Faltering central bank demand for agencies …
Central bank holdings of Agencies at the New York Fed have fallen by $9.4b this month (from $981.7b to 972.3b), while central bank holdings of Treasuries are up by close to $28.4b (from $1394.6b to 1423.0 b)
Most central banks hold the bonds the Agencies themselves issue, not the bonds they guarantee. But there is a big exception: China. And China too seems to be scaling back its purchases. In the course of a (good) article on the Agencies, the Economist notes that China was — until recently — buying $5 billion of Agency MBS a week.
The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks.
$5 billion a month is a large sum: $60 billion annualized. But it seems a bit low to me. The Treasury survey indicates that China bought nearly $100b of Agency MBS between June 2006 and June 2007 (bringing total Chinese holdings of Agency MBS above $200 billion), and Chinese reserve growth has picked up substantially since last June. (Edited from the initial post, see the note below)
Over the last year (think the period after the subprime crisis), central bank holdings of Agencies and Treasuries have increased by $419.5 billion — with a clear shift toward Treasuries recently after a long period where Agency holdings were growing faster than Treasuries. This quiet bailout far exceeds the roughly $35 billion that sovereign funds have invested in US banks. The US TIC captured most of these investments, and its shows $34.2 in official purchases of US equities over the last 12ms, with almost all the increase coming right after the big recapitalizations. The total would be higher if UBS and Barclays are added in — but also remember that many central banks don’t use the New York Fed’s facilities, and some rely on outside managers for even a Treasury and Agency portfolio. Central banks likely added more than $420 billion to their total holdings of Treasuries and Agencies over the last year.*
Americans have long criticized other countries for financial systems that direct credit to sectors favored by the government. Many argued that such directed credit contributed to the Asian crisis. It was inefficient. Countries would be far better off if they let the market pick winners. Or so the argument went.
Yet I think you can argue that the US right now isthe recipient of the largest government directed credit program in the world.
On one end, a private Chinese saver adds to their RMB account at a Chinese state bank. That state bank in turn buys the short-term bills the central bank issues to sterilize its reserve growth, or, put differently, the central bank finances its growing external portfolio by borrowing money rather than printing money. The central bank, having bought dollars in the foreign exchange market using the RMB it borrowed from the state banks, then buys US agency bonds — in effect, directing credit to the US housing market.
And on the other end, the US government-sponsored agencies bundle mortgages into securities that are sold globally — whether MBS with an Agency guarantee or the bonds the Agencies themselves issue to finance their retained portfolio — not on the basis of underlying credit but on the basis of the implicit US government guarantee.
That feels like directed credit to me. It only could have happened on the scale it did with the support of governments on both sides of the Pacific. The Chinese government took currency risk that private investors in China weren’t willing to take. The US government turn mortgages into liquid bonds that risk-adverse central banks would hold out by promising — implicitly — to take the credit risk.
And the resulting flow has been huge — and until recently, it was getting bigger. It now seems to have come to something close to a stop. Unless it restarts quickly, I suspect the US government will have to make its role in the process explicit.
In the short-run, the US needs this directed credit program to continue. Demand for non-Agency MBS has disappeared. And if credit isn’t available to buy homes, home prices will fall further, faster — adding to the distress of the US financial sector.
In the long-run, though, the US probably shouldn’t continue to favor investment in housing over investment in other sectors (to be precise, the US supports borrowing to buy homes, and thus indirectly supports the housing sector) to quite the degree it does now. The United States skill at turning mortgages into foreign exchange reserves interacted with China’s desire to avoid renminbi appreciation to produce an unhealthy economic cocktail.
NOTE: I initially reported that the Economist claimed that China was buying $5b a week in Agency MBS (which seemed a bit on the high side, though not implausible). The Economist actually said (as should have been clear from the quote I pasted in) that China was buying $5b a month in Agency MBS, which conversely seems on the low side. The text has been adjusted as a result. Thanks to Mitch (in the comments) for catching this.
* The increase in the Fed’s custodial holdings recently has been larger than recorded official purchases in the TIC data, yet more evidence that the TIC data understates official purchases. The last TIC data release shows — including a strong rise in holdings of t-bills and taking the rise in other short-term custodial holdings as a proxy for Agencies — $272.8 billion in Treasury and Agency purchases. The 12m increase in the FRNBY accounts at the end of June was $347.16b. I suspect the survey data will end up showing an increase of over $500 billion.
bsetser: In the long-run, though, the US probably shouldn’t continue to favor investment in housing over investment in other sectors (to be precise, the US supports borrowing to buy homes, and thus indirectly supports the housing sector) to quite the degree it does now.
For the US government to undertake policies that discourage home ownership will have extremely radical economic and social effects. Not saying that it won’t happen, but encouraging home ownership even at the cost of massive government subsidization has been something that the United States has been doing since the 18th century (see the Homestead Act and the sale of vast amounts of Western land).
The basic problem is that if you look at the personal balance sheet of most Americans, the vast majority of personal wealth is tied up in their house. There are limits to which any US government can allow housing prices to drop without facing a very nasty voter backlash. Ownership in land and property has been at the core of the American identity and the at the very definition of “middle class”. If that changes, you are going to see some pretty huge sociological changes.
bsetser: Unless it restarts quickly, I suspect the US government will have to make its role in the process explicit.
And it is not going to restart without the US government making its role explicit. The PBC or any other central bank is just not going to buy any more agencies until the US government makes clear what happens in case of a default by Freddie and Fannie.
And that will be a bailout without punishing shareholders etc, because they can only be wiped out if the agencies go bankrupt. And agency bankruptcy is not a good idea internationlly. In addition, there may ell be a legal case to mke that the F&F shareholders and managers were in fact encouraged by the government to play a certain role after the private sector had given up, and that the result of that activity was the proximate cause of the agency’s failure.
