Or perhaps – with a bit of reverse financial engineering – into “apples, pears, strawberries and all the rest.” 

Martin Wolf is the latest observer to note that the US has created a lot of financial lemons that left a sour taste in the mouths of investors around the world.   Lemons that have prompted policy makers around the world to seek a bit more say in how the US regulates its financial markets. 

And lemons in the economic sense as well.   

Buyers of used cars have to worry that the original owner is selling the car because the seller knows that the car has problems – and since the seller knows more about the car than the buyer, the risk that the seller is trying to pass on a lemon inhibits transactions.   Buyers of used securities apparently have similar concerns about a lot of complex financial products.  Martin Wolf writes:

What is driving this is “asymmetric information”: buyers believe sellers know more about the quality of what they are selling than they themselves do. This seems to be precisely what has now happened to trading in certain classes of security. The crisis is focused in markets in structured credits and associated derivatives. The cause seems to be rampant uncertainty. Investors have learnt from what happened to US subprime mortgages that these securities may be “weapons of financial mass destruction”, as Warren Buffett warned. With the suckers fled, the markets have frozen. The people who created this kind of stuff distrust both the instruments and their counterparties.

That distrust is one reason why the stock of outstanding money market instruments has shrunk by close to $250b — an amazing number — over the past three weeks. 

I suspect – and I am certainly not an expert on this, only an interested observer – that a lot of this complexity is central to a certain part of the securitization process. 

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Josef Joffe:

[Can Moscow and Beijing] mend a global financial system battered by subprime crisis?   Where are the central banks of Russia and China? 

Hmmm.    The fact that China and the oil exporters are running a large current account surplus does – in a lot of ways – help to explain why so much credit was available for so long for so many Americans looking to buy homes.   At the same time, I am not sure that Russia and China can really do much to solve the subprime crisis.  It, after all, stems from a combination of over-indebted US households that no longer can make mortgages payments and a crisis of confidence in US financial engineering.

But credit should still be given where credit is due.  Russia’s central bank has helped, in its own small way.  Its willingness to sell dollars and euros over the past two weeks helped foreign investors take some risk off the table, and in the process, helped supply liquidity to the market.   

China is also helping, though in a different way.   Its banks clearly will be absorbing some of the losses from subprime.   SAFE likely will absorb some losses too – though we don’t yet know how much.     

I have spent a bit of time recently trying to guess China’s subprime exposure.    The three big Chinese state commercial banks have disclosed about $12b (11.94b to be exact) in subprime exposure (BoC has the most exposure, but also the most foreign debt).    

These three banks collectively held – at the end of 2006 — $155b in dollar denominated securities and $199b in foreign securities.  That works out to almost all of the $228b in “private” Chinese holdings of debt securities that show up in China’s net international investment position data.   

In addition to holding a fair amount of subprime exposure, they also likely have a lot of exposure to “prime” US mortgages, and probably a range of other US assets as well. 

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A sage commenter once suggested that this blog should be titled follow the money – since it has focused, more than anything else, on trying to understand how the US finances its large current account deficit. 

About two years ago, that quest took me to the world’s oil exporting economies.  In 2005 and in 2006 their external surpluses topped China’s surplus, and they added more to their reserves and official assets than China added to its reserves and investment funds.    China will regain the lead in 2007 – the oil exporters cannot match half a trillion dollars.   But they still have a lot of cash to invest.

The US data – whether the TIC data or the survey data – doesn’t really tell us much about what the oil exporters are doing with their money, or rather it tells us that they are investing the funds in ways that don’t register in the US data. 

But over time,  the flow of petrodollars has started to make some sense.

We know for example, that Russia’s central bank manages Russia’s oil fund.  While Russia has dramatically reduced the dollar share of its reserves, even 50% of $400b plus works out to a substantial sum.  Russia, though, has invested its dollars and euros very, very conservatively.   That may change next year, when Russia’s stabilization fund is split into two.      

Other oil exporters — Libya for example – have also been fairly conservative.  Libya seems to have a lots of funds on deposit in Europe.

But setting Russia aside, the really big money is in the Gulf.   And thanks to the reporting of the Wall Street Journal's  Henny Sender and a nice synthesis piece by James Mawson and Renée Schultes the way the Gulf manages its money is starting to come into better focus. 

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The recent custodial data from the Fed leaves no doubt that foreign central banks have dramatically reduced their Treasury holdings in August.    Thanks to Russ Winter, I realized that the New York Fed reports two numbers for foreign custodial holdings – the average holdings over the course of the week, and the number on the end of the (reporting) week.   Using the end of week data, the Fed’s custodial holdings of Treasuries fell by $44.2b from August 1 to August 23.   That’s big.    Most of the fall came in the past two weeks. 

Custodial holdings of Agencies rose by $12.6b – offsetting some of the fall in Treasury holdings.   But overall central bank custodial holdings still fell significantly – by close to $30b.   That hasn’t happened for a while.

