PhD Economist Derp: Safe Assets
Safe assets represents yet another area of massive PhD Economist Derp.
As the ECB said in its review of the literature on safe assets:
The recent banking crisis was largely unanticipated, and has forced a major reassessment of views on risk creation during credit cycles.
At the risk of going down the rabbit hole, what did the PhD Economists find in this reassessment?
A novel insight comes from the recognition of a fundamental demand for safety, dis- tinct from liquidity and money demand, with a major role in shaping contracting and the structure of financial intermediation. This survey focuses on the nature and consequences of safe asset demand, in particular how it shapes the behavior of financial intermediaries, and encourages the private supply of (quasi) safe assets. This enables to understand financial innovation during the credit boom, when novel forms of tranching, funding and hedging were developed to satisfy a strong demand for safety. Ultimately, a critical issue is whether pressure for safety contributes to aggregate risk.
And how are safe assets defined?
Naturally, no asset is absolutely safe. We will use the term safe assets to describe unconditional financial promises with no credit risk, so that nominal repayment is certain. This defines as safe any debt issued or guaranteed by a “safe” government, implying a country with an own central bank, stable currency and good protection of property rights. Although the safe asset literature has so far ignored inflation risk, a low inflation environment presumably is a prerequisite for a safe asset.
So a “safe” asset is a thirteen week US Treasury Bill.
We define the safest privately issued claims as quasi-safe, implying that they have no credit risk outside of major crises. Most private quasi-safe assets arise in the process of inside money creation by private intermediaries, such as short term and secured debt. While generally safe, at time of systemic distress, these private assets lose their perceived safety and become rapidly illiquid.
We have now waded into massive DERP.
What would be an example of a quasi-safe asset?
While money claims with a government guarantee (including insured deposits) are safe and liquid, uninsured deposits are quasi-safe forms of immediate payment, and are accepted until banks become insolvent.
Private quasi-safe assets are safe and liquid only outside of systemic crises. The safest among non monetary private claims are repos, ranked by the quality of their collateral, followed by short term financial debt and money market fund shares. In the upper right quadrant are senior tranches of AAA asset backed securities, which were designed to be extremely safe but proved otherwise. [emphasis added]
The list of quasi-safe assets includes uninsured deposits that lose their value when a bank becomes insolvent and the senior tranches of AAA rated asset-backed securities which turn out not to be safe.
Maybe it is just me, but those quasi-safe assets created by the private sector don’t look like they are particularly “safe” if you are an investor who is looking for certainty in repayment “safe” assets are suppose to provide.
I will save the reader time and just say the PhD Economists pile the derp ever higher in their discussion of how the demand for safe assets drove Wall Street to create all those AAA-rated tranches of structured finance securities that subsequently blew up.
Sorry, but this story about the existence of quasi-safe assets is just not believable at any level. It is complete derp.
Regular readers are familiar with the Information Matrix.
Information Matrix
| Does Seller Know What They Are Selling? | |||
|
Does Buyer Know What They are Buying? |
Yes | No | |
| Yes | Perfect Information | Antique Dealer Problem | |
| No | Lemon Problem | Blind Betting | |
Both uninsured deposits and AAA-rated tranches of structured finance securities are examples of investments found in the Blind Betting quadrant. They are sold based solely on a story Wall Street tells. While investors are suppose to Trust, but Verify, the opacity of these investments prevents an investor performing their own risk/return assessment of these securities.
This opacity also means if the valuation story of these assets is ever called into doubt, there is no logical stopping point in the downward valuation of these assets other than zero. Hence, these assets are the very definition of what an investor who is looking for certainty of repayment should never buy.
At this point, it is time to banish the notion of “safe” assets from the Economics profession’s vocabulary. It only confuses Economists.
Instead, we should stay with Finance 101 and the idea assets range from “low” risk to “high” risk.
The Blind Betting quadrant investments Wall Street sells have high profit margins for a reason: Wall Street is hiding “high” risk in an opaque investment and telling the investors a story where the investment is valued as being “low” risk.
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