Gary Gorton, who has written some very informative papers on the 2008 credit crisis, recently released a new paper on the safe assets share of total assets in the US economy. The basic observation is that, although total assets have exploded from 400% of GDP in 1952 to more than 1000% of GDP in 2010, the percentage of assets considered safe has remained very stable around 1/3 of total amount, including government debt (Treasuries), central bank liabilities (bank reserves), deposits and private sector debt (mainly MBS/ABS and high quality corporate debt). It seems that, despite the financialization and debt buildup of the economy in recent decades, only a certain part of assets (debt) need to be considered ‘safe’ (information insensitive) in order to facilitate transactions efficiently. During 2008, a large part of securitized assets considered safe, became information sensitive, lowering the transactions ‘multiplier’ and increasing demand for the remaining risk-free assets (mainly government liabilities in the form of Treasuries and bank reserves). Only when the government expanded the share of safe assets (by exchanging MBS for bank reserves, providing collateralized lending facilities which acted as a temporary asset exchange, expanding government debt and guaranteeing various private sector liabilities like MMMFs) did the credit crisis stop.

The following graphs from the paper are quite informative:

What is interesting is to try and do a similar exercise in the case of the Eurozone. The latter clearly faced a similar situation with bank credit increasing in risk (due to falling house prices) and demand for safe haven assets increasing. Unfortunately, not having a common government debt instrument backed up by the central bank (like in other countries) resulted in ‘asset selection’ with periphery sovereign debt becoming information sensitive and core countries securities acting as safe haven.

Assuming that private debt securities considered safe have probably not increased since 2009, we can look at the other available safe assets and their net change since then. I am assuming that ECB bank reserves/banknotes and core countries government debt (Germany, France, Austria, Netherlands, Finland) are safe assets, while periphery debt (Greece, Ireland, Portugal, Spain, Italy) moves to the risky assets category. Net loss is calculated with haircuts of 20, 40 and 60%. I am using the latest (24 April 2012) financial statement of the ECB instead of 2011 data to include the second 3-year LTRO (numbers in billion €):

One should bear in mind that a periphery bank can get hold of safe assets basically in the following ways:

  • Sell its own assets to a willing buyer in order to acquire bank reserves and/or core countries sovereign securities, which in the current market will only exacerbate the risky assets price fall.
  • Borrow secured or unsecured in the money markets, something which seems to be very difficult given the periphery banks balance sheet quality.
  • Borrow bank reserves from the ECB using risky assets as collateral. In this case, ECB performs an ‘asset upgrade’ without pressuring the underlying collateral market price.

As a result, the net change in ECB liabilities plays a crucial role, much more important than an increase in the total amount of low risk sovereign debt in the market. The net change due to the 3Y-LTROs is quite evident as well as the reason why they provided a near term stabilization in the money and bond markets. Nevertheless, the current market turmoil suggests that either a higher haircut (more than 40%) is applicable and/or that higher losses in bank private credit assets are expected (which is highly likely due to the deteriorating situation in most of the periphery countries, especially Spain).

A stronger supply of safe assets seems to be needed. A European Term Securities Lending Facility would probably be very effective, with the caveat that the ECB does not have a portfolio like the Fed’s SOMA, apart from the SMP assets. The problem seems to be that European sovereigns do not have a similar asset upgrade mechanism for their own debts which results in an endless vicious cycle of austerity.