Liquidity Squeeze Drives Opportunity for Change?
As a result of experiencing what most treasury organisations have found to be a very challenging financial and economic period, managers are taking stock of how their stress-tested treasuries performed and are now looking for ways to bolster weak spots that were exposed by the ordeal.
Prior to 1 July 2007, the model followed by many treasuries was one of investing surplus cash with a bias towards low-risk, short-term securities, guided by a conservative investment policy that was pre-approved by the board. In essence, this model would often run on something close to ‘autopilot’ with minimal supervision. Someone on the treasury staff would collect balance information, set a cash position and then communicate with a handful of trusted broker/dealers and bank trading desks or investment advisors about what to buy – often with a casual regard for investment policy.
Otherwise, they simply used bank sweep accounts where balances over a threshold would be automatically swept and invested in approved funds, deposits or securities. These were ‘sheltered waters’ where sharks had not been seen for decades. Short-term investment was not what senior management and the board of directors wanted, or needed, to worry about. But not any more.
The turbulence that started with sub-prime mortgages, and later leaked through esoteric securities into the cash markets, has now effectively undermined the general creditworthiness of many commercial banks and brokerages. With the ensuing frenzy in the investment markets and the flight to quality that followed, treasuries with funds to invest were suddenly receiving, and continue to receive, plenty of attention from senior management and boards.
Adding to the paranoia, in certain cases, a high credit rating alone was not enough to reliably rubber stamp the safety of several instruments. Certain asset-backed securities were found to be much riskier than assumed. In some cases, the insurers and banks that presumably ‘stood behind’ these securities were not able to perform. As a result, there was a flight to quality that rapidly impacted yields and supply.
Investors bailed out of whole classes of securities including auction-rate preferred (if they could find a buyer), asset-backed commercial paper and anything that might involve an exposure to sub-prime mortgages. Enhanced cash funds suffered, as well as funds that had never broken the buck have had to defend their portfolio holdings. Certain agencies backed through direct or implicit support from the US government, e.g. large mortgage-related government supported enterprises (GSEs) also came under scrutiny. As some top banks reported large losses and experienced increasing risks of failure, investors were even challenging money held as deposits in major global banks. Money cascaded into treasuries, agencies and conservative corporate money market funds (MMFs).
The immediate fallout of this environment was increased demand from investors for enhanced visibility of their holdings. A higher level of due diligence was now required; corporate investors were expected to look beneath the surface to discover the underlying nature of the instruments. With the growing burden of due diligence, some investors made a shift from in-house investment to the use of outside investment managers who were presumed to have the time, experience and technology to investigate the salient issues more effectively and safely.
While the hottest fires have already burned out on the investment side, access to credit remains under duress. Banks are clearly building up their loan-loss reserves and being very careful about how they allocate scarce capital.
As a result, some companies, especially middle-market firms with less than stellar credit ratings, have seen their banks increase scrutiny around the overall profitability of their relationship. Some have just plain balked at the notion of renewing credit commitments. With syndicated lines, this puts pressure on the other participants to either increase their commitment or attract others to the syndication.
Treasury staff are working to relieve some of that funding pressure by improving their management of working capital – squeezing out cash that may be trapped in inefficient treasury processes. Many companies that experienced diminished access to commercial bank funding have seen increased pressure up and down their supply chain. A visible example of this situation is that many companies are now being more cautious about their trade credit strategies. Marginal customers with poor payment practices are much more likely to be cut off today than under the practices that were in place even two years ago. But a critical supplier that cannot be replaced may get some funding help from downstream. Customers may take on a bank-like role by accelerating their payments to keep such a supplier going.
Over the past six months of intense turbulence, stretching from 1 July 2007 to 1 January 2008, corporate liquidity fell for the first time since 1999, declining by US$250bn or 5%. As of 1 July 2008, total corporate liquidity totalled US$5.25 trillion. While corporate investors did incur some short-term investment losses, the drop in liquidity was largely driven by the need to use excess cash to fund operations. Additionally, the mix of liquidity by investment type notably changed.
Under duress, corporate investors made dramatic moves to protect their cash from waves of risk. There was a strong flight from commercial paper, auction-rate securities and repurchase agreements, and a rush to bank deposits and sweep accounts as well as conservative MMFs.
Altogether, treasuries pulled US$623bn out of commercial paper, a staggering 75% drop in commercial paper’s share of the investment pie. Those who could find an exit did so and cut auction-rate holdings by US$72bn – a 43% shrinkage. Repos took a US$58bn beating, down 42%, while enhanced cash funds tumbled US$51bn, down 25%.
