Ut-oh
Agency spreads have widened. See John Jansen for all the gory details.
The New York Fed’s custodial holdings of Agencies haven’t grown at anything like their typical pace over the past few weeks. In the first two weeks of August, custodial holdings of Agencies fell by $6.7b while custodial holdings of Treasuries rose by $24.7b.
And — via Yves Smith – comes word that foreign central banks have been a bit more reluctant than usual to buy the debt the Agencies issue to refinance their retained mortgage portfolio. Lynn Adler of Reuters writes:
Overseas investors took an atypical back seat in Fannie Mae’s three-year note sale this week.
Central banks bought just 37 percent of the $3.5 billion issue, down from 56 percent in May’s $4 billion offering of the same maturity. Asia accounts took just 22 percent of the notes, down from 42 percent in May. “Most fixed income investors to whom we have spoken believe that a capital infusion by the government into Freddie and Fannie is a prerequisite for turning sentiment around in mortgage-backed securities and, by extension, in the broader fixed income markets,” Barclays Capital analysts Rajiv Setia and Philip Ling wrote in a report The longer the debate drags on, the more tentative foreign interest in the sector is likely to become. Even though the GSEs are adequately capitalized, investor confidence has been shaken,” the analysts wrote. “A slowdown in international investor interest remains the major risk factor for agency spreads, in our view.”
No wonder there is a lot of interest in Asian (read “central bank”) demand for Tueday’s Freddie Mac auction.
The Treasury’s bailout plan for Agencies sought to retain the Agencies current “hybrid” structure, one where the Agencies continued to be privately owned even as they borrow in the market at (relatively) low spreads based more on the expectation that they are too big, too important and too Chinese to fail than on the strength of their balance sheets. Larry Summers noted: “almost every outside observer agrees that pre-crisis, the GSEs could only borrow because of their implicit government guarantees. Since the crisis their position has sharply deteriorated, and will deteriorate further.” The Treasury’s plan hinged in the first instance on strengthening the perception that the US government stood behind the Agencies rather than strengthening the Agencies actual balance sheets. And with ongoing deterioration in the housing market — and rising losses on Alt-A mortgages, it seems like the world’s central banks aren’t buying it.
It isn’t all that hard to see why. If one of the Agencies goes bust, no reserve manager wants to be responsible for having lost a ton of money. Not now. Not after the size of some countries’ Agency holdings started to attract a bit of attention. That may force the Treasury’s hand. The spreads the Agencies can afford to pay are too small to compensate reserve managers for the reputational cost — and political fallout — they would face should the Agencies ever default.
And I would bet the fact that the US is at odds, politically, with one of the largest holders of Agencies hasn’t helped; the Russia’s central bank was scaling back its Agency portfolio even before the conflict over Ossetia broke out.
Most analysis of the housing boom tends — in my view — to leave out the role of Agencies played in channeling central bank funds into the housing market.
That strikes me as a mistake. True, the Agencies weren’t growing their balance sheets that rapidly at the peak of the housing boom. And foreign central banks generally didn’t buy the kind of risky repackaged mortgages that caused the most trouble over. The central banks tended to stick to more traditional kinds of “product.”
But in more subtle ways, the rise in central bank reserve growth combined with the United States’ almost unique capacity — through the Agencies — to transform a pool of mortgages into an acceptable central bank reserve asset to fuel the boom. Central bank demand for Treasuries and Agencies kept overall interest rates down. Particularly after 2004 — when the fiscal deficit started to fall and the Japanese stopped intervening — central banks started to buy a lot of Agency bonds.
Low long-term rates pushed up housing prices, helping to create expectations that home prices would rise and it was safe to buy a home with little down — and that it was safe to lend money to someone buying homes with little down.
The inverted yield curve made it hard for a lot of vehicles that borrowed short (by issuing short-term paper) and lent long (by buying longer-term securities) to make money. Or to make money without taking on a lot of credit risk. That contributed to the rise in demand for riskier securities. Pension funds that needed a bit of yield to honor their commitments also started taking on more risk.
Central banks bought the safe stuff, holdings its price down. And private actors took the money freed up by the sale of Agency bonds to central banks and bought riskier debt. It all sort of worked, at least for a while.
The irony of course is even though the Agencies ability to tap central bank demand to support the housing market contributed to the current crisis, the Agencies ability to continue to tap central bank demand to support the housing market is also central to the resolution of the current crisis. Or at least central to hopes that the current crisis can be resolved without much larger falls in home prices, much bigger financial losses and the need for the government to step in and backstop the banking system more directly. Right now the Agencies account an ungodly share of new mortgage lending.
