HTM Assets Markets - Simplified
Liquidity
As consumers, we don’t usually carry the concept of liquidity at the forefront of our lists of worries. Banks, corporations, and businesses have this concept of liquidity as a primary issue that must be juggled correctly, or it could mean their business’s downfall. But what is liquidity? We may want to search this on a website or our small dictionary, but liquidity in finance has a particular meaning. According to Business Insider,
“Liquidity is a term that describes how quickly and easily a financial asset or security can be converted into cash without losing significant value or affecting its market price.”
This definition refers to the availability of cash and cash equivalents to trade securities, bonds, or other non-cash assets, which is essential in business and banking. Companies require readily available liquidity. Still, today we will only look at banks and how they are affected by liquidity, specifically within their holdings and strategies of investment.
Historical View of Cash On Hand
“Cash is king” is an adage that was said to be created during the 1930s Depression. During the 1930s and after, the primary concern for businesses and banks was the trend for all goods becoming cheaper as time passed, otherwise known as deflation. Thus, those with cash could purchase assets and investments at prices lower than their intrinsic value, sometimes returning their investments within a few short years. Today, the sentiment is different, with the US’s historical 2% yearly inflation rate, especially in today’s hot inflation economy.; Investors are forced to decide whether they continuously lose their purchasing power solely on inflationary terms or risk having nominal losses at the possible upside of retaining purchasing power through sound investments. Banks have a slightly different problem.
Liquidity in Banks
Banks cannot hold our money for free. They have operating costs, and the government requires forms and paperwork to be able to hold a banking charter. These are all expensive upkeep, so banks can use their customers’ deposits to extend loans to companies and other consumers.
A fundamental view of how a bank works is that a customer deposits $1,000 to a bank. Those who deposit money at a bank are called depositors. The bank, in turn, creates a loan of up to?$1,000. One key concept of banks and loan creation is fractional reserve banking, but this concept exceeds the scope of this white paper. The depositor has $1,000 in the account at the bank, on paper. In short, the bank owes the depositor $1,000, excluding any promised interest; we can call this transaction an unstructured loan from the depositor to the bank. The bank turns around and loans the money to another customer for $1,000. The bank has created a note (otherwise known as a promissory note or debt) with the debtor and expects to receive the $1,000 with interest in the future. Liquidity becomes of issue when the depositor returns to the bank and requests $1,000. The bank does not have the money, as it had loaned it. The bank has two options; to default on its promissory note to the depositor (the $1,000 the depositor is requesting) or sell the loan it created from the deposit to another bank to receive the cash to pay the depositor.
In short, this previous issue is known as “maturity mismatching” between the loan the bank issued and the immediate request of the depositor. The depositor can request their deposits at any moment, but the loan the bank issued can only be recalled at maturity.
Investment Markets
When selling bonds, is the issue only the availability of the buyer for the loan required to be sold by the issuing bank to receive the deposits it owns to its depositor? The simple answer is no, and we will see how it plays out with a recent example, Silicon Valley Bank (SVB).
As a disclosure, the numbers used in this white paper do not reflect the actual issue at SVB. Still, its intended purpose is only to represent one of the many issues SVB bank had. This material is only to be used for educational purposes on Mismatching Maturities.
Silicon Valley Bank (SVB) had several holdings before its doors closed. According to SEC filings (1), as of February 24, 2022, SVB had in its Balance Sheet
Of all their holdings, we will look only at their HTM or the Held-to-Maturity assets. Held-to-Maturity assets are assets expected to be held for more than a year. These include corporate bonds, treasury notes, mortgage-backed securities, and other long-term securities or tranches. The SEC requires all assets expected to be liquidated later than one year to be put in this category and to mark any expected losses if required to liquidate that year. Losses are marked on a good faith estimate based on several factors. One simple formula is the future’s value formula of Present Value multiplied by the quantity of yearly compounded interest rate plus one, raised to the power of the number of compounding years.
Bond Markdowns
Let’s look at mortgage-backed securities (MBS), as many news outlets state, were on SVB’s balance sheet. We can glimpse how vital available liquidity is and what happens when you have to mark down secured and risk-free investments but are forced to sell before maturity. Let’s assume the same $1,000 bond from our depositor of the previous example—a 10-year MBS at 2%. The value of the bond is $1,000 plus the expected earnings across the ten years. The bond’s value is $1,000 plus 2% or $20 a year for ten years. That equals $1,200 as the value of the bond. The bond price is the initial cost you pay to invest in the bond. The current price at par is?$1,000?as the bond issuer gives the debtor $1,000 for ten years. Note to the reader that the price of a bond can be par price or at a discount rate, which includes the expected yield. We will only assume the bond issuance price is its par price and the trading of bonds in the market for liquidity at discounted prices from their future value and market rates.?
