Evan Soltas
Apr 12, 2012

Safety Dance

There is also a shortage of mid-risk assets. And it matters.

Paul Krugman sends us to the Financial Times this morning with news on the safe asset shortage, which I mentioned in a post last week. David Beckworth has an excellent and broader treatment of the subject here, too.

But we should also look at the changing conditions for riskier assets. As important as the safe asset shortage is to capital market efficiency, the shortage of mid-risk investment opportunities is devastating. Unlike safe assets, riskier-asset markets that work well are important for private-sector growth, as corporations rely on them to hire, meet payroll, create inventories, and expand production. All the things that we'd need to see for an "investment" recovery in national output figures.2008 was a balance sheet recession. That should be crystal-clear from the chart. Asset values -- and this is almost entirely in corporate real estate -- plummeted. Corporations reduced their liabilities, but more importantly, they've held down liability growth as they try to return to higher net worths. This has been somewhat facilitated by rising valuations of their real estate holdings, but notice that liability growth remains well below trend.

And remember: your company's liability is my business or my asset.

This matters because in a healthy mid-risk capital market, assets and liabilities grow in tandem as companies invest, which accrues liabilities but also increases their asset base.

It's not an issue of companies sitting on cash, either. Cash holdings have grown -- witness Apple -- but they constitute a tiny fraction of corporate assets: 2 percent.No, the story here is that corporations have plowed their record profits into deleveraging.

That, unfortunately, is making the problem worse, in essence. Deleveraging eliminates liabilities for the corporation; however, it also reduces one-for-one the amount of mid-risk assets available.This graph shows us the extent of the deleveraging. After the dot-com bust, mid-risk assets clearly shifted from commercial paper to mortgages, as firm cut down on their liabilities in the former and transferred to the latter. This has put the entire weight of mid-risk asset creation on corporate bond issuance, which really can't cover the replacement needs in this category.

We could be sure something like this was happening, say, if we saw that BBB-rated bonds were returning far more than AAA-rated bonds, but even as risk decreased, the riskier asset prices remained high -- that would be a supply-and-demand for assets story. And that, of course, is what has happened.