I think former Treasury Secretary Larry Summers got this right in the Financial Times a few weeks back. He wrote:
we need the GSEs to be highly active in support of the housing market and financial system in the months ahead. If the authorities can see a path to their being able to play such a role in a framework where it can honestly be said that their borrowing is based on confidence in their financial position rather than primarily on federal guarantees, then this is obviously the preferred alternative. But after what we have seen, such a judgment cannot be based on the GSEs’ own claims, the understandable desire of government officials to maintain confidence and attract private capital, or the fact that they are able to borrow – which only reflects the strength of federally provided credit assurances.
If this preferred alternative is, as I fear, not realistic given the state of GSE finances, the government should use its new receivership power to protect taxpayers and the financial system. In the process, payments to stock holders, holders of preferred stock and probably subordinated debt holders would be wiped out, conserving cash for the benefit of taxpayers. The GSEs’ borrowing costs would fall considerably, helping prospective homeowners.
In this scenario, the government would operate the GSEs as public corporations for several years. They would then be in a position to extend credit where appropriate to support resolution of the current housing crisis. Once the crisis has passed, the federal government would divide their functions into government and private components, the latter of which would be sold off in multiple pieces. The proceeds could be used to fund the low-income housing support activity that was previously mandated to the GSEs. (emphasis added)
This option is obviously not good for the GSE’s current share holders. But it is hard to ask private shareholders to risk large loses in the pursuit of public policy goals. And right now the US government wants the GSEs to lend, not to conserve their capital.
And it certainly seems like the GSE’s creditors aren’t in the mood to extend credit just on the expectation that the GSE’s will be backed by the government if there is a need. The world’s central banks want to the Treasury to show them some money. That means changing the GSE’s current structure.
Do svidaniya…
Equity, preferred, and subordinated paper are a relatively thin slice of FNM and FRE’s capital structure, something like $40 billion from the numbers I can find. I wouldn’t be surprised if a rescue left those out in the rain as a bit of a warning to those playing the moral hazard trade.
I still see no way a haircut could be imposed on the senior debt, though, without international ramifications and obliteration of bank balance sheets. That leaves an exceedingly expensive bailout to be done.
The implications and ramifications the background and different schools of thought can be discussed ad infinitum. In the end the reactions of individuals are not hard to understand really.
The real questions are, why did it go on so long, why was it so hard to know when the inevitable would happen, how far will it go and what other outcomes will there be.
Having written the above I can see why its best to stick to discussing the facts on hand. lol
“we need the GSEs to be highly active in support of the housing market”
Does the US really? What if GSE’s activity ceases? (independently from whether existing GSE debt is payed off or not)
Lack of mortgage credit ->
-> house prices fall further ->
-> eventually they fall below construction cost ->
-> residential construction grinds to a halt.
Which, from a Hubbert’s Peak-aware perspective, is exactly what the doctor orders. Because construction of more suburban and exurban McMansions is just digging further in the already deep hole most of the US population is in, as inevitably higher fuel prices will turn those homes into traps for their occupants.
Sure enough, Professor Summers’ are hardly the only views incompatible with the constraints imposed by physical reality. The recent Greenspan’s advocacy of increasing immigration must have given PO-aware Americans the shivers.
The problem with all of this is that the economics do NOT support continue expansion of the housing market. There are millions and millions of americans that cannot afford to service the debt on there homes.
I laugh my A$$ off watching congress and the chinese try to pull every trick out of the book in order to keep this doomed system afloat. US consumes and the ROW lends it more and more savings. Its over and now everyone is running around with there heads cut off.
In the next couple years I think leadership around the world is going to change dramatically.
A lot of media attention these days for an article in Barron’s about the demise of Fannie and Freddie (which is at the bottom of this Debt Rattle).
Shares in both companies have fallen 15% so far this morning. Their combined market cap is now approaching a mere $10 billion, and that is supposed to support $5.3 trillion in debts and obligations.
The shares will keep falling, they’re beyond redemption; Barron’s includes the statement -which I’ve made here for ages- that common shareholders will be ceremoniously sacrificed. So will management. But they get to keep their pirated casino bonuses.
Since Barron’s estimates that Fannie and Freddie’s real value is negative $50 billion -each-, look for the Treasury and the Fed to figure out a way to pump $100 billion past the receding event horizon that envelops these companies.
And that will by no means be the last we hear of this. After all, $100 billion is still a far cry away from $5.3 trillion. If -make that when- US housing continues to falter, a lot more money will be needed. Long before Christmas.
