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Too Chinese (and Russian) to fail?

by Brad Setser
July 12, 2008

The epicenter of the US financial crisis now seems to have shifted to Fannie Mae and Freddie Mac — the government sponsored enterprises that dominate the market for US housing finance. Few institutions matter more for the US economy. They currently buy or guarantee an astonishingly high fraction of all new mortgages in the US. Absent that financing, home prices would fall further — dragging down the value of a lot of the “private” mortgage-backed securities issued at the height of the crisis, and health of a lot of (troubled) private financial institutions.

But Fannie and Freddie aren’t just “too-big-to-fail” US financial institutions. Not anymore. They are now global financial institutions. They have been central to the process that has turned US mortgages into securities held by the world’s central banks. Official — meaning central bank — holdings of Agencies have soared over the past two years. The US “TIC” and survey data suggests that central banks now have at least $925 billion in “Agency debt.” That is almost certainly an understatement: the monthly TIC data tends to understate official purchases, leading to large revisions when the more accurate survey data is released in June. Total official holdings are likely above a trillion — or about 20% of the $5 trillion or so in Agency debt outstanding.

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As a result, the governments of China and Russia are now almost as exposed to the “Agencies” as the US government.

agencies-8.JPG

* This graph makes use of data collected by the CFR’s Arpana Pandey.

Consider the following:

China, according to the US data, has $422 billion of long-term Agency bonds. That is roughly 10% of China’s GDP. It is also almost certainly understates China’s holdings. Based on the pattern of revisions in past surveys and the scale of China’s foreign asset growth, I would guess that China now holds between $500 and $600b of Agencies — or about 10% of the outstanding stock.

Russia, according to the US data, holds $90 billion of long-term Agencies. Russia also has a large portfolio of short-term Agency bonds (with a maturity of less than a year). Based on past survey data, I would guess that almost all of Russia’s holdings of “other short-term negotiable securities, negotiable CDs and other custodial securities” are short-term Agencies. That brings Russia’s total holdings of Agencies up to $156 billion — or roughly 10% of Russia’s GDP (a bit more actually).

Japan, according to the US data holds $251 billion of Agencies — but not all of these are held by the Ministry of Finance and the Bank of Japan. Japan started shifting from Treasuries to Agencies in late 2005 or early 2006 (see the technical notes below, and note that official holdings start to grow faster than the sum of Chinese, Russian and Asian NIC holdings around this time). Japan still has far more (relative) exposure to the Treasury market than the Agency market. But Japan’s government also likely has around $150 billion of Agencies, a sum equal to about 3% of Japan’s GDP.

China’s exposure to Blackstone (bought for $3 billion, now worth less) and Morgan Stanley (bought at $5 billion, now worth less) pales relative to its exposure to the Agency market. China undoubtedly would view Roubini’s plan to force holders of Agency bonds to accept a haircut in return for a government guarantee as a policy directed at China. Sure, China would get a mark-to-market windfall if its Agencies became Treasuries (i.e. backed by the full faith and credit of the United States), but SAFE would argue that it plans to hold its Agencies to maturity in any case, so it won’t get more than the bond’s face value. I would certainly expect that Vice Premier Wang is on the phone to Paulson this weekend, politely asking how exactly the US plans to backstop the Agencies.

At Davos, former Treasury Secretary Summers noted — correctly — that accepting large capital infusions from sovereign funds into “private” US banks and broker-dealers meant that, should any such bank or broker-dealer subsequently collapse, its collapse would be a foreign policy issue. CITIC never made an investment in Bear, so that particular bullet was dodged — at least for now.

But the same point applies to the Agencies. The enormous increase in central bank holdings of Agencies has made their fate a matter of high politics, not just a debate over getting incentives right and good financial policy.

If — as I suspect is likely — the Agencies are too big, too important to the housing market and too Chinese for their debt ever not to be honored on time and in full, that has another implication:

China’s holdings of Agencies are effectively holdings of Treasuries, and China’s combined holdings of Treasuries total at least $924 billion. In reality, given the pattern of revisions and the scale of China’s reserve growth, its current holdings of Treasuries and Agencies now easily tops $1 trillion.

$1 trillion is roughly 25% of China’s GDP. That is a rather concentrated position. It shouldn’t be a surprise if China thinks it should have a voice shaping big US policy choices.

In some sense, it is remarkable that the system for channeling the emerging world’s savings into the US housing market – a system that relied on governments every step of the way, whether the state banks in China, that took in RMB deposits from Chinese savers and lent those funds to China’s central bank which then bought dollars and dollar-denominated Agency bonds, or the Agencies ability to use their implicit guarantee to turn US mortgages into a fairly liquid reserve assets — hasn’t broken down after the “subprime” crisis. The expectation that the US government would stand behind the Agencies is a big reason why.

That allowed the US government to turn to the Agencies to backstop the mortgage market once the “private” market for securitized mortgages dried up, as emerging market governments continued to buy huge quantities of Agencies.

And it now seems that this game will break down on the US end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.

History, it is said, rhymes rather than repeats. Bretton Woods 1 broke down because some key governments weren’t willing to import inflation from the US. Bretton woods 2 has survived — even intensified — the subprime crisis because many emerging market governments have preferred importing inflation to currency appreciation. China seems more worried about textile job losses than inflation, negative real returns on household deposits or the risk of financial losses on its (large) holdings of Agencies.

The costs of a system that channeled huge sums of emerging market savings into the US real estate market — contributing to a bubble in US housing that is now collapsing, at a significant cost to all involved (private market players who bet that housing would only go up, the US government, and emerging market governments who bet on the dollar) and now a surge in inflation in the emerging world — are now quite apparent. It has produced a massive misallocation of resources on a global scale. Nouriel is right. Emerging market savers will get a negative real return on their dollars because of the currency risk, and the US has over-invested in housing.

But the hard work of shifting to a new system likely will have to wait until the crisis in the current system is resolved.

Note: I updated the second graph to add in Japan’s holdings in a way that illustrates, I hope, why not all of Japan’s Agencies are held by the BoJ and MoF, and I also added a bit more in the text on Japan. See the technical notes for more on Japan. I also would recommend Dr. Hamilton’s post — he does a great of explaining the Agencies balance sheets and their role in the mortgage market. He is too much of a gentleman to note that the concerns he raised at Jackson Hole last summer look very prescient.