There’s probably a law against this; but, why can’t the Fed just buy the Agency bonds to help keep them solvent for the next year until the housing market bottoms. Thanks to foreign CBs the US has sold alot of low yielding US Treasuries to help finance the deal. That way the US taxpayer benefits when the turn around happens.
Good piece. I am not surprised that China has pulled out of MBS assets. Is that official or private? $250 million is pittance compared to the $503 billion in total banking system losses to date (as of 08/13), and that doesn’t include losses of Fannie and Freddie (source: Bloomberg).
In all the business regarding possible bail out of Fannie Mae and Freddie Mac, I suppose that foreigners, who used to regard the mortgage giants’ debt as US treasuries, are pulling out. This would have the unintended effect of pushing the firms toward an even-more precarious position than they were already in (insolvency).
Huizer: And that will be a bailout without punishing shareholders etc, because they can only be wiped out if the agencies go bankrupt.
I think Freddie and Fannie shareholders are completely wiped out if they is a bailout. They really don’t form a politically powerful enough group to do anything, and they also make a convenient target of anger.
aim–turn around next year? lmfao
housing prices won’t reach the previous peak again till about 2016
The Economist article says that China’s central bank was buying $5 billion of Agency MBS per month, not per week as you have it. Only $60b annualized, not $250b.
Huizer: In addition, there may well be a legal case to mke that the F&F shareholders and managers were in fact encouraged by the government to play a certain role after the private sector had given up, and that the result of that activity was the proximate cause of the agency’s failure.
Sovereign immunity would likely prevent that cause of action against the government.
Also what matters in securities legal cases is not what makes logical sense, but what makes money for the lawyers. I’m sure that in any bailout there will be money reserved for paying out shareholder lawsuits, but that most such lawsuits will be settled.
Mitch — good catch. my bad. I will correct it. $5b tho seems a bit low –
x-man: turn around next year? lmfao
housing prices won’t reach the previous peak again till about 2016
By turn around I didn’t mean return to the peak. Actually, I was thinking more like 2017 to return to the peak 2007 price (new res const). I’m talking about a bottom in 1 year (to get back to trend 2007 pricing) then a return to price appreciation.
2Fish: For the US government to undertake policies that discourage home ownership [...]Ownership in land and property has been at the core of the American identity
Ownership?? 1/3 of people who bought a house in the past 5 years have negative equity. That doesn’t qualify as “ownership” in my book. More like artificially expensive rental. If voters had a brain, there should be a voter backslash against this Federally organized scam. I guess it defines the new identity of the American middle class: as debt slaves. And politicians should learn that manipulating the markets tends to backfire.
I’m trying to think of what the US hasn’t done to “support” home ownership in this country.
The GSE system is unique to this country, as far as I know, and does provide lower cost loans than anywhere else in the world.
Mortgage interest is tax deductible, and now they let first time homebuyers use 401k funds for a down payment, so that’s another tax incentive.
But who needs a down payment or even verified income with the creative financing banks came up with?
You can get a reverse mortgage if you can’t afford your house anymore. but don’t want to sell and move.
If you run out of potential credit worthy borrowers, then structured financing came to the rescue.
So we started the stampede that started the housing bubble growing.
Anyone over the age of 10 new we were having a housing bubble. A real monetarist knows that wherever you put large amounts of money, prices will follow. Then for years, Greenspan denies that we are having a housing bubble. Whatever we have for regulation was asleep at the switch. California house prices out perform the S&P500.
Congress trips all over itself to vote yes whenever someone introduces a bill to increase GSE loan limits. (where are the monetarists when you need them?)
Bank appraisers approve everything, but what else can they do when the place next door just sold for a ridiculous price?
In S.Cal the net result was the median price in south central L.A hit $400K. (this area is the polar opposite of “Location, Location, Location” for those not familiar with it). I just can’t think of why we would want that to happen.
Now we dust off FHA and “modernize” it by giving it $750K loan limits.
Now they can even smell something is fishy from the other side of the world.
So a bailout is about the last thing left.
As a taxpayer I think of it kind of like getting a timeshare in a slum, except you can’t go there, which I guess is ok.
“In the short-run, the US needs this directed credit program to continue. Demand for non-Agency MBS has disappeared. And if credit isn’t available to buy homes, home prices will fall further, faster — adding to the distress of the US financial sector.”
Please bear my reinstating a thought from a previous post.
Awareness of the physical limits to growth - mainly but not only the impending peak in the global oil extraction rate - leads one to see that, in the short-run, the best thing for the US is precisely that this directed credit program be discontinued.
Sure enough, home prices falling further and faster would add to the distress of the US financial sector. But when they fall below the cost of construction, they will bring construction activity to a halt. Which is the best outcome for the US as long as that activity follows the suburban paradigm (precisely what is most likely to happen in the short run if construction goes on).
Sounds like tough love and it’s just that. Because construction of more suburban 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.
And to the possible objection that the market should decide what and where to build without interference from a supposedly enlightened authority, it can be replied that authorities currently do interfere with the market’s decisions about what to smoke or sniff. Using this analogy, my suggestion amounts to cutting credit to an addict.
Along this line, I was pleasantly surprised recently by the latest newsletter from investment manager Jeremy Grantham (second half).
“Going forward, the types of problems we will have to deal … need broad-ranging thinking that must be long term and must put the common good above corporate interests. Unfettered capitalism, however desirable in principle, can never handle these problems! It can never prevent over-grazing or over-fi shing of common property any more than it can handle over-carbonizing of our common atmosphere. Whether the think tanks and
libertarians like it or not, tragedies of the commons need enlightened government, cooperation, and leadership.”