The upcoming resets in Alt-A mortgages over the next few years provide an ironclad guarantee that US real estate, and hence Fan and Fred, will be hit hard. And the resets are but one in a long range of factors.
That makes all this not a financial, but a political issue. Whatever money will be used to buy out the two, will come from public coffers. And people will increasingly demand to know why the money should be used the way it is, especially as the whole economy starts contracting painfully later this year.
But it will be too late by then: the debts of the gambling community on Wall Street will have been transferred to your pockets, and you’ll be powerless to do anything about it. Fannie and Freddie will be nationalized in one form or another, so they will belong to you soon, debts included.
Both parties in Washington strongly support the biggest financial crime in world history, and there’s nobody else you can vote for. Really, it’s a closed system, it’s been thoroughly tested for leaks.
A good way to get an idea of what lies ahead for all countries comes from UK real estate: Asking prices for houses in London fell 5.3% in August, a $40,000 drop in value per home, in a single month.
I still see numbers floating around of a 30-40% drop in US real estate prices, peak to trough, and I’m starting to get annoyed at these numbers. They’re wild guesses based on nothing much at all. Please someone explain what exactly it is that is going to stop the decline once it’s past 30%.
I don’t see anything that could do that. There is a fast and furious contraction of available credit going on, and no lender will be left to finance home purchases on any workable scale.
EDITOR’S COMMENT: THIS COMMENT SEEMS TO HAVE BEEN LIFTED FROM ANOTHER BLOG AND POSTED WITHOUT ATTRIBUTION
Score: While you were watching Michael Phelps win 8 golds, Merrill Lynch was busy losing $29 billion in its London office.
Half-full Faith and Credit: Having the US bail out Fannie and Freddie is (a) socialism (b) fascism (c) necessary because the US needs foreigners to keep buying the GSE’s debt. Okay, that was easy. Now explain why even with the ‘full faith and credit’ pledge behind Fannie and Freddie they still have to pay 215 baisis points over the yield on Treasuries.
Crime Doesn’t Pays: Although charged with “multibillion-dollar consumer and securities fraud” and with overwhelming evidence proving it, Wachovia, JPMorgan, Morgan Stanley, UBS and others have gotten ‘do-overs’. They buy back the auction-rate securities, pay minimum (and tax-deductible) fines of about one-half of one percent of the amounts involved, and promise not to get caught again.
This is a game of chicken. The US should NOT yield to this foreign pressure to change the rules. To get back to trend growth, the US new res construction price needs to fall 20 percent from it’s peak in Mar 2007. Demand needs to fall more. It’s been over a year and we are down about 8 percent.
guest: I still see numbers floating around of a 30-40% drop in US real estate prices, peak to trough, and I’m starting to get annoyed at these numbers. They’re wild guesses based on nothing much at all. Please someone explain what exactly it is that is going to stop the decline once it’s past 30%.
There are plenty of fundamental reasons to believe the decline should stop around there. The price to median income ratio and rental yields are two extremely important metrics that would return to sane levels with a drop of that magnitude. It’s somewhat time sensitive as well, with a slower implosion requiring less steep drops in nominal price, assuming inflation somehow manages to stay positive(and I’m serious about that caveat).
There’s a great deal of ceteris paribus — interest rates, employment, oil, etc. — and no accounting for a potential overshoot due to market conditions in those numbers. But they’re probably about correct.
guest wrote: “Whatever money will be used to buy out the two, will come from public coffers.”
My understanding is that USG is running a deficit. No cash in the coffers.
F&F’s current situation, between bankruptcy and government ownership, is the worst of all possible worlds.
If their debt was gvt guaranteed (and if they resumed functioning, but under a stricter mandate ) that might help the housing market, reduce the ultimate cost to the taxpayer and make the taxpayer (who is probably more interested in the value of his house than worry about a (max) a few hundred billion extra money invested in maintaining a market in the most important asset most US households own. Wars to promote democracy (?) are a bit of a luxury for debt-ridden governments, but this is duty.
If they somehow manage to scrape by in a twilight zone until the economy recovers (by magic?) without wiping out managers, shareholders and reckless subordinated creditors, that can only happen if their lending is so constrained that it may well have procyclical effects.
Hence Summers is right. The problem is probably, how to wipe out these moral hazard artists. That is the game of chicken. F&F residual claimants vs the public interest. I would not expect these managers and employee shareholders to roll over, the opportunity to blackmail the gvt is their chief asset..
I’m afraid that guest@9:25 pm has nicked Ilargi’s commentary yesterday on the very good The Automatic Earth blog.