Update: Russia claims it has no exposure to Fannie or Freddie. If any one knows if there are enough Ginnie Mae and other bonds out there to account for Russia’s known holdings of “Agency bonds,” please let me know. The US TIC data doesn’t indicate which “Agency” debt Russia holds — and given the limits on the portfolio of Russia’s central bank, it wouldn’t surprise me if Russia preferred the bonds of those Agencies with explicit government backing.

Update 2: Russia only claimed that the reserve fund and future fund — which are managed by the central bank but technically are the resources of the Finance Ministry — don’t hold Agencies. The Central Bank itself reports holding $100 billion of Agencies in May, including Fannie and Freddie bonds. The US data suggests a higher number — $155 billion — at the end of April, but that higher total includes Agency bonds held by private investors and it is possible that Russia reduced its Agency holdings during May. As the graph below shows, it has been reducing its short-term Agency holdings recently.

Technical notes

I produced the data series for long-term Agencies by adding the monthly flows to the stock data in the survey. This risks over-counting Agency holdings, because the monthly flows only capture new purchases, not amortization payments on the existing stock. However, the TIC data consistently undercounts official purchases, so in recent years the survey has constantly revised official Agency holdings up not down. I have assumed that the majority of the Agency holdings of China, Russia, the Gulf and the Asian NICs are held by the central banks. Technically, though, the country data includes both official and private holdings and thus cannot be strictly compared to the official total. In reality, though, the majority of Agency holdings from these countries are from their central banks.

agencies-9.JPG

The other large official holder of Agencies is Japan’s Finance Ministry, which has been shifting from Treasuries to Agencies over the past few years. However, there are also large private holders of Agencies in Japan (adding Japan to the country total brings total holdings above official holdings) so I didn’t feel comfortable adding Japan to the country by country breakdown in quite the same way as the other countries.

A plot that shows the securities held by the MoF and the BoJ against Japan’s known US holdings of Treasuries and Agencies strongly suggests both that there are significant private holdings of both sets of assets in Japan and that there has been a reallocation of Japan’s reserve portfolio toward Agencies over the last couple of years.

agencies-7.JPG

Finally, many central banks do not manage their Agency portfolio “in house” as they prefer not to worry about amortization payments and the like. As a result, even the survey data likely understates true official holdings of Agencies.

There is no monthly breakdown of official holdings of short-term Agencies. Rather, the US reports data on official holdings of “other short-term negotiable securities, negotiable CDs and other custodial securities.” This data can be compared with official holdings of short-term Agencies at the time of the survey. I have assumed that the proportion of Agencies in the total is constant. That is a big assumption. I also filled in gaps in this data series. The “fill” is easy to spot, as I assumed Agency holdings increased in a straight line.

agencies-4.JPG

This is clearly an estimate – not a precise total. But often a down and dirty estimate is all that it takes to tell a story. And there is little doubt that Russia is a particularly big player in the short-term Agency market.

61 Comments

  • Posted by Rien Huizer

    We can only watch: if agency capital adequacy declines too much, either, someone adds capital, or not. If not, it depends on the US government to either bail out (nationalize or guarantee liabilities) Budget-wise, nationalization by injecting a lot of capital (if, indeed, neded) would be cheaper than guaranteeing. But guaranteing would be a stronger signl. And, since everyone has always believed that the US would not let the agencies go under, why not do something that leaves nothing on the table for management and speculators. Wipe out the shareholders, fire management, guarantee the current liabilities and establish a de novo entity with sufficient initial capitlization that is credibily uninsured, for the single purpose of profitably guaranteeing (1) new homes (2) first time buyers. That will not be good for the housing market but very good for the integrity of the financil system. Let’s face it families and houses come and go, but the financial system should be permanent, at least in a reserve currency country. No sacrifice should be too great.. I am not so sure tho my new entity would find any customers.

  • Posted by Rien Huizer

    Further, the international dimension of agency failure (I doubt that is imminent, but that is another strory) should be ignored. Foreigners are obsessed by greed and in their zeal to raise the yield on the nation’s portfolio, the heroic portfolio managers of China and Russia were alerted to the opportunities in the US agency market, by a reltive of m Mugabe, a Dilon Read partner who had not noticed that Paine Webber was acquired by the Swiss. Nevertheless it is not the duty of the US taxpayer (whoever that may be) to compensate the Chinese and Russians for mistakes committed while under the spell of said Mugabe, etc

  • Posted by JKH

    Very interesting post; one observation:

    “Sure, China would get a mark-to-market windfall if its Agencies became Treasuries (i.e. backed by the full faith and credit of the United States), but SAFE would argue that it plans to hold its Agencies to maturity in any case, so it won’t get more than the bond’s face value.”

    True, but SAFE will continue to earn the book spread of agency yields over treasury yields (on existing agency bonds) until maturity. If agencies become treasuries, that’s an economic windfall for the remaining duration of the bonds. This will show up in the price of the bonds because existing agencies will trade at premiums to treasuries if their book rates remain unchanged. The premium represents the windfall; new agencies by comparison will presumably offer rates equivalent to treasuries.

    Roubini’s argument was powerful as usual. But the conversion of agencies to treasuries actually eliminates a huge class of assets for which moral hazard was an open question due to the ambiguity of the government’s backstop position. That ambiguity will no longer be the case for this asset class, ex ante, whether or not there is an economic windfall on conversion, ex post. So his moral hazard risk concern partly depends on the continuation of other situations where the question still remains ambiguous and open to moral hazard exposure.

    In any event, pissing off China et al by forcing a purely economic conversion seems a bit risky at this juncture.

  • Posted by Missed Info

    But the hard work of shifting to a new system likely will have to wait until the crisis in the current system is resolved.

    are you certain we will get a chance?
    isn’t the current crisis the direct result of old system unable to function any longer? In which case resolving the crisis may actually mean moving to a new system.

