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Creditors sometimes do get a vote

by Brad Setser
August 25, 2008

I was on CNBC on Thursday – and the planned segment on the role non-democratic governments play in financing US deficits morphed into a discussion of Chinese and Russian Agency holdings. The segment was hyped as “Do America’s creditors own the US” but the actual discussion swerved the other way: America’s creditors now depend on the US government to bail them out of their bad investment in Agency bonds. The implication seemed to be that the US still held the upper hand.

Count me unconvinced.

No doubt any large debtor does have leverage over its creditors.

Moreover, many countries finance the US not because they like US financial assets but rather because they want to hold their exchange rates down in order to support their export sectors.* They certainly haven’t done so for the returns. That gives the US a bit of room to maneuver: the US was able to attract central bank financing even as it cut US interest rates and the dollar slid.

Finally, the sheer scale of the surpluses in the oil-exporting economies and China limits their options. China and the oil-exporters will combine to run a $1 trillion dollar surplus. That implies a $ 1 trillion deficit elsewhere in the global economy. India’s $1 trillion economy cannot support a $1 trillion deficit. Realistically, that kind of surplus has to be offset by a large deficit in the US and Europe. There is a reason why the Gulf’s purchases of US assets almost certainly rose after Dubai Ports World, and CNOOC/ Unocal didn’t stop China from financing the US. Sovereign wealth funds options are a bit more limited that is sometimes claimed — at least at a macro level.

The alternative to large-scale purchases of US financial assets is even larger scale purchases of European financial assets, or policy changes that reduce the surplus of the oil-exporting economies and China.

But the United States isn’t in a position where it can disregard its creditors either. The US now relies heavily on central bank purchases of Treasury and Agency bonds – what I have called the quiet bailout – to sustain its current account deficit. Without that flow, the US couldn’t run a counter-cyclical fiscal policy – and the Agencies couldn’t step up their purchases of mortgages to offset a collapse in the market for “private” mortgage backed securities. America’s creditors couldn’t stop financing the US without provoking a sharp fall in US demand that would damage their export sectors – but the US also cannot avoid a far large contraction that has happened to date without ongoing central bank financing.

So far, central bank demand for US debt has been remarkably resilient — far more resilient than I ever would have expected a few years back. But a restructuring of the Agency bonds is one of the things that might bring this flow to a sharp end. Yu Yongding of the Chinese Academy is not exaggerating when he writes that ““If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic … If it is not the end of the world, it is the end of the current international financial system.” “

China holds far more than $376 billion Agencies Bloomberg reports. That data point is now over a year old, as it comes from the June 2007 survey. Adding the Agency purchases in the TIC data to that total suggests that China holds $446 billion of long-term Agencies. And that total is almost certainly too low. The TIC data tends to understate China’s purchases significantly — and, as a result, the Chinese total holdings tend to be revised up after each US survey.

We know that China added $120 billion to its long-term Agency holdings between June 2006 and June 2007. If it added an equal number over the past year, it would now have around $500 billion of agencies. I would bet it has more than that. Between June 2006 and June 2007 China added about $400 billion to its foreign assets. Between June 2007 and June 2008 China likely added close to $800 billion to its foreign assets.

Think of it this way. China’s holdings of Agency bonds — conservatively estimated — exceed 10% of its current GDP, and perhaps significantly exceed 10% of its GDP. The equivalent sum for a US sized economy would be at least $1.4 trillion. And I am pretty sure that if another government’s “Agencies” didn’t repay the US government on time and in full on $1.4 trillion loan, the US public would insist that the US stop lending any new money to that country.

Restructuring the Agencies bonds truly would put the political basis of the ‘Bretton Woods 2” financial system at risk. China has to expect to take large losses when the dollar depreciates against the RMB. But it doesn’t expect to take additional losses; it generally has shied away from credit risk – not sought it out. China’s public wouldn’t understand how China could have lost huge sums from a failure of the US to repay.

Sure, the Agencies aren’t formally guaranteed. But the fact that the US wants SAFE to keep on buying Agencies gives China a bit of leverage.

China’s huge holdings have another implication – if the US were to adopt say Mr. Ackman’s restructuring plan and ask existing bondholders to swap their existing Agency bonds for new bonds and a bit of equity, it would effectively hand ownership of a central institution of the US housing market over to China and a few other governments.

