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Liquidity Crunch Impacts Brokered CD Market

From the meltdown in subprime mortgages to the turmoil in asset-backed commercial paper and the deterioration of monoline bond insurers, the credit markets continue to experience uncertainty. From a pricing perspective, uncertainty translates to volatility, and nowhere has this been more evident than in the variability in rates paid by financial institutions to obtain liquidity over the past six months. Pricing for brokered certificates of deposits (CDs), a traditional source of liquidity for banks, has been no exception.

During the third and fourth quarters of 2007, the steady stream of unsettling developments encouraged a significant number of investors to shift their cash to the safety of insured bank deposits. Furthermore, the relatively flat shape of the Yield Curve during this period discouraged some banks from leveraging these deposits into longer-term investments, freeing up more excess deposits for the brokered CD market.

This shift fueled short-term funding as many banks were able to raise sizable amounts of brokered CD funding every week. But as the liquidity crisis among financial institutions worsened and demand for brokered CDs continued to rise, the interest rate spread needed to attract this type of funding also increased.

FHLBank Advances Offer Source of Liquidity

As the spreads on brokered CDs spiraled higher and higher, many banks turned instead to lower cost FHLBank advances as a source of liquidity, as evidenced by historically high advance activity throughout the FHLBank System. More recently, interest rate spreads on brokered CDs have narrowed from historically wide levels, prompting many participants to return to the brokered CD market, including those banks on the supply side of the equation.

Under normal circumstances, an increase in the number of “sellers” should increase supply and therefore provide downward pressure on brokered CD spreads. This has not been the case however, as the downward adjustment in brokered CD spreads has lagged behind the rapid decline in short-term rates that has followed the Federal Reserve’s unexpectedly aggressive reductions.

The Future of Brokered CD Pricing

Will the volatility in the prices of brokered CDs end anytime soon? Rate indications distributed recently by several major dealers of brokered CDs suggest the answer to that question is, “not likely.” Prior to the recent credit crisis and subsequent liquidity crunch, the variability between indicative "all-in" rates (total cost) quoted by the ten largest dealers of brokered CDs averaged approximately 5 basis points for any stated maturity (1 month, 3 months, 9 months, etc.).

An analysis of brokered CD indicative rates as of February 12, 2008 uncovered levels with ranges varying on average between 10 to 15 basis points for stated maturities among major dealers, a full two- to three-times the historical pricing variance. If this trend continues – and market conditions certainly suggest it will – we can be sure of at least one thing with respect to the cost of this important source of liquidity for banks: more uncertainty, not less.

DISCLAIMER
FHLBank makes no representations or warranties, express or implied, as to the accuracy, completeness and timeliness of any assumptions or any other data presented in the article.

The information presented in the article  is not investment or business advice, nor is it an offer to extend credit or buy any security or financial product. Readers must not rely on any of this information when making any investment, business or credit decision.