RealThink: need broad-ranging thinking that must be long term and must put the common good above corporate interests. Unfettered capitalism, however desirable in principle,
The devil’s dictionary of politics
Common good - what helps me and hurts you
Special interests - what hurts me and helps you
People are all for “enlightened government and leaders” as long as they or people like them are doing the leading. People are all for cutting back, as long as it is someone else cutting back.
In this situation corporate bashing doesn’t work because it turns out that the banks and homeowners are in the same boat.
One other thing. I don’t think that the housing bubble would have gotten anywhere near as large as it had if not for another fact which is that personal incomes have been stagnant for the last decade. The fact that people could withdraw cash from their house hide this fact for a while.
In a hard-hitting Op-Ed in this morning’s Financial Times, Singapore’s Kishore Mahbubani writes that The West is strategically wrong on Georgia
… most of the world is bemused by western moralising on Georgia. America would not tolerate Russia intruding into its geopolitical sphere in Latin America. Hence Latin Americans see American double standards clearly. So do all the Muslim commentaries that note that the US invaded Iraq illegally, too. Neither India nor China is moved to protest against Russia. It shows how isolated is the western view on Georgia: that the world should support the underdog, Georgia, against Russia. In reality, most support Russia against the bullying west. The gap between the western narrative and the rest of the world could not be greater.
He extends that diagnosis to our overall approach to the world (as quoted below the fold) and makes a convincing case that the West has an incoherent strategy towards the rest of the world. I would like to suggest, however, that the current ’strategy’ has a narrow rationality intimately linked to our current dysfunctional politics.
Western thinkers must decide where the real long-term challenge is. If it is the Islamic world, the US should stop intruding into Russia’s geopolitical space and work out a long-term engagement with China. If it is China, the US must win over Russia and the Islamic world and resolve the Israel-Palestine issue. This will enable Islamic governments to work more closely with the west in the battle against al-Qaeda.
The biggest paradox facing the west is that it is at last possible to create a safer world order. The number of countries wanting to become “responsible stakeholders” has never been higher. Most, including China and India, want to work with the US and the west. But the absence of a long-term coherent western strategy towards the world and the inability to make geopolitical compromises are the biggest obstacles to a stable world order. Western leaders say the world is becoming a more dangerous place, yet few admit that their flawed thinking is bringing this about.
Mahbubani’s main theme is that of the emergence of competing powers outside the West (in particular in Asia) that cannot be simply dominated by the West as they used to be. While he suggests that there is actually room for a lot of cooperation between new and existing powers, he acknowledges that the situation creates rivalries and that those might be seen - and deserve to be treated - as strategic enmities. His point is then to note that, in that perspective, it is stupid, and counterproductive, to treal all other powers as hostile and dangerous at the same time. His realpolitik suggestion is therefore simple: pick an enemy, and stick to it, and try to bring others on your side. Try to neutralise them or, at the very least, not to antagonize them.
The West, led by Bush & Cheney’s White House, but idiotically, complacently, undoubtedly supported by European leaders, has indeed taken a belligerant approach to the world, treating all as enemies or potential dangers. Iraq and Afghanistan have been invaded, Islam as a whole is crusade-worthy, Russia is being encircled and demonised, and China is still seen as a threat both in the short term (for jobs) and in the long term (for political and economic influence around the world). When facts on the gorund prevent actual action, bluster and aggressive rhetoric fills the columns of a manifestly compliant and/or uncritical media (this FT Op-Ed and a few others notwithstanding).
Is it simply hubris? Or is something else at play?
One thing that our long list of enemies have in common is energy. They are either significant providers of energy for us (a good chunk of the Islamic world, Russia, Venezuela) or rival importers of the stuff (China). A sane strategy, rather than focusing on countries or geopolitical groupings, would simply look at energy policies. Given that we have a US administration largely coming from the energy sector, we are faced, once again, by the same quandary - manifest incompetence, or something else at play?
Now, a simple “something” would simply be to say that they don’t come form the energy world, but from the oil world, and from the perspective of oil companies, things are going well, thank you. But this is not really the case. Despite their huge profits, oil companies are actually dying animals, without a clear future. Their production has been going down over the past several years, their reserve base is shrinking, and their prospects are rather dismal. Oh sure, they will make a bundle from their remaining assets as prices keep on increasing, but they are increasingly irrelevant on the global stage - they are not needed for most of the world’s production to happen, and their political influence, other than in their increasingly dysfunctional home polities/markets, is becoming rather feeble. Sure, some will say that their “home polities” (the US and the UK) are all that matter, but I don’t think they need a bellicose foreign policy to dominate that - well paid lobbyists will do just fine.
No, the harsh secret is that this energy-savvy administration is persuaded - and, to be honest, I see very little to convince me that they are wrong - that a sane energy policy is a political loser, and thus that they must continue with the increasingly chaotic international policies of the past to ensure that plentiful spice keeps on flowing. That policy has, for them, the additional advantage of helping on the domestic political front by creating plentiful external enemies that just beg for a party STRONG ON NATIONAL SECURITY, and by indulging the pro-military exceptionalism inherent in a large chunk of the US population - but I don’t think that’s the main goal.
No, the fact is, it’s easier to convince voters to support a “war on terror” than it is to tell them that we need to start using energy differently because energy is not, in fact, cheap as it has long appeared to be in purely monetary terms.
Call our politicians cowards, call them pragmatists, but that’s the reality. We won’t have an energy policy until we are forced by reality to have one, and by then it will be a lot more painful to deal with that reality, but at least we’ll have plenty of enemies to deflect the blame.
