Ricardo Caballero argues that the current crisis stems from (flawed) efforts to construct safe assets out of risky assets in order to meet a surge in investor demand for safe assets.
He is on to something.
There was a surge in demand for safe assets that pushed yields on Treasuries (and Bunds, OATS and Gilts) down at the peak of the boom. And investment banks – with help from the rating agencies -- did respond by constructing new kinds of products that combined higher yields than Treasuries (or Agencies) and the appearance of safety.
Global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash. Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets – the market moved to create synthetic AAA instruments. .... The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector, especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields.
I don’t think that is quite right. Central banks and sovereign funds weren’t the main buyers of “structures" that produced a "synthetic" triple AAA credit Central banks generally stuck to instruments with cleaner cash flows and less risk. Many have mandates that require that they invest in fairly short-term instruments that have explicit government backing.
Let’s review the portfolios of the key players:
-- Japan (MoF mostly) remains overwhelmingly in Treasuries, with a small number of Agencies. As far as I know, that is about as far as the MoF and BoJ went.
-- Brazil’s central bank basically holds Treasuries.
-- Russia’s central bank held a lot of short-term Agencies. But it liked the Agencies own debt, not the mortgage backed securities they guaranteed. Russia’s its investment guidelines are quite restrictive. It needed a government guarantee. It wasn’t buying any "private lablel" structured product.
-- India has been quite conservative. It doesn’t even hold many securities. Most of its reserves are on deposit at an international institution -- likely the BIS. Who knows, maybe the BIS dabbled in structures, but India wasn’t a big source of demand for CDOs.
-- Mexico didn’t go further than dabbling with Agencies. Agency MBS were a bid deal. It is mostly in Treasuries.
-- Saudi Arabia is a bit of a mystery. I doubt it holds any structures on its own book. But it also likely outsourced the management of a fraction of its fixed income portfolio, and well, maybe the managers had a mandate that allowed them to take a bit of risk. I just don’t know. The Gulf’s sovereign funds liked equities (and private equity) more than they liked complex debt instruments – though they probably invested in hedge funds that made levered bets on complexity. I would be surprised if the Gulf has more than $100 billion of exposure to structured products. the Gulf’s big bet was on the equity market.
-- Korea clearly took a few more risks back when it wanted to juice returns to offset the won’s appreciation (how the world has changed). But even if it put a third of its dollar portfolio (say 20% of its total portfolio) in dollar bonds that lacked government banking, it wouldn’t have bought more than $50 billion of “product.”
-- Norway also took credit risk with its bond portfolio. But the US only made up about a third of its bond portfolio. Back when bonds were 60% of Norway’s portfolio, Norway could not have have had more than 20% of a $300 billion portfolio in US bonds of all kinds. It thus could not have accounted for more than about $60b of demand for various structures. And it clearly wasn’t just buying structures.
Sum those countries up and they account for a large share of total central bank assets: Japan has a trillion portfolio, the big Gulf sovereign funds probably combined to hold around $800 billion of assets at their peak (less now); Russia and Saudi Arabia were around $500 billion; Norway, India, Brazil and Korea were in the $200-300 billion range.
That leaves China. China clearly dabbled a bit with some kinds of risk. The state banks got $100 billion or so to play with in 2006 (they seem to have gotten burned and retreated; they have been selling their foreign portfolio since mid 2007). SAFE bought a few high quality corporate bonds. It was a big buyer of Agency MBS – and perhaps bought a few structures too. But the overwhelming majority of its assets remained in Treasuries and Agencies not in “structures.’ China, inc – counting the state banks – might have bought $300 billion of bonds that lacked an explicit or implicit government guarantee, but probably not more.
The numbers just don’t work. Unless my accounting is way off, most central bank assets remained in fairly safe assets.* The big shift in the world of reserve management was the shift from Treasuries to Agencies after 20004. Most central banks still wanted bonds with explicit or implicit government guarantees.
