution to go down, due in part to bad MBS investments. In July, IndyMac Bank, FNMA and FHLMC got bailouts and were conserved by September.
On Friday, September 12, the overnight LIBOR rate, an unsecured lending rate, traded at 2.14%. By Monday it had increased approximately 100 basis points to 3.10%. The tipping point was when the third bank failed. Tuesday, LIBOR jumped to 6.43% when news broke that the Federal Reserve couldn’t find a buyer for Lehman Brothers, resulting in a market crash and 429 basis point increase.
Simultaneously, the Fed funds traded at 3.04% on Friday and 3.15% on Monday. Then, from September 22 to November 3, it traded in a range of 3.78% to 3.835%. This reaction in the Fed funds market was not higher rates but requests for additional collateral. Lenders notified borrowers to post more collateral in the form of U.S. Treasuries (USTs) or face liquidations. From the bottom to the top, the change was an 80 basis point swing, a 340 basis point difference from LIBOR.
From these events, the manipulation of LIBOR was discovered, which led to replacement of LIBOR with the overnight SOFR rate. SOFR uses repos for its prices and posting of USTs for collateral. LIBOR was an unsecured lending rate – no collateral needed, only rate adjustments in volatile markets. The example above shows that the top priority in a crisis, from a lender’s perspective, is not the return on their investments, but rather the return of their investments.
Liquidity events to consider
Fast forward to today and the markets are again concerned about recession. Will the FOMC break something? Is inflation sticky? Will rates stay higher for longer than expected? Will commercial real estate loans bring down lenders?
Will SOFR react the same way repos behaved during the 2008 crisis, considering SOFR requires collateral to be posted? Will there be a lag effect on rate adjustments and how will that affect floating assets tied to the SOFR rate? These are the questions credit unions need to be asking themselves, and it all comes down to preparation.
Historically, even otherwise safe, well-intentioned credit unions have found themselves in unfortunate positions. A few credit unions in 2008 faced their outstanding loans getting called away before maturity at the most unfortunate time. Though it was just a handful of credit unions around the country, it was a very difficult position to be in.
With these possibilities in mind, maintaining sufficient sources of liquidity and contingent sources of additional liquidity is very important in uncertain economic conditions. In addition, a Non-Maturity Deposit study could provide information on how long deposits could remain and how quickly they could leave.
Prudent liquidity strategies
It’s important to evaluate deposits not only for pricing relationships, but for how “hot” funds will behave at these new levels. Many credit unions would benefit from examining how their deposits behaved in 2007 and 2008.
Maintaining enough available collateral to pledge, if needed, is another strategy to consider. Different liquidity providers will accept different types of collateral. Over the last couple of years, we have seen agency bullets spread to UST flat, a couple basis points over UST, and sometimes negative to UST rates. As a result, many credit unions built sizable positions of USTs in their portfolio. In a crisis, Treasuries are the preferred collateral to have and use, as they are the only thing trading. If you would like to add USTs to your portfolio, your Investment Officer can show rates from short term T-Bills to 10-year U.S. Treasury notes.
One of the better liquidity options is Catalyst’s issuance program through Primary Financial. The recent program expansion now gives users access to the DTC markets in addition to our credit union network to issue non-member deposits. Our trading desk can provide market color on call features and terms. If rates fall, there’s the ability to call the offering and reissue again at lower rates. Catalyst’s issuance program allows you to issue anywhere from six months to five years or longer, without having to post any collateral, keeping you free to sell, swap or pledge as needed.
If you have any questions about our programs, please reach out to your broker or advisor at Catalyst.