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A bit more on the Agency portfolios of the world’s central banks

by Brad Setser
July 14, 2008

My post over the weekend attracted a bit of attention. I thought I would clarify a few points that came up in the discussion, refine a few calculations and try to put central banks’ Agency purchases into context.

One key point that I didn’t initially emphasize is that that different central banks hold slightly different Agency portfolios. China holds a lot of Agency “MBS” (also called Agency pass-throughs). These are mortgage backed securities that the Agencies guarantee, as opposed to the debt the Agencies issue in their own name to finance their retained portfolio. Other central banks, by contrast, tend to own the debt the Agencies issue themselves, not the debt they guarantee.

There are a couple of ways of seeing this. Compare for example the “Agency” portfolios of China, Russia and Korea (using the data released in the Treasury survey).

agencies-1-08.JPG

In June 2007, the US data indicates that China had $11 billion of short-term Agency debt, $170.1b of long-term Agency debt and $206.2b of Agency MBS.

In June 2007, the US data indicates that Russia had $38.6b of short-term Agency debt, $75.3b of long-term Agency debt, and $0.001 billion of Agency MBS.

Here I want to note that my initial $155 billion estimate for Russia’s current Agency holdings is significantly higher than the $100 billion the Russian central bank claims to hold. That may reflect a reduction in the central banks’ holdings since April (the last data point), or the limits of methodology. My estimate makes two key assumptions: first, Russia’s central bank accounts for almost all of Russia’s total holdings of Agencies (i.e. private holdings are minimal) and second, almost of all of Russia’s holdings of short-term negotiable securities, CDs and other custodial liabilities are short-term Agencies. That was true in June, 2005, in June 2006 and in June, 2007 (the survey showed $38.6b of Agencies, v $42.1b in short-term custodial holdings). But it is possible that things have changed since then. I assumed that all of Russia’s 66.6b in short-term custodial holdings are in Agencies, which is a big assumption.

$100 billion, incidentally, is still a large sum relative to Russia’s GDP. Russia’s finance ministry claims that the finance ministry funds managed by the central bank — the stabilization fund and the future fund — do not include any Agency exposure.

There is another way of illustrating how large a role China has played in the “Agency MBS” (or pass-throughs) market: a plot showing China’s holdings relative to total official holdings and total foreign holdings. Such a chart clearly shows that China has been the main official purchaser of Agency MBS — and Chinese demand has pushed overall foreign holdings up. In June 2007, China had $206.2b of Agency MBS — only a bit less than the $235.8b held by the official sector. The $98.7b increase in China’s holdings from June 2006 to June 2007 accounts (I suspect) for most of the $118.1b increase in official holdings over this period, and over half the $184b increase in all foreign holdings.

agencies-2-08-mbs.JPG

Here it is worth noting that many central banks likely outsource the management of their Agency MBS portfolio to private fund managers, so total central bank holdings of Agency MBS — counting indirect holdings — are likely to be higher than the US data indicates.

China, by contrast, has been less of a factor in the market for the Agency’s own debt than other central banks. But the other central banks have been big players. Their holdings of the Agencies own issuance has increased faster than overall foreign holdings. And with the Agencies — until recently — not growing their own book, central banks were accounting for a rising share of the outstanding stock.

agencies-3-08-no-mbs.JPG

Central banks held $520 billion of the Agencies long-term debt at the end of June 2006, and an additional $79.8 of short-term Agency paper — for a total of almost exactly $600b of the Agencies own debt. Based past patterns(and the rise in the New York Fed’s custodial accounts, it is reasonable to think that central banks now hold between $700b and $800b of this paper. Probably closer to $800 billion. The outstanding stock of the GSE’s own debt increased from $2685b at the end of June 2007 to $2940b at the end of March 2008 (data comes from the Fed’s Flow of Funds), so it is reasonable to think central banks hold around 25% of the stock of the debt the various Agencies have issued in their own name. My guess is that they own a higher share of certain parts of GSE curve than others, but I cannot deduce the details from the survey data alone.

Finally, it is worth looking at how the growth in foreign holdings of Agencies compares with the total stock of Agencies outstanding.

agencies-4-08.JPG

A few points are worth noting:

First, the stock of Agencies didn’t grow rapidly from mid-2003 to mid-2007, while the stock of private MBS did. This reflects limits on what the Agencies could do, the boom in subprime, Alt-A and all other kinds or mortgages and strong demand for these mortgages from private investors.

Second, the stock of Agencies is now growing rapidly. That reflects the policy decisions the US made after the “subprime” crisis.

Third, central banks starting buying significant quantities of Agency bonds when the total stock of Agencies was not growing, and have continued to buy over the past few quarters.

These trends are actually easier to see — given the large outstanding stock of Agencies — by looking at the annual change in official holdings, “private” foreign holdings and “private” holdings in the US.

agencies-5-08.JPG

My interpretation of all this is that during the 04-06 period, central bank demand for (relatively low yielding) Agencies freed up private capital to be deployed in the higher-risk, higher-reward portions of the mortgage market, with disastrous results. No doubts others will interpret the data differently.

43 Comments

  • Posted by anon

    Mukherjee refers to the risk premium on agency debt. I assume this would also apply to agency guaranteed MBS, held by China for example (in addition to any prepayment risk premium).

    This would benefit China’s hold to maturity strategy if the market risk premium narrowed to a level that was less than China’s book cost risk premium. This would make China’s holdings cheaper than the market (i.e. paying more interest to maturity) in an opportunity cost sense.