The GSEs would be sponsored by more than one government.

Though in some sense they already are.

I don’t think it is realistic for the US to expect to be able to rely as heavily as it currently does on other governments for financing without giving up at least a bit of policy autonomy. The enormous holdings of Agencies by the world’s central banks (along with the Agencies held by US domestic banks) are — in my view — a constraint on the options available to US policy makers struggling to get ahead of a seemingly still deepening credit crisis. Dr. Yu isn’t exaggerating. The world needs the US to pay, but the US also needs the world to keep buying.

47 Comments

  • Posted by PeeDee

    I’m not sure how robust the “They’ve got to put it (surpluses) somewhere” argument is. I’ve got a bridge I’ll sell them in a pinch. Although it’s hard to imagine the quantity of real investment assets it would take to satisfy that flow.

  • Posted by Sundblad

    In the latest issue of the Economist, it was suggested that banks associated with Fannie and Freddie now need to purchase (or “switch”) older debt issues from clients in order to be able to sell the new F&F debt issues.
    In your opinion, can Fannie and Freddie keep up their purchases of new mortgages, or will they be forced to cut back? To me the latter seems more likely, given the difficulties with refinancing and their deteriorating balance sheets.
    Another question is where the “switched” debt issues end up – with the Fed?
    (Lastly, thank you for providing one of the most interesting blogs on the ‘Net.)

  • Posted by Sundblad

    Sorry, I overlooked the discussion of my first question in your previous post.

  • Posted by Rien Huizer

    Brad,

    Very good posts. Seems like the topic is maturing. Ackman’s plan is simply not feasible (from a foreign policy perspective). It appears that the current situation is beginning to reward the view (held by many) that the agencies are nothing more than a window dressing tool, be it, by now, a very expensive one. I believe that simple, explicit government guaranteed financing of housing would have been much cheaper. No government sponsored housing finance (except for the very poor etc) would have been far better of course. Many civilized countries have no gvt sponsored finance, no tax deductability and no specialized institutions. Yet people who can afford it under those circumstances (basically everyone) have some kind of roof over their heads, or access to shelters and hostels.

    I would still prefer the federal government to make an offer to (a) swap all existing agency debt and derivatives for similar obligations owed by the US gvt (and bearing interest at UST levels (hence some sacrifice in exchange for clarity), and the agencies to continue lending, but under very strict guidelines (nothing private purely public interest) under a congressional ceiling for new swaps for new production and a steep fee to be paid by F&F for those swaps in order to accellerate the wiping out process. Unsubordinated creditors should be told that they can either (1) wait and see and possibly end up with impaired securities, or (2) sign up for an option scheme as mentioned above. The crazy anomaly of a private business making people believe its obligations are the responsibility of the federal gvt should end forthwith. If not by receivership then by creating a scheme that would completely bypass existing shareholders and accelerate the point where federal regulators can step in without having to fear shareholder lawsuits. I cannot believe shareholders and employees/managers of F&F have many friends in congress or can afford those friendships.

    Whatever happens, the flow of credit to prospective homebuyers that would have qualified two year ago at then prices, should not be interrupted. Also, there should be no loss of principal for foreign holders and the cash cost to the US treasury should be minimized.

  • Posted by anon

    “Moreover, many countries finance the US not because they like US financial assets but rather because they want to hold their exchange rates down in order to support their export sectors.*”

    Quite a loaded statement. But very true. That’s the crux of the whole problem.

  • Posted by charlie

    I would like to see the central banks take some sort of haircut on their agency holdings. They received a higher yield than treasuries and had to know there was greater risk. Left on their own, I think the vast majority of agency bonds would continue to perform. Some of the riskier ones, like Alt-A would see a much higher default rate.

    I don’t think a loss on the order of say 10% would cause an end to BWII. It would cause a lot of belly aching from China, but in the end it would just be for show. They would continue to buy USD and would have to do something with their USD.

    Having said that, I don’t think they’ll lose that much. At least on face value. The US gov’t will step in. In reality, since a bailout will likely devalue the dollar, they’ll lose their 10% one way or the other.

  • Posted by RebelEconomist

    I agree with Charlie. The US government has consistently denied that the agencies are guaranteed, so haircutting agency debt to avoid a gain on giving it an explicit guarantee would be reasonable and moral. Repudiating debt by engineering dollar depreciation would be immoral.