:: ::
The other thing that comes on top of that to promote aggressive internationalist policies is the “winner-take-all” nature of our current ideological paradigm. The Thatcher-Reagan revolution - all the neo-gangs thatt have come to the fore - has not just promoted greed and profit creed, they have explicitly called for the destruction of all social links (”society doesn’t exist,” Thatcher said famously) and for a morality that specifically states that we have what we deserve and we deserve what we have. There is an unsaid addendum: as long as you don’t get caught (and everything will be done to weaken the organs that could catch you), anything goes and you can keep what you grabbed, plundered or swindled. Success is defined by how much you can accumulate, and, with increasing few restrictions along the way, that has meant an increasingly brutal arms race at the top, with everybody else as collateral damage of the plunder.
That logic also applies to countries - see how we love our rankings, whether of companies, medals, GDP or billionaires, and “we” have to win that race too. “We” is really our elites, but too many of the rest of us are too easily suckered into these jingoistic games. And what “we” want is total dominance across all measurable fields. Thus China needs to be cut down to size. Same with Russia or, occasionally, when their more favorable numbers get too obvious, Germany or Europe.
It is of course ironic that it is the plunderers’ policies to outsource activity to pollution-welcoming and labor rights- indifferent China et al. that has made them into the economic powerhouses they are now, their policies to replace wage-driven consumption at home by the debt-driven kind (stagnant wages make for bigger profits) that have given huge financial clout to Asian and other countries and simultaneously destroyed our banks, as they sink under the weight or increasingly bad debt. But hey, we lived above our means, and “we” made gigantic profits, and headline growth, along the way.
After all, all “we” care about is to win in the billionaires’ rankings, and if it takes bluster, arrogance and hubris on the world stage to hide that reality from the rest of us, that’s what will happen.
In short, we have no strategy about china, Islam, energy or anything else,, but “we” have found a great way to get rich and keep friendlies in power.
I dont know whether or not you have seen this: “Financial stability, the trilemma and international reserves;
Maurice Obstfeld, Jay C. Shambaugh, Alan M. Taylor
NBER Working Paper No. 14217
Issued in August 2008
NBER Program(s): IFM
They conclude: “It took some time for Henry Thornton’s ideas to be fully appreciated in 19th century England; they appear to have been much more readily grasped in 21st century China.” Ah-ha!! The politburo knows what it’s doing after all.
Euroguest
Excellent commentary and appreciated.
Looking at the various comments, it occurs that in order speculate on an informed basis about this one needs the following:
a) formal/legal
- the exact mission of the F&F regulator and the duty of care vs all relevant stakeholders embedded in it.
- the in- or explicit instructions given to the regulator by relevant branches of US gvt wrt F&F’s role after the breakdown of the private residential mortgage market
- the case that can be made by shareholders against management, regulators etc
- the ruling legal US doctrine regarding regulatory behavior causing injury to regulated parties
b) options available to the US gvt and its agencies:
- can the agencies be seized or otherwise transferred into gvt control by the gvt in case of near-insolvency short of a default and without triggering default clauses in security documentation? If so at whose discretion? At what cost?
- would such a transfer of control require compensating existing shareholders over and above the most recent stock price?
- could a gvt appointed administrator issue fresh capital without interference from existing shareholders? (and could their residual claim be cut to the extent that they would never recover more than the current value of their stock?
- could the administrator impose a haircut on other capital instruments (prefs, subordinated loans)
Why all these questions? The options for the US gvt lie between two extremes (more or less): (a) a commitment by the Treasury (backed by congress, outside the budget for at least 10 years) to buy any agencies (non MBS) offered by investors at the equivalent treasury yield and something valuable for the MBS holders as well.The commitment would apply to the current stock plus an annual increment to be approved by congress. The increment for 2009/10 should be large and announced simultaneously, in order to create a suggestion of abundance to the housing market. The agencies would pay a punitive fee to the US gvt equal to the NPV of the average interest differential between agencies and treasuries in the 12 month preceding the announcement of the plan (not its approval) for any security tendered under the scheme.
This would have many unintended effects: no agencis might be tendered (hence no cost to F&F, and no gain or loss to the US treasury), debt prices would rise (windfall for the investors) and, given a large enough allocation of incremental stock, housing finance would become abundant again (but with more stringent criteria than before the bust, hence still a slow recovery, if any), and F&F equity more attractive. No one would know how to account for the contingent premium, but assuming that no one would tender, that premium would never be paid, the agency debt would remain off the gvt balance sheet except in a severely deflationary environment, where it would make Keynesian approaches more difficult and when, in addition F&F would probably fail (because of the premium.
It would still be a good idea to install a highly conservative management and move oversight to a financial regulator.
The other extreme would be for the gvt to declare that it would do nothing except applying the regulations. If the agencies would become insolvent, there would be restucturing on terms to be determined then. I guess that that would immediately trigger insolvency-provoking investor strategies, probably with quick results. There would be a default (with highly uncertain effects on the derivatives portfolio), some diplomatic nuisance (SAFE? never heard of it..) but in the end the bare minimum could be achieved, wiping out all equity etc claimants, paying debt holders with some delay (and only at the equivalent treasury price, hence an immediate haircut for those preferring cash), a temporary panic in the housing market (you ain’t seen anything yet) followed by eternal happyness once the new gvt guaranted F&F started their congress mandated 25% cumulative annual asset growth through 2018.
Interestingly, neither of these options can be costed with any degree of certainty, but both would be preferable to waiting much longer, the difference is mainly that each solution has different winners and losers. I would have a slight advantage for the latter, because it would cost the taxpayer less, but it would also cause enormous aggravation. The first option can be structured in such a way that, accounting-wise, it would be virtually costless (assuming the US debt capacity is large enough to add a considerable amount (but with nearly matching revenue attached). The key should be that in any scheme, managers and regulators should be harmed in such a way that recurrence is made less likely.