  • Posted by don

    I wonder how much true risk premium there is on agency debt. I think most U.S. states tax interest from agency debt, but not from U.S. government bonds. To the extent U.S. investors arbitrage returns to the two types of debt, agency debt should pay a higher pre-tax rate.

  • Posted by Rien Huizer

    What about giving the capitalists all the rope they need to hang themselves?

    F + G have about 40% of their exposure in 2005/6 vintage loans. The portion originated before that is seasoned (2000 was pretty bad too) and had more conservative original LTV ratios. If the housing market does not get worse (big if), ample agency solvency can probably be maintained with capital injections (preferred stock, if necessary mandatory convertible preferred) in the range of 15-30 bn. Two problems:
    (1) how to prevent a clean-up plus reform making the housing market (too) much worse
    (2) how to minimize non taxpayer gains resulting from taxpayer expense.
    The big issue with (1) is pro-cyclicality, difficult to manage, also in the presence of high oil prices, structural unemployment (part caused by China etc) and sharp hardening of budget constraints by commercial lenders (credit cards, home equity loans). A combination of reduced after tax&gas family income, higher commercial debt burden and lower LTV ratios could push affordable house price levels to perhaps 40-50% below the 2006 levels, in certain states more or less of course. That would clearly be catastrophic. Now, the path to those levels could be made less steep if care is taken with n intermediate solution (muddle through PLUS an credible new structure for the long term) The muddle through could look like this: Even assuming that the stock of unsold new residential property will sit on the shelves forever (and new construction is temporarily dead), the main problem for the agencies is to facilitate the sale of delinquent properties (also those of commercial lenders) and the relocation market. That should lead to very small new vintages (but as commercial channels are temporarily closed, still a few hundred billion a year). In essence that would lead to book that hardly grows in nominal terms, but becomes increasingly dominated by high LTV ratios on a mark-to market basis. Not quite procyclical but certainly a Japanese-style drag on the economy for perhaps three congressional terms. It is quite easy to simulate the agency books on that basis and no doubt congress has the benefit of that type of work. I would expect that what the politicians would like to see then is a generous amount of wage inflation, because that -if combined with low or negative real interest rates- would arrest the slide of house prices by increasing the affordable nominal price. Obviously the accompanying FX scenario would be continued USD weakness, in a positive feedback loop. Very bad economic policy. But the FED has not demonstrated (to me at least) that it can not be recruited for such a job. Point is, how, in say 2012, do you get out of that, assuming housing is healthy again (population growth) by then. Tight fiscal policy (no wars for a while), lower oil prices (many reasons to believe that). But still, highly problematic.

    As to (2,) assuming a scenario of muddling through, China etc will not lose on their investment in USD terms (gain a little on their most recent purchases). Pass throughs should tend to prepay much slower than expected, so perhaps some drag. But the biggest problem would be lack of new stock. So I would suggest that the various SWFs should voluntarily and heroically offer to contribute to a less painful solution: SWFs purchase a massive amount of (non voting pse, agency common stock, in terms of dividend subordinated to employee-owned stock). That would leave the myth of the implicit guarantee intact, and more importantly, allow the agencies to go on doing what they do best, create purchasing power for housing. For this purpose they could perhaps adopt LTVs “through the cycle” (say lend up to 120% of the current value of a house in Michigan). That would make things much easier for a while and it would not cost the taxpayer a penny. (well there should be some welfare losses somewhere). Also, it would make it easier for the BRICs to manage their currencies, avoiding big capital losses on their agency stock, and on their USD investment altogether. The USD 20-30 bn would be quickly earned back by the agencies and may be retired in 2 to 3 years. Everyone wins, right? That is how you use debtor power… A fairy tale, s a former US president might say.

    Brad, good post and food for thought.

  • Posted by Rien Huizer

    Don, you are right, Fannie and Freddy are not exempt from state tax. Ginnie is exempt, I believe.

  • Posted by W P Gardner

    I have to ask a question that maybe all the others know the answer to already: if bondholders in agency debt have to take a haircut (as Roubini recommends), which will lose more hair? Agency MBS? Or the more ordinary agency debt? Which is senior to which? I am guessing the US is not going to do anything to alienate China in this regard, certainly not to cut off its queue.

  • Posted by bsetser

    WP Gardner –

    that raises the issue of how you do a haircut on a uncalled guarantee … which strikes me as difficult. my guess is that the agencies own debt could be restructured more easily than the guarantees (you would do a swap, trading an agency bond for a new bond that has the full faith and credit of the us, and in return accept a haircut). you could not haircut a guarantee until the guarantee is called — tho i guess the us could just announce that it will only make good 95% of the value of what it initially guaranteed, and all cash flows will be adjusted accordingly (and if you don’t like it, take us to court) … either that or you would need to do a swap, where you swap the existing fannie guarantee for a new guarantee that guarantees a lower principal value but is a full faith and credit guarantee rather than a fannie guarantee.

    i am thinking out loud here tho. my gut says a guarantee is technically harder to restrucutre than a bond. but i also think it is 100% clear that the agencies debt isn’t going to be restructured. not now.

  • Posted by Rien Huizer

    W P, benevolence commands that China donate hair voluntarily. The Russians, not so sure. R agency debt vs mbs. With MBS the homeowners are the principal source of repayment, but with a guarantee by the GSE. Agency debt is only the agency’s assets (primarily claims on homeowners secured by mortgages. The notes and the contingent liabilities have the same pool of assets, but if a morgage is close to default, the underlying mortgage is close to becoming an agency asset against an agency payable. So in times of stress you would expect the assets of an agency to expand against a contraction of its contingent liabilities (ignoring ordinary repayments and new production). In the traditional sense there is no difference in seniority, both type of creditors (contingent and non-contingent) are unsecured at the same level. But theoretically, MBS owners could survive an failure of a GSE better, because their primary resource is the homeowners who will still be around, and maybe solvent. Weird stuff.

