FT Alphaville " Goldman Sachs on fewer "safe assets" First of all, a big congratulations to Goldman Sachs for jumping on board the safe assets debate approximately 12 months late. And, in so doing, challenging (but not really challenging) what we still think is the biggest trend of the post-crisis era. From their latest Global Economics Weekly note, a little sense of "we must now find something contrarian to say": Are There Fewer "Safe" Assets T han Before? The twin effects of the US housing and mortgage crisis and the European debt crisis have seen a large pool of assets formerly regarded as "safe" come to be viewed as risky. Although what has happened here is less a reduction in the supply of safe assets, and more a realisation that those assets were never as safe as they were priced, it has seen several trillion dollars of assets lose highly-rated status, in two waves. The notion that the universe of risk-free assets has shrunk sits oddly with the fact that developed market governments have seen very large increases in their public debt levels. It is hard to believe that both stories are true and, by and large, they are not. As we show here, the absolute supply of safer sovereigns has risen and the overall supply of safer bonds has remained quite stable. It is, however, true that rising demand for these assets has outstripped rising supply. And it is also true that there have been dramatic changes in the composition of the safe asset pool. And here, ta dah, are the charts to prove their argument! In other words all of this is a demand issue, not a supply problem. Apart from being a strange point to raise in its own right - we don't think anyone ever questioned that this was the case - it hardly changes the fact that there aren't enough safe assets to go round. Some more observations: The fact that the price of safe sovereigns has risen substantially in the face of increased supply indicates that supply shortages are not the major driver. Instead, what has happened is that demand has increased dramatically and it is important to understand why. We think the largest effect comes from the ongoing deleveraging process and the broad weakness in this post-bust recovery. The increase in government supply is itself a part of this process and the demand for safe securities is the other side of the same coin, not a separate force. If these pressures ease, the demand for safe assets is likely to fall, but so is the supply. But not all of the increased demand is "cyclical." The secular increase in EM reserve accumulation, changes in bank regulation and shifts in collateral usage may drive some underlying increase in the demand for safer assets over time. The situation in Europe is different. The supply of Eurodenominated safe assets has fallen significantly. Moreover, the inability to provide broad public backing and the "incompleteness" of the currency union have emerged as a major source of growth risk and credit risk relative to the US and other similar non-EMU economies. Indeed, the contrast between the US and European experiences is striking. That problem could be changed by more radical changes to EMU's structure itself, but it highlights the peculiar systemic risks that the Euro area structure has generated. And some stuff that's already been extremely well covered by Manmohan Singh and Peter Stella: Two major events over the past five years have seen assets formerly regarded as safe come to be viewed as risky. The first is the US housing and mortgage crisis, which precipitated sharp downgrades to AAA-rated ABS (Asset-Backed Securities) and non-Agency MBS (Mortgage-Backed Securities. The second is the European sovereign crisis that has seen downgrades to sovereign ratings, substantial widening in peripheral sovereign spreads and shrinkage in highly-rated private markets (such as covered bonds, ABS and MBS). To finish, here's Goldman getting all philosophical about what counts as a safe asset anyway (a debate we think peaked during the circa 2011 debt debacle): No asset is truly risk-free, so the issue of how to classify safety requires some judgment. Traditionally, AAArated assets have been viewed as the appropriate universe. Since the US government is no longer AAArated, any comparison on that basis quickly comes to the conclusion that the supply of safe assets has fallen. But the fact that US Treasuries still see strong demand during any flight to quality sits oddly with that conclusion. Absolute spread levels provide another potential means of differentiating, but may reflect differences in liquidity and bond structure. A more intuitive measure of whether the market treats bonds as safe is the extent to which they are positively correlated to increases in global risk aversion. ...you don't say. And they conclude: The "Death of Safe Supply" Story Holds in Europe But Is Overstated Elsewhere If Safe Asset Supply Is Not Down, Demand Must Be Up Demand for Safety is Largely the Flipside of Crises Simply. Inspired. Commentary. And they're still missing the point. Related links: The AAA bubble - FT Alphaville Breaching the AAA bubble, charts du jour - FT Alphaville The decline of "safe" assets - FT Alphaville Central Bank reserve creation in the era of negative money multipliers - VoxEu When safe assets return - FT Alphaville Goodbye to the risk-free rate - FT Alphaville This entry was posted by Izabella Kaminska on Thursday, June 28th, 2012 at 12:20 and is filed under Capital markets. Tagged with goldman sachs, risk free rate, safe assets.