from Follow the Money

Why no auction rate securities?

February 19, 2008

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Or for that matter asset-backed commercial paper? Or leveraged loans? Or mortgage-backed securities that lack an Agency guarantee? Danske bank has pulled together a nice survey of all the parts of the market that are hurting.

Sovereign investors are -- at least according to their talking points -- intrinsically stabilizing, long-term investors. Never mind that some sovereign investors are also big investors in the leveraged, short-term focused hedge funds and private equity firms they like to contrast themselves to.

But right now the most important sovereign investors are piling into the safest assets precisely that the moment private investors have lost their appetite for risk. Chris Giles of the FT reports:

Managers of foreign exchange reserves within central banks have become much more risk-averse since the global credit squeeze started, with safe assets back in favour.

A survey of investment managers within 51 of the world’s central banks responsible for reserves totalling $2,390bn (£1,220bn, €1,630bn), said the pressure on them to search for higher yields remained but riskier assets necessary to achieve higher returns were rapidly going out of favour.

Compared with a year earlier, more than 80 per cent of reserve managers surveyed said junk bonds, asset-backed securities and mortgage-backed securities were less attractive, according to a Royal Bank of Scotland/Central Banking magazine survey. By contrast, highly rated government securities were seen as more attractive by large majorities.

(Hat tip Rebel Economist)

The recent rise in central bank risk aversion may be prudent, but it isn’t stabilizing.

Right now, there is no shortage of private demand for safe assets (even if today was not a good day for the bond market) while there is a dearth of demand for anything with a whiff of credit risk. Martin Wolf isn’t the only person reading Dr. Roubini’s grim warnings.

The results of the Central Banking/ RBS survey coincides with my own sense. There was some very indirect evidence before August that central banks had started to take on a bit more risk. Total demand for Treasuries and Agencies wasn’t rising at the same pace at central bank reserves so even on the assumption that all private buyers of Treasuries and Agencies were really central banks or intermediaries buying "inventory" to sell to central banks, it seemed like central banks were taking a bit more risk -- whether credit risk or equity market risk.

After August though central banks seem to have gotten a lot more conservative. Just look at the roughly$70b increase in "official" holdings of short-term debt in q4 (see the TIC data release). The case only gets stronger if a lot of the $60b in long-term Treasuries bought by private investors abroad in q4 were sold to central banks (maybe in January?), adding to the $15b in long-term Treasuries and $20b in long-term Agencies central banks are known to have bought.

We already know that central banks added over $50b to their FRBNY custodial holdings in January. That is a lot of Treasuries and Agencies.

Indeed, in some aggregate sense, sovereigns seem to be following a version of a barbell investing strategy -- with a lot of very safe investments and a few very risk investments. Apparently a barbell strategy refers to holding short-term and long-term bonds but not much in between. I though first heard of it in the emerging market bond world, back when investors liked either the best credits or the yield on the worst credits but shied away from the middle of the credit distribution.

And that in some sense seems to be what sovereigns are doing now.

Some central banks -- concerned about taking losses -- are adding to their Treasury and Agency holdings.

And a few big Gulf funds, flush with the windfall from $100 a barrel oil, are buying a lot of large stakes in big banks. Singapore has redeployed its accumulated wealth in a quite aggressive way. Korea still seems keen to redeploy some of its funds into flashy stakes too.

The banks though need more than capital. They also need a bit more global demand demand for credit risk. Taking on credit risk (and then repackaging it) is really their core business.

And I wonder China isn’t also pursuing a barbell strategy. China’s high profile investments in Blackstone, Morgan Stanley and its rumored participation in a JC Flowers and TPG fund are tiny relative to its $500-600b in annual foreign asset accumulation. They account for maybe 3% of the total, and certainly less than 4%.

It sure seems like the Chinese state bank bid for riskier residential mortgage backed securities and various forms of corporate debt has disappeared -- though it is impossible to know for sure. They certainly seem to have stopped buying foreign securities.

And I would assume -- though I certainly don’t know -- that SAFE’s fixed income division hasn’t fully made up for the fall in state bank demand by increasing its own appetite for credit risk.

SAFE is still where the big money is. If it is still buying a lot of Treasuries and Agencies, China is still buying a lot of Treasuries and Agencies.

That said, there is at least a plausible argument that SAFE has increased its risk-taking to try to get a bit more yield in the face of its rising sterilization costs ...

It needs the income now more than in the past. And Treasuries don’t pay what they used too.

On one hand, SAFE was quite happy to be able to announce that it didn’t have any subprime exposure back in the fall. On the other hand, SAFE really could use some yield right now.

Something to watch.

I am pretty sure SAFE doesn’t participate in Central Bank’s survey.

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