  • Posted by a

    Great post, thanks.

    Saw your name in a Bloomberg article on China and Fannie. The quote seemed a little more definitve than your wont, but I can’t find the story. Anyway, good to see your name in the MSM.

  • Posted by Twofish

    bsetser: tho i guess the us could just announce that it will only make good 95% of the value of what it initially guaranteed, and all cash flows will be adjusted accordingly

    It couldn’t just announce it. I could announce that I would make good on all Freddie/Fannie debt or that I was the King of England, and that wouldn’t do anything.

    For the US to have a credible guarantee it would require Congress to pass legislation making something subject to the “full faith and credit of the US”.

    One reason that Roubini’s plan makes no sense to me is that the US can’t force someone to give up their current securities, and giving someone a 95% return on principal is likely to leave them worse off in the case of pass-through mortgages. You can only issue new securities which are more attractive than their current securities.

    The big threat that bondholders have is that they can refuse to buy new bonds. The question that you have to ask is will these guarantees extend to new issues.

    bsetser: (and if you don’t like it, take us to court) …

    You forget here that people *do* take people to court of these sorts of things and if the original contract is clear, they win. Suing someone or being sued is something that people in the finance business don’t particular hesitate in doing.

    The trouble with saying “take us to court” is 1) you might lose, and 2) even the process of going through courts take months in which case you’ve lost any confidence.

  • Posted by Twofish

    Huizer: But theoretically, MBS owners could survive an failure of a GSE better, because their primary resource is the homeowners who will still be around, and maybe solvent. Weird stuff.

    Just guessing…

    MBS owners would like lose about 2-3% or so if a GSE where to default. A agency bond holder would likely lose about 30-40% if there is a default and no bailout.

  • Posted by W P Gardner

    Thank you all for your remarks about the haircuts. I don’t think the haircut really will happen but various big people will talk about it a lot.

    I don’t have a position in agencies at all. I do have positions in JPY, CHF, EUR and RMB currencies. The RMB I have is an iffy sort of dollar-settled contract that the CME has put out. It is based on the official rate. That contract went up a chunk last night (but it’s thinly traded, so that may mean nothing).

  • Posted by Dave Chiang

    Don’t Bail Out Fannie, Freddie: Jim Rogers
    http://www.cnbc.com/id/25684069

    The Treasury and the Federal Reserve should not bail out Fannie Mae and Freddie Mac as this would increase the already gaping U.S. public debt, investor Jim Rogers, CEO of Rogers Holdings, told “Worldwide Exchange.”

    “In two years or three years, when six or eight other people are failing, America won’t have any more bullets left,” Rogers said, adding that Sunday’s move increased the burden of public debt and did not solve the root cause of the crisis. “The patient has cancer, Band Aids won’t help.”

    Letting the two fail would throw the country in recession but would ensure that the system is cleansed, he added. “It would cause problems in the economy but we’ve got problems in the economy anyway.”

  • Posted by RebelEconomist

    This an informative post Brad; well done! One thing I would add is that I believe that central bank ownership of agency debt is very widespread (67% of respondents to the annual Central Banking Publications Reserve Management Trends survey in 2006 said they held agencies; only 25% held MBS). A haircut would upset an awful lot of countries, including ones that are much closer to the US than China or Russia.

    By the way, I would have thought that an uncalled guarantee was extremely easy to haircut if the guarantor is deemed to have gone bankrupt – the guarantee is worth zero! The debt haircut would represent one minus the recovery rate for creditors following the effective bankruptcy of the agencies themselves. Note that the implication of such action would be that the shareholders are entirely wiped out.

    I know that it is not saying anything new, but it does look to me as if what Paulson is proposing does not solve the underlying dilemma – ie are the agencies government backed or not – but simply keeps the show on the road until the government has changed.

  • Posted by Rien Huizer

    WP, if that’s all the exposure you’ve got and your expenses are in USD, you are OK for the time being. Hang on to your Yen. They should go up, despite the impact on Japanese life insurance and pension funds. Or should they? Actually, this is probably a time where the USD is reasonably well valued against the EUR, too expensive against the RMB (but the RMB cannot move if JPY stays so close (especially in real terms) to its mid 2005 RMB parity). And extremely expensive against the JPY. Why are people bashing China? Nothing to do with Agency Plight though..

  • Posted by Rien Huizer

    Rebel,

    As I said in my fairytale, keeping the myth of the implicit gurantee alive is good. But I would let the BRICs pay, not via haircuts, too messy, but by them, instead of Treasury, injecting capital (non-voting) and no haircuts of course, far too messy.
    Better than this silly incrementalism, but, then again, what else could you expect? What happened to benevolence towards (even) barbarians? But USD 15 bn is a little too little, there may still be room for the proper thing from the East..

  • Posted by Rien Huizer

    Sorry, No idea why but the BRICs seem to be replacing China, Japan and Russia in my disturbed mind

  • Posted by Dave Chiang

    A default on Fannie Mae and Freddie Mac debt to the Chinese and Russians wouldn’t impact their respective economies significantly. Even a 20% haircut on Chinese GSE bond portfolio representing $80 billion is less than 2% of China GDP (ie. $3.5 trillion at current exchange rates). The Chinese economy has outgrown its financial dependence on the US market. American taxpayers should not bailout Fannie Mae and Freddie Mac.

