Monday, December 17, 2012

The Economist on Safe Assets

The writer mentions that "Izabella Kaminsky [sic] has written many thoughtful posts on this subject in the context of the collateralised lending markets."
A quick search at The Economist's sister property, FT Alphaville, turns up 307 posts containing "safe assets" with the 100th getting you all the way back to April......2012.
The Alphavilleins are either prolific or promiscuous on the topic, I'll wager the former.
From The Economist's Free Exchange blog:

The safe asset shortage 
EVERYONE needs to save. People need to be able to cover unexpected expenses and income reductions, to say nothing of retirement. To accomplish this, we buy equities and bonds, hoard gold coins and physical currency, open bank accounts, accumulate real estate, purchase insurance coverage, and even stock up on canned food. All of these savings vehicles help us hedge out different risk exposures we face in our daily lives. For example, an unleveraged position in shares can be expected to generate higher absolute returns over very long periods of time relative to an unleveraged position in government bonds. Investors who cannot use leverage should therefore own some equities to hedge against long-term liabilities like the cost of retirement. But shares’ higher returns over very long periods are offset by greater volatility. Moreover, shares generally lose value whenever the economy slows, which makes them a particularly poor hedge against the risk of job loss. So investors need to own things besides shares to hedge against the vicissitudes of life. However, relative to what people want right now, there may not be enough of these “safe assets” available. This would help explain the negative real yields on TIPS and inflation-indexed government bonds issued by other countries. Why would there be a relative shortage of safe assets?

One reason is that people are more aware of downside risk than in the past, thanks to the collapse in middle class wealth and the massive increase in joblessness; there is more demand for safe assets. This is actually healthy and overdue. In fact, there is good reason to think that the process still has a long way to go.* The safe asset shortage can also be attributed to the fact that many assets previously thought of as “safe” are no longer seen that way, whether they are Italian government bonds or subprime mortgage securities. Thus, the supply of safe assets declined even as the demand for them soared. Izabella Kaminsky has written many thoughtful posts on this subject in the context of the collateralised lending markets. I was reminded of this because of a conversation I had over Twitter with David Beckworth, an economist who writes the Macro and Other Market Musings blog.

We agreed that there are too few safe assets relative to the demand. But where I thought the government ought to issue more Treasury bonds to satiate investors, he thought that the solution was to induce the private sector to “create” more safe assets. I doubted whether that is possible.
To see why, it helps to understand what makes for a genuinely safe asset. They are liquid—you can always sell them at short notice for goods and services without needing to offer a discount on price—and they have no credit risk. Safe assets may sometimes pay investors less than inflation but they always pay out what they say they will. The most extreme example is a piece of physical currency, which in America is described as “legal tender for all debts public and private”. As long as the government is able to enforce the law, those pieces of paper and metal will always be worth what they say they are, no matter what. Gilts with face values of £100 always pay £100 in principal upon maturity, even if that is worth less than you might like relative to goods and services. (The value of a gilt can be quite volatile before it reaches maturity, however, depending on its duration.) This is because the government can always print the money it needs to prevent default. Assets that only sometimes keep their promises cannot be called safe, however, even if they fool people into believing otherwise for significant periods of time.

So, can the private sector issue genuinely safe assets? I don’t see how, since private borrowers always have some default risk. Moreover, this risk changes depending on economic conditions. The market reflects this by charging private debtors a premium over the government’s borrowing costs. This premium adjusts according to investors’ beliefs about how likely they are to get their money back. Of course, the transition is rarely smooth. In practice, investors in private credit act as if there is almost no risk for long periods of time before suddenly freaking out. When everyone decides to sell their loans at the same time, it becomes very difficult for any individual investor to dump his holdings. Thus, private debt also has a nasty tendency to become illiquid. These are not the characteristics of a safe asset....MORE
Harking back to last week's post on the robotic ride to serfdom the villein occupied the social space between the freeman and the slave, below the thane but above the feudal cotter (cottage in return for labor).
Thus the alpha-villein would be top dog.
And of course, a cotter rill is the brook beside the cottage.