BEWARE OF PERCEIVED SAFE HAVENS / THE FINANCIAL TIMES MARKETS INSIGHT ( A MUST READ )

Last updated: July 27, 2011 11:04 pm

Beware of perceived safe havens

By Richard Milne

Risky assets do not cause crises. It is those perceived as being safe that do.


Such a statement might sound counter-intuitive. However, it reveals much about the current crisis as well as the recent past. The subprime crisis of 2007-08 was exacerbated by the fact that so many of the mortgage-backed securities spewed out by banks were rated triple A. That meant they could essentially be considered “risk-free” for banks, when, of course, they were anything but.


“Follow the money” might have been the mantra for Bob Woodward and Carl Bernstein in investigating the Watergate scandal. But “follow the debt” would be a better way of summing up where investors should be looking for the next bubble.


And that all points to government debt, which is following in the footsteps of emerging markets, corporates, banks and consumers over the past 15 years. The sovereign debt crisis is not just limited to the eurozone but may spread throughout the developed world. That risk is evident in the fact that government debt has become the triple A asset of choice since the credit crisis. It has gone from representing about 10-15 per cent of total securities issued over much of the past decade to 35 per cent in 2009.


The danger behind this is that current and future banking and insurance regulations place triple A rated issuance, particularly from governments, on a high pedestal as the risk-free asset. Financial institutions complain, often discreetly, that they are being forced to buy assets they don’t want to.


But the fact that regulators have pushed them into buying triple A government debt means the fallout from the current sovereign problems in Europe and the US would quickly spread throughout the entire financial system.


The scale of the problem is highlighted by a recent report from the Bank for International Settlements, spotted by my colleague Tracy Alloway. It revealed how asset-backed securities accounted for about two-thirds of the explosive growth in triple A securities between 1990 and 2006. In all, triple A issuance went from representing about 20 per cent of all securities in 1990 to 55 per cent in 2009, helped by the big rise in government debt. The push by regulators for banks and insurers to own sovereign debt leaves a sour taste in many people’s mouths, even being likened to “premeditated theft” by professor Geoffrey Wood of Cass Business School. At the very least, it looks odd to force financial institutions through rules to buy assets from the countries that helped draft those rules.


The problem for banks stems from the Basel II regulations from 2004. In the words of one banker, they “empowered rating agencies beyond their wildest dreams”. The rules allow banks to set aside no capital for any sovereign debt rated above double A minus. Even for debt rated below that, if it is the debt issued by the country where the bank is based, there is “national discretion” to apply a lower risk weighting.


To be fair, regulators on both sides of the Atlantic are trying somewhat to reduce the reliance on ratings in the new regulations being published. The Dodd-Frank laws in the US require regulators to reduce their reliance on ratings, raising questions about whether the Basel rules can be introduced there. In Europe, the European Commission announced a similar desire to cut the dependency on ratings this month as it presented its plan to introduce Basel III rules.


But it is clear that ratings will still play a big role with triple A debt the star. For instance, Basel III’s rules on liquidity say that so-called level 1 assets – the highest-quality ones – can include anything given a zero risk weighting by Basel II as well as domestic government debt.


Solvency II, the new regulations for insurers, takes a different approach but ends up in a similar place. It forces insurers to mark their liabilities against a risk-free rate, essentially derived from government borrowing costs. This, in turn, forces them to invest in sovereign debt as, if they don’t, there would be huge volatility between the valuation of their assets and liabilities, leading to big rises and falls in an insurer’s capital. The new rules also make insurers set aside more capital for what are deemed to be riskier investments, heightening the push to buy government bonds.


All this makes the consequences of any “safe asset” blow up all the more serious. Regulators have assigned higher risk ratings to activities such as providing loans to small and medium-sized businesses in a move likely to put a brake on bank lending.

But by favouring triple A government debt they are increasing the risks throughout the financial system as well as in the sovereign bonds themselves by allowing governments to increase their debt burdens so cheaply. The nervousness over a potential US downgrade shows the potential for trouble should this risk-free illusion be shattered.
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Copyright The Financial Times Limited 2011