Risk and the Dollar: Brad Setser Muses
Brad Setser writes:
http://www.rgemonitor.com/blog/setser/207738: The original idea behind all of my efforts to track reserve growth was to get some advance notice if central banks ever decided to turn away from US assets. That hasn't happened; all available data suggests record official demand for US assets.... The markets haven’t seized up because central banks stopped buying dollars, or stopped buying dollar-denominated bonds. Rather, they have seized up because a lot of private investors who had reached for yield over the past few years, in part because central banks drove down the yields on “safe” assets as well as contributing to a fall in market volatility, seem to have reached a bit too far....
Mohammed El-Erian puts it well. For a while, “individual investors' performance was essentially a function of the degree of their exposure to the most illiquid and leveraged asset classes.” That naturally created pressure to take on more leverage to buy more illiquid assets. Things now have changed. Lots of subprime mortgages were bundled into mortgage backed securities and various tranches of different mortgage backed securities in turn were bundled together in often illiquid CDOs. Some of those CDOs were bought with borrowed money. That turned into a problem.... More recently demand for LBO debt disappeared, in part because of concerns that some companies may be taking on more debt than they could service.... [T]o quote PIMCO's Bill Gross, the market resembles a constipated owl.
To be blunt, they seem to be thinking that if Moody’s and Standard & Poor’s have done such a lousy job of rating subprime structures, how can the market have confidence that they’re not repeating the same structural, formulaic, mistake with CLOs and CDOs? That growing lack of confidence – more so than the defaults of two Bear Stearns hedge funds and the threat of more to come – has frozen future lending and backed up the market for high yield new issues such that it resembles a constipated owl: absolutely nothing is moving.
Felix [Salmon] notes that the fact that a lot of the new instruments that emerged to satisfy investors demand for yield back are untested isn’t evidence that they are unsafe. All new instruments by definition haven’t been tested. But it still seems to me that the market for a lot of instruments that hadn’t been tested by a downturn got really big really fast. Right now that worries me more than the risk that central banks will suddenly lose their appetite for all dollar assets...