  • Posted by anon

    If its so crystal clear that the agencies haven’t been (implicitly) guaranteed, why are they called GSEs?

  • Posted by Twofish

    At this point it makes a huge difference if you are talking about MBS issued by GSE’s or if you are talking about corporate bonds issued by the GSE’s. These are two completely different beasts. If Fannie and Freddie were to default, the MBS’s would lose maybe 5-10% of their value whereas the corporate debt issued by the GSE’s would lose something on the order of 50-70%.

    I should point out that the two types of debt are often confused because it is in a lot of people’s self-interest to confuse them.

  • Posted by glory

    why 10%? exhibit A, exhibit B! :P

  • Posted by Twofish

    Huizer: I would still prefer the federal government to make an offer to (a) swap all existing agency debt and derivatives for similar obligations owed by the US gvt (and bearing interest at UST levels.

    The problem with this is that the two different types of debt become important. It’s really not in someone’s self-interest to swap MBS’s for treasuries. It is however is someone’s wild self-interest to swap GSE corporate debt for US Treasuries. What this means is that if you don’t make distinctions, then people with good stuff will keep the good stuff. People with crap will do the swap.

    The other big problem is calliability. If you have a pass-through mortgage and the homeowner refinances because they move, then the principal gets paid and the obligation disappears. If you swap callable MBS’s for non-callable treasuries this means that the government is still paying out interest after the loan has disappeared.

    What makes more sense to me is if the government massively expands the Ginnie Mae program, and acts as guarantor for mortgages that are still outstanding.

  • Posted by Rahul Deodhar

    Absolutely amazing post. This is now becoming a game involving Big money and nerves. The reasons for China holding on to US debt are waning faster. The more it becomes question of nerves – the more scared I get.

  • Posted by KnotRP

    “If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic … If it is not the end of the world, it is the end of the current international financial system.”

    Perhaps the goal *is* to end the current international financial system? Or, if we take the charitable point of view, maybe the Chinese knew it would be (A) pay OR (B) a change in pecking order — so (A) is pretty good, at a higher than Treasury Bill interest knowing (B) is lurking to enforce (A). They get something either way, no? I don’t subscribe to the idea that they blundered into this situation….I suspect they saw it as a reasonably good position to be in, no matter what outcome. Scenario planning, if you will.

    And no matter how it plays out, the Chinese will be reasonably ok, I suspect. They can switch to servicing their citizenry….I’m not sure who the US can go to for the next hit of debt, however.

  • Posted by bsetser

    Rebel — the US has been very clear that it would not direct its macroeconomic policy toward protecting the dollar’s external value. I think it has been a bit more ambiguous (and i know the letter of the law is that the Agencies aren’t guaranteed but they were called GSEs, had a treasury line of credit and the US recently reinforced that line etc ) about the Agencies status.

  • Posted by Cedric Regula

    Rien:

    “Many civilized countries have no gvt sponsored finance, no tax deductability and no specialized institutions. Yet people who can afford it under those circumstances (basically everyone) have some kind of roof over their heads, or access to shelters and hostels.”

    We have a similar solution here that we call “apartments”. They seem to have sprung up nearly everywhere with little or no supporting federal program. Many people say “yuk” when you mention the word, but there are very nice ones too. And I suspect we have conditioned Americans to think that way, ie The American Dream…Homeownership”, then try to rig things so it appears to be a good investment.

    Also, expanding housing into distant suburbs and having commuters with a 40-100 mile round trip commute to work is looking counter productive in light of the energy shortage. If anything we should be having federal and state policies encouraging more close in development of higher density housing.

    So I think we just let the Agencies go where the free market takes them (bring on the bond vultures), and the Chinese can invest in US apartment REITs if they still want to.

  • Posted by RebelEconomist

    Brad,

    What the US has done is promised to maintain the internal value of the dollar – only on Friday, Bernanke said that the Fed is “committed to achieving medium term price stability and will act as necessary to obtain that objective”. That should provide an anchor for the external value of the dollar. While I agree that China must accept any slippage of the external value of the dollar against that anchor, if the US cuts (the anchor) and runs, that would be immoral.

  • Posted by Twofish

    One big problem with the implicit government guarantee on the GSE’s is that it made them de-facto monopolies. Ordinarily if someone were making lots of money securitizing mortgages, you’d have more people trying to enter the business.

