Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Dark flows

by Brad Setser Tuesday, September 30, 2008

Many argue that sovereign wealth funds have been a stabilizing force in global markets.

I keep wondering how anyone could possibly know.

The majority of sovereign funds do not report data on the composition of their portfolios. The increase in their funds over the past couple of years under management doesn’t seem to have made the world a more stable place — though you can argue it would be even more unstable absent their stabilizing presence. As far as I know, no one truly knows if sovereign funds have been piling into Treasury bills, European government bonds, bank deposits (if you can find a safe bank for big deposits) and money market funds along with everyone else — or if they have been buying US and European equities as they slide. I rather doubt sovereign funds have been buying a lot of toxic subprime debt off banks balance sheets. By contrast, we do know that the Chinese state banks, which are effectively playing with the dollars they received from the CIC as a result of their recapitalization,* have been reducing their holdings of risky US debt – -and perhaps otherwise reducing their exposure to the global financial system. We certainly don’t know if sovereign funds are going to start to pull funds from leveraged investors with poor recent returns — contributing to the “run” on hedge funds that Nouriel Roubini and others now fear — or if they are going to keep putting money into the hands of leveraged players.

But sovereign funds aren’t the real story. Central banks remains far more important. Unfortunately, we also know less and less about how central banks are impacting the markets through their reserve growth. There will be lots of analysis about the (small) fall in the dollar’s share of reported reserves in today’s COFER data release. Ignore most of it. There is a bit of data suggesting that those emerging economies that report data to the IMF started to diversify away from the dollar in q2 (but only after propping the dollar up in q1). But that doesn’t actually tell us much. Right now, the majority of global reserve growth now comes from countries that do not report data to the IMF — so we frankly simply do not know if the actions of those countries that do report data to the IMF are representative or not. Consider the following chart.


Here are a few numbers.

In q2, countries that do not report data to the IMF accounted for $82 billion of the $126b increase in global reserves. That actually understates the size of the “dark” central bank flows. The “other foreign assets” (think bank dollar reserves) of the People’s Bank of China increased by $74.5b, and the “non-reserve foreign assets” of the Saudi Monetary Agency increased by $29b. That brings total “dark” foreign asset growth to around $185b — and the total increase in global reserves to around $230 billion.

Between 60% and 80% of that likely went into dollars (I think countries that do not report data generally have a higher dollar share of their reserves than their more transparent cousins) — so “dark” dollar flows likely added between $110 and $148b to global dollar reserve growth. My baseline estimate is around $130b — which would bring total dollar reserve growth to around $143b in q1.

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A new reason to be bullish on America: It is (almost) Sweden

by Brad Setser Tuesday, September 30, 2008

A Merrill Lynch strategist seems to have come up with a new reason to buy stocks: The US isn’t far from adopting the “Swedish” approach to managing a financial crisis – and that didn’t turn out to be bad for the Swedish market. Forbes reports:

“The failure of TARP legislation worsens the short-term credit situation. But in so doing it increases the likelihood of a Swedish-style recapitalisation of the banking sector in the U.S,’ says Merrill Lynch emerging equities strategist Michael Hartnett. The Swedish government in Sept 1992 decided to guarantee the whole banking system and transfer bad debt to state ownership. ‘This chemotherapeutic event marked the beginning of a multi-year bull market in Swedish equities,’ Hartnett says.”

This crisis has produced a lot of surprises.

I never thought I would see the Wall Street that pitched privatization as the solution to most of the emerging world’s problems in the 1990s enthusiastically welcome (partial) state ownership through sovereign wealth funds. That though may have reflected my own naivete. Fees talk; many large fund managers have been close to the big sovereign funds for some time.

I never thought David Brooks would channel Dani Rodrik and warn of the danger of too much capital sloshing around – and imply that financial liberalization had gone too far. That concern presumably extends to too much Chinese central bank money sloshing around; China after all was the ultimate source of a lot of the money sloshing through the US housing market.

But you really know there is a true crisis when parts of the Street are arguing in favor of the (temporary) nationalization of the financial sector.

Who knows, if this continues the Street may soon be arguing for taxing carried interest as income and suggesting that the US might be able to reduce the cost of health care by looking closely at the French model …

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Do not doubt that this is a real crisis: more on Fed’s balance sheet

by Brad Setser Tuesday, September 30, 2008

My colleague at the Council on Foreign Relations, Paul Swartz, has graphed the shift in the composition of the Fed’s balance sheet. The Fed has extended a lot of credit to the financial system — and supplied even more liquidity by letting the investment banks borrow some of its Treasuries.