  • Posted by Rien Huizer

    Well, not letting the agencies fail (and who knows how far they re from failure) might have the unintended consequence of investors (including the Chinese but also some very unpleasant non-Chinese people participating in some odious off shore fund) getting a better investment than they bought. That would not diminish or jeopardize the intended effect of preventing a systemic crisis. However, despite agreeing with government assistance (and naturally, only to creditors), I do not agree with ongoing government risk support for housing. (1) there is plenty of housing in the US already (possibly in the wrong place etc, but..) (2) it distorts the incentives of all parties involved. And if the agencies (as GSE’s) are not special class of guarantor (immune to bankruptcy), what re they? Why would people accept that gurantee, if it was not for the rather common belief that the gvt will prevent the GSEs from defaulting. So the idea to put the old guarantees in a “bad bank” and go on with something that is credibly uninsured is good for creditors and taxpayers (in the short run). How to finance the stock of unsold houses is a problem for the developers, as unsold cars are for manufacturers. One could consider the posibility that presently insured homebuyers tranfer their financing (cum guarantee) subject to conformity of course, to their successors in the same house. That might in fact mak the bad bank better. Government sponsored housing finance plus tax deductability of mortgage interest are and anachronism.

  • Posted by Twofish

    Huizer: I do not agree with ongoing government risk support for housing.

    US support for housing has a long history dating back to at least the 1930′s. The idea is that if people own houses, they will be less attracted to radical political movements, and is a major reason why the US has never had a strong Socialist Party. Until the late 1970′s, the US enforced low interest rates on deposits so that low loans would be available to homeowners, and Fannie and Freddie was the result of the collapse of that system in the early 1980′s.

    Supporting home ownership has also been a policy of the Chinese government with the same theory that people who own houses are less likely to want to overthrow the current political system. One reason savings rates in China are high is that most urban dwellers were given title to their previously state-owned houses in the mid-1990′s and so have no mortgage debt.

    Huizer: One could consider the posibility that presently insured homebuyers tranfer their financing (cum guarantee) subject to conformity of course, to their successors in the same house.

    US mortgage laws were changed in the 1970′s specifically to prohibit this. The problem is that the credit of the person who sells the house is very likely to be different from the credit of the person that buys the house, so the interest rates and conditions of the loan are likely to be very different.

    Huizer: Government sponsored housing finance plus tax deductability of mortgage interest are and anachronism.

    That’s debatable, and one has to consider the social benefits of home ownership. The big one which is important for both the US and the Chinese governments is social stability. College radicals that support overthrowing the government get much less radical when they end up owning a house, which they will lose if there is some fundamental social revolution.

    It might seem really silly that the US would now have a communist revolution, but it was much less silly in the 1930′s when people were thinking about these issues, and the fact that it seems silly just shows how successful home ownership policies in the US have been.

  • Posted by Twofish

    Just to clarify, if Fannie and Freddie go under, it’s agency bonds do not become worthless. The bonds that people hold get their funding not from Fannie and Freddie, but by the people that own the mortgages in those securities. Fannie and Freddie do guarantee repayment and insure against default of the homeowner, and that is what gets lost of Fannie and Freddie can’t pay.

    Given that to be the case, I don’t see how converting agency bonds to treasuries will result on a windfall. You lose the credit spread. The really big problem is converting agencies to treasuries is that the government then ends up with monster prepayment risks. People can prepay their mortgages at which point you lose all interest. If the government gets paid in amounts that can be prepayed, and then issues securities (Treasuries) that can’t be, you are looking at a massive crisis at some point in the future.

    Also the default risks involved in holding Fannie and Freddie are much smaller than the other risks. Any amount the China or Russia stands to lose from a crisis in Fannie or Freddie is much smaller than the amount they stand to lose by just holding dollar denominated securities.

  • Posted by Twofish

    I don’t think that owning large amounts of US debt gives China that much leverage over US policy decisions. It’s very easy to think of ways that China could destroy the US economy. It’s hard to think of ways that China could destroy the US economy without destroying the Chinese economy.

    The only scenario I can think of in which China would declare “economic war” on the US would be if it felt its national survival to be at risk, and the only plausible situation in which I can think of this happening is explicit US support for Taiwan independence. The fact that the Bush administration moderated its policies toward Taiwan between 2001 and now was I think driven in part by economic considerations, but that is the only issue I can point to where US debt played a part.

    One other thing that economic considerations have played a part in is that Chinese holdings of US debt have eliminated whatever small support there is for a policy of “neo-conservative regime change.” There is no way that the US could fund a major effort at destabilizing the Chinese government (and a few thousand dollars to dissidents that everyone ignore doesn’t count) since that money comes from China.

    One note is that the neo-conservatives were particularly idiots at economics, and the fact that they were such idiots and self-righteous, arrogant idiots meant that no one with the slightly amount of business sense would talk to them. So they ended up financing their “war for freedom” by borrowing massive amounts of money from the regimes that planned to eventually overthrow (Saudi, Russia, and China). The only good thing about this is that it discredited them before they could start World War III.

    Just like having China embedded in the world financial system and dependent on the United States was intended to keep the idiots out of power in China, I think that having the US embedded in the world financial system and depedent on China keeps the worst idiots out of power in the US. So the influence that China has on US policy (which I might add is still nowhere near the influence that the US has on China policy) is IMHO, not a bad thing. (google for the term constrainment)

  • Posted by S

    Few observations,

    “People can prepay their mortgages at which point you lose all interest. If the government gets paid in amounts that can be prepayed, and then issues securities (Treasuries) that can’t be, you are looking at a massive crisis at some point in the future”

    Well the radically higher mortgage rates will take care of that issue. Table it.

    As for China,

    Brad it would be interesting to consider that the total amount of 401K money in the USA is XXX. What oif the governement simply said that X% of 401K had to be put into the economic restucturing bonds scaled by age bracket. Kind of a economic war bonds program. I don;t know the exact number but this would easily take care of the CHina issue. I’m not suggesting we stick it to them, but make the rate attractive enough and I can assure you people would run from the equity market into the bonds. This would be a healthy long term structural change as well. The free lunch promised by 401ks and thier enablers have had a free ride in bilking fees from “savers.” The 401K sham is a forced subsidy for the equity markets and cpaptive money. As I understand it the gov. of Australia forces people to put x% of money into their pension. Why not impose such a program?

    I for one have been very suspect of the capital raises by the banks. IT was reported on a host of issues that strategivc long term incvestors were buying. I have always belived this was cover for using 401K money that was trapped in the system to subsidize the bailout. ie Paulsen calls Fido, Wellington etc.. and say you are going to participate in these offerings. Why not, the 401K anniut stream is better than the tax anniuty.