    However, because, the GSE’s had this implicit government guarantee and no one else did, no one could enter the field.

  • Posted by Cedric Regula

    2fish:

    One item on Greenspan’s list of dwindling kudos was his observation that two large GSE’s are pushing many banks out of the biz due to lack of competitiveness. I’m sure that’s why many banks just became a marketing front end for F&F and were satisfied with the fees from originating loans. But my suspicious mind thinks that may contribute to a lax loan approval process.

    Now Greenspan think we need to break up F&F into 10 or more smaller companies. They would resemble S&Ls, I guess.

    But whatever. I know you had mentioned paying for talented performance was a big factor in the steller job the SEC and Fed are doing in regulating the tricky financial markets and institutions. So I clipped this from the news today for next years performance review.

    Looks like the SEC, Fed and FDIC need a heads up meeting on how preferred shares are handled in bankruptcy court (current SEC policy is to light them on fire). The Fed thinks they are perfectly good bank reserve assets. The FDIC insures it. Oops.

    +++++++++++++++++++++++
    Regional banks with the largest exposure to Fannie and Freddie preferred stock as a proportion of their capital include Sovereign Bancorp Inc., Westamerica Bancorp, Gateway Financial Holdings Inc. and Midwest Banc Holdings Inc., according to a research note from Samuel Caldwell at Keefe, Bruyette & Woods.

    Caldwell estimated that 38 regional banks together hold about $1.3 billion in preferred stock of Fannie and Freddie.

    Banks in general are permitted to hold preferred shares as “core capital,” which they use to guard against losses, said David Barr, a spokesman for the Federal Deposit Insurance Corp.

    A government rescue of Fannie and Freddie — whose share prices have plunged in recent weeks as they struggle with billions of dollars in losses from bad mortgages — could be costly for scores of investment, banking and insurance companies that hold billions in their preferred shares.

    The two companies had nearly $36 billion in preferred shares outstanding as of June 30, according to filings with the Securities and Exchange Commission.

    With a total of $4 billion worth of Fannie and Freddie’s preferred stock, U.S. insurance companies also are among the largest holders, according to A.M. Best Co. Inc. But that still represents less than 1 percent of reserves that the insurance industry holds against losses.

    Preferred shares usually pay a fixed dividend and have priority over common stock when it comes to dividends and bankruptcy liquidation. While slightly riskier than bonds, which have the highest priority in times of trouble, companies often invest in preferred shares for certain tax advantages.

    Still, on Wall Street, Fannie and Freddie’s existing preferred shares are trading like junk bonds, yielding around 17 percent to 19 percent instead of around their 6 percent dividend levels. The higher yield is an inducement to investors to accept the higher level of risk that the dividends won’t be paid.

  • Posted by Michael

    I give Brad the Gold Medal for providing the clearest, most honest, and most sophisticated discussion of the most important subject in the nation. Rien and Twofish can share the Silver and/or Bronze for their contributions

  • Posted by anon

    “the US has been very clear that it would not direct its macroeconomic policy toward protecting the dollar’s external value”

    It seems more ambiguous than that. They haven’t used the fed funds rate and arguably they’ve made policy blunders that contribute to dollar weakness. But I don’t think they’ve been “clear” in expressing a policy of non-support. Perhaps I’m splitting hairs. Or am I missing a technical point?

  • Posted by pswartz

    At a time when Federal Regulators are encouraging financials firms to raise capital and implicitly helping them do so by improving the profitability of their business by providing liquidity, moving forward with paying interest on reserves, and giving them a steep YC (at least for the banks that can fund themselves with deposits), it would be a somewhat surprising lack of policy coordination to wipe out the preferred shares and thus have the same bureaucracy that will have to bail out the banking system giving it another body blow. Admittedly the GSEs should never have existed (at least not in the enormous – highly leveraged ticking time bomb form and probably not at all) and it is likely that the marked to market balance sheet of the agencies show that the preferred are not worth anything inside of a reorg.

    What about economic justice and moral hazard? Risk was taken and the investors should take the loss, even if that means certain bank’s equity is wiped out. Although I wouldn’t disagree in principle it is odd to ignore the ancillary (further deleveraging and strain on the banking system flowing through to the real economy) and net enforcement costs (the taxpayer finance bailout and the increased regulatory burden including the increased time line to handle other banks that will fail) of an action in ideological pursuit of capitalism (justice is blind but maybe the financing shouldn’t be). I suspect the right path is to save the preferred shares and thereby pull back on this body blow for the banks.

