MBS Liquidity: a Good Thing for BorrowersBy Rob Chrisman,
Rob Chrisman's Perspectives, Secondary Markets, Uncategorized
HERE’S A CATCHY INTRODUCTION. Okay, now that that’s over and I have your attention let’s get down to brass tacks and answer a question on everybody’s mind: the U.S. Treasury Market liquidity has not deteriorated. Given all of the recent volatility due to Greece, China, Russia, and the Fed, bonds have come through all of this in great shape. And securities backed by mortgages have also sailed along very well. That’s right folks, you heard it here first!
Well, actually, not here. Liberty Street Economics did a study on the current state of the liquidity in the U.S. Treasury market. What they found is to follow but first a quick review on why liquidity matters and how you measure it.
Why is liquidity so important? The inability to buy and sell something, whether it is a purple Ford Pinto or a $1 million Ginnie Mae security, directly determines its price. The U.S. Treasury securities market is the largest and most liquid government securities market in the world. Treasury securities are used to finance the U.S. government, as an investment and hedging instrument, as a risk-free benchmark for pricing other financial instruments, and, not least, by the Federal Reserve in implementing monetary policy. Having a liquid market matters for all of these purposes and is thus of keen interest to market participants and policymakers alike. So about as important as remembering your wedding anniversary.
How do we measure the liquidity? As we all know, liquidity typically refers to the cost of quickly converting an asset into cash. For example Liberty Street Economics measures this in a few different ways: “calculated using high frequency data from the interdealer market, as well as two additional measures calculated using daily data.” Most measures are for the most recently issued (on-the-run or benchmark) two-, five-, and ten-year notes, the three most actively traded Treasury securities. And every MBS trader and hedging firm knows that some coupons, and securities, are much more liquid than others – and this is reflected in rate sheet pricing for borrowers.
During the last ten years, which include the 2007-09 financial crisis, the taper tantrum, and the flash rally, how is the liquidity doing? One of the big indicators of how liquidity is doing is the bid-ask spread (the difference between the highest bid price and the lowest ask price for a security) and they suggest ample liquidity. Not every high-frequency measure, however, shows this. Order book depth (measured as the average quantity of securities available for sale or purchase at the best bid and offer prices) points to some deterioration but isn’t unusually low at present by recent historical standards.
Measures of the price impact of trades also show some recent deterioration of liquidity. When the estimated price impact per $100 million is high, that is a sign of reduced liquidity and the impact is especially high by recent historical standards. Daily measures suggest normal liquidity conditions. “Large pricing differences indicate unexploited profit opportunities, which could in turn reflect constraints on market making capacity and/or poor liquidity” per Liberty Street. These pricing differences have remained relatively low and stable. Daily measures remain pretty consistent on showing liquidity doing just fine.
Overall, Liberty Street Economics findings were as follows, “The evidence suggests that market participants’ liquidity concerns are not emanating from average levels of liquidity in the benchmark Treasury notes.” Essentially they are saying that the signs of deterioration are coming from unusually liquid conditions.
So why are people so concerned about the liquidity of treasury bonds if they are doing well by historical standards? “One possibility is that the unease is not so much about on-the-run Treasury securities, but about less liquid Treasury securities or other fixed-income securities such as corporate debt securities.” “Or perhaps the concerns are not so much about average liquidity levels, but about liquidity risk.”
So what does this mean for residential mortgage bankers? Events and episodes of sharp, seemingly unexplained price changes in certain markets have heightened worry about events in which liquidity suddenly evaporates. There is always a risk of future loss of liquidity. And as noted above there are certain coupons (rates) and products (often ARMs or non-current coupon MBS) that suffer in liquidity. One always runs the risk of a possible imbalance between liquidity supply and demand. However, with all of these worries, let’s end with a positive: at the present moment liquidity is doing well by historical standards. And that is good for MBS, and thus for borrowers.