Recommended for those of a gloomy cast of mind.
i will edit guest’s comments to indicate they were nicked in a bit; i am not thrilled that anyone would lift someone else’s words without proper attribution.
“Low long-term rates pushed up housing prices, helping to create expectations that home prices would rise”
Exactly so. Price is at the heart of every bubble and it is nice to read that somebody understands that.
RealThink: What if GSE’s activity ceases?
No one will be able to buy or sell a house without pay 100% cash up front, which means that no one will be able to buy or sell a house.
RealThink: house prices fall further
This is the tricky part in unwinding a market. If you have a situation in which the price of houses drops but people are still buying and selling houses. This is a good thing. What you want to avoid is a situation in which no one is buying and selling at any price, and the market disappears. This is a bad thing.
Personally, I’d like to see Fannie and Freddie either split up into eight or nine institutions or else develop rules so that if someone wants to get into the same business as Fannie and Freddie they can.
The problem is that if you have two institutions and no possibility for new entrants, you end up with institutions that are too big to fail and too big to regulate. If you split things up so that there are eight or nine institutions, this increases both market discipline and regulatory discipline.
But I don’t see this happening….
guest: Both parties in Washington strongly support the biggest financial crime in world history, and there’s nobody else you can vote for.
And both parties support these sorts of things because ultimately that’s what the voters want them to do. Greed and corruption is something that people complain about when other people get the money. People are all for bailouts when its them that are getting bailed out.
guest: Please someone explain what exactly it is that is going to stop the decline once it’s past 30%.
Scared politicians that will do anything to keep themselves in power. Once things get bad enough then people will be screaming for a solution to the problem, any solution.
guest: There is a fast and furious contraction of available credit going on, and no lender will be left to finance home purchases on any workable scale.
If things get bad enough then the US government will intervene on a massive scale.
Brad,
No matter how many times you repeat the suggestion that central banks caused the US housing bubble, I will not believe it because:
(1) credit spreads narrowed not widened
(2) the Fed held, and continued to accumulate, plenty of safe debt themselves (unlike most other central banks)
I think your comment that “Pension funds that needed a bit of yield to honor their commitments also started taking on more risk” gives the game away. Pension funds did not NEED anything of the sort. Their first recourse should have been to increase the contributions. The problem has been, and still is, that Americans demand that their financial system gives them low interest rates on their debts without low returns on their assets.
rebel — you are right that pension funds could have sought higher contributions rather than taking on more risk to seek higher returns. but i think the evidence suggests that they opted for more risk. it wasn’t central banks alone;it was how central bank demand for the safe stuff impacted the rest of the market.
it is also true that SIVs could have shut up shop once it wasn’t profitable to play the yield curve. the evidence though suggests that they responded by taking on more credit risk. the absence of macro and financial market volatility made that seem like a good bet. and everyone was doing it. it may not have been forordained, but it was a reasonably predictable — or should have been — response to the artificial flattening of the yield curve from CBanks.
as for the absence of spread widening, you clearly don’t believe my story that funds displaced from the treasury and agency market found a home in riskier assets, bringing down spreads. and since i do think that was part of the dynamics of the time, i don’t find your argument about credit spreads persuasive. we will have to agree to disagree
certainly now spreads have widened . and i think the obvious explanation for why is the credit crunch; the channels that led private investors to seek risk and more return broke down last fall. so we have central banks and other investors all crowding into safe bonds.
Displacements are typically driven by an increase in potential difference, not a decrease.
[When the U.S. “Catches a Cold”, So Does the Rest of the World] — Northern Trust
“We never understood how there could be as much economic globalization but that a recession in the largest economy would leave the rest-of-the-world’s economies relatively unscathed. Consider that U.S. nominal imports of goods and services were 6.6% of the rest of the world’s nominal GDP in 2006, up from 4.5% 10 years earlier in 1996 (see Chart 1). Now that U.S. imports are contracting in real terms, both year over year and quarter to quarter (see Chart 2), wouldn’t you think that this would be having a negative impact on economic growth in the rest of the world?” — Paul Kasriel
The U.S. is just too big
ndk wrote, “there are plenty of fundamental reasons to believe the decline should stop around [30%]. The price to median income ratio and rental yields are two extremely important metrics that would return to sane levels with a drop of that magnitude.”
But, ndk is missing the psychological component. Usually when a bubble bursts, prices end up falling too far. Lots of people who bought houses during the bubble and lost their life savings will not likely take the plunge again. I’m betting that housing prices will decline much farther than 30%, even if easy credit is available.
And let’s not forget that it was President Clinton’s 1997 change in the capital gains tax treatment for housing that may have gotten this bubble started. Bad economics policies can be extremely destructive.