Huizer: the exact mission of the F&F regulator and the duty of care vs all relevant stakeholders embedded in it
The OFHEC has no legal duty at all to the shareholders or the bondholders. The duty of the regulator lies with representing the public and hence there is no legal liability if a financial regulator issues a regulation that damages shareholder or bond values. Also, the government has sovereign immunity against lawsuits unless there is specific legislation that allows for that lawsuit.
The only legal constraint that I can see are 1) the “takings” clause of the US Constitution in that the government can’t simply seize shares of F&F and 2) the specific powers of the regulators. One of the reasons we got into this mess is that Freddie and Fannie are not regulated by the standard agencies that control this sort of thing.
Huizer: can the agencies be seized or otherwise transferred into gvt control by the gvt in case of near-insolvency short of a default and without triggering default clauses in security documentation?
If the shareholders agree, then anything is possible. If there isn’t a missed payment then there is no default. However, while the government *can* shut Freddie and Fannie down it can’t just take stock. Also, it can’t force bondholders to exchange old bonds for new ones.
What this means is that you need to be at a crisis or close to one for the government to be able to step in and do a bailout. If what is being proposed is worse to the shareholders and bondholders than “do nothing” then you can’t force them to agree to the plan. The government can say “if you don’t accept this plan, we’ll have OFHEC shut you down.” The trouble with that is then it becomes a game of chicken in which the stakeholders say “go ahead, we’d like to see you do that.”
Huizer: a commitment by the Treasury (backed by congress, outside the budget for at least 10 years) to buy any agencies (non MBS) offered by investors at the equivalent treasury yield and something valuable for the MBS holders as well.
The problem with this is then what do you do about new agency borrowing? It doesn’t matter if the old bonds are guaranteed, if the new bonds aren’t, and if the new bonds are guaranteed, this would be very stupid unless the government had control over the activities of Freddie and Fannie.
Huizer: The other extreme would be for the gvt to declare that it would do nothing except applying the regulations.
The trouble with this is that you can declare anything you like, but people might not believe you. There is no easy way that the government can credibly guarantee that it *won’t* bail out Freddie and Fannie.
To be a little more exact re option 1 above, the treasury would of course not discount the original agency cash flow at the equivalent treasury rate, but swap the agencies for treasuries (thus taking the agency-treasury spread away). That would probably not appeal to most buy and hold owners (CBs), so they would not swap, but hold. New agency notes would be issued much closer to treasuries and gradually (within 5 years) the stock would, again become one of quasi-treasuries. It would depend on many factors if the agencies would still have to default under such a scenario, but if masive swapping would occur, the punitive premium to be paid by the agencies would quickly wipe out their capital ,clearing the way for a proper nationalization, which in turn could pave the way for a break up and refocusing of the fission results.
Twofish,
Like your remark about home equity loans having kept consumption up while wages were stagnating. The lack of protection for US workers against (fair or unfair) wage competition from abroad is a complex phenomenon, but the availability to the government of a very special housing market, very special housing finance institutions, tax deductibility of interest for even home equity loans, must certainly have muted the political feed back from workers that otherwise might have suffered stagnant consumption
It will be interesting to see how US politics function without this pain killer in the future, if this is really the end of that wonderful story. Washington would be the poorer for it.
Twofish,
Our comments must have crossed. I guess you saw that I would expect the gvt to allow increments of the stock (meaning that it would also swap new agencies). It goes without saying that the regulators would install a new management and modify business practices. I am not so sure that sovereign immunity would play an important part. Previous crises (specially the S&L) have seen successful (but expensive) litigation against regulators. But, it would of course depend on the fine print with which I am not familiar. However it appears to me that the US gvt has played some form of stimulating role (a conflict between regulatory oversight and other deemed public interests) that might give cause for injured parties to seek compensation.
I agree with you (and have maintained that earlier) that the hardest part is probably the getting rid of existing shareholders etc. This would support the do nothing option, which I think could be made credible enough. This is an election year, after all. Time for politicians to signal their great loyalty to the US taxpayer and total disregard for populist giveaways..
Of course there will be some action but it will be drawn out and it will not wipe out shareholders (except the suckers who sell too early or buy too late), will not create such a lack of ambiguity that agencies deserve no risk premium and will take into consideration that wiping out the pref holders will hurt many banks that cannot afford further pain and also many legitimate F&F employees not deserving the fate of their Enron colleagues.
legally, i do not think taking over the agencies is hard; “receivership” was one the options discussed a few weeks ago. i suspect the us government has plenty of legal authority (in much the same way it can take over a regulated bank and wipe out the bank’s equity). politically it is hard, but that is a different story. Alternatively, the USG could just buy a lot of stock at very dilutive terms …
the big obstacle may be the treatment of the agencies preferred stock, which is apparently held widely by small banks and the like.
Rien — i doubt the us would bother with a swap that tries to reduce the windfall that goes to bondholders from a Treasury capital injection/ placing the agencies in receivership. it is messy. and the us probably thinks it is more important to get the agencies lending (or really buying up mortgages) again than it is to try to capture say 30-50 bp on the $2 trillion in pure Agency debt outstanding. Net of fees, you don’t get much …
Far too much clamour about the moral necessity of “wiping out” the shareholders. The same moral outrage happened with Bear Stearns. It wasn’t enough that the stock dropped from $170 to $ 2 or $ 10. Much ado about obsessive compulsive vengeance.
Similarly, the “wipe out” obsession for F&F can’t be realized without formal bankruptcy, which means it won’t happen.