    Call be conspiratorial but I susspect you puick through the convert pref offerings and youll find all the major long only 401K folks were in the Q! No hedge fund would be dumb enough to buy that paper. OR if they did, they are probably winding down about now.

    Thoughts?

  • Posted by RebelEconomist

    In my opinion, there is a better case for a modest enforced reduction in principal of existing agency debt in return for a government guarantee than there is a stealth inflationary repudiation of US debt generally. While the US government has kept up a strong dollar mantra, and the Fed would never admit that rising inflation was welcome, the US government has consistently denied that the agencies are guaranteed and the issue has frequently been discussed in Congress. If central bank holders lose a bit on their agency holdings, they cannot say that they were not warned.

    Presumably, such a debt restructuring can only occur if Fannie and Freddie shareholders are wiped out, but I suppose that both must continue operating under government ownership of some kind for now because their departure from the market would be too big a shock. To get off this treadmill, the government might legislate such a large downpayment on mortgages that a government guarantee made little difference. That would also raise the US savings rate.

    How the credit rating agencies can justify a top rating for the US while rating Japan’s yen debt several notches lower I cannot understand.

  • Posted by euro

    Good comment Rebel.

    Congratulations, Brad, for your mention of Japan!

    Elaine Meinel Supkis will be very surprised.

    On the other hand, is that story the reason you complained about some countries buying treasuries instead of agencies not long ago?

    The AAA rating of USA is a joke.

  • Posted by euro

    The American dream turns into a quagmire

    The incipient collapse of Freddie Mac and Fannie Mae will in all likelihood dump an additional $5 trillion in debt onto the national books by making explicit the companies’ dependence on the American taxpayer as their ultimate backstop.
    No glib politician, let alone Treasury Secretary Henry Paulson, will be able to talk their way out of this one.

    And the world’s leading sources of capital, China and the Gulf oil states aren’t about to sign on to support the political priorities of Washington, D.C. politicians looking to subsidize home ownership and get themselves re-elected.
    Instead, America is just going to have to work its way through this mess on its own.

    It will not be a pleasant process.

    Wall Street will cherry-pick the productive mortgages, and the rest will be dumped on everyone else’s doorstep.

    People who didn’t borrow cheap money they couldn’t afford and who paid their mortgages on time, will nonetheless have to pony up more taxes to cover the losses incurred by their profligate fellow citizens at the prodding of an elected class that sought to extend homeownership to every American capable of casting a vote.

    Maybe, just maybe, the political class will finally have to own up to making some difficult choices: eliminating a couple of aircraft carriers for a start, and that $100 billion a year they spend on the department of education.

    It might be a good idea to scrap that new air tanker contract too, given that they can’t seem to get it awarded anyway.
    If they had any real guts, they’d use this occasion to get rid of the mortgage interest deduction. After all, given that Congress’ popularity rating is in single digits already, why not take advantage of the opportunity?

    And if the Iraqis can’t use their oil wealth to outsource their internal security needs with oil pushing $150 a barrel, they’re never going to be able to.

    A high school teacher of mine used to say it didn’t matter how much money the government borrowed because it was a measure of how much faith Americans had in their future.

    We’re about to find out.

    - Tom Bemis, assistant managing editor of Marketwatch.

  • Posted by HZ

    Brad,
    The agencies are in deficit of common equities, but on top of that they have a large cushion of preferred equities as well — so they can remain well capitalized even if common goes worthless.
    The most likely scenario is that they will continue to operate but it is unclear what the current common holders will end up with. Their market positions have strengthened in the down turn and they are doubling guaranty fees. Future borrowers are the ones paying the price for their past sins, not taxpayers.

  • Posted by HZ

    Let’s do a quick and dirty to see how big the loss could be: let’s say we reach 10% foreclosure for existing loan portfolios and recover 50% of home value after cost (so that loss of foreclosed loan principal is about 40%) we are looking at a 4% one time loss of principal. This is peanuts compared to currency losses and interest losses from Fed rate cuts.
    The loss is large only relative to the equity positions of the two GSEs.

  • Posted by a

    Why no mention of your former boss’ (Roubini’s) proposal? Haircut to the bondholders, in order to pay for a recapitalization. This is how capitalism is supposed to work, not American taxpayers’ bailing out foreigners.

  • Posted by Crimson Ghost

    Japan holds about as much agency paper as China and much more than Russia.

    So why no mention of Japan in Brad’s post?

  • Posted by Rien Huizer

    Should the US taxpayer bail out (a) GNMA etc shareholders? (b) creditors (c) persons and entities with commitments to finance not yet funded.
    Should it matter that a big portion of the stock of GNMA backed debt securities is held by foreign official investors
    Should it matter that the term “agency” erroneously suggests some form of government connection and possibly liability?

    It is disgrace that this institutional structure has been allowed to persist. This is the time to kill it (and let the market find a solution (not very easy, pretty painful, but in the long term someone will be allright), or make it truly into one ( or more) agencies with unambiguous government backing.

    Of course there could be room for a bit of mischief: announce that no federal help will be forthcoming in case the “agencies” would cease to be complying with regulations (without relaxing the regulations of course). US domestic holders only (pension funds, municipalities, mutual funds, individuals, etc) should benefit from a scheme to protect against losses up to a certain percentage (say 90%) provided they hold their securities to maturity. For new morthgages, GNMA’s charter should be expanded to allow for reasonably smooth transition to new mortgage market where there is explicit government support (with all its implicit subsidies) on a means tested basis only.

    That would make the US system still by far the most socialist housing finance scheme in the developed world (especially interest deductability, which would have to continue) Or should we scrap interest deductability as well. Why not?

  • Posted by Rien Huizer

    HZ, Euro, Like your comments. Shows tht economics have very little to do with politics. See what the politicians will decide. Someone will make money out of this.

  • Posted by ZFC

    Japan holds a lot more Agencies than Russia. Yet Brad’s statistics omit all references to Japan.

  • Posted by Judy Yeo

    Imagine, the world’s second largest economy, Japan, being dragged into the agency mess, or are allies protected? vs ahem, Russia or China?

  • Posted by bsetser

    a — I linked to Roubini’s post twice, and there is one very explicit reference to it in the post “China would view Roubini’s plan … ”

    I didn’t include Japan because I wanted to focus on official holdings, not private holdings — and Japan’s large holdings are a mix of private and official. I believe that the holdings of the countries included in the graphs are almost exclusively held by their central banks. I do not believe the same is true of Japan (see the technical note at the end). I will make this a bit clearer — and see if I can develop a way of making a plausible estimate of the size of Japan’s official holdings.

