Saturday, July 2, 2011

Disclosure and the hunt for yield

A Telegraph article reported on the Bank of England's Paul Fisher's speech in which he discussed the implications for financial market stability from investors hunting for yield in a low rate environment.

As predicted under the FDR Framework, investors are crowding into those assets where they have access to all the useful, relevant information in an appropriate, timely manner.  Included in these assets are debt with government guarantees and high grade corporate bonds.

Mr. Fisher is concerned that as spreads on these assets tighten to pre-credit crisis levels, investors will turn to securities they do not understand to pick up additional yield and this will in turn create financial instability in the future.

This is ironic.

At least in the US, it is an explicit goal of zero interest rate policies to force investors into riskier assets.  The Fed has gone so far as to reduce the supply of risk-free assets by purchasing treasury securities.  By doing so, they have artificially depressed the yield across the entire treasury yield curve.

This mis-pricing of the risk-free rate carries over to all other debt securities.  As the spreads over treasuries on these other debt securities return to their pre-credit crisis level, this is an indicator that these debt securities are over-priced.


Because the mis-pricing of the risk-free securities is now embedded in the pricing of the other debt securities.  For example, say that under the Fed's policy the risk-free securities are trading for 0.25% less than they would without Fed intervention.  This same 0.25% is now embedded in the pricing of the other debt securities when their spreads return to pre-credit crisis levels (otherwise the spreads would be 0.25% higher than pre-credit crisis levels).

It appears that Mr. Fisher is making an artificial distinction by focusing only on those debt securities for which investors do not understand what they are betting on when the largest categories of debt securities are mis-priced too.
"Investors know – and must remember – that there is no such thing as a free lunch, and that additional return involves additional risk," said Mr Fisher, the Bank's executive director of markets and a member of its interim Financial Policy Committee. 
Intelligence gathered by the Bank has flagged up a "number of pockets of increasing risk appetite and a few specific markets which have been showing signs of excess," he said, with the trend most marked in the US. 
Investors are on the hunt for higher yields, or returns, against the backdrop of the massive emergency injection of liquidity into the financial system by the world's central banks. They [central banks] bought up government bonds in vast quantities, which pushed down the yields from these "safe" assets and encouraged investors to look elsewhere. 
The worry is that the lower yields on these traditionally low-risk assets is now coinciding with an apparent shortage of high-quality assets, therefore prompting investors to move into products where the risks are not so understood, Mr Fisher said in a speech to institutional investors released yesterday. 
Mr. Fisher's statement suggests that the stated intent of Fed policy poses risks to financial stability.  Having identified the risks, the question becomes what is the appropriate response by policy makers.  The choices include:

  • The Fed stops pursuing zero interest rate policies and the purchase of risk-free debt securities.  This will increase the supply to the market and ease the pressure to move into products where the risks are not understood.
  • Governments actually making sure that market participants have access to all the useful, relevant information in an appropriate, timely manner.
  • Reminding investors that the last time they purchased debt securities they did not understand, think sub-prime mortgage backed CDOs, they lost a bundle.
Mr. Fisher opts for reminding investors.
... "The combination of portfolio rebalancing and this reported shortage of specific high-quality assets might have wider implications for financial stability if it encourages investors to look for additional yield by moving into more illiquid products ... or into more complex products (which they might not fully understand)," Mr Fisher said. 
He highlighted exchange traded funds (ETFs), which are traded like shares. Their rapid growth has been characterised by "increasing complexity, opacity and interconnectedness, and ... if left unchecked, could grow to pose risks to the stability of the financial system", he said. 
It is not surprising that ETFs are becoming increasingly complex and opaque.  Wall Street is engineering them this way because they know that the regulators are not requiring that all the useful, relevant information be disclosed in an appropriate, timely manner.
However, the most immediate threat to markets was seen as problems around governments' debt and the potential impact on European banks.

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