The Supply of Safe Assets: the Other Side of the Equation

The recent IMF Global Financial Stability Report has gotten us thinking more about the dynamics of safe assets. This blog has written extensively about the demand for safe assets (primarily looking at CCPs) but the shrinking supply side of safe assets needs to be examined too. Some might wonder how that could be with the primary deficits that sovereigns are facing – creating what feels like huge wall of supply. But it isn’t that simple. Lets take a look why.

 The IMF defines safe assets as:

  1. low credit and market risk
  2. high market liquidity
  3. limited inflation risks,
  4. low exchange rate risks, and
  5. limited idiosyncratic risks

For sovereign debt, the reduction hasn’t been a function of less issuance. It has been driven by fewer sovereigns considered safe. The IMF Global Financial Stability Report said, “On the supply side, the number of sovereigns whose debt is considered safe has fallen, which could remove some $9 trillion from the supply of safe assets by 2016, or roughly 16 percent of the projected total.” And “…the recent considerable deterioration of some advanced economies’ fiscal profiles has reduced the supply of sovereign debt perceived as safe. The sharp increase in advanced economies’ public indebtedness after the global financial crisis, combined with low tax revenues and high current and future public expenditures, has raised concerns about the sustainability of their debt. Such concerns have been augmented by government difficulties—including the political gridlock in the United States and Europe—that have impaired the ability of advanced economies to devise credible adjustment strategies that properly balance short-term concerns about economic activity with long-term fiscal consolidation. Thus, while 68 percent of advanced economies carried a AAA-rating at end-2007, the proportion dropped to 52 percent by end-January 2012.”

There is also the private side to consider. AAA rated RMBS were considered to be safe assets. No more. The IMF reminded us “as of August 2009, 63 percent of AAA-rated straight private-label residential mortgage-backed securities issued from 2005 to 2007 had been downgraded, and 52 percent were downgraded to BB or lower.” The IMF wrote “Total private sector securitization issuance declined from more than $3 trillion in the United States and Europe in 2007 to less than $750 billion in 2010. The extraordinary volume of pre-crisis issuance was driven by the perception that the instruments were nearly risk-free while offering yields above those of the safest sovereigns.”

Third to consider are synthetic safe assets. The bond basis trading business was built on a foundation that the combination of a bond plus buying protection on that bond created a risk free asset. Finadium’s February, 2012 paper “The Credit Default Swap vs. Repo Trade” (a link to a synopsis is here) discussed how the bond basis trading business collapsed when the Achilles heel of the market – funding – imploded post-Lehman.  What looked like a safe asset certainly didn’t behave that way. How many investors in negative basis on Greek sovereign debt still think the trade created a safe asset or buying CDS fully hedged the exposure?

Finally, the velocity of collateral – how often paper turns over in the marketplace via re-hypothecation — has been falling, reducing the amount of safe assets available. Lumped in with “shadow banking”, re-hypothecation has been attracting a lot of negative attention. No matter which side of the re-hypothecation argument you are on, it is hard to dispute that there is less of it, as measured by velocity. IMF economist Manmohan Singh’s research showed that velocity has dropped precipitously from 3.0 in 2007 to 2.4 in 2011 (a link to the research is here). We wonder if part of this has to do with increasing amounts of paper that is ending up in CCPs, where it cannot be re-hypothecated. The Global Financial Stability Report wrote, “Tying up high-quality collateral in CCP guarantee funds and initial margin to improve CCP solvency profiles may reduce liquidity in OTC derivative markets and, more generally, in repo markets; as a result, various shocks could lead to price spikes and shortages of high-grade collateral.” Another reason for the decline of velocity (and these are not mutually exclusive) could be the reduction of balance sheet dedicated to repo and prime brokerage businesses.

Squeezed both on the supply side and the demand side (we wrote about the increase on the demand side last Thursday in, a link is here) safe assets will be harder and harder to find.

A link to the IMF paper is here.

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The IMF's Global Financial Stability Report looks at coming collateral shortages
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