The decline of “safe” assets

Presenting the unwanted mutant offspring of the most important chart in the world*…

You’ll find the above on page 143 of the Credit Suisse 2012 Global Outlook, which we’ve stuck in the usual place.

It shows how the world’s outstanding stock of safe haven assets denominated in either dollars or euros has evolved, adjusted to account for the Fed’s purchases of US Treasuries and other assets in recent years as part of quantitative easing.

You can see just how impressive the decline has been since 2007, and we’d also note that if Credit Suisse had been feeling uncharitable, they would have been justified in excluding French sovereigns.

The chart helps explain much of what’s happening in global financial markets now, especially in Europe (not on its own, mind you — we said “helps” explain):

– Begin with the ongoing collateral crunch, and how the decline of safe assets is directly tied to the dramatic fall in the availability of high-quality collateral in European lending markets. So much of it is now encumbered via direct bilateral funding agreements or by sitting at the central bank drawing liquidity.

Now, if you’ve read your Manmohan Singh (or your Izzy Kaminska or your Tracy Alloway), you’ll know that this availability is the first of two parts of the collateral shortfall effect. The other part is the shortening of “re-pledging chains”, otherwise known as a reduction in the velocity of collateral and which Singh explains thusly:

Intuitively, this means that collateral from a primary source takes ‘fewer steps’ to reach the ultimate client. This results from reduced supply of collateral from the primary source clients due to counterparty risk of the dealers, and the demand for higher quality collateral by the ultimate clients.

And why does it matter? Singh again, emphasis ours:

The “velocity of collateral”—analogous to the concept of the “velocity of money”—indicates the liquidity impact of collateral. A security that is owned by an economic agent and can be pledged as re-usable collateral leads to chains. Thus, a shortage of acceptable collateral would have a negative cascading impact on lending similar to the impact on the money supply of a reduction in the monetary base. Thus the first round impact on the real economy would be from the reduction in the “primary source” collateral pools in the asset management complex (hedge funds, pension and insurers etc), due to averseness from counterparty risk etc. The second round impact is from shorter “chains”—from constraining the collateral moves, and higher cost of capital resulting from decrease in global financial lubrication.

When you hear concerns that the ECB has lost some control over monetary policy because of a liquidity-starved credit channel — or indeed when you hear Draghi himself say that he’s cognizant of the “scarcity of eligible collateral” – this is why.

– As was perhaps inevitable, the decline in safe assets has come at a time when investor demand for these assets has only climbed for them and as the deep freeze in European unsecured lending has meant a big shift towards collateralised lending. Hence the widening discrepancy in repo prices for different types of collateral (also noted by Draghi) and, in particular, the negative spread between Libor and the secured repo rate, on which Izzy superbly elaborates. For all but the strongest banks, i.e. those with surplus cash reserves, the ECB is increasingly the only shop still open.

– There are future policy considerations here as well. Back to Singh one last time:

Recent regulatory efforts will require significant collateral on many fronts—Basel’s liquidity ratios, EU Solvency II and CRD IV, and moving OTC derivatives to CCPs. Unless there is a rebound in the pledgeable collateral market, the likely asymmetry in the demand and supply in this market may entail some difficult choices for the markets and the regulators.

It stands to reason that the collateral grab has been exacerbated as financial institutions anticipate the onset of these regulations. This has already led to much talk about a burgeoning collateral transformation industry, though apparently there remain questions as to how big it will get and what kinds of unintended systemic risk could result.

– A somewhat obvious and related point here, but the loss of “safe” status for so much debt contributes to the deleveraging burden of European banks and their American subsidiaries; by definition it means higher risk weightings for these assets.

Declining asset quality is surely also one reason that European banks had trouble funding themselves in US repo markets, and the resulting stress in the currency basis swap markets as banks sought dollars elsewhere led to last week’s intervention.

And it’s probably why US money market funds, worried about what the absence of safe asset holdings at European banks means for their stability, have continued retreating as a source of wholesale funding, and why the American subsidiaries of these banks are now liquidating their dollar reserves to make up for it.

– Another obvious and related point, which is that the ECB is now accepting everything but your dirty socks as collateral. Not much choice in the matter, we suppose, if it wants to ease the liquidity strains caused by the broken interbank market. What else can it lend against?

– Historically, a Triffin Dilemma — and that’s kinda what this is — leads to funky innovations in the shadow banking system and all the complications that such innovations bring. Will the whispers of new kinds of financial alchemy get louder?

– You can see in the chart that before the crisis, US Treasuries were an important but minority amount of the world’s stock of safe haven assets. Treasuries are now the vast majority of such assets. But this is because of the extraordinary decline in the other kinds of assets and because of quantitative easing by the Fed, not because the outstanding stock of Treasuries has increased by so much.="http:>

Issuance in recent years hasn’t been nearly big enough to make up for the decline in other kinds of safe assets or, certainly, to correct the imbalance between investor demand for safe assets and outstanding supply. We’re not saying it should have been — only that this further confirms how absurd it is that the US government has spent so much time this year bickering over deficits rather than economic growth, and that the US economy confronts a fiscal drag beginning next year.

* This chart isn’t a perfect comparison with the AAA chart that Tracy posted in July. The earlier chart featured annual flows rather than stocks, and this one curiously omits corporate bonds. But we think it’s good enough to get the above points across.

Related links:
Draghi: “We are aware of the scarcity of eligible collateral” – FT Alphaville
ECB as Pawnbroker of Last Resort (POLR) – FT Alphaville
Financial system creaks as loan lubricant dries up – FT
The AAA bubble - FT Alphaville

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