Remember the Global Financial Crisis?! – Safe Assets and the Global Savings Glut
“Runnable debt” is effectively “money”, and it comes in many forms.
In its simplest form, such debt was produced by banks in the form of demand deposits.
What Are Safe Assets?
- No incentive to produce information about the asset
- Can also think of this as “no adverse selection”
- Not the same thing as “risk free” — this is tricky!
- Government bonds of stable countries
- Insured deposits in banks
- Private debt of third parties
- Government bonds of unstable countries
Why do we need safe assets?
- Investment portfolio for consumers, institutions, and other capital pools
- Collateral for financial transactions
These are the same functions we often ascribe to traditional money
The Global Savings Glut Hypothesis
Between 2003 and 2007, short-term interest rates in the United States increased, which would normally also increase long-term rates.
That didn’t happen. Ten-year rates stayed about the same.
Ben Bernanke proposed that one cause of this “conundrum” was a “global savings glut” (GSG) from emerging-market and commodity rich countries with large current-account surpluses.
Supply of Safe Assets
- Precious metals
- Debt and currency of stable countries: U.S., U.K., Germany
By 2007, we were running out of U.S. securities for to serve as safe assets.
- Insured deposits in commercial banks can act like safe assets… but there aren’t enough insured bank deposits.
When there is excess demand for something, we can expect somebody to try to make it.
“Manufacturing” Safe Assets
- The key principle is to use only part of an asset as collateral.
- A house is purchased for $1 million in cash. How safe would a security be that is based on getting at least $1,000 on that property? How much work would you need to do to figure that out?
- A large tech company has a market capitalization of $100 billion in equity, with zero debt.
- How safe would be the first $1 million of debt? The key here is to set the debt to value ratio low enough that nobody has an incentive to analyze default probabilities.
This is not the same thing as “default is impossible”!
Why do it this way?
- Risk that bank’s management makes a mistake and harms the rest of their business operations
- But since these assets don’t require maintenance – they just collect cash payments –you don’t need the bank’s management to be involved any longer
- If the value of the assets fall far enough, the special purpose vehicle has unique bankruptcy rules which are much cheaper than usual bankruptcy costs
Special thanks to Timothy F. Geithner (Lecturer in Management, Yale SOM, Former U.S. Secretary of the Treasury, Yale School of Management) and Andrew Metrick (Michael H. Jordan Professor of Finance and Management, Yale School of Management)
This entry was posted on 02/22/2016 by beckersbest. It was filed under Banking, education, Family Office, Investment Banking, Uncategorized and was tagged with agency risk, Ben Bernanke, debt, information insensitivity, investments, market risk, precious metals, risk free, safe assets, shadow banking, transactions.