Christopher Papagianis

The policy response that perhaps best connects the U.S. financial crisis and the still brewing eurozone problem is that regulators have endeavored to make financial institutions more resilient. Policymakers on both sides of the Atlantic have focused on increasing financial institutions’ capital and liquidity positions to try to limit future bank failures and systemic risk. Both goals are served by increasing banks’ holdings of “safe assets” that are easily sold and retain value across different global economic environments.

But what if there simply aren’t enough safe assets to go around? After all, safe assets aren’t only being gobbled up in the name of financial stability. Today, the global investor universe is undoubtedly more risk-adverse and is naturally hungrier for these same stores of value. From insurers to pension funds, the demand for safe assets – and the corresponding dearth of supply – has led to strange, if not ominous, distortions in the market.

For example, over the last few years there have been numerous periods where the yields for short-term U.S. and German sovereign debt have turned negative. The real yields, or the amount earned after adjusting for inflation, on front-end Treasury notes are currently less than -1 percent. This means investors have been putting aside their search for yield, willing to lock in (small) losses with their new purchases because there were very few alternative and liquid markets where they could park their money on better terms.

In a recent report, the IMF explores this growing tension between the supply and demand of safe assets – and the takeaways are nothing short of frightening.

Let’s start with what are considered safe assets today – even though, of course, this categorization is crude and likely to be overly inclusive. There is sovereign debt (with debt ratings above A/BBB), investment grade corporate debt, gold, and also highly rated securitizations and covered bonds. The IMF estimates that there are approximately $75 trillion of these safe assets in the market today.

With banks, pension funds, insurance companies, sovereign wealth funds and central banks all gorging on these assets to differing degrees, real prices have been on a tear. But, surely the market will eventually adjust as the supply trajectory for these assets grows overtime to meet the new demand, naturally releasing some of the pressure around prices?

A close look at just the narrative around government bonds reveals the extent of the problem ahead and why the market shouldn’t be counted on to self-correct. Back in 2007, before the housing bubble popped in the U.S., roughly 70 percent of the sovereign debt for the world’s most advanced countries was rated -AAA. Today, this rating only applies to 50 percent of these countries, a drop affecting approximately $15 trillion in “safe” sovereign assets.

The fluid crisis in Europe is one reason that a snapshot of countries’ credit profiles is of limited value, at least for the foreseeable future. The IMF projected that more than a dozen countries could fall from the class of safe asset issuers in the coming years. It concluded that by 2016 the total pool of safe assets might fall by 16 percent, or more than $9 trillion. In short, global fiscal retrenchment – here in the U.S. and across Europe – is expected to be slow and painful.

Some might argue that a drop in the supply of safe assets means that buyers will have to move down the safety scale and purchase assets that are only a little bit riskier. But this only makes the system more vulnerable. If the financial crises of the last few years have taught one consistent lesson, it’s that there really isn’t such a thing as a truly safe asset. Practically everyone now appreciates that there is no hidden part of the globe where an investor can buy an asset that doesn’t contain at least some amount of credit, inflation, currency or market risk.

There is a problem with the theory that the global economic crises have corrected all the past flaws with how risk is measured and priced, particularly with regard to once-heralded safe assets like sovereign bonds or mortgage-related securities.

First, it overlooks just how ingrained the concept of safe assets is in the global financial regulatory architecture. The problem in the euro zone banking system is partly due to banks holding their home government’s debt for regulatory and central bank funding purposes. Banks and other financial institutions are increasingly asked to use high-quality collateral as margin in derivatives trades. Reforms in this area make sense since derivative bets were insufficiently capitalized – but the impact of new rules, like margin requirements, on the demand for safe assets and on credit availability has to be acknowledged.

The problem is that all the regulatory efforts that seek to reduce leverage in the financial system not only presuppose the existence of safe assets but also assume that what is and is not a safe asset can be known with any degree of certainty.

Japan’s government debt, for example, is still considered to be among the safest in the world, despite a gross debt to GDP ratio of over 200 percent. How can one know if or when market participants will regard Japan’s debt with the same apprehension that they regard Spain’s today?

On the supply side, there are very few bright spots. Sure, a greater number of  emerging countries will join their more developed brethren over time, but few analysts expect a flurry of new emerging economies to start issuing AAA-rated sovereign debt in the near term.  Building the required legal institutions and financial architecture will take years, if not decades, for some countries to make this transition.

The private sector used to be a prime provider of safe assets through production channels like securitization. Private-sector issuance in the U.S. alone has declined by more than $3 trillion since 2007. There are obvious tensions between the desire for additional debt issuance and its impact on the safety of the issuer. The future of the housing government-sponsored enterprises (GSEs) also looms large given the importance of their debt and mortgage-backed securities as collateral.

While some are rightfully calling for a rebalancing of the U.S. mortgage market away from the government (since it is guaranteeing practically all new mortgages today), others are worried that this transition will lead to less government-backed MBS issuance – an important component of the current global supply of safe assets.

Eventually, the labored search for safe assets will drive prices to the point where investors have to settle for riskier assets. With interest rates that are expected to stay close to zero for some time (reflecting a world with slow growth and increased financial stress), the market is only becoming more susceptible to ripple effects from sudden drops in prices that turn safe assets almost overnight into unsafe ones, which then may no longer count or satisfy a key regulatory requirement. As the IMF puts it: “Demand-supply imbalances in safe asset markets could also lead to more short-term volatility jumps, herding, and cliff effects” – and even fuel new asset bubbles.

Ratings downgrades on U.S. and European sovereign securities teach us that what is a safe asset one day can be almost toxic the next. Building a regulatory architecture on these assets becomes dangerous because the transition from “safe” to “toxic” is likely to come at the same time that a bank’s dependence on the asset’s safety is greatest. As we have seen, the biggest panics are those that involve what were presumed to be safe assets, like the short-term commercial paper of Lehman. By hinging regulation on them again, the world seems to be tempting fate.