And, obviously, central banks reduced Treasury holdings didn’t exactly imply reduced demand for Treasuries.   Treasury yields fell (and prices rose).  The ten year yield fell from 4.8% or so to 4.6%; T-bill yields went from around 5% to around 4% with a little detour down to 3% on Monday.

That, on the surface, seems like a refutation of the argument that central bank demand has played a key role in keeping Treasury yields down over the past few years. 

So what is happening?

Well, there obviously has been a bit of a liquidity crisis, as investors lost confidence in a lot of CDOs — and financial firms that borrowed in the money market to purchase CDOs.   The total stock of outstanding commercial paper fell by about $200b over the past two weeks – and a lot of money that wasn’t reinvested as commercial paper matured seems to have flowed into the Treasury market. 

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Christopher Swann of Bloomberg noticed the line in the IMF’s most recent Article IV report indicating that senior US officials objected the IMF’s conclusion – based on their model for equilibrium real exchange rates – that the dollar is overvalued (hat tip, Naked Capitalism).

Swann quite rightly notes that the US is shooting itself in the foot.   The US – led by former Treasury Under Secretary Tim Adams and his deputy for IMF affairs Mark Sobel  – spent a lot of time trying to get the IMF’s surveillance to focus more on exchange rates.   That was the right thing to do as well. 

But if the US government isn’t prepared to accept that the IMF’s assessment that the dollar is overvalued, China certainly isn’t going to accept the  IMF’s assessment that the RMB is undervalued.    

Now the US will likely argue that it argued that the dollar’s value is determined in the market, while the RMB’s value is not.   Thus, the IMF’s model is far more germane for China than the US.

Swann reports

Treasury officials criticized the IMF analysis for relying too much on trade in goods and services and not enough on capital flows. While the U.S. has run record trade deficits in recent years, foreign capital also continues to flow into the country at an even stronger rate.  The Treasury also was “skeptical about the notion of overvaluation for a market-determined exchange rate such as the dollar,'' the report said.

But, alas, while the value of the dollar against say the euro is determined in the market – albeit a market shaped by the portfolio decisions of China and a host of oil exporters – the dollar’s value against the RMB and a host of emerging currencies is not set in the market. 

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John Cassidy is right.  The leading US export to China is high-quality housing debt.  

The toxic waste generally went elsewhere – thought there are now hints that China (perhaps the state banks) may have bought a few triple AAA rated CDOs composed of the tranches of subprime-mortgage backed securities.   We just don’t quite know much of this ended in China  — or where the rest went. Elsewhere in Asia?  Europe?  US hedge funds? US money market funds? 

But we do know that China provided – through its purchase of Agency bonds and other mortgage-backed securities – an awful lot of credit to American households over the past two years.

Consider the period from the end of June 2005 to the end of June 2006. 

During that period, the US sold – according to the BEA — $48b of goods to China.

That total was dwarfed by the $83.5b of Agencies and $22.5b of long-term corporate bonds that China bought.  “Corporate” debt includes mortgage-backed securities that do not have an Agency guarantee – and China is widely thought to have been a big buyer of these securities.  Combine Chinese Agency and corporate bond purchases together, and it is not all together out of the question that China bought $100b of US housing debt between mid-2005 and mid-2006.   Most of this was the still-good stuff, not subprime.

We know, for example, that China bought as many — $51.5b — of MBS backed securities with an Agency guarantee (Agency MBS, a subcategory of Agencies) as it bought US goods. 

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The process that turned subprime mortgages into triple AAA rated securities is, by now, pretty well known.   Rich Bookstaber (his blog is here) describes the process nicely.

Here's the recipe for a CDO: you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches. Then, you pay to play. Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be — some are not even investment grade. The assumption has been that even if the toxic waste bonds really stink, the quality tranches can keep the CDO above water. And life goes on.

The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds. 

Nouriel is characteristically more blunt.  He concludes a recent post on the securitization of subprime lending by noting:

That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.

One of those unlikely places is the money market.   Perhaps not directly — but it sure seems like a lot of financial firms issued commercial paper to finance what look like mini-credit hedge funds.   Blogger RIIP:

Banks, investment banks, hedge funds, and PE firms have been issuing commercial paper as funding for carry trades. They put in capital of $100, borrow $2,000 in CP, and invest the proceeds in higher yielding stuff: CDOs, MBS (including sub-prime) and other ABS. So, sports fans, this is why we are all rushing to call our Schwab brokers and blowing out our cash sweep accounts and other money market funds as though they were leveraged Egyptian equity funds. The (ex-)masters of the universe were using the commercial paper market – formerly a way for quaint old fashioned “companies” to get short term funding – as financing for leveraged carry trades. Now some of these conduits (also known as SIVs, structured investment vehicles) may be related to the bank’s operations (e.g., a bank makes mortgage loans and then sells them to the off-balance sheet conduit) but .. a lot of these vehicles … look suspiciously like off-balance sheet credit hedge funds.

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The dollar rallied a bit last week, but nothing like the yen.