Clinton replaced President Truman’s sensible capital gains deferment when homeowners sell one home to buy another with a new treatment that encouraged speculation. See our Enter Stage Right commentary: ( http://www.enterstageright.com/archive/articles/0808/0808ecgrowth.htm ) or our blog posting about the congressional attempt to finally close the barn door that Clinton opened ( http://tradeandtaxes.blogspot.com/2008/08/clintons-1997-tax-cut-contributed-to.html )
Howard Richman
Usually when a bubble bursts, prices end up falling too far. Lots of people who bought houses during the bubble and lost their life savings will not likely take the plunge again. I’m betting that housing prices will decline much farther than 30%, even if easy credit is available.
I think our only disagreement is how broad my “market conditions” clause was. No question, this is a possibility and perhaps a probability.
Thanks for flagging the tax change. I’m luckily too young to have been financially aware back then. It’s a serious mistake — amongst many made — that would’ve been even more consequential if our IRS were sufficiently staffed to even do its job. The more I learn about history and the world, the more inspired and awed I am that we’ve made such amazing progress despite ourselves.
Rebeleconomist,
Your second para hits the nail right on the head. But why are people so stupid to believe all those snake oil salesmen offering low borrowing costs and high investment yields? Because they do not believe, realize, have not been taught, etc that lunches have to be paid by someone. I do not think people a stupid, they are just optimistic about their own ability to avoid paying. They expect that everyone else (the community that pays tax) will pay.
And they are right up to a point. I believe that the US taxpayer should be not too concerned about bail-outs (there is of course the moral issue that reckless equity investors and crooked managers took on risks voluntarily that were so transparent that they do not deserve a bail-out. But Joe taxpayer might expect that next to warfare, the gvt may also spend a little on his more specific welfare. And over time, that is what has happened, and then bracket creep bailed out the government, and even more lately, an even less painful process took care of things, greater fools from abroad.
Brad,
Come to think of it, the idea of displacement inspires another argument against the theory that central banks played an active role (as opposed to a passive role through their currency pegs) in creating the US debt bubble. That is that the volume of spread product created exceeds the growth of foreign exchange reserves. From the beginning of 2003 to mid-2007 when the credit crisis struck, global dollar foreign exchange reserves grew by about $2tn, whereas US non-government debt grew by about $8tn. The outstanding stock of CDOs alone grew from very little to about $2tn in the same period.
Perhaps dollar-pegging central banks can be blamed for not raising the level of the overflow outlet as they entered the bath, but the US borrower kept the taps fully open.
In my view, the facts are more consistent with a story in which the irresistible force of a US credit boom ran into the immovable object of dollar currency pegs.
I think Russia will sell all its GSE portfolio in coming months. The problem is getting the public attention - almost every day on TV I can see the reports conserning russian investments in american mortgage papers. The absurdity of situation is coming clear - US tries to humiliate Russia, calls it “argessor”, uses double standards in international relations and in the same time waits for “help” ie buing the Agencies and Treasuries. That is ridiculous!
The meltdown of Agencies is only the begining, the Treasuries will be next.
Rien Huizer,
I agree that people are not stupid. On the contrary, they have learned that if enough other people are taking the same financial risks as them, their downside will be limited by the political imperative to bail them out.
Rebel,
Sound like the myth of the irrational voter to me. You know the guy is not irrational, right?
Rebel: “From the beginning of 2003 to mid-2007 when the credit crisis struck, global dollar foreign exchange reserves grew by about $2tn, whereas US non-government debt grew by about $8tn.”
When I noted that Americans hold a lot more Agencies than foreigners, Brad pointed out that flow was more important. I’m glad to see the US/foreign flow breakdown on spread product.
flow is important. the stock of agencies outstanding wasn’t growing for a while (b/c of the accounting issue/ concerns about unfair competition with private “MBS” issuers) while CB holdings were rising, so Americans were selling some existing agency bonds to foreigners, getting cash that needed to be redeployed elsewhere.
the US v foreign flow spreakdown on spread products would be interesting, but it will also be distorted by all the SIV activity/ hedge fund activity offshore. There was a huge surge in foreign demand for spread product from the UK from 03- mid 07, but it looks to me to have been artificial, meaning that entities in the uk borrowed from the us (via the money market) to buy long-term us debt, and were only offshore in the tax and legal sense. they weren’t intermediating foreign savings.
Rien Huizer,
Never heard of that myth…..please explain. I think that people’s behaviour is a rational response to the incentives they are given. The problem is that the incentives, which amount to macro moral hazard, are not sustainable.