  • Posted by bsetser

    Rien — why is the JPY a constraint on the RMB rather than say the RMB a constraint on the JPY? I see how the JPY constrains the KRW. and i see how the RMB constraints THB, INR, PHP, and others closer to China’s income level. but i would think that CNY/ JPY wouldn’t matter quite as much to each of the big players and the CNY matters to the smaller asian economies with low per capita GDPs or the CNY/ JPY matter to Korea.

  • Posted by bsetser

    Wow, DC — I assume you have thought through the implications of defaulting on China? I am not sure SAFE would see it as losses of only “2% of China’s GDP’ rather than a hostile act against the people of China. and presumably it would imply an end of China’s willingness to buy Treasuries as well as agencies (if the US can default on one, why not the other) – and, in practice, an end to BW2. If china stopped buy US debt, it would have a hard time managing its currency v the $.

  • Posted by Twofish

    RebelEconomist: but simply keeps the show on the road until the government has changed.

    That’s a very large factor here since we just won’t be able to do major surgery on the system until after the elections.

    One thing I think would be a good idea is to split up Freddie/Fannie so that you have five or six companies rather than two, and to create a mechanism by which someone can credibly start a new company that guarantees mortgages if necessary.

    The reason for doing this is that if you have more companies, it increases the power of the regulators, and also it means that if one company has trouble you can credibly let it fail and get taken over by other company.

  • Posted by Twofish

    bsetser: I am not sure SAFE would see it as losses of only “2% of China’s GDP’ rather than a hostile act against the people of China.

    If only freddie/fannie defaulted, I doubt that anyone would see it that way. Any nationalistic backlash would come from the streets and that would happen if people on the street lost money in the deal, and I don’t see an easy mechanism for that to happen.

    If the US defaulted on treasury bonds, then things would be different, but at that point it would be the end of the world financially speaking. I do think that the people in the PBC and SAFE know the difference between a bond that is backed by the “full faith and credit of the United States” and those that aren’t.

    One question that then has to be asked is how much of the PBC holdings are Ginnie Maes, which unlike Fannie Maes and Freddie Macs *are* backed by the “full faith and credit” of the US government.

    bsetser: presumably it would imply an end of China’s willingness to buy Treasuries as well as agencies (if the US can default on one, why not the other)

    Because the US used the magic words “full faith and credit of the United States” on one and not the other. The US government has never, never, never explicitly promised that it would back Freddie and Fannie in a crisis, and every time you force it to give an answer, it’s answer has always been the opposite.

    bsetser: – and, in practice, an end to BW2. If china stopped buy US debt, it would have a hard time managing its currency v the $.

    Which would force the PBC to appreciate the RMB, and I thought you believed that this was a good idea…..

  • Posted by Twofish

    Huizer: The underlying mortgage is close to becoming an agency asset against an agency payable. So in times of stress you would expect the assets of an agency to expand against a contraction of its contingent liabilities (ignoring ordinary repayments and new production).

    Mortgage backed securities don’t work this way. What happens when a homeowner defaults is that Fannie/Freddie pays the principal in full to the holder of the MBS, and then forecloses on the property which then sold off over several months.

    This is why MBS’s are liquid because if the borrower defaults, the bond holder immediately gets their money as a mortgage prepayment rather than having to go through a foreclosure process before they get their cash.

    So if you do have stress, what will happen is that off-balance sheet liabilities become real on-balance sheet ones, and assets are increased with illiquid properties. The danger is that if you have a large number of defaults, then Freddie/Fannie need to pay out a large amount of cash immediately. They may get the cash back from the value of the forclosed property, but even if there is enough value in the property you could have liquidity problems.

    This is one big hole in the system. Fannie and Freddie could end up totally solvent with more than enough assets than liabilities, yet still default because people want cash and not unsold houses. Commercial banks can rely on the Fed as the lender of last resort, but there is no real lender for the GSE’s.

  • Posted by Dave Chiang

    Brad writes “I assume you have thought through the implications of defaulting on China?”

    The GSE debt along with US Federal Debt is unrepayable. Period. The US is de facto defaulting by devaluating the currency. The Washington Consensus never intended to repay its debt obligations to the world. Instead of continuing to pour surplus money down the rathole into US denominated bonds, it is better long-term for the Chinese to take their haircut upfront.

  • Posted by bsetser

    I do think a controlled RMB appreciation is a good thing; a sudden appreciation that coincided with an end of chinese purchases of US debt would be an altogether different matter.

    Incidentally, 2fish, my various conversations with low level Chinese officials have led me to conclude that China actually does put a lot of faith in the implied guarantee of US to stand behind the Agencies. And remember, the Agencies are financed by PboC liabilities, so a big fall in their value would create a need to recapitalize the PBoC (or for the PboC to operate with negative equity) and that might trigger a sense that the man on the street was losing out. More generally, everyone would know that the SAFE had put China’s savings into aGencies, and there would likely be a sense that SAFE had squandered China’s wealth — and SAFE would in turn deflect blame to the US.

  • Posted by Dave Chiang

    Rogers, Soros call Fannie, Freddie plan a disaster
    http://dailybriefing.blogs.fortune.cnn.com/2008/07/14/rogers-soros-fannie-freddie-plan-a-disaster/

    Investor Jim Rogers tells Bloomberg that the Treasury Department’s plan to shore up market confidence in Fannie Mae (FNM) and Freddie Mac (FRE) is an “unmitigated disaster” and that the country’s largest mortgage lenders are “basically insolvent.” “These companies were going to go bankrupt if they [the government] hadn’t stepped in to do something, and they should’ve gone bankrupt with all of the mistakes they’ve made,” Rogers reportedly said.