Note: I updated the graph in response to the comments below. The CFR’s web technology does not currently allow the graphs to be expanded. More of Paul Swartz’s graphs — including a new graph on the impact of the house vote on various financial markets — can be found on the CGS website.

The amazing thing about this graph is that it doesn’t capture all the credit central banks extended to the financial system last week (Paul used the weekly average numbers, not the data for the end of the week) or the new credit that will be provided by the programs that were expanded today. Those programs should allow the Fed to increase its lending even further.

This graph also does not capture the $500 billion the Fed has lent to other central banks through various swap lines — dollars that other central banks have lent to their own troubled institutions.

Right now, the world’s central banks are truly providing the short-term financing to host of troubled banks that are having trouble raising funds in the market. Laurence H Meyers of Macroeconomic Advisers notes:

“The liquidity measures are a stopgap … You’re funding the banks’ balance sheets, but nobody wants to lend money to them because they’re all afraid of insolvency.”

That sounds right to me. Right now, the US is relying a bit too heavily on the Fed to keep this crisis from spiraling truly out of control. That avoids hard political choices –notably hard choices about how best to recapitalize the financial system — but it also creates some long-term risks for the Fed.

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More extraordinary moves: $620 billion is real money, and it isn’t even for American financial institutions …

by Brad Setser Monday, September 29, 2008

Give the world’s central banks credit for using swap lines to cobble together a global lender of last resort:

The Federal Open Market Committee (FOMC) has authorized a $330 billion expansion of its temporary reciprocal currency arrangements (swap lines). This increased capacity will be available to provide funding for U.S. dollar liquidity operations by the other central banks. The FOMC has authorized increases in all of the temporary swap facilities with other central banks. These larger facilities will now support the provision of U.S. dollar liquidity in amounts of up to $30 billion by the Bank of Canada, $80 billion by the Bank of England, $120 billion by the Bank of Japan, $15 billion by Danmarks Nationalbank, $240 billion by the ECB, $15 billion by the Norges Bank, $30 billion by the Reserve Bank of Australia, $30 billion by the Sveriges Riksbank, and $60 billion by the Swiss National Bank. As a result of these actions, the total size of outstanding swap lines is $620 billion.

All of the temporary reciprocal swap facilities have been authorized through April 30, 2009.

Dollar funding rates abroad have been elevated relative to dollar funding rates available in the United States, reflecting a structural dollar funding shortfall outside of the United States. The increase in the amount of foreign exchange swap authorization limits will enable many central banks to increase the amount of dollar funding that they can provide in their home markets. This should help to improve the distribution of dollar liquidity around the globe.

hat tip: Alphaville

Call this a consequence of the emergence of Europe (and London in particular) as an offshore banking center for the US. A host of European institutions (and probably some US institutions too) without US dollar deposits seemed to have dollar funds to buy dollar-denominated securities during the peak of the boom. And well the boom is turning to bust.

I suspect this activity explains all the risky bonds — including asset-backed securities — that the US sold to investors in the UK during the peak of the boom. And I also suspect the collapse of this activity explains the sharp fall in both inflows and outflows in the United States balance of payments data. Much of the “shadow” financial system was offshore.

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It is (almost) official: the quiet bailout is roughly equal in size to the US current account deficit

by Brad Setser Sunday, September 28, 2008

It is hard to focus on a routine, backward looking data release amid the most profound financial crisis the US has experienced in a long-time — a crisis that in its own way will likely rank among the most significant events of recent history. I am not sure if the (apparent) fall of Wall Street ranks up there with the fall of the Berlin Wall, but it does feel like an era has passed.

Questions are beginning to be raised about the United States’ ability to finance itself. Moreover, the questions are being framed appropriately: rather than focusing on whether private investors want US assets, folks are debating whether China will still want US assets. And looking back is probably as good a way as any to begin to answer those questions.

Despite the big contribution from net exports to US GDP growth in q2, the current account deficit didn’t fall in q2. Blame high oil prices. The rise in the petroleum deficit offset the improvement in the non-petroleum deficit. The recent improvement in the income balance also came to a halt, largely because the profitability of US firms investment abroad didn’t jump up. In a lot of ways, though, the current account release matters more for the data on capital flows than for the data on the current account.

However, reading the capital account data takes a bit of skill — or at least knowledge of how the data is likely to be revised over time. One example should suffice: back in early 2007 (before the data from the June 2006 survey or the June 2007 survey had been released and incorporated into the data), the US estimated that official creditors — sovereign funds as well as central banks — had provided the US with about $300b in financing in 2006. That implied the majority of the current account deficit* had been financed by private inflows. The most recent data release — which