Meanwhile, US$474bn poured into MMFs, raising their share of portfolios by 32%. Bank deposits and sweep accounts gained US$279bn, increasing their share by 36%.
It may be premature to call these remarkable flows signs of a sea change, but that idea is reinforced by what is happening not just in portfolios, but more broadly in the daily practices of many treasury organisations as seen in the chart below.
While it’s too soon to pronounce the financial crisis over, the markets are starting to sort themselves out, and post-trauma investment strategies are becoming clearer. Among large corporates (with revenue of US$5bn and over), those expecting to increase their cash balances by 20% or more will not be using bank deposits heavily according to a recent survey by Treasury Strategies. Most of that new money is destined for MMFs, commercial paper and offshore.
Table 1
| United States – Expected 20% Increase in Balances | |||
| Rank | Large Corporate | Mid-Coporate | Middle Market |
| 1 | MMF | MMF | Sweep |
| 2 | CP | Sweep | MMF |
| 3 | Offshore | CP | Notes/Bonds |
Among large corporations expecting to see a greater than 20% decrease in their cash investments, the greatest exodus will be from money markets, followed by commercial paper and auction-rate securities.
Table 2
| United States – Expected 20% Decrease in Balances | |||
| Rank | Large Corporate | Mid-Coporate | Middle Market |
| 1 | MMF | ARS | MMF |
| 2 | CP | MMF | ARS |
| 3 | ARS | NIB DDA | Notes/Bonds |
Commercial paper is making a comeback, but only when investors understand and have confidence in the issuer. These days, asset-backed paper trades on the reputation of the issuer, not so much on the over-collateralisation ratios. The auction-rate market remains inactive with no clear prognosis for its recovery potential.
The composition of large corporate liquidity portfolios is a fairly balanced mix – 39% direct instruments, 37% bank deposits and 14% MMFs. Actively managed portfolios are also popular particularly among mid-corporate (US$1-5bn revenue) and middle-market (US$250m-1bn revenue) companies in the US.
During the peak of these turbulent times, the pain many firms experienced was intense, but recovery from the trauma is underway.
The riskiest and hardest issue to understand is that securities have been washed out of the market. Some weak internal investment staff have been replaced by more knowledgeable outside managers. People who were tempted to dabble in unfamiliar markets and pick up deals that looked too good to be true have learnt a hard lesson.
The credit rating agencies, badly burned in some cases, have taken stock of what went wrong and are taking steps to improve reliability of these services in the future. Investors are now operating with a healthy scepticism that will no doubt fade as the market stabilises and losses once again become rare. But there are still risky securities out there with new names, having discarded tainted names but not the underlying risk.
One of the biggest challenges in the aftermath of these tumultuous times will be the required build-up of processes, technology and tools to improve treasury operations. Most finance executives have now recognised that they need the best technology available so that routine processes happen efficiently – automatically when possible – and securely.
The companies that have fared the worst in this recent downturn were those with ineffective processes, structures and technology. Treasuries that were operating with manual, inefficient processes, too many banks and insufficient staffing learned that a hostile market can send a rain of bullets their way – more than they could possibly cope with. For these companies, it has become abundantly clear that before they face the next financial crisis, they must put in place a much more defensible treasury.
Well-prepared treasuries found that their strong processes, structures and technology have acted as a sort of ‘armour’, preventing potential bullets from getting through. Having good systems, processes and people in place left them in a position to react deliberately to a small number of threats and find reasonable solutions without going into panic mode. They didn’t have to neglect important long-range projects, and they learned that being 95% bulletproof isn’t such a bad thing.
As a result of bulletproofing their treasury functions, organisations can free up far more time to address important strategic initiatives and objectives, such as:
The silver lining of the turmoil and all the attention from top management and corporate boards is a heightened awareness of the need to fend off disruptions and maintain control. This climate presents an opportunity for treasuries to move forward with projects that could upgrade systems, provide greater visibility of cash and investment holdings, achieve fuller straight-through processing, and embed security features in automated routines. Lack of money or IT resources has been holding back some treasuries and now may be their best time to take a giant step forward.
Treasury staff now have a window of opportunity. Flaws have been exposed. Senior management and corporate boards are eager to shore up liquidity defences. This is the time to forge ahead with the purchase of best-of-breed systems, the automation of routine treasury activities with built-in safeguards, the rationalisation of banking structure, and the hiring and training of key personnel.