  • Posted by bsetser

    Missed info — you comment raises an important point, what makes me confident the US will have the time? The answer is in my previous post: China looks set to slow the pace of RMB Appreciation, meaning it will continue to accumulate foreign assets and it will have to invest them somewhere. If not Agencies, then Treasuries. Basically, the US has responded to the crisis by increasing the supply of the one US asset without credit risk on the market — i.e. Treasuries, and foreign central banks have snapped them up. I suspect that process continues.

    But it is a fair warning. Indeed, I suspect the risk that creditors would pull funds out of the US more broadly if it backed away from the implicit guarantee (or adopted Nouriel’s proposal of “charging” a 5% haiircut or fee for converting into Treasury bonds) is a big reason why such options are off the table. That and the fact that a lot of already troubled US banks (whose depositors have an explicit guarantee) already own the paper.

    Rien — I have a lot of sympathy with your basic view that housing is too subsidized and somehow the subsidy should be ended. In the past, I have published various rants about how the NY Times and the Washington post are far more willing to call for the end of ag subsidies than to offend their core readers and call for an end to the tax subsidy for high end housing, which actually costs way more than farm subsidies. I fully agree with Nouriel’s point that the US has overinvested in housing — i.e. the bubble produced a real misallocation of resources.

    That said, you cannot stop the subsidy for new purchases without affecting the price of the existing stock. And changing the tax treatment of housing now would lower prices further, and add to the aggregate losses in the financial system. The time to change was back when housing prices were rising — but no one wanted to do anything that might get in the way of the boom. hell, we didn’t even tighten regulation.

    Bottom line: the basic bargain with central bank purchases of agencies was that the US government took on the credit risk (making a bundle of mortgage securities an asset central banks could hold with limited risk of loss) while foreign governments took the currency risk. ultimately the currency losses will be far bigger than the credit losses, and my guess is that the US will end up taking on credit risk in order to assure that foreign central banks remain willing to take on the currency risk for a while longer.

    Now let me see if I can get a good time series for Japan.

  • Posted by Rien Huizer

    Brad, of course what I suggested is not realistic. And I agree that the chances are that ultimately mtm loses against domestic currency may well exceed credit losses (or let’s hope so..) But the US government did not do very good regulatory job. That said, it did not take a rocket scientist to see what the agencies were doing during the past 18 months. Any decent analyst could have seen that they were taking lot more risk. Had Roubini and you any idea that this (or housing finance in general) would be an important condition during the final days of BW II?

  • Posted by bsetser

    Rien — our “end days for Bretton Woods scenario” involved housing, but not in the way it has played out. Our initial argument was that a flight from dollar risk by central banks would push up US rates and trigger a housing crisis. It has played out in the opposite way — a retreat from housing risk caused pressured the dollar and led to more central bank intervention, and more dollar risk assumption by central banks.

    That said, I have consistently noted a couple of things (especially in comments to journalists):

    1) The short-hand that China is a big buyer of Treasuries misses their huge purchases of Agencies and huge role in the housing finance market.
    2) As the supply of Treasuries shrank from 04 to 06 (the fiscal deficit fell), central bank demand for agencies rose — and in broad terms central banks shifted from financing the government’s deficit to financing the deficit in the US household sector.

    More controversially, the second point in particular is one reason why I came to believe that the global savings glut contributed to the fall in US household savings (and rise in residential investment) in the US — exchange rate management encouraged investment in China’s tradables sector v the US tradables sector, lowered US rates (generally) and there was a strong channel (the agencies, with their implicit guarantee) for bringing Chinese savings to the US household sector.

    The US and China both could have taken steps to cut off this flow as the “boom” was building. Neither did. And once the bubble started to burst, there was strong pressure not to rock the boat and add to the pressure on home prices. Few governments want to be blamed for policy steps that generate big moves in asset prices — so there is always a tendency to be reactive.

  • Posted by a

    Brad – sorry about that.

    “But SAFE would argue that it plans to hold its Agencies to maturity in any case, so it won’t get more than the bond’s face value.” The whole point of mark-to-market, is that it takes in the probability of *not* getting your money back. SAFE’s plan to hold to maturity does not mean that the expected value of its pay-out is 100; the expected value is less than that, because the GSEs may not pay anything out. If SAFE doesn’t understand that a higher yield brings with it higher risk i.e. a possible loss of principle, then it needs to learn the hard way. It’s not the American taxpayers job to make good for foreigners’ financial losses.

  • Posted by a

    “I suspect the risk that creditors would pull funds out of the US.” Sorry, and put them where? If you have USDs you can only convert them into another currency if someone else is willing to take on the USDs. The net is 0.

    What you *will* see is I think a buyer’s strike of GSE debt, if the U.S. does not give indications that an explicit guarantee is coming. The WaPo (via Calculated Risk) is saying that the government is planning for this contingency by planning to have friends or even itself buy the debt. But that can’t go on forever.

    It would be far, far better to put Roubini’s plan into effect immediately (although I think a slightly higher haircut, on the order of 8-10% is called for).

  • Posted by bsetser

    a — true, someone has to buy. but the price can adjust, the dollar will have to fall to the point where private investors are willing to buy it b/c they don’t think it can fall further. The effect of a buyers strike on the Agency market would likely be higher Agency v treasury spreads, as Agency buyers would buy Treasuries instead. And on Friday, that didn’t seem to happen; the opposite happened — Treasuries sold off on the expectation that the US would take over the agencies and increase the effective supply of Treasuries. Monday may be interesting — I just saw a press report (via SWF radar) that the russians are getting asked about their Agency exposure and the like.

    You are technically right, of course, that risk premium exist b/c there is risk and marking to market is way of reflecting the changing probability that you will get repaid in full. That doesn’t mean though that China won’t argue that it bought Agencies with the expectation of holding them to maturity and with the expectation that the US government wouldn’t make policy choices that work against China’s interests in the Agency market. The problem here is that the way the risk gets realized, ultimately, is that the US government doesn’t back the Agencies. That is a very explicit decision. And it would be viewed, i think, as an anti-Chinese decision.