There we are
via calcrisk: “If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,” [Yu Yongding, a former adviser to China's central bank] said in e-mailed answers to questions yesterday. “If it is not the end of the world, it is the end of the current international financial system.”
glory — thanks. the chinese are worried; all sources agree on this.
anon — i think the US does have the ability to take over (i.e. put in receivership, which is similar to bankruptcy) the agencies. what i object to is guaranteeing the debt without getting (all or most) of the equity — which is where the us seemed to be heading. the guarantee wasn’t explicit, but it was supposed to be there. the only problem is that the world’s central banks didn’t seem to buy it. they don’t want ambiguity –which could force the united states hand.
I equate bankruptcy with receivership, and agree that the US has the “ability” to put the agencies through this process.
But no matter how you define it, this involves selling off assets. And an asset breakup and sale is the only way you can determine that the value of equity is 0 on a book value basis, if that’s what it is. Existing shareholders are then “wiped out” on a book value basis, with the market value trading down to 0 or 1 cent or thereabouts, and that’s the only unambiguous way in which they can be truly “wiped out”.
My point is that the vengeful anti-Wall Street hordes crave this result, without realizing that the only way you can get this result is via bankruptcy/ receivership.
My further point is that this won’t happen, mostly because Treasury doesn’t have time to orchestrate it even if they wanted to, because they don’t have the time to organize and or execute such a plan while maintaining the confidence of the financial markets.
They only have time to recapitalize it. And in doing so, they can’t simply declare that the shareholders are “wiped out” on a book value basis, and they can’t simply issue an edict saying that the market value is also 0. The market value is what it is so long as the organization is not broken up and so long as the existing equity shares remain outstanding.
Moreover, the same urgency of taking action without the luxury of being able to plan and organize a longer term solution via liquidation of assets is precisely the problem they faced in the case of Bear Stearns. This was the problem with the indignant spewing of the vengeful hordes in that case – they were seeking a result that simply wasn’t feasible from an operational perspective. And a deal from JPM at $ 2 or $ 10 wasn’t punitive enough to satisfy them.
And even more, Bernanke has acknowledged this “liquidation” problem in his speech yesterday. They simply don’t have a liquidation template in place for either the investment banks or F&F that would allow them to “wipe out” the shareholders while maintaining market continuity.
OFHEO which regulates Fannie and Freddie don’t have
receivership authority and they also do not have authority to change the boards of officers for Fannie and Freddie.
http://www.gao.gov/htext/d08563t.html
anon: But no matter how you define it, this involves selling off assets. And an asset breakup and sale is the only way you can determine that the value of equity is 0 on a book value basis, if that’s what it is.
The whole purpose of bankruptcy and receivership is to avoid asset sales and breakup of viable institutions. The value of equity is what people are willing to pay for it, and the purpose of bankruptcy and receivership is to give you breathing space to see if a company is salvageable or not.
anon: And a deal from JPM at $ 2 or $ 10 wasn’t punitive enough to satisfy them.
Whatever you do, there will be some people that will be screaming at you, but you can control the amount of volume so that you can make the deal.
There is just no way that the Fed could have done a bailout if the share price was at say $30, because people would have been screaming (justifiably) that the top executives walked away with several hundred million of taxpayer money. So the Fed had to insist on a low share price before it could put in taxpayer money.
The trouble with $2/share is that a the employees of Bear-Stearns hold restricted stock, and at $2/share you had all of the other investment banks licking their lips and ready to poach all of the Bear-Stearns employees at which point JP Morgan would have just ended up with an empty building.
Huizer: However it appears to me that the US gvt has played some form of stimulating role (a conflict between regulatory oversight and other deemed public interests) that might give cause for injured parties to seek compensation.
In situations like this, you always see a tidal wave of lawsuits since these sorts of things are very profitable for securities lawyers. I doubt that they will try very hard to go after the US government since that is much more work for much less payout. More likely they will sue Fannie and Freddie directly for improper disclosure, whoever is running Fannie and Freddie will settle for a large amount (probably in the $5-10 billion range) and the lawyers will go away. The people that make huge amounts of money from this sort of thing are the trial lawyers.
I don’t know if being common stockholder in an Agency is any different than being one in any other public held company.
Assuming it’s not, common shareholders are cannon fodder whenever anything goes very wrong. The capital structure of a company is given the following preference when liquidating it in bankruptcy court.
In reverse:
Common stockholders
Preferred stockholders
Bond holders
Secured lenders
Accounts receivable to vendors
Payroll checks
I watched closely how WorldCom went (I won’t say why). In bankruptcy court the SEC appointed lawyers to represent the bond holders, but not the shareholders. Fraud was involved here and private lawsuits where filed outside of the actual bankruptcy proceedings, but recovery of damages was minimal.
I have to say I do sympathize with common stockholders in general, because in theory we are supposed to be the watchdog over the company and change things when they are not right by voting out the BOD and putting in new management that will set the company on a proper keel again. Yes, really. In spite of the fact we get lied to so much, and companies don’t really listen to us. But in practice, when faced with a Fight or Flight decision the pragmatic decision among most shareholders is Flight.
So if we need a watchdog in the real world to guard against some major calamity, like say, collapse of the world financial system, it’s rather silly to rely on common shareholders to save the world, and regulators/congress/administration would be the other choice.
However, I was amused when the Fed decided on Sunday to buyout Bear Stearns for $2, then on Monday morning it was announced as a done deal. Shareholders do get to vote on that. They could vote against, and watch the stock slowly fall further, but the Fed was worried about backstopping counter party risk and had to do something fast. So I guess I don’t know the answer to that one.
In the case of Agencies, now that things have gone very wrong, investors(both stock and bond) naturally want the “implicit” guarantee to become “explicit”. Here I think courts like written contracts much more than verbal ones, and whether implicit implies that we make everyone “whole” again would set a new precedent in the investment world.