Who then were the investors who wanted “safe” – i.e. highly rated – structures? Saturday’s Wall Street Journal provides the needed clue. Think State Street. Actually, think conduits run by State Street. Levitz and Anand in Saturday’s Wall Street Journal:
“It got into conduits, which are instruments that buy such things as asset-backed and mortgage backed securities, using short-term borrowings. It shifted its investment portfolio from predominantly government bonds into mortgage-backed securities which rose the housing boom. And then last year the housing market fell apart and ensnared the financial world – and State Street – in a credit crunch.
I don’t think State Street was alone.
As central bank demand pushed yields on Treasuries and Agencies down (and as the fed raised rates), a host of financial institutions took on more risk. Other financial institutions supplied the product that they wanted. And when it blew up, the financial sector – not the world’s central banks – was left with big losses.
Caballero’s argument works, but with one additional step. Central bank demand pushed yields on Treasuries and Agencies down, and low yields on traditional, safe assets triggered a surge in demand for assets that appeared safe but offered the kinds of returns private investors were used to.
Very low medium- and long-term real interest rates have in turn driven two effects:
First, they have helped drive rapid growth of credit extension in some developed countries, particularly in the US and the UK – and particularly but not exclusively for residential mortgages – with this growth accompanied by a degradation of credit standards, and fuelling property price booms which for a time made those lower credit standards appear costless. And secondly, they had driven among investors a ferocious search for yield – a desire among any investor who wishes to invest in bond-like instruments to gain as much as possible spread above the risk-free rate, to offset at least partially the declining risk-free rate. Twenty years ago a pension fund or insurance company selling annuities could invest at 3.5% real yield to maturity on an entirely risk-free basis; now only 1.5%: any products which appear to add 10, 20 or 30 basis points to that yield without adding too much risk look very attractive.
... The fundamental macro economic imbalances have thus stimulated demands which have been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments.
Incidentally, One implication of Caballero’s argument is that the US should have been running bigger budget deficits to meet the rise in demand for safe assets. That would have kept yields up and reduced incentives to create “synthetic” triple AAA. Rather than following Dr. Chinn’s advice and trying to bring about rebalancing with a tight fiscal policy, the US should have met the world’s growing demand for truly safe reserve assets by running large fiscal and current account deficits.
Who knows - that could be where we are heading.
Caballero attributes the surge in demand for safe assets to the integration of the emerging world into the global economy. He writes:
"since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high-saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies. The immediate consequence of the high demand for store-of-value instruments was a sustained decline in real interest rates.
I would add two additional factors.
China’s integration into the global economy coincided with a huge rise in China’s savings rate. There is a world of difference between a China that saves and investing a constant 35% of its GDP and a China that goes from saving and investing 35% of its GDP to savings 50% (or more) of GDP and investing 40% (or more) as its economic size increases. In the first case China isn’t a net lender to the world. In the second case it is. China’s savings rate hasn’t been constant, and China matters.
And exchange rate management. China didn’t buy a lot of US bonds just to protect itself from a repeat of the Asian crisis. it had (and has) a host of controls that limit its exposure to a big swing in interbank flows. its reserve cover has been exceptionally high for a long time. China bought a lot of bonds because it didn’t want the RMB to rise even as China’s booming exports created natural pressure for appreciation. It is hard to separate the surge in demand for safe assets from the rise in Chinese reserves growth (counting the increase in hidden reserves) from under $50 billion a year to close to $700 billion a year (at its peak -- it is now lower). Especially as that surge came at the same time that rising oil prices pushed up oil savings and the demand for reserve assets from the oil exporting economies …
Had China allowed its currency to rise in 2004 rather than tightening fiscal policy and limiting lending to avoid inflation, I rather suspect that Chinese demand for safe US and European financial assets would have become demand for US and European goods. That would have produced a more balanced – and ultimately less risky – global economy.
And, well, if the US and UK governments hadn’t looked the other was as leverage in the financial sector rose -- as financial institutions made bigger bets to keep profits up as spreads fell -- that too would have produced a more balanced and ultimately less risky global global economy.
* Many questions about the global economy could be answered more definitively if central banks disclosed more information about their portfolios to the IMF. Aggregate data on central banks equity holdings would be useful -- as would aggregate data about the composition of their fixed income portfolio. Of course, getting more countries just to provide data on the currency composition of their reserves would be a nice start ...