    Won’t this establish a precedent that will encourage all banks to hold these higher yielding assets as capital? Yes but if the GSEs are broken down into properly capitalized and smaller private companies and preferred stock is removed from allowable core capital the precedent will apply to a situation that no longer exists. Lastly shouldn’t bailout be explicit and transparent? Yes, but think about the trade off between timeliness and transparency. In this case I fall on the side of timeliness (less bank need to be bailed out).

  • Posted by Cedric Regula

    anon:
    “It seems more ambiguous than that. They haven’t used the fed funds rate and arguably they’ve made policy blunders that contribute to dollar weakness. But I don’t think they’ve been “clear” in expressing a policy of non-support”

    My interpretation would be that they are giving the external value of the dollar a low priority. But a central bank can’t really expressly say that.

    Top priority is providing a steep yield curve so banks can heal themselves, and they minimize new bank failures. That’s right off page one of the central banker’s playbook.

    2nd and 3rd priority have to do with the official Fed charter- balance employment with low inflation. Here I think they give employment the nod. They will take falling oil as an opportunity to tell us inflation may abate on its own.

    External value of the dollar comes in 4th I’m afraid. But Trichet decided to sound ambiguous lately too, saying inflation will stay high for sometime, but he doesn’t know what he will do with rates for sure. That helped the dollar.

    So there is always a lot of jawboning going on because the central banks want to keep inflation expectations anchored, fearing both a wage price spiral and market interest rates rising. Then they want to provide adequate stimulus to the economy, avoid spooking the stock market if they can, and support a strong currency. But obviously they can’t do all that at the same time with interest rate policy.

  • Posted by anon

    Cedric Regula,

    Thx for thoughtful reply.

  • Posted by pseudorandom

    Twofish: At this point it makes a huge difference if you are talking about MBS issued by GSE’s or if you are talking about corporate bonds issued by the GSE’s. These are two completely different beasts. If Fannie and Freddie were to default, the MBS’s would lose maybe 5-10% of their value whereas the corporate debt issued by the GSE’s would lose something on the order of 50-70%.

    I think the difference between Agency debt and MBS is likely to be much smaller than this. Despite appearances, these are not such radically different beasts: agency debt is primarily debt that is backed by the collateral of mortgage loans kept on the books of Fannie and Freddie, whereas MBS is colalteral on MBS that has been sold on.

    Since both types of debt have comparable collateral (or do you have any data to suggest otherwise?) and the agency guarantee becomes worthless for both bonds in the event of default, I don’t see how one would lose 70% and the other 15%.

  • Posted by Twofish

    pseudorandom: I think the difference between Agency debt and MBS is likely to be much smaller than this. Despite appearances, these are not such radically different beasts: agency debt is primarily debt that is backed by the collateral of mortgage loans kept on the books of Fannie and Freddie, whereas MBS is colalteral on MBS that has been sold on.

    No they are very, very different beasts. An MBS is a passthrough security, Fannie and Freddie don’t directly own you any money. The money that you get from an MBS comes directly from the homeowner, who are the people that own you money. It’s only if and only if a homeowner doesn’t pay that Fannie and Freddie owe you anything. Also the lending requirements on the MBS were pretty strict so these are all prime mortgages, so the people that do own you money have good incomes. If Fannie and Freddie disappeared, then the MBS’s would lose their insurance but they would still pay,
    since they debts that are owed you are not Fannie and Freddie’s debts. Since they are prime mortgages, default rates are typically less than one percent, so if you assume really bad things happening, you still get only a 5-10% haircut.

    Agency corporate debt are direct obligations of Freddie and Fannie. Soi in the event of default, they will immediately stop paying, since that is the first thing that a bankruptcy judge will order in a default. What you end up with is what is left after all of the debts get paid. The problem is that unlike MBS’s, the corporate debt was used to buy subprime’s and Alt-A’s, things that basically they were simply not allowed to do with MBS’s.

    One way of thinking about this is that if the corporate headquarters of an insurance company burned to the ground, you would be in a completely different situation if you owned a house that was insured by the company, or if you owned a piece of the office building that the insurance company was in.

  • Posted by KnotRP

    If they fear a wage-price spiral, they don’t understand what’s going on in the real
    world.