    Rogers is a former partner of famed hedge fund manager George Soros and the current chairman of Rogers Holdings. He said that taxpayers will be saddled with debt if Congress approves Treasury Secretary Henry Paulson’s request for the authority to buy unlimited stakes in and lend to Fannie and Freddie; and that the mortgage giants’ stocks could fall further. Goldman Sachs (GS) analyst Daniel Zimmerman agrees, saying shares could slide another 35%. He lowered his price estimate for Fannie to $7 from $18 and for Freddie to $5 from $17. The analyst note isn’t surprising, given the government’s reported indifference to the fortunes of company shareholders. Fannie Mae’s market cap is now about $9.5 billion, down from $38.9 billion at the end of 2007. Freddie Mac’s market value has shrunk to about $4.4 billion from $22 billion at the end of last year.

    Soros got a jab in, too. The billionaire investor told Reuters that “Freddie Mac and Fannie Mae have a solvency crisis, not a liquidity crisis.” The real problem, he says, is that Fannie and Freddie are “extremely leveraged,” and that “deterioration in the housing market, the foreclosures, are going to cause losses which exceed their equity.”

  • Posted by Twofish

    bsetser: I do think a controlled RMB appreciation is a good thing; a sudden appreciation that coincided with an end of chinese purchases of US debt would be an altogether different matter.

    The PRC government has been trying to do a controlled RMB appreciation for the last several years and getting grief from people that think it is too controlled. The big problem is that if the PRC panics and stop buying US debt, it will likely be at the same moment that everyone else on the planets panics and stops buying debt.

    bsetser: Incidentally, 2fish, my various conversations with low level Chinese officials have led me to conclude that China actually does put a lot of faith in the implied guarantee of US to stand behind the Agencies.

    They really shouldn’t. One question about implied guarantees is why the guarantee should be implied.

    What ends up happening is that you end up telling the government, since you aren’t guaranteeing my behavior, you have no reason for putting limits on me. But at the same time, you are telling potential lenders that you have this guarantee and so you should lend to me at low interest rates. You then borrow at low interest rates and then lend for extremely speculative stuff.

    Is this guaranteed or not? It’s a simply yes or no answer, and if you can’t get a yes or no answer, something is wrong.

    bsetser: that might trigger a sense that the man on the street was losing out.

    For this cause public anger you need something that causes the man on the street to feel that they have lost something. This involves inflation, unemployment, taxes, or bank failures. If those don’t happen, then no one is going to care.

    bsetser: More generally, everyone would know that the SAFE had put China’s savings into aGencies, and there would likely be a sense that SAFE had squandered China’s wealth — and SAFE would in turn deflect blame to the US.

    But this is unlikely to turn into public anger unless there it starts hitting people in the pocketbook. If you have a major recession or worse in China as a result of Fannie Mae’s failure, then yes you would get anger. If the losses are paper losses, then you won’t.

    In any case, the nationalism card is extremely dangerous for the Chinese government to play, and my guess is that the government will do everything they can to avoid having people angry at the US. The trouble is that people will be angry at the US doing stupid things and losing Chinese money for about a day or two, before the anger gets redirected at the officials that caused the money to be lost.

  • Posted by Twofish

    Jim Rogers via DC: Letting the two fail would throw the country in recession but would ensure that the system is cleansed, he added. “It would cause problems in the economy but we’ve got problems in the economy anyway.

    Sounds like those idiots in the IMF and Washington Consensus that recommended shock therapy to Russia and Indonesia back in the 1990′s.

  • Posted by satish

    We haven’t had a dollar fall yet translating into higher oil prices. By rescuing these reckless financials there are going pour fuel into oil price by enormous printing of paper money. If US continues such bailing out, inflation will hit triple digits within another 2 years given that US govt must bail out another 150 to 200 financial centres.

  • Posted by FG

    Twofish: In any case, the nationalism card is extremely dangerous for the Chinese government to play…

    If the economy turns bad and there are riots or other serious challenges to authorities, it will be tempting for the Chinese government to play that card and seek a national rally behind it.

    Twofish: Sounds like those idiots in the IMF and Washington Consensus that recommended shock therapy to Russia and Indonesia…

    Every step of the way there was a choice between a painful resolution of the problem and a temporary postponement of that resolution. So the resolution keeps getting postponed. i.e. the government will borrow even more money and the Feds keep rates negative.

    The problem is that the degree of pain required for the resolution has become worse and worse and eventually something will happen that will force it.

  • Posted by Rien Huizer

    Twofish, yr # 22. We man the same: when a borrower defaults, the agency pays and thus reduces its stock of guarantees. But simultaneously it turns cash into a different sset, intially a mortgage, later a foreclosed property, after a succesfull sale, cash again. What I meant is that foreclosures (ceteris paribus) increase the balance sheet.

    Brad: re the CNY/JPY: I believe the Japanese have a non-mercantilist argument to support he USD (and they have wide range of informal/unofficial ways to do that, learned during their trade guerilla days), i.e. the solvency of the life insurance and pension system. Contrary to China, in Japan exchange losses matter, because they would hit the private sector very hard and that would be bad for politicians. In China, the losses would be for account of the whole people, i.e. no one. China and Japan both have an interest for mercantilist reasons too, but at the current stage, China benefits more from policy that supports Japanese MNCs etc internationally than from FX competition with Japan. With Japan thus having a policy space that may be considerably narrower than China’s, but is blessed with a much more opaque FX intervention apparatus, I would assume that there is a point in the future where China thinks it has done enough, that the Japanese agree with them and where the rate is still in reasonable territory for Japan (ie USD/JPY between 105 and 120. Currently there is little room for the USD to weaken to JPY 110-115, but that would be it. Hence my advise to hang on to the JPY and my view that pretty soon Chinese-Japanese considerations will start to override Chin-US ones. Not scientific I am fraid..

