The S&P Downgrades And Our Global Shortage Of Safe Assets

Standard & Poor’s Rating Service downgraded nine Eurozone countries; Cyprus, Italy, Portugal, Slovakia, Slovenia, Spain, France, Malta, and Austria, four days ago. This has surely affected the shock waves currently running through a now likely Greek default (Fitch now proclaims it so!), and perhaps a now likely German flight from the Euro. S&P gave a fairly comprehensive reasoning for the downgrades, including; “primarily driven by our assessment that the policy initiatives that have been taken by European policymakers in recent weeks may be insufficient to fully address ongoing systemic stresses in the eurozone…” They also incredibly said what has been painfully obvious to anyone with a modicum of common sense; “We believe that a reform process based on a pillar of fiscal austerity alone risks becoming self-defeating, as domestic demand falls in line with consumers’ rising concerns about job security and disposable incomes, eroding national tax revenues.”

Anyhow, back in December of 2011 David Beckworth alerted the blogosphere to the problem of disappearing AAA-rated assets. Economic shocks, causing downgraded sovereign debt ratings, creates a shortage of safe assets, of which in turn, are in greater demand because of the shocks. This phenomenon has been occurring since the fall of both private and public mortgage backed securities as shown the chart below; solid maroon and light blue blocks represent MBS.

The problem displayed by the chart is not only that we have lost so much of our “safe” assets, but that global wealth was built and even outgrew these “safe” structures. The world’s central banks, the Fed and the ECB, starting in 2008, pursued passively tight monetary policy, pushing aggregate demand down and damaging sovereign nation’s ratings and reputations. This cyclical side due to the global economic shock which we currently reside in, must also be understood alongside the structural shock of a lack of truly “safe” assets due to collapsing Japanese, and Southeast Asian markets in the 1990s. Asian country’s rapid growth in the 2000s outstripped “safe” assets just as did the U.S. housing bubble. Our current regression means the system of global financial repurchase agreements, or the repo market, does not have enough AAA-rated assets to go around. These AAA-assets, which before the crash were mainly MBS, are put up as collateral in repo agreements to secure the loan of the agreed upon securities (usually Treasury bonds), and formed a sort of depository for the shadow banking system. Of course we know these MBS put up for collateral were the worst tranches, containing only the riskiest mortgages. So with these assets out of the game, the whole medium of exchange has been cut down by more than 50%.

Beckworth does not make the point that AAA-rated assets are not the only way to ensure safety. Many of the now downgraded sovereign debts have hedged the risky European debt with credit protection through credit default swaps. Also the glut of AAA-rated assets in the 2000s was not only useful to the shadow banking system but in banks as storage to avoid the Basel capital requirements. Seeing as new, higher capital requirements from the Basel III banking regulations are now in effect for 2012, I think AAA-assets will be in even more demand. If the Eurozone crashes and burns, it puts yet more pressure on U.S. Treasuries to pick up the gaping slack.

In happier news, Spain is heading to complete oblivion as unemployment rises above 23% and meanwhile Greek unemployment hits 18%, the diaspora has begun, and suicides have risen dramatically.


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