  • Posted by Twofish

    Huizer: For new morthgages, GNMA’s charter should be expanded to allow for reasonably smooth transition to new mortgage market where there is explicit government support (with all its implicit subsidies) on a means tested basis only.

    One thing that worries me about that approach is that some of the biggest opponents of government support for Freddie and Fannie were the people that argued that with this new CDO financial technology, that Freddie and Fannie were obsolete and that the mortgage market should be turned over to private investment banks.

    It’s worth noting that the default rates on most of the $5 trillion in MBS aren’t particularly high, and part of the current system includes restrictions on who Freddie and Fannie could lend to, and those have proven quite useful.

  • Posted by a

    “that the US government wouldn’t make policy choices that work against China’s interests in the Agency market.”

    So the US government is supposed to make policy choices that work against its *own* interest (i.e. the US taxpayer)? I think the Chinese, with their long history of real politick, understand full well that that kind of thing doesn’t happen – actions are dictated by one’s own best interest, not for the benefit of others – and their words to the contrary are only part of the game to get the best deal possible.

  • Posted by Twofish

    bsetser: China looks set to slow the pace of RMB Appreciation.

    This is hard to say. Chinese policies seems to be changing on a month-to-month basis. Personally, I think you’ll either have RMB appreciation or inflation.

    Huizer: But the US government did not do very good regulatory job.

    One thing to mention here is that Freddie and Fannie weren’t regulated by the Fed or the SEC, but rather by Office of Federal Housing Enterprise Oversight in the Department of Housing and Urban Development. Most everyone has thought that they were very overwhelmed.

    Also the big, big risk in mortgage backed securities has never been credit risk. The big, big risk has always been repayment risk. Historically defaults on conforming mortgages have been <1%, and when someone defaults Freddie and Fannie will repay principal.
    However, if someone decides to refinance, you lose two-thirds of your expected cash flow.

    Sure, you can reinvest, but people are more likely to refinance when interest rates are low.

    Also the way that MBS’s handle default makes things a bit tricker for Freddie and Fannie than with most bond insurance. If a home owner defaults then Freddie and Fannie need to repay the total principal at the moment of default rather than interest rates over the life of the loan.

  • Posted by Twofish

    bsetser: You are technically right, of course, that risk premium exist b/c there is risk and marking to market is way of reflecting the changing probability that you will get repaid in full.

    The default risk premium on MBS’s has always been essentially zero. The premium on MBS has been because the buyer of the MBS has taken on the risk that the seller might want to refinance. If you don’t carefully fix the problem you’ll end up with a situation in which homeowners are effectively locked into their houses because they can’t pay off the mortgage.

    Mortgage backed securities are some of the most complex securities that have ever been devised, and their complexity results from the demands of homeowners. Most homeowners want a fixed interest rate over the life of the loan, they want fixed monthly payments, and they want to be able to pay off their mortgages if for example they want to move.

    With all due respect, Roubini’s plan makes absolutely no sense to me. You can force to bondholders to do anything, but if people stop buying MBS’s, then people will end unable to finance houses at any price, and I don’t see this as politically realistic.

    Right now, what Roubini suggests looks much, much worse to the MBS holder, then letting Freddie and Fannie collapse and having no insurance at all for the MBS.

  • Posted by Twofish

    bsetser: China would get a mark-to-market windfall if its Agencies became Treasuries (i.e. backed by the full faith and credit of the United States).

    a) It wouldn’t change the MTM

    b) It would be financial idiotic for the US to convert mortgage-backed securities to treasuries. Treasuries and MBS have radically different cash flow properties, and you end up having the US government eating prepayment risk.

    To repeat something that is very, very, very important. The key characteristic of most homeowner mortgages, is that you can go to a bank and say. I own $80,000 on my mortgage, here is $80,000, and the bank has to accept the money even though they are going to end up losing money. You can’t do this with treasuries or most bonds, and if the the government converts MBS’s to treasuries it will end up paying interest for loans that are no longer existent.

  • Posted by S

    FNM has $850B of ddebt at the company level notwithstanding the portfolio of mortgages. What exactly is ebing swapped for treasury, is it the corproate debt or are we taling about the actual underlying mortgage pools and pass throughs? Two totally diffferent things.

    Not looking like such a strong move…per 10Q

    ” primary source of cash is proceeds from the issuance of our debt securities. As a result, we depend on our ability to issue debt securities in the capital markets on an ongoing basis to meet our cash requirements. Our short-term and long-term funding needs in the first quarter of 2008 were relatively consistent with our needs in the first quarter of 2007; however, we shifted our funding mix to a higher proportion of lower-rate, short-term debt during the first quarter of 2008 to benefit from the steeper yield curve during the quarter.”

  • Posted by anon

    Balderdash. GSE spreads have widened considerably, and it’s not because of prepayment risk.

  • Posted by a

    “a) It wouldn’t change the MTM”

    Others things being equal, it would. The default risk goes down.

    When an X company is taken over by an AAA company, the value of the bonds go up (when X < AAA). Given the size of the GSEs, it’s entirely possible that the U.S.’ rating will go down some and the GSE bonds won’t go up quite as much as they should have if the GSEs had been smaller, but other things being equal, they will go up. Or are you saying that there are enough “other things” which have the opposite tendency? If so what are they?

  • Posted by a

    “The default risk premium on MBS’s has always been essentially zero.”

    That’s not true. The spread on the MBS’s has been shooting up recently, and this is not a function of refinancing, but of default risk.

    “Investors are demanding a higher interest rate to buy Fannie’s bonds to compensate for perceived risk that the mortgage company could run into serious problems. This week the company auctioned off $3 billion worth of two-year notes and they yielded 3.27%, 74 basis points more than comparable U.S. Treasuries. According to Bloomberg, that’s the biggest spread since Fannie Mae first sold two-year benchmark notes in 2000.”

  • Posted by bsetser

    I agree with a. the spread on agencies (pass-throughs that is) reflects:

    a) what might be called a complexity premium, as the cash flows are more complicated that a treasury fixed rate/ fixed maturity bond, and there is also prepayment risk/ convexity and all that.
    b) a risk premium, as the agencies that provide the credit guarantee aren’t 100% good as gold (or as a good as the US treasury).

    taking over the agencies means that the quality of the guarantee improves, so there should be a smaller spread.

    and I think the debt the agencies issue to finance their retained portfolio would effectively become a close substitute for a treasury, as something like a 2 year fannie mae note is pretty plain vanilla. I don’t see why it would have a complexity premium.

    incidentally, central banks — with China being an enormous exception — have generally bought the notes the agencies sell to fund their retained portfolio rather than the pass-throughs with an Agency guarantee. Most central banks haven’t wanted to mess with the more complicated cash flows and set up information and trading systems to manage a pass-through portfolio.

