Brad Setser

Brad Setser: Follow the Money

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Good thing that there are plenty of Agencies left …

by Brad Setser
May 30, 2007

Since it sure seems that there aren't many 3 to 10 year Treasuries still floating around for central banks to buy.  Central banks have already bought up most of the stock!

The US clearly has — thanks to the government sponsored Agencies — a comparative advantage turning mortgages into something that can be sold to foreign central banks.  The increase in central bank Agency holdings so far this year has been breathtaking.  Look at the Fed's custodial data.  There is a lot of money that has to go somewhere.

I personally was pleased by the Bloomberg story for another reason: it confirmed something that Elisa Parisi-Capone and I argued last year, namely that central bank demand isn't limited to the short-end of the Treasury curve.   When the details of the 2006 survey come out, we will have to update our analysis.

The fact that central banks aren't just buying Treasuries — in part because the US isn't, in a sense, issuing enough to meet demand, in part because central banks want a bit more yield — does make it somewhat harder though to estimate how central bank demand is influencing the US interest rates.  Warnock and Warnock used to adjust for custodial bias by looking at total foreign demand for Treasuries, as they argued a lot of bonds were buying bought through London custodians and other intermediaries for central banks.   They were right, but that adjustment alone won't work now that foreign custodians are buying a lot of Agencies and other bonds for official investors.   Looking at all foreign purchases of bonds — and then trying to estimate the share coming from central banks — presumably would still work.   

I don't think central banks are behind every move in the Treasury market.  But I do think that they are one big reason why Treasury yields have consistently been below what most models would predict.

8 Comments

  • Posted by Guest

    and CDOs too…

    CDO Boom Masks Subprime Losses, Abetted by S&P, Moody’s, Fitch
    http://www.bloomberg.com/apps/news?pid=20601009&sid=ajs7BqG4_X8I

    The three leading rating companies, all based in New York, say that policing CDOs isn’t their job. They just offer their educated opinions, says Noel Kirnon, senior managing director at Moody’s.

    “What we’re saying is that many people have the tendency to rely on it, and we want to make sure that they don’t,” says Kirnon, whose firm commands 39 percent of the global credit rating market by revenue.

    S&P, which controls 40 percent, asks investors in its published CDO ratings not to base any investment decision on its analyses. Fitch, which has 16 percent of the worldwide credit rating field, says its analyses are just opinions and investors shouldn’t rely on them.

    Joseph Mason, a finance professor at Philadelphia’s Drexel University and a former economist at the U.S. Treasury Department, says the ratings are undermined by the disclaimers. “I laugh about Moody’s and S&P disclaimers,” he says. “The ratings giveth and the disclaimer takes it away. Once you’re through with the disclaimers, you’re left with very little new information.”

    [...]

    Credit rating companies help the financial firms divide the CDOs into sections known as tranches, each of which gets a separate grade, says Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia University in New York.

    Credit raters participate in every level of packaging a CDO, says Calomiris, who has worked as a consultant for Bank of America Corp., Citigroup Inc., UBS AG and other major banks. The rating companies tell CDO assemblers how to squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings, he says.

    [...]

    CDOs have been a bonanza for the rating companies. In the past three years, S&P, Moody’s and Fitch have made more money from evaluating structured finance — which includes CDOs and asset- backed securities — than from rating anything else, including corporate or municipal bonds, according to their financial reports.

    The companies charge as much as three times more to rate CDOs than to analyze bonds, published cost listings show. The companies say these fees are higher because CDOs are so complex compared with a single bond…

  • Posted by Guest

    Chanos, Betting Against Buffett, Sells Moody’s Short
    http://www.bloomberg.com/apps/news?pid=20601087&sid=af__shnh8Zw8

    James Chanos, president of Kynikos Associates Ltd., is bearish on Moody’s Corp., the bond rating company whose biggest shareholder is Warren Buffett.

    Kynikos sold Moody’s stock short, betting it will fall, Chanos said today. He said Moody’s may face lawsuits for keeping its ratings of loans to the riskiest home borrowers too high.

    “That’s a ticking time-bomb,” Chanos, who oversees $4 billion at Kynikos, said in an interview in New York.

    Buffett’s Berkshire Hathaway Inc. owns 48 million Moody’s shares, valued at $3.39 billion, giving it a more than 17 percent stake. Berkshire spent $499 million to buy those shares, according to the company’s annual reports. Given the potential problems ahead for Moody’s, maintaining that stake may be ill- advised, according to Chanos.

    “Warren Buffett makes mistakes, too,” Chanos said…

    Chanos, 49, one of the first investors to raise questions about Enron Corp.’s accounting, said Moody’s is “integrated into the whole underwriting cycle of structured finance,” or bonds based on the repayment of mortgages and other loans. “We believe they and the other rating agencies have been reticent to downgrade anything.”

  • Posted by Emmanuel

    I applaud the efforts of various economists in applying econometric modeling to how much bond yields have been depressed by CB buying. However, I do think that the effects of central banks pulling out would be more pronounced than what the models generally indicate (around 0.60%-1.00%). It’s that old bugbear of sentiment as everyone starts fleeing USS Debtlandia that suggests to me that the effects would be greater, much greater.

    Can it happen? Let’s see what occurs if Congress slaps the likes of Ryan-Hunter or Grassley-Baucus-Schumer-Graham on China. It should be interesting, to say the least. As Marvin Gaye used to sing, “Let’s Get It On.”

  • Posted by Guest
  • Posted by Guest

    ” I don’t think central banks are behind every move in the Treasury market. But I do think that they are one big reason why Treasury yields have consistently been below what most models would predict. ”

    CBs are buying treasuries because they have the money to do so. They have the money because they intervene in FX markets. They intervene in FX markets in large part because of current account surpluses and/or hot money inflows.

    This is a significant chain of causation and consequences. You can’t explore the question of CB effects on interest rates separately from the existence of the other preconditions. The hypothetical of CBs not buying treasuries should really consider that the rest of the world would almost certainly be very different as well if this were the case – there is considerable potential for models that are quite naive in this regard and that overstate the case as a result.

  • Posted by madphycom

    Mr. Sester,

    Saw you on AEI Forum on the Falling Dollar; you did well…what were you impressions? Did you know any of those asking the questions?

  • Posted by bsetser

    madphycom — thanks. appreciate the review. i wasn’t 100% happy with my performance — it was a hard audience to read, and i wasn’t entirely sure if “visual aids” would work or not, given the format. I was glad Ken Rogoff challenge Anne Krueger on the returns on investing in the us … better him than me.

    of the questioners, i only knew one (robin brooks of goldman — an ex-imf economist) — and I know him far less well than I know ted truman (IIE, ex-treasury, ex-fed)

  • Posted by gab

    Emmanuel said, “Can it happen? Let’s see what occurs if Congress slaps the likes of Ryan-Hunter or Grassley-Baucus-Schumer-Graham on China. It should be interesting, to say the least. As Marvin Gaye used to sing, “Let’s Get It On.”

    I think, to some extent, the possibility of the above is getting priced into the credit markets now. Yields have rallied substantially, and have been explained away by “strong” economic numbers in the US, but the reality seems to be something going on below the surface, and protectionism seems like a likely candidate for the blame.