Also, I can’t help thinking that perhaps Asia may be more inclined to listen during trade talks, or when we think they should reduce pegging and let their currency rise, if they thought there was some real risk in just re-cycling dollars back into Treasuries and Agencies. Then you can’t just assume you get all the jobs, can build rather than buy US products, and get paid on your investments too.
Sure “where are we going to get our financing” is a problem. But making Treasuries the new gold standard is scary and somehow we need to kill all the Agency monsters, including the new pup, FHA.
Re the procedure for tking control of a GSE: once there is a shortage of regulatory capital (may already be the case or happen soon) the Director of OFHEO can appoint an conservator who will sume the powers of mnagement and shareholders and can, inter alia arrange for fresh capital. Getting to the point where a conservator is appointed looks a little tricky, though.
Brad, My idea about providing an OPTION to swap (but into a lower yielding but default-free instruments, would probably be enough incentive to make current buy-and-hold owners hang on to their securities for the term of the option. If on top of that a similar option is provided for freshly issued agency debt under a congressional ceiling (separate from the regular budget), and simultaneously the activities of F&F were restructured to focus on stabilizing the housing market and looking after original core tasks (affordable housing etc) this could work quite well. No one would like to swap the old debt and the new debt should be priced close to treasuries. No swapping there either. If at the same time capital is replenished in a dilutive manner, I would not worry about the prefs and the subordinated, just let them be where they are. Later on some income might start to accrue again and then the subordinated creditors and pref holders would be first in line. Part of the plan should of course be longer term measures, such as tax changes (home equity loans, possibly a cap for interest deductibility etc. ) and a phasing out of financing support for private housing, except for the very poor (by for instance extending the role of existing public sector institutions. The housing industry in some states is already dead, so little to save there.
Wonder how these issues would look from the perspective of a campaign strategist?
Rien — I still don’t see how it all works.
stabilizing the housing market requires an expansion of the agencies activities not a contraction (see the increase in agencies outstanding over the last year), unless you want housing prices to fall fast (which would likely destabilize the banks that lent v housing collateral/ the broader economy). and the agencies have a lot of short-term debt that they have to roll over.
presumably the new issues are as good as treasuries …
I don’t think you can hive off a bad bank that has the bad assets that you get stuck with on the old bonds (unless you agree to the swap) unless you convert all s-term agencies into long-term agencies (via a restructuring and more or less say — you lent to this organization with this much equity and these assets and let’s see how much the bonds are worth … )
what am I missing?
I think it is quite easy, s long as you promise to swap all the outstanding agencies, as well as all of the new agencies to be issued. If in my crazy idea congress would authorize say a 25% in crease (or perhaps even more, 40%) but with reasonable lending standards for new commitments, then the housing market would slowly come back to normal. And, no one would like to exercise an option that has many more years to run and is more profitable if you do not exercise it. It is ugly but do not say it would not work. Since I do not pay taxes in the US, nor have a an interest in US financial institutions, and no property there, I really do not care too much what happens, as long as we do not get deflation. But I would like the US to be comfortable about housing again so that it can tke away all those silly incentives. Now is the wrong time of course.
Rien:
“…I really do not care too much what happens, as long as we do not get deflation..”
This is a perception of whether the glass is half full or half empty.
Avoiding deflation means re-inflating housing to bubble levels. I know that deflation is the scariest thing that economists can think of, because of it’s destructive effects on the financial system, but the rest of us worry about other things as well.
House prices were in bubble territory by any measure you want to use. Very high relative to incomes, very high relative to equivalent rents, interest rates were at historic lows allowing for a higher house price(not necessarily a better house), and we used every creative financing gimmick including a massive “structured financing” scam to qualify more and more borrowers for more and more borrowed money to spend.
I know its fashionable for the press to talk about all the McMansions we were building in the suburbs, but in reality there aren’t that many and the housing stock of existing homes is about 80 million units. In populated areas like the east and west coast, the prices on these generally doubled, give or take, in 5 years. The historical house price appreciation was closer to 2% a year.
So the housing price has to deflate, to get in line with what people can pay. If rising inflation causes market long term interest rates to rise, then more of a mortgage payment will go towards interest and a further decrease in house price is the only other variable that can change.
So the mortgage instrument market is backed with insufficient collateral, and losses will be incurred, the magnitude depending on how many defaults we get. I don’t believe we can re-flate the collateral.
So it’s now a matter of who gets stuck with the loss, the financial system or US taxpayer.
I’d prefer of course that somehow we could avoid these little boo-boos, but we didn’t. We can have the US taxpayer lose the game and save the system, if it’s really in mortal danger(maybe we need more patience to find out?). But if the US taxpayer keeps losing this battle the economy and financial system is toast someday anyway.
I think that it is inevitable that some US taxpayers are going to get stuck with a loss, but which taxpayers? Having heard proposals about windfall taxes on oil companies, I suggest a windfall tax on financial executive payoffs in recent years (Grasso, O’Neal, Prince etc). Say, reduce them to their last $5mn. It used to be argued that high income taxes discourage productive work, but this would be a backward-looking tax on work that we now know was not at all productive. Let’s have a 21st century version of the Reign of Terror!
Huizer: If in my crazy idea congress would authorize say a 25% in crease (or perhaps even more, 40%) but with reasonable lending standards for new commitments, then the housing market would slowly come back to norma
The problem then is who is going to enforce the new standards. Without some sort of structural change, what is likely to happen is that Fannie and Freddie will just take the money and it will be business as usual with US government holding the bill. It makes no sense to have a Federal guarantee on debts of an agency that is not being controlled by the Federal government.
RebelEconomist: I suggest a windfall tax on financial executive payoffs in recent years (Grasso, O’Neal, Prince etc). Say, reduce them to their last $5mn.
The trouble is that 1) you won’t raise that much money and 2) the day after you pass those taxes, you’ll find tax attorneys with very clever ways of getting around those taxes.