  • Posted by Rachel

    One reason for the possible discrepancy re Russia’s holdings – Their 100b estimate is from the end of 2007, and I think Russia added agencies in those 4 months. perhaps not enough to make up 55b, but it might make the estimate closer. great post!

  • Posted by Judy Yeo

    Very interesting

    FG

    It might be tempting to play the nationalism card, South Korea seems to be moving in that direction, of course, the unfortunate turn of events does not help matters. However, I agree with 2fish, it’s a dangerous card to be played. The sentiment could turn against the government; dissatisfaction against the central government has come from various different sectors, nationalism might prove the glue that turns scattered bits to a unified bloc, that might prove disastrous.

    Rien:But simultaneously it turns cash into a different sset, intially a mortgage, later a foreclosed property, after a succesfull sale, cash again.

    Hmm, sounds a little like the physics transformation of energy. But seriously, that particular events cycle has a unpredictable timeline, if it even completes at all. Bloomberg had a special some months back where they highlighted the fact that foreclosures had dropped in numbers ‘cos not only were the court proceedings complicated by the selling on of mortgages and therefore complications in documentation, sdome of those financial institutions involved were sitting on non-paying or those customers in default as the additional costs in the procedures required for a sale of the property mase their losses even worse. The last part; the sale; is the probably the “realization of losses” which financial institutrions wish to give a miss, after all, they are probably looking at negative equity, hence realized losses.

    Twofish:Sounds like those idiots in the IMF and Washington Consensus that recommended shock therapy to Russia and Indonesia back in the 1990’s.

    aah, but he’s probably betting that the US has a better chance of turning out the Russian way rather than Indonesia. So, perhaps the idiotic question is, who’s going to have the putin effect?

  • Posted by flow5

    The housing solution is the same as it was in 66. So how does the FED follow a “tight” money policy and still advance economic growth.? What should be done? The commercial banks should get out of the savings business (REG Q in reverse-but leave the non-banks unrestricted). What would this do? The commercial banks would be more profitable – if that is desirable. Why? Because the source of all time deposits within the commercial banking system, is demand/transaction deposits – directly or indirectly through currency or their undivided profits accounts.

    Money flowing “to” the intermediaries (non-banks) actually never leaves the com. banking system as anybody who has applied double-entry bookkeeping on a national scale should know. The growth of the intermediaries/non-banks cannot be at the expense of the com. banks. And why should the banks pay for something they already have? I.e., interest on time deposits.

    It fosters an increase in the supply of loan funds at a lower rate of interest…to the benefit of the com. banks, the non-banks,and the economy.

  • Posted by Rien Huizer

    Flow 5: the FED is simply the fall guy of a cleverly designed political responsibility transferring system. As to Reg Q, I guess you have never ben a bank treasurer, and certainly not in 1981. Your proposal would grant competitive advantage to islamic banks. They have figured out how to keep deposits without paying interest (formally).
    I would have no problem with changing deposit insurance (lower mount, a personal guarantee (of max USD 250000 rather thn a guarantee that applies to institutions, plus regulatory supervision that would identify eligbile deposittakers. Premiums should be paid by depositors themselves. The trouble is that FDIC-like schemes have spread ll around the world, in the wake of financial sector reform (s a “best practice”) and it is imposible to design them in such a way that they () offer some legitimate protection to consumers and (b) remove the basic agency problem of banking. But then again, banks are genuinely useful (i.e. they are very hard to replicate by financial markets and non-bank service providers) and they tend to be popular among politicians who exploit a variety of irrationalities profitably. Just accept that banks will be either weakened by non bank competition in good times and require occasional bail outs in bad times. And now there i also attention for entities without a banking charter that do things looking like banking, pretty soon my children will have an opportunity to be bailed out if I fail to produce the promised inheritance when my time comes..

  • Posted by RebelEconomist

    “My interpretation of all this is that during the 04-06 period, central bank demand for (relatively low yielding) Agencies freed up private capital to be deployed in the higher-risk, higher-reward portions of the mortgage market, with disastrous results. No doubts others will interpret the data differently.”

    Yes, others will! I note that the dip in the US private holdings of agency debt in your last graph is much larger than the rise in foreign private or official holdings.

  • Posted by flow5

    To the individual commercial banker, non-banks are obviously competitors. Funds transferred from his bank to a non-bank usually resulted in a loss of deposits, and often the opportunity to make bankable loans. Bankers, Congress, and most of the banking authorities have simply not been able to grasp and to construct our financial institutions in a systems context. From a system standpoint the non-banks and the commercial banks are not competitive, but have a relationship that can be mutually beneficial to the economy.

    The drive by the commercial bankers to expand their savings accounts has a totally irrational motivation, since it has meant, from a systems standpoint, competing for the opportunity to pay higher and higher interest rates on deposits that already exist in the commercial banking system. But it does profit a particular bank, Citibank, to pioneer the introduction of a new financial instrument such as the negotiable CD until their competitors catch up; and then all are losers. The question is not whether net earnings on CD assets are greater than the cost of the CDs to the bank; the question is the effect on the total profitability of the banking system. This is not a zero sum game. One bank’s gain is less than the losses sustained by other banks.

  • Posted by flow5

    Add the Euro-Dollar into the equation. It has been, and will continue to be, a superfluous and harmful addition to the already excessive national monetary stocks of the world.