The Wall Street Journal’s Mark Whitehouse conflates – at least in my view — deleveraging with safe haven flows.   

Deleveraging means that you borrowed dollars to buy something else and now need dollars to repay your debts.   Folks who borrowed yen (and dollars) needed to buy yen (and dollars) to pay their creditors back.   Safe haven flows by contrast imply that you own assets denominated in another currency and, in times of stress, would rather hold dollars.

I would interpret the dollar’s rally against most emerging currencies and the euro is a sign that the dollar was, along with the yen, a rather popular “funding” currency for a host of carry trades.   The dollar was just in the rather strange position of being a destination currency for some yen carry trades even as it was a funding currency for a host of other trades. 

The headline of the Journal’s story consequently seemed off to me.   Saying “Foreign investors view the dollar as a refuge currency in times of stress” suggests that there was a surge in foreign demand for US assets from investors who hadn’t previously borrowed dollars to buy other assets.   I am not sure that was the case.   

The defining characteristic of the US credit market last week was that there simply wasn’t any demand – whether foreign or domestic – for a host of US dollar-denominated bonds (Treasuries are an obvious exception).   That is why the Fed cut the discount rate, and why some hedge funds may give their funding banks bonds to exchange for cash at the discount window. 

So where did the demand for dollars come from?   My guesses would include:

• Investors who borrowed dollars and invested in higher yielding currencies were forced (or opted) to cut back on their bets.
• Investors with profits on their bets on emerging market equities wanted to either lock in their profits or raise cash – cash that they needed to cover losses elsewhere or to meet potential redemptions (see Jenny Anderson of the New York Times)
• European banks who had set up conduits and SIVs (think of them as minature credit hedge funds) couldn’t roll over their dollar denominated commercial paper, and had to borrow from their parents.   If they borrowed in euros, they needed to trade those euros for dollars to repay their dollar denominated liabilities.

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Yves Smith of Naked Capitalism is right – If Gillian Tett of the FT disappeared, we would be in a whole lot of trouble. I wouldn’t be surprised if a lot of central bankers rely on her reporting to understand developments in the arcane parts of the credit market almost as much as I do.

Her coverage of conduits and SIVs – basically mechanisms for banks to borrow short and lend long, but to do so in the modern “off-balance-sheet” and acronym-intense way – has been absolutely invaluable.

The troubles with these vehicles – it turns out that some of the acronyms they bought may not be worth quite as much as they paid, that the acronyms are difficult (if not impossible) to sell right now and that at least some of the money market funds who previous lend money to these “vehicles” would rather not continue to finance them – explain a large part of the recent liquidity crunch.

Tett, Davies and Cohen earlier this week:

“regulators are scrambling to understand what is happening in structured investment vehicles (SIVs), a breed of often huge, mainly bank-run, programmes de­signed to profit from the difference between short-term borrowing rates and longer-term returns from structured product investments.These have proliferated in recent years and control assets worth hundreds of billions of dollars.

Depending on whether they are fully rated by credit rating agencies and on how strictly they have to conform to certain rules, they are known as SIVs, SIV-lites, or conduits.They are typically quite opaque, invest in complex securities and often do not need to be displayed on a bank’s balance sheet.It seems they have played a key role in last week’s liquidity crunch. ….

These programmes typically invest in credit market instruments, such as US subprime mortgage-backed bonds and collateralised debt obligations. These assets tend to be the highly rated, supposedly safe versions of such debt, but in the recent fear-driven turmoil have shown just how illiquid and hard to value they can be.

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There clearly has been a flight to liquidity recently.  T-bill yields have collapsed (See the Econocator).   Perhaps because of the Fed.  Perhaps because folks are hoarding cash and nothing that pays interest is as close to cash as a T-bill.

And a rather significant unwinding of the carry trade.   The Icelandic krona has fallen by more than 15% against the yen.   The Kiwi has also sold off.   Ms. Watanabe didn’t step up to dampen this bout of volatility … 

The yen has rallied.  Significantly.  That makes sense.  It was a big funding currency.   And if credit is no longer going to be quite as readily available to finance deficits, the currencies of countries with current account surpluses are – one assumes – safer than the currencies of countries with large deficits.

Most big deficit country currencies are falling: the Australian dollar, the British pound, the Turkish lira as well as the Icelandic krona and the New Zealand dollar. 

But the currency of one deficit country – the United States dollar — also rallied.  

No matter that that the origins of this particular crisis are clearly in the US – and in the one area of the finance (turning subprime mortgages into triple AAA credit through financial engineering) where the US unambiguously had a comparative advantage.    A couple of weeks ago the IMF even argued – in its summary of the staff papers that accompanied the Article IV — that the United States’ unique ability to create complicated financial structures would continue to pull funds into the US, and thus help finance the US current account deficit. 

“Many industrial countries still have much to gain from further international diversification.  Combined with innovative US fixed income markets providing many assets that simply are not available elsewhere this suggests … that a significant fraction of industrialized countries funds …will be directed toward US fixed income assets.”

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