    But some have hired outside managers to run this kind of portfolio, so “true” central bank exposure to the agency market is likely higher than the number reported by the Treasury, even after taking into account the undercounting of central bank purchases in the monthly TIC data v the annual survey

  • Posted by Twofish

    a: GSE spreads have widened considerably, and it’s not because of prepayment risk.

    No they haven’t.

    a: This week the company auctioned off $3 billion worth of two-year notes and they yielded 3.27%, 74 basis points more than comparable U.S. Treasuries

    Those aren’t mortgage backed securities. Freddie and Fannie issue two types of debt. One type is mortgage backed securities which are packaged mortgages. The role of Fannie and Freddie in those securities is to serve as a guarantor. These securities are priced to have essentially zero default risk, and whatever default risk they have is usually incorporated into prepayment risk which is much. much higher.

    The second type of security is corporate debt which Freddie and Fannie issues, and those have your standard credit spread. If Fannie and Freddie were to default, I doubt that those corporate bonds would be worth much, but China and Russia, as far as I know don’t hold very much of this agency corporate debt.

    One way of thinking about it is that Freddie and Fannie create mortgage backed securities in the same way that General Motors produces cars. If GM were to default on its corporate bonds the cars that GM had produced would be worth less, but they wouldn’t be worthless.

    Even if Fannie or Freddie were to default, things would have to get much, much worse before agencies would be worth 80-90 cents on the dollar. The big problem is that if Fannie or Freddie were to default, there wouldn’t be any new securitizations of mortgages which means that the housing market would stop dead.

  • Posted by Alessandro

    Brad, one of your best posts ever, thanks for sharing your thoughs and your research.

  • Posted by anon

    GSE spreads have widened considerably, and the credit deterioration shows up in the pricing of both their own paper and their MBS as guarantor. This is separate from the prepayment risk pricing component.

  • Posted by Twofish

    bsetser: taking over the agencies means that the quality of the guarantee improves, so there should be a smaller spread.

    But the guarantee spread is usually tiny as it is. Even with the latest mess we are still looking at 1-2% default rates in prime mortgages and that doesn’t take into account any recovery due to foreclosure. One reason that the default rates are low is that there are standardized conditions for issuing mortgages.

    bsetser: and I think the debt the agencies issue to finance their retained portfolio would effectively become a close substitute for a treasury, as something like a 2 year fannie mae note is pretty plain vanilla

    But those are standard corporate bonds have have nothing to do with the mortgage backed securities that China, Russia, and everyone else holds. I see absolutely zero reason why the US government should assume one penny of Fannie corporate debt.

    One thing that I have noticed over the last several years is that there seems to be an effort to confuse the different types of debt that Fannie and Freddie issue. I got the feeling sometimes that people were selling Fannie/Freddie corporate debt as if they were the same thing as the MBS’s that they produce, when they are no such thing.

    Also, it should have been obvious that there was going to be a problem for several years. When you ask the question “if this happens will the government bail me out?” The answer should be “yes” or “no.” If the formal answer is “no” but the person saying it is winking and making funny faces when saying “no” then you have a problem.

    bsester: incidentally, central banks — with China being an enormous exception — have generally bought the notes the agencies sell to fund their retained portfolio rather than the pass-throughs with an Agency guarantee.

    Oh…. My…. God…. I didn’t know that….

    I suppose it is a good thing that the Chinese central bank had people working on Wall Street that could offer independent advice. One issue that has come up here is that often the buyer relies on the seller for investment advice, and that’s never a good thing to do.

    bsetser: But some have hired outside managers to run this kind of portfolio, so “true” central bank exposure to the agency market is likely higher than the number reported by the Treasury.

    I hope someone things weekend is burning some extra hours trying to figure out what the central bank exposure is to Freddie/Fannie corporate debt.

  • Posted by anon

    “Credit-default swaps linked to the debt of Fannie Mae dropped about 17 basis points to 60 basis points today, according to CMA Datavision. Contracts on McLean, Virginia-based Freddie Mac declined 19 basis points to 58 basis points. Before today, both contracts had more than doubled in the past two months”

    In other words, credit risk is up net from two months ago and up a lot more from a year ago. This is reflected in pricing of both bonds and MBS guarantor risk.

  • Posted by Twofish

    It’s your classic agency problem. If A guarantees B then A has to maintain enough control and regulation to make sure that B doesn’t do something stupid. If B wants the freedom to be stupid, that’s fine but you need to make sure that B can fall apart without expecting A to come to the rescue.

    The ideal situation for B is that if they have the freedom to do stupid things that pay off big if they work, but have A’s support if they don’t. This is great for B. Totally lousy for A.

    One issue with the financial system is that things are so critical, that it is almost impossible for the government not to get sucked in even if it doesn’t want to be.

  • Posted by Twofish

    One thing that will make your head really spin is to think about how to calculate the risk that the person who sold you the credit default swap won’t be able to make payments if there actually is a default.

  • Posted by HZ

    Agree with 2fish that the agencies are in the business of hedging interest risk. They should not be really in the credit risk business at all. I don’t understand why they get privatized in the first place: their shareholders have very little control of their operations. Government should own a majority of the common (Congress acts as if it owns the pair anyway) and issue preferreds and debts to raise capital.

  • Posted by bsetser

    HZ — the agencies were originally in the business of offering credit insurance on mortgages, which seems like a credit risk business. A lot of the criticism they get came when they grew their retained portfolio, which involves a combination of interest rate risk and credit risk. But from their creation, they have been the credit insurance business. At least that is how I understand it.

  • Posted by anon

    Fannie Mae last week paid record yields over benchmark rates on $3 billion of two-year notes amid concern the company didn’t have enough capital. The 3.25 percent benchmark notes priced to yield 3.27 percent, or 0.74 percentage point more than comparable U.S. Treasuries. That’s the biggest spread since Fannie Mae first sold two-year benchmark notes in 2000.

