Just when they are needed most, safe financial assets are becoming scarce.
The financial volatility of the past few years has made investors so desperate for assets that can be easily sold that the downgrade of the U.S. credit rating had no impact on the price of Treasuries.
In retrospect, that makes sense. Greece, Portugal and Ireland had been bailed out, and Spain and Italy emerged as likely candidates. That removed a significant supply of "risk-free" assets from the market, as the sovereign bonds of those nations suddenly become quite risky. For all its troubles, no one thinks the U.S. government is about to go bankrupt. In a period of surging demand and dwindling supply, the debt of the U.S. remains a relatively safe bet.
But all of this is rather abstract; it's vaguely understood, but hasn't crystallized in the discourse between financial markets and policy makers. A new paper by the International Monetary Fund should change this, clearly defining the forces that are shrinking the supply of safe financial assets and laying out the risks this poses to the global financial system.
The IMF reckons some $8-trillion in advanced economy debt – the equivalent of about 16.4 per cent of the 2012 supply – is no longer considered an essentially riskless investment.
The fund bases this estimate on the spreads of credit default swaps (CDS) at the end of 2011. Greece, Hungary, Ireland, Italy, Portugal, Slovenia and Spain all had spreads of more than 3.5 percentage points over the benchmark rate. The CDS spreads of Belgium, France, Iceland, Poland, the Slovak Republic and Turkey were higher than 2 percentage points. Perhaps some investors would be willing to hold French or Polish bonds as hedges against their riskier bets, but surely not many. A spread of 2 percentage points or more suggests the debt of all of those countries now holds the same status as equities and other risky assets.
Governments aren't the only creators of safe assets and the reduced credit worthiness of so many advanced economies is not the only factor behind the diminished pool of safe assets. Financial institutions issued securitized assets worth $750-billion (U.S.) in 2010, compared with more than $3-trillion in 2007. This market has yet to recover.
At the same time, demand is rising. Many of the changes to financial regulation being contemplated by the Group of 20 will require banks and other financial institutions to boost their reserves of safe assets. The requirement for banks to hold more liquidity relative to their lending could boost demand for easily sellable securities by between $2-trillion and $4-trillion, the IMF estimates.
Central banks' willingness to extend temporary loans in return for riskier collateral is offsetting some of the impact of the supply shortage. But this is hardly sustainable. Emerging markets such as Brazil could offer an increased supply of highly rated debt, but as the IMF points out, the financial markets in many of these countries lack the legal protections that make buying securities in advanced economies attractive. Securitization could pick up – think increasingly popular covered bonds, which attract AAA ratings because they are backed by pools of assets rather than the issuer – but probably not fast enough to make a big difference.
The IMF took the trouble to explain all this because it believes the lack of safe assets threaten the financial system. The price of highest quality debt will rise. That's good, considering safe assets probably were underpriced before the financial crisis. However, scarcity could cause prices to overshoot, creating price bubbles and adding to volatility when they burst. The IMF also worried about "cliff effects," or a sudden drop in prices that could be brought on by the reclassification of highly rated asset.
A shallow market also increases the possibility of credit crunches. The IMF in its report reminds that in the wake of the collapse of Lehman Brothers, only short-term Treasuries were widely accepted as collateral in short-term financial transactions. The price of Treasuries was bid so high that the yields turned negative.
The IMF's advice to policy makers: Get your fiscal houses in order, and be flexible on the demands you put on financial institutions to hold high-quality capital. "Investors' cost of safety will inevitably rise, but an adjustment process that is too abrupt or too volatile may compromise financial stability," the report says.