  • Posted by KnotRP

    What they should fear is a price spiral without increasing wages….that is what will shrink the
    economy down to the size of a peanut.

  • Posted by Rien Huizer

    Twofish,

    Thought you were a finance person. My idea (and it is crazy see below) would be to make agency debt (i.e. non passthroughs, those would need only a residual gvt guarantee) swappable (right for the holder, not an obligation) (and only once) into (a special class of ) treasuries. That right should apply to all outstanding debt (non MBS of course). It should be valid for a long enough period to ensure (because swapping would mean sacrificing yield) that very little would be swapped, pricipally only when the notes would approach maturity. The option would mean that the principal of the notes would be safe (I am aware that there are some financial mathematics problems involved, but hat is a technicality) as long as the option exists. Stripping etc of the notes should not be posible.

    This would entail two things:
    (1) the market for notes would disappear, buy and hold owners would probably hold and whatever paper would be in trading portfolios would move to b&h as well. Many years ago something similar happened to GO municipals in bank portfolios. Old ones were grandfathered for tax exemption and banks simply would keep them till maturity. In the absence of serious measures to improve the credit quality of the agencies themselves (another issue, largely independent of this proposal), the Federal option to swap would be the sole determinant of credit quality. Should the agencies find fresh capital etc, with or without gvt assistance, the agency component might become valuable again and option holders might even b prepared to relinquish their rights. (2) a commitment on the part of the US to also swap freshly issued F&F notes would basically allow the gvt to set the upper limit on the volume of mortgage purchases, foreclosure inventory, debts incurred as part of unwinding the hedging program etc, as ell as an amount set aside for MBS creditors, in order to guarantee that MBS continue to be attractive to investors. So there would be something left to do for politicians: setting the annual amounts for donations to the MBS fund, the ceiling for fresh Agency notes swaps and the broad mandate of the Agencies with respect to the way the resulting funds are deployed (underwriting, inventory and investment standards, minimalist interest rate risk management program, etc).

    All of this would not involve formal haircut of common creditors, allow the derivatives portfolio to continue, etc, and involve very little gvt cash. It could be done while mnagement is still fighting for its life or after the appoinment of a conservator. With a reasonably large swaption program and some plain financial guarantees for short term cash flow imbalances, the agencies would ned no capital, on the one hand, and have no cash for the payment of dividends etc on the other.

    Meanwhile a solution could be found for what to do next with housing. Nationalize finance permanently ( for instance by expanding the role of GNMA) or truly privatize most and structure that as part of the common financial system (hence no tasks wrt affordable housing etc). The social mission of the GSE sems to have had a backseat recently anyway.

    As mentioned, this is just a crazy idea, because the politicians would not like it, the financial services industry would not like it, etc . All of Becker’s wise words about regulation apply to this industry. Housing, finance, health and defense are extraordinarily attractive areas for a wide variety of special interests, who are far better at organizing themselves than the housed, investors, borrowers, sick and citizens in need of security, the true stakeholders in government activity.

    The interesting thing about the discusion on this blog is that no one seems to notice that the current reality is far crazier than this crazy scheme. Look at the cost, the unintended consequences, the pain suffered by individuals who got themselves into things they were told were a sure thing. All as a result of poor design (the US must have the most irrational housing finance system in the world) , lax enforcement and lack of political will to identify and tackle a problem before it is to late. From this perspective, the problems of investors, including the official foreigners, and US officials dealing with them are irrelevant. The US gvt will ensure payment (probably in such a way that yet another interest group makes money) and that will no doubt destroy the remaining credibility of disciplining institutional features like insolvency of large entities. Which will lay the foundations for the next crisis..

  • Posted by Cedric Regula

    Crazy is how we do things. You just get jaded after a while.

    Anyway, I’ll try to connect the path of least resistance. But I’m just an amateur at running the economy, so this could all be wrong.

    The biggest problem right now for the Fed is banks that have preferred F&F stock. As soon as they stop the dividend it will drop to 1 penny over what the common stock goes to with a cut dividend (don’t know if they did that yet).

    This is a major constriction in the money supply as far as the affected banks are concerned.

    Per the news today:
    “Caldwell estimated that 38 regional banks together hold about $1.3 billion in preferred stock of Fannie and Freddie.”