  • Posted by HZ

    Brad,
    Right they were created that way. But a true conforming mortgage should have very little credit risk averaged over the nation. A large scale conforming mortgage default will hit the economy so hard that it is inconceivable that the situation will be allowed to develop in today’s credit money environment. USD is no longer on the gold standard (as it was when Fannie was created).
    The problem of having them privately owned is that they would invariably end up being a pro-cyclical factor in pursuit of profit. As GSEs they should really counter cyclical. This is the bind that the Government is in. It wants them to lend more in the current down turn. But without more capital they will lend less in order to survive. Hence the rescue plan….

  • Posted by ZFC

    “So the US government is supposed to make policy choices that work against its *own* interest (i.e. the US taxpayer)? ”

    Americans hold 4 trillion in Agency debt. That is 4 times more than foreign holders of that debt, eight times more than China’s holdings. 4 trillion is 30% of US GDP (compared to Chinese holdings at 10% of GDP).

    The real issue isn’t too Chinese to fail. The real issue is why were Fannie and Freddie levered 100 to 1, when comm banks cannot be levered more than 10 to 1 ?

    Who really stood to benefit from the existence of FNMA and Freddie ? Were bank executives using FNMA and Freddie as a place to dump loans, to get around their own regulatory capital requirements (gasp) ?

  • Posted by ZFC

    Also, how did China create the US housing asset bubble and drive down rates through excess savings, when Americans hold 8 times more Agency debt than the Chinese (4 trillion versus 500 billion).

  • Posted by bsetser

    ZFC — think about flows as well as stocks. the growth in China’s holdings of agencies over the past few years has been extraordinary. $100b a year isn’t an overstatement.

    it also isn’t either or. the agencies were undercapitalized and overleveraged — and have been for some time. at the same time, chinese demand for agency debt made it easier for them to buy mortgages/ support the us housing market, and no one in china seems to have worried about the risk of extending credit to such undercapitalized institutions. in my view, there is plenty of blame to share on both sides of the pacific – trying to apportion it all to one side or the other won’t get very far. the point of my post was primarily that china’s large holdings are a constraint on the US government’s policy options, something i deeply suspect is true.

  • Posted by ZFC

    bsetser: “Most central banks haven’t wanted to mess with the more complicated cash flows and set up information and trading systems to manage a pass-through portfolio.”

    Think GIC.

    Another question I have is: is it public knowledge that PBOC is holding more MBS/passthroughs than Agencies ?

    bsetser: “think about flows as well as stocks.”

    What are the US flows ?

  • Posted by ZFC

    To price MBS over the last 10-15 years with the same credit risk as the US govt is a serious capital markets distortion (that is being corrected now). Ignoring the de facto govt backing, how much Agency flow would exist if Fannie simply had capital requirements like other commercial banks ? Well, the maximum would be order 500 billion in Agency debt (on 50 billion in capital), not the 5 trillion we see today, 4 trillion of which are in the hands of Americans (e.g. Pimco, BlackRock et al. managing money for major US multinationals engaged in labor arb in places like China and Vietnam).

    I suspect a lot more flow from the US side than China- you don’t get to 4 trillion without a reasonably good flux.

  • Posted by Rien Huizer

    HZ, full marks for your comments here. Let us wait till this rescue effort becomes a little clearer. Drip-feeding capital to an agency ptoblem (2 Fish) introuble does not make the problem go away.
    Also: foreign CBs would not have much of an MBS back office and risk mnagement resource. That may well be another problem in the making, if the service provider is an investment bank.
    Also: foreign CBs holding FNMA etc corporate notes; not such a good idea from arisk management perspective. Strangely enough, having never given this much thought, I would have expected that CD “agencies” would be GNMAs. But then you would need prepayment risk infrastructue..Questions..
    Brad can we revisit this topic when things are a little clearer?

  • Posted by Twofish

    ZFC: how much Agency flow would exist if Fannie simply had capital requirements like other commercial banks ?

    Not true. The pass-through securities are not part of Fannie Mae’s balance sheet so they aren’t counted against the capital requirements. This happens also to be the precise reason that the SIV mess happened.

  • Posted by bsetser

    2fish — I find it hard to believe that the agencies don’t have to hold some capital against the guarantee side of their business. insurers need capital too.

    ZFC– i can try to pull together data on the size of CB flows v the increase in Agency stocks. It became significant recently. And i think it really played a significant role after 04, when the uS fiscal deficit came down but EM savings and CB reserve growth stayed up and the “deficit” in the US economy shifted to the household sector.

    It certainly isn’t common knowledge that China holds Agency MBS/ pass-throughs. But it is quite obvious if you look at the details of the Treasury survey. China holds a lot of “Agency MBS” –

  • Posted by Judy Yeo

    2fish

    Pass through securities are just one part of the SIV matrix but the problem has a simple root;banking and financial institution executives who only want one half of the equation whilst discarding or shoving the potentially negative half under the carpet. It isn’t even an illusion, they are re-enacting the emperor’s clothes with collective illogicality as a basis of treatment; where streams of income are recognised through P&L should have the relevant corresponding assets and liabilities should be included in the balance sheet – how else is the income generated?!

    If the Fannie Mae and Freddie Mac situation is a sign of agency mismanagement, look at the bloomberg special on Citi’s potential trillion dollar “invisibles”. They should really be teaching the magicians the disappearing act.

  • Posted by shrek

    No one told China to have such a large and concentrated financial position. In case they havent noticed no financial professionals ever advocate that strategy. What a bunch of morons.

  • Posted by don

    Informative and useful post. I continue to believe that the breakdown of the current ‘Bretton Woods’ agreement will come when developed countries get tired of the currency manipulations stealing aggregate demand, rather than the manipulators running out of taste for reserves.

  • Posted by Primordial Dwarf

    I think what happened was Russian backlash
    over the Georgia incident , where they were protecting
    the tunnel.

    will be double-edged.

    Russia was building up their reserves in Treasuries,
    in order to pay big debts due end of 2008.

    I just think Russia stopped buying the U S
    Treasuries — which caused the panic.

    The U S Commander-in-Chief , with Emergency powers,
    has forced the U S banks to buy nothing but
    U S Treasuries , in order to keep the U S
    afloat. And that caused the credit freeze-up.

    Next question: will Russia repay the debt due end of 2008.

    They did not in 1998.

    primordial dwarf

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