    It is estimated by the BIS that more than 7.44 trillion Eurodollars were in existence as of 2004, and the E-D bankers have increased their earning assets by approximately that amount. This figure is approximately equal to the size of the U.S. means-of-payment money supply (M2 – 7.67 trillion).

    This vast addition to the world’s money supply has substantially contributed to the high rates of inflation and thus to the mounting portfolios of the world’s Central Banks.

  • Posted by Rien Huizer

    flow 5 : you have an intriguing view of intitutioality. Once, the banks that started to compete by paying interest on previously idle balance, in order to (a) defend against non-bank competition (b) take turf away from more timid banks and (c) build a business that would look more like the european universal banks with their diversified earnings streams, could have been constrained by aggressive regulation (like investment banks could have been forced to stick to fixed commissions (although the Supreme Court might have been a problem). But not happen. Do you sincrely believe regultion solves any problems in excess of the cost of regulation? There may be a few instances but they are not in finance. But, the risk averse public can be preayed upon and perhaps their piece of mind is worth something. I would say (expletive) the laobaiqing..

  • Posted by Rien Huizer

    flow 5: excuse the many unintelligible typos! I am working with a new computer and it seems to defeat my attempts at typing English
    Sentence 1: intuitioality must be institutionality
    sentence 2: balanceS
    Sentence 3 should read “But that did not happen”
    sentence 4: self-evident
    sentence 6 preyed upon, peace of mind..

  • Posted by flow5

    If I go too far just delete the post:
    The most egregious error in Keynesian economics is the insistence that commercial banks are financial intermediaries:
    A commercial bank becomse a financial intermediary only when there is a 100% reserve ratio applied to its deposits.

    Any institution whose liabilities can be transferred on demand, without notice, and without income penalty, by data networks, checks, or similar types of negotiable credit instruments, and whose deposits are regarded by the public as money, can create new money, provided that the institution is not encountering a negative cash flow.

    From a systems viewpoint, commercial banks as contrasted to financial intermediaries: never loan out, and can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits (TRs), or time deposits (TDs) or the owner’s equity or any liability item.

    When CBs grant loans to, or purchase securities from, the non-bank public (which includes every institution, the U.S. Treasury, the U.S. Government, state, and other governmental jurisdictions) and every person, except the commercial and the Reserve Banks), they acquire title to earning assets by initially, the creation of an equal volume of new money- (TRs).

    The lending capacity of the member CBs of the Federal Reserve System is limited by the volume of free-gratis legal reserves put at their disposal by the Federal Reserve Banks in conjunction with the reserve ratios applicable to their deposit liabilities (transaction accounts), as fixed by the Board of Governors of the Federal Reserve System.

    Since 1942, money creation is a system process. No bank, or minority group of banks (from an asset standpoint), can expand credit (create money), significantly faster than the majority banks expand.

    From the standpoint of the individual commercial banker, his institution is an intermediary. An inflow of deposits increases his -gratis legal reserves, not a tax [sic] – and thereby it’s lending capacity. But all such inflows involve a decrease in the lending capacity of other commercial banks (outflow of cash and due from bank items), unless the inflow results from a return flow of currency held by the non-bank public, or is a consequence of an expansion of Reserve Bank credit. Hence, all CB liabilities are derivative.

    That is, CB time/savings deposits, unlike savings accounts in the “thrifts”, bear a direct, one-to-one, unvarying relationship, to transactions accounts. As TDs grow, TRs shrink pari passu, and vice versa. The fact that currency may supply an intermediary step (i.e., TRs to currency to TDs, and vice versa) does not invalidate the above statement.

    Monetary savings are never transferred to the intermediaries; rather monetary savings are always transferred through the intermediaries. Indeed, as evidenced by the existence of “float”, reserve credits tend, on the average, to precede reserve debits. Therefore, it is a delusion to assume that savings can be “attracted” from the intermediaries, for the funds never leave the commercial banking system.

    Consequently, the effect of allowing CBs to “compete” with S&Ls, MSBs, CUs, MMFs, IBs and other intermediaries (non-banks) has been, and will be, to reduce the size of the intermediaries (as deregulation did in the 80’s) – reduce the supply of loan-funds (available savings), increase the proportion, and the total costs of CB TDs.

    Contrary to the DIDMCA underpinnings, member commercial bank disintermediation is not, and has not been, predicted on interest rate ceilings. Disintermediation for the CBs can only exist in a situation in which there is both a massive loss of faith in the credit of the banks and an inability on the part of the Federal Reserve to prevent bank credit contraction, as a consequence of currency withdrawals. The last period of disintermediation for the CBs occurred during the Great Depression, which had its most force in March 1933. Ever since 1933, the Federal Reserve has had the capacity to take unified action, through its “open market power”, to prevent any outflow of currency from the banking system.

    However, disintermediation for financial intermediaries-S&Ls, MSBs, CUs, (non-banks), etc., is predicated on their loan inventory (and thus can be induced by the rates paid by the commercial banks); earning assets with historically lower fixed rate and longer term structures. In other words, competition among commercial banks for TDs has: 1) increased the costs and diminished the profits of commercial banks; 2) induced disintermediation among the “thrifts” with devastating effects on housing and other areas of the economy; and 3) forced individual bankers to pay higher and higher rates to acquire, or hold, funds.

    Savers (contrary to the premise underlying the DIDMCA in which CBs are assumed to be intermediaries and in competition with thrifts) never transfer their savings out of the banking system (unless they are hoarding currency). This applies to all investments made directly or indirectly through intermediaries. Shifts from TDs to TRs within the CBs and the transfer of the ownership of these TRs to the thrifts involves a shift in the form of bank liabilities (from TD to TR) and a shift in the ownership of (existing) TRs (from savers to thrifts, et al). The utilization of these TRs by the thrifts has no effect on the volume of TRs held by the CBs or the volume of their earnings assets.