    The Fed did talk about using a few billion to buy fannie stock as a bailout move. This was before the Treasury decided they needed to pacify F&F bond investors with some more vague promises.

    At the time, the Fed offer sounded anemic, but I’ll give Bernanke credit for being a smart guy and now it looks to me like they meant they will buy the preferred stock, and most likely from the affected regional banks.

    So now we get the mess somewhat unraveled.

    1)The banks survive that with a couple billion cost to the Fed. Not bad.

    2)As 2fish pointed out MBS pass thrus trade on there own. All bond prices go up and down, thats nothing new. And provided they are high quality and default rate expectation is minimal, not being backed by a guarantee has minimal impact on price.

    3)F&F as entities are now isolated and could be dealt with anyway we see fit. I’m happy with just letting them hang out there and seeing what the market does to them. Either they get more money on their own, or they get dumped in the receivership blender. Or the government might still try and fix them as is, but I’m not a fan of that option.

  • Posted by Twofish

    Let’s stop back for a second.

    What is the public policy rationale for the government giving one cent to holders of corporate agency bonds? I don’t see any.

    The government could take over the GSE’s role of guarantor for the MBS’s without giving the corporate agency bonds one penny.

  • Posted by Twofish

    My annoyance is that the two types of debt were massively confused and there was a lot of intentional bait-and-switch over what was implicitly guaranteed by the government.

    Corporate debt by GSE’s was rated AAA by the bond rating agencies. Now being rated AAA means that there is a chance that you will default. If there is an implied government guarantee on something, then it wouldn’t be rated AAA. It wouldn’t be rated at all (which is the case with the MBS’s which don’t have bond ratings at all because they are considered to have no default risk.)

    So as far as I’m concerned GSE agency bonds were *NEVER* implicitly guaranteed by the government, and I really don’t see what the bad outcome is if they just default, assuming the MBS market remains liquid.

  • Posted by bsetser

    2fish — the public policy rationale is that the US wants to keep the flow of mortgage financing going to support new home purchases and thus housing prices while the private MBS market is bust. the agencies own portfolio is part of that. this policy may be a mistake, but it is part of an overall strategy for trying to keep the us banks afloat –

    no credit = bigger falls in home prices
    the more homes that are underwater, the more defaults (And the bigger the losses on said defaults)
    the more defaults, the bigger the losses in the banking system.

    the argument is that there is a dual equilibria — one where credit is extended to qualified home buyers and the market clears at a reasonable price (certainly not the prices of the past few years), and another where no credit is extended and the market clears at a firesale price. the US would rather be in the first equilibria. the risk is that the US keeps the market from ever clearing through price keeping operations of a sort.

    anon — I agree with what Cedric said. The Fed’s mandate doesn’t include the dollar’s external value, and it has generally been quite opposed to any international commitments that would constrain its monetary policy autonomy. Finally, if you look at the discussion of exchange rates in the 2006 and 2007 IMF article IVs, the Fed said quite explicitly that it didn’t direct monetary policy at maintaining the dollar’s external value. There was no ambiguity.

    the Fed has said that to the extent the dollar’s external value influences domestic prices, it does care — but only b/c of the potential impact on domestic price levels (part of its mandate). That is pretty thin – it really couldn’t say anything else. Compared to most other central banks, it assigns a lot less weight to the dollar’s extenral value in than most (in part b/c it has concluded that so called pass-through of exchange rate moves to domestic prices is limited). that said, Bernanke did hint over the summer that the Fed was starting to pay a bit more attention to the dollar’s external value.

    But in the grand scheme of things, it ranks quite low in the Fed’s list of priorities in normal times, and i think Cedric has the fed’s current priorities about right.

  • Posted by Steve Wart

    How much time does Congress have to pass legislation to rescue F&F, how can this be debated in a way that politicians can understand, and how much money will they need to allocate?

    How likely is a “technical default” of F&F before 30 September in case the politicians are unable to come to an agreement, presuming there will be no small amount of rhetoric regarding bailing out foreign governments?

  • Posted by Cedric Regula

    That’s what I kind of worry about. No one ever went bankrupt because your stock and corporate bonds went to zero. It happens the other way around.

    So as far as I can tell they survive as long their internal bond portfolio pays enough to cover expenses, and maybe dividends on the common, preferred, and corporate debt, but only if they want to be charitable…they don’t even have to do that.

