A major FT exclusive on Monday:
Standard and Poor’s has warned Germany and the five other triple A members of the eurozone that they risk having their top-notch ratings downgraded as a result of deepening economic and political turmoil in the single currency bloc.
The US ratings agency is poised to announce later on Monday that it is putting Germany, France, the Netherlands, Austria, Finland, and Luxembourg on “creditwatch negative”, meaning there is a one-in-two chance of a downgrade within 90 days.
It warned all six governments that their ratings could be lowered to AA+ if the creditwatch review failed to convince its experts.
In doing so, S&P surely also questions the AAA future of the EFSF. Many will also question the timing of any S&P announcement, coming shortly after Merkozy’s latest deal and with the “crucial” European summit a few days away. But…
Why is this (long overdue) realisation important? For one thing, as noted on FT Alphaville earlier on Monday, the universal pool of ‘risk-free’ investments has been contracting since 2008 anyway:
That in turn has caused a major run on the few remaining ‘safe assets’ out there.
A situation which in itself has fueled record low yields and negative repo rates on quality collateral, but rising yields, repo rates and hair cuts on ‘unsafe collateral’. Collectively, the two phenomena have choked up access to cheap secured funding. Regulatory moves to increase the amount of ‘quality collateral’ held unencumbered on banks’ balance sheets, as well as a general move towards central counterparty (CCP) trading relationships — all of which require more pledged collateral — have hardly helped to ease the collateral crunch.
Without enough ‘quality collateral’ to go round, some governments have even turned to synthetic alternatives to try and fill the gap.
But what does the end of risk-free really mean in this context?
We’d say the fact that there is no such thing as a principal protected investment anymore — no matter how pronounced the dash for the underlying security itself is. One way or another, the investor is now prepared for the fact that he may lose principal — either as a result of gambling in risky securities, or by paying a charge to be invested in less risky securities.
You could say, the investment world has gone from a world of absolutes to a world of relative investments as and how they compare to cash deposits.
If you want to ensure that you’ll get your money back over time, you now have to pay up for the privilege of doing so via a possible negative yield. It’s the de facto depreciation of money in play. There’s no such thing as a safe investment and you can’t expect an interest rate unless you take a sizeable risk.
On a relative scale, it doesn’t really matter which debt investment is considered the safest.
The difference between negative yielding debt and positive yielding debt is now about the difference in risk perception. The first sees the investor knowingly erode his wealth for the privilege of investing in the safest asset out there, the second sees the investor chance his wealth for the privilege of receiving a yield.
The first allows an investor to offset the wealth erosion effect via a lending fee, since the cash he receives can only be invested with exposure to greater risk. The second expects the investor to compensate the market (via a larger haircut payment) for the greater risk associated with lending cash against ‘unsafe assets’.
In the first, the investment is considered safer, or as safe, as cash deposits (after national insurance costs are factored in), while in the second, the investment is considered much riskier than cash deposits alone.
The riskier the asset, the larger the haircut.
Both, nevertheless, see cash unwittingly re-collateralised. Too much cash relative to existing collateral equals a natural contraction and what might be described as a self-enforced move towards negative rates in assets perceived to hold value, against a self-enforced move towards higher rates (and haircuts) in assets deemed likely to depreciate.
A point well explained by Gary Gorton and Andrew Metrick of the Yale School of Management in a paper entitled Securitized Banking and the Run on Repo in 2010:
In a world with known and certain values for collateral and no transactions costs for selling collateral, repo rates should be equal to the risk-free rate, and spreads would be zero: a lender/depositor would have no fear of default, since the collateral could be freely seized and sold.
In reality, collateral pricing can be uncertain, and illiquidity and volatility in the secondary markets for this collateral can induce large transactions costs following a default. In this case, measures of bank-counterparty risk (LIB-OIS) may be relevant to lenders, and in the case of default they would be sensitive to uncertainty about collateral values. Lenders could then demand higher rates and/or higher haircuts. Higher rates would occur because the loans are no longer risk free; higher haircuts could occur to adjust for the uncertain value of the collateral, since each dollar of collateral may be worth much less by the time it can be sold.
Related links:
Goodbye to the risk-free rate – FT Alphaville
Why debt investors are taking leave of their senses – FT Alphaville
In a brave new world, there are no benchmarks – FT Alphaville
The decline of “safe” assets – FT Alphaville