How about life in prison for them, there is no tax loophole for fines, 100% inheritance tax on the amount over $1M for everyone, and the elimination of trust fund tax loopholes.
They may have wives, kids, and grandkids. I would hate to see them just move to Monte Carlo and avoid our fate.
Twofish: The trouble is that 1) you won’t raise that much money and
Nonsense. What was the total bonus payments on Wall St between 2003-2006? Something like $200B? How about clawing back some of the bonuses that were based on bogus valuations that had to be later written down?
Twofish: 2) the day after you pass those taxes, you’ll find tax attorneys with very clever ways of getting around those taxes.
The IRS has some fine accountants too. Let them fight it out. At least make the useless financial parasites work for it a little.
pseudorandom: Nonsense. What was the total bonus payments on Wall St between 2003-2006? Something like $200B?
More like $50 billion, which isn’t nearly enough to cover the hole even if you take it all. Also, everyone on Wall Street gets bonuses from the CEO to the secretaries. If you claw back bonus payments, you aren’t looking only at top executives.
pseudorandom: The IRS has some fine accountants too. Let them fight it out. At least make the useless financial parasites work for it a little.
Actually no. The problem with IRS and regulators is that sense you make more money in industry than in government, the better tax attorneys and accountants end up in industry rather in government, and in any case what happens is up to Congress. If the political heat gets high enough Congress will pass something that takes a lot of income from top executives, followed the next day by people redefining income and top executive.
In order to fix that you need to boost salaries. Part of the reason that the Fed and the SEC do very well at regulation is that they aren’t subject to the normal civil service restrictions on salaries and so they can pay for talent.
You just need people writing IRS tax law to make it simple enough for dumb accountants and lawyers to figure out.
Normal civilian taxpayers and most businesses would like that too.
Can’t comment on the SEC’s and Fed’s link between pay/talent and performance. That would take a study beyond my means to come up with any defensible conclusions.
Not to say that we could do without regulation, of course.
Twofish,
Of course congress can ensure that reasonable lending standards are enforced. It can make hence change laws, including the laws that govern GSE regulation. The current law (I read it meanwhile) describes organizations that look pretty different from current reality anyway, so changing the mandate and capacity of the regulator should be easy nothing is not broken and everything needs to be fixed. There are excellent regulators in the rest of the financial system. So perhaps moving the financial oversight (not the social aspect) to say the FED or Treasury would be easy, though politically difficult. But we are outside political reality here anyway
I was interested in what type of responses people would but I seem to have not provoked much creative thinking here.
Housing policy is very simple. Houses are non-tradable and the ratio of stock to production is small. Supply is constrained by zoning and building codes. Demand grows with the population (rather number of households), but is roughly a function of population growth. Demand is strongly constrained by household budgets and the latter has been the problem during the boom, where the market for financing seemed to offer no constraints whatsoever for many groups, including ones previously almost excluded.
What one needs is a housing market where the cost of home ownership is made more predictable (for instance the existing house price stays closer to a trend, the trend picks up somewhere in the average of the past five years and simply tracks a composite of building cost and CP indices. Interest rates for mortgages originated for the -not de jure but de facto nationalized- housing finance system could be administered ones, with a gradual phase-out of the old prepayable fixed rate system (which exist virtually nowhere else). The successor agencies (of all of the current ones, incl GNMA) would set underwriting standards for their own production and production by third parties which they would gurantee. The agencies would fund themselves at treasury-equivalent prices and their annual production (incl guarantees for mortgages funded by others (mainly subsidized, municipalities, charities etc)) would be set by congress which then would control (a) the growth of the stock of federally financed housing (b) the national housing price level. No other mortgage debt would be tax-deductible, except for private investors in rental housing (for which financing would not be guaranteed by the gvt) . The system would lower ex ante yields for fixed income investors and lower borowing costs. It would virtually eliminate speculation and wuld need a properly aligned land release and zoning policy, but that should not least to measurble costs (in public accounting terms) either. This would create room for the government to gradually reduce the tax deduction of interest (a powerful incentive to excessive consumption of housing) and redeploy those funds to the social security system, a more efficient locus for subsidizing households. Reasonable economics, bad politics, specially in the dysfunctional US of A
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Twofish: More like $50 billion, which isn’t nearly enough to cover the hole even if you take it all.
It is definitely much more than $50B. If memory serves right, Goldman Sachs alone had a bonus pool of $16B for 2006 alone. In any case, it may or may not completely fill the hole, but at least some justice would be served. Bailing out BSC and LEH will be a little less reprehensible if ill-gotten bonuses were confiscated to help the taxpayer out.
Twofish: Also, everyone on Wall Street gets bonuses from the CEO to the secretaries. If you claw back bonus payments, you aren’t looking only at top executives.
Ah the old Wall St bogeyman of “don’t do that or the poor secretaries will get hurt”. Thats BS. Let the secretaries or anyone making less than $100k keep their bonuses. We all know that 90% of that bonus pool goes to the fat cats not the secretaries.
$50bn, $200bn? I don’t know, but it would be better than nothing, and certainly a lot better than an inflation tax on those who remained in cash rather than speculating beyond their capacity.
I do not think any special policies are needed to have a stable housing market. All that is needed is rigorous monetary policy, so that people know that they will not be bailed out by lower interest rates if they take on a commitment they cannot fulfil. Look at Germany, Switzerland etc….no boom, no bust. The US is just too soft.
At the risk of beating this subject to death, just to find out our fact finding is incomplete, I just saw a very recent headline in RGE Monitor stating that Fannie needs to roll over about $225B in bonds by the end of the quarter. They should at least be given small country status by the IMF. Possibly even G10. So I guess the september 30 deadline is more of a problem than we thought.