    So they don’t technically fail. It’s just that they won’t be able to do their mission of providing new loans.

    And the Chinese and everyone else is now trying to beat a firmer commitment out of the USG before buying further into the scheme.

    But no one knows really knows how bad the default problem will be. And they already passed a housing bill which will act like a magnet for bad loans from the subprime sector. I could even see fannie taking advantage of that with the Alt-A portion of their internal portfolio.

    There’s a difference between being foreclosed on due to inability to pay, and merely being upside down in a mortgage. I’ve been upside down in the distant past and I just went to work and paid anyway. Didn’t even think of mailing my keys to the bank and moving out onto the street.

    So I think there needs to be some educated and critical thought about what they think they are really fixing, but don’t know if we’ll get that in Congress.

  • Posted by Twofish

    bsetser: the public policy rationale is that the US wants to keep the flow of mortgage financing going to support new home purchases and thus housing prices while the private MBS market is bust.

    True, but that can be done without bailing out holders of agency bonds. You could have the government guarantee MBS’s and then finance things through the Ginnie Mae program.

  • Posted by Cedric Regula

    Saw a picture on TV of the Fannie building in DC. Looks a little like the Smithsonian, much bigger and nicer than the White House.

  • Posted by pseudorandom

    Twofish: The problem is that unlike MBS’s, the corporate debt was used to buy subprime’s and Alt-A’s, things that basically they were simply not allowed to do with MBS’s.

    Can you back this up? AFAIK, the Agencies neither bought nor guaranteed subprimes. In fact that was the very definition of “subprime” – mortgages that do not meet the quality standards of Fannie and Freddie. If anything, the Agencies retained higher quality mortagages on their books and passed through the relatively lower quality ones.

  • Posted by Cedric Regula

    You’re describing the old F&F.

    But I’ve read some news reports stating they did buy up subprime stuff for their internal portfolio.

    Also heard that discussed on the Mr. K for Kapitalism show.

  • Posted by Twofish

    pseudo: Can you back this up? AFAIK, the Agencies neither bought nor guaranteed subprimes.

    Take a look at Table 26 from Fannie’s report and Table 22 from Freddie’s

    http://www.freddiemac.com/investors/ar/pdf/2007annualrpt.pdf

    http://www.fanniemae.com/ir/pdf/annualreport/2007/2007_annual_report.pdf

    The problem is that you just don’t make that much money guaranteeing prime mortgages. It’s very boring business. You get some fees for guarantees, but they are low because people don’t expect prime mortgages to default.

    Around 2002, someone got the bright idea that what they would do is to use the GSE’s borrowing ability to borrowing money at low rates and then buy high interest mortgages. They made huge amounts of money for a few years before those mortgages went bad.

    So what basically happened was that low-interest good mortgages got packaged and sold off. High-interest mortgages the GSE’s kept. Now those high interest mortgages are going bad.

  • Posted by Twofish

    The one bit of good news is that it is a slow motion train wreck rather than a fast train wreck. In the case of Bear-Stearns things were falling apart hour by hour, whereas in this situation, you do have the luxury of being able to think about what to do. It’s basically the difference between someone with a heart attack and someone with emphysema.

  • Posted by Cedric Regula

    Agreed, 2fish

  • Posted by tl

    “True, but that can be done without bailing out holders of agency bonds. You could have the government guarantee MBS’s and then finance things through the Ginnie Mae program.”

    Would Ginnie Mae debt get an explicit government guarantee ? If not, what special financing terms would it have (especially seeing it has more leverage than passthroughs) ? If it doesn’t have special financing terms, how does it stay solvent ?

  • Posted by Twofish

    Ginnie Maes already are backed by the “full faith and credit of the United States”.

  • Posted by Cedric Regula

    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. I think 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.

  • Posted by tl

    “Ginnie Maes already are backed by the ‘full faith and credit of the United States’”

    So you’re calling for a direct bailout from the government.

  • Posted by jo6pac

    This is really very simple, China and everyone has known for years that the paper was worthless but until the O Games were in play there is no longer a reason to help the shell game continue.
    jo6pac
    The race to the bottom continues.

  • Posted by Cedric Regula

    Not quite so simple.

    Congress and the Admin gave the Tresurury carte blanc authority to fix any problem they see before sept 30.

    So we may see the national debt increased by another $225B.

    I hate it when that happens.