    In the context of their lending operations it is only possible to reduce bank assets and TRs by retiring bank-held loans, e.g., the only way to reduce the volume of demand deposits is for the saver-holder to use his funds for the payment of a bank loan, interest on a bank loan for the payment of a bank service, or for the purchase from their banks of any type of commercial bank security obligation, e.g., banks stocks, debentures, etc.

    The financial intermediaries can lend no more (and in practice they lend less) than the volume of savings placed at their disposal; whereas the commercial banks, as a system, can make loans (if monetary policy permits and the opportunity is present) which amount to server times the initial excess reserves held.

    Financial intermediaries (non-banks) lend existing money which has been saved, and all of these savings originate outside the intermediaries; whereas the CBs lend no existing deposits or savings; they always, as noted, create new money in the lending process. Saved TRs that are transferred to the S&Ls, etc., are not transferred out of the CBs; only their ownership is transferred. The reverse process, which is called “disintermediation”, has the opposite effect: the intermediaries shrink in size, but the size of the CBs remains the same.

    From a System standpoint, time deposits represent savings have a velocity of zero. As long as savings are held in the commercial banking system, they are lost to investment. The savings held in the commercial banks, whether in the form of time or demand deposits, can only be spent by their owners; they are not, and cannot, be spent by the banks.

    From a system standpoint, TDs constitute an alteration of bank liabilities, their growth does not per se add to the “footings” of the consolidated balance sheet for the system. They obviously therefore are not a source of loan-funds for the banking system as a whole, and indeed their growth has no effect on the size or gross earnings of the banking system, except as their growth affects are transmitted through monetary policy.

    Lending by intermediaries is not accompanied by an increase in the volume, but is associated with an increase in the velocity of money. Here investment equals savings (and velocity is evidence of the investment process), where in the case of the CB credit, investment does not equal savings but is associated with an enlargement and turnover of new money.

    The difference is the volume of savings held in the commercial banking system is idle, and lost to investment as long as it is held within the commercial banking system. Such a cessation of the circuit income and transactions velocity of funds, funds which constitute a prior cost of production, cannot but have recessionary effects in our highly interdependent pecuniary economy. Thus, the growth of time deposits shrinks aggregate demand and therefore produces adverse effects on GDP and the level of employment.

    PUBLICATIONS
    Dr. Leland James Pritchard (MS, statistics – Syracuse, Ph.D, Economics – Chicago, 1933) described stagflation 1958 Money & Banking Hough McMillian
    “The Economics of the Commercial Bank Savings-Investment Process in the United States” — “Estratto dalla Rivista Internazionale di Scienze Econbomiche & Commerciali “ Anno XVI – 1969 – n. 7
    “Profit or Loss from Time Deposit Banking” — Banking and Monetary Studies, Comptroller of the Currency, United States Treasury Department, Irwin, 1963, pp. 369-386.

  • Posted by Twofish

    I don’t see how this works. Bank loans me $1000, I then use the $1000 to buy Treasuries. That cash goes to the US government which then reduces its liabilities to the Fed. I now have $1000 in Treasuries that are not balanced by any deposits in the commercial banking system.

    I can also deposit my money with an investment bank which then enters into exactly the same sorts of transactions that a commercial bank does. The $100 I loan to my bank isn’t any different from the $100 I loan to my broker.

  • Posted by flow5

    The Treasury didn’t retire the notes. And the Treasury will spend it’s new deposits. And the shifting to and from the General Fund account does effect bank reserves but the “trading desk” offsets any change.

    And the money loaned to you (which you use to purchase Treasuries) is not existing money, but it is newly created money (the product of fractional reserve banking). As Friedman would say – “the bookkeeper’s pen is at work”. And don’t expect anything to balance (the expansion coefficient), when legal reserves are no longer “binding”.

  • Posted by flow5

    The I-Bank customer deposits are maintained with a commercial bank. I-Banks are the customers of the commercial banks. Deposits maintained by commercial banks with other CBs are called interbank demand deposits or clearing balances.

    I set the parameters for defining CBs. The transactions of I-banks behave differently.

    Example: Since Mutual Savings Bank’s (MS B) inception, it has been illogical that their account balances in the Member Commercial Banks (MCB)were designated as inter-bank demand deposits (IBDD’s –balances maintained by customer banks in correspondent banks), presumably because MSBs were called banks (with the exception of 6 MSB banks that had MCB regulations) and were insured by the Federal Deposit Insurance Corporation (FDIC) and not the Federal Savings & Loan Insurance Corporation (FSLIC), and not counted in M1.

    At the same time S&L’s deposits were insured by the FSLIC and their balances in the MCBs were not designated as IBDDs (were counted in M1); neither institution had the right to hold deposits transferable on demand, without notice, and without income penalty (the legal basis for becoming a MCB), prior to the Depository Institutions Deregulation & Monetary Control Act (DIDMCA); both were the customers of the MCBs; and neither had Regulation Q restrictions prior to 1965.

    Thus the M1 figure, even now, increasingly overstates the quantity of the means-of-payment money. This upward bias is the consequence of classifying Savings and Loan and Credit Union Deposits as commercial banks (but not Mutual Savings Bank deposits) as demand deposits, rather than inter-bank demand deposits. M1 thus includes both the Negotiable Order of Withdrawal (NOW) account balances and the thrifts’ balances in the commercial banks – a double counting of our means-of-payment money.