If you notice, the cost/price of the bond and the future value of the bond do not match 1:1. They are different. Bond prices are a simple concept, but it can get complicated when marking up or down the price of a bond, depending on the market forces. For now, we will assume that par price is the cost to invest in the bond, and the future value is the original cost of the bond plus the expected gain after the predetermined years to maturity.
Future Value of Bonds and Market Prices Prior to Maturity?
Let’s assume two years have transpired since we purchased the bonds. We want to mark the value of the bond, and we want to try to confirm the price. The bond remains at $1,000 for our initial investment, but now, we estimate eight instead of calculating ten years. We do not add the previously distributed interests paid on the bond, as they were paid and are no longer a part of the present or future value of the bond. One key note about bonds is that bonds pay out their yearly interest semi-annually. In other words, the annual yield is paid that year, and the payments are disbursed twice a year, once at the beginning of the following year after issuance and six months from the current year. Since we are assuming two years have passed, we assume any interest accrued in the previous two years has been disbursed within those two years. With an issuance of $1,000 and 8 years left on our MBS at 2%, the value of the bond is now $1,160, as there is an expected $20 to be distributed in each of the next eight years, plus the repayment of the total initial investment of $1,000.
What is the price of the bond if we are forced to sell? Let’s assume the market is the same as our MBS, 2%, for eight years. We can look at prices across different years, but that is more of a speculative action, and in most cases, the interest rate for the expected remaining years is what is compared. We will assume a market based solely on current market prices and not expectations of inversion or increases. Thus, all things being equal, at 2%, a $1,000 MBS with eight years to maturity has a value of $1,160 across the whole market; the expected price at par should not change and is expected to be $1,000, as the entire market expects the same amount of distribution of interest in a similar bond from other vendors. The price of our MBS, if sold on the market, would be?$1,000, as all other bonds are the same value and expect the same number of disbursements and amounts.?
If the rates for bonds in the market drop to 1%, the value of the market bonds of $1,000 plus the expected income, or $10 for each of the next eight years, thus a total of $1,080. The value difference between the market bonds and our MBS is $80 greater for our MBS at 2%. The selling price of our MBS can rise to?$1,080, as our MBS is expected to earn more than the current bonds in the market. If we sold this bond to pay our depositor, we would gain $80 above the par investment we initially took, giving us a gain of 8% realized gain on the day we sell.
If the rates for the bonds in the market rise to 3%, we have the opposite issue. The value of our MBS remains at $1,160 or the initial $1,000 of issuance plus 2% for the remainder of the eight years to maturity. If the market offers a $1,000 bond for 3% or $30 per year, the bondholder holds the debt that is $10 above our MBS. The bond’s total value of 3% interest for the remainder of the eight years to maturity is $1,240, or $80 above our MBS. If we are forced to sell the bond in this market to pay our depositor, the market may cause us to sell our bond as low as $920 or at an 8% loss from our initial investment in our bond. We may consider the gain of $40 from the previous earnings of that same MBS for the two years of interest paid to us, but the immediate loss on the bond is what is considered, not the gains prior to the year the bond was sold. As speculation, if we did add it, we are still $20 less than our initial investment or a 4% loss in our initial investment.?
If we look at a market of 4%, the value of a bond at $1,000 is $1,320 or $160 above the value of our MBS. If we are forced to sell in this market, we may sell at $840, or a maximum of 16% loss on our initial investment on this bond. Now imagine a 16% loss of $95 billion. That’s a loss of about $15.2 billion. That does not include the outstanding loans the SVB bank had on their balance sheet or their possible losses on available-for-sale securities.
Current Liquidity Concerns
In short, held-to-maturity assets are risk-free when you can hold to maturity, and the debtor to the bond can pay. Yet, as many have seen, 10-year bonds just two years ago yielded less than 2%, and a 3-month US Treasury is yielding as high as 4.97% as of 4/25/2023. Many banks that added substantial portions of MBS and other debts before 2020 to their portfolios are holding HTM assets at current market prices, their loss exceeding 20%. If these banks are forced to sell at market prices to pay out their depositors or for other liquidity concerns, many will look at bankruptcy if they are not insolvent already.?
Liquidity is a crucial concern for banks and companies that finance their growth and invest heavily with unused cash reserves in order to protect their purchasing power due to hot inflation. Still, with high volatility, this old style of protection may become a liability, and short-term treasuries may be in greater demand than long-term debts. This shift creates a rift between companies and corporations that requires significant debt financing for extended periods of time, while banks or investment firms are unwilling to provide the debt due to high volatility and increased risk of lack of liquidity. This may stunt growth and investments in many speculative areas, such as construction, technology, etc. This is not a prediction or investment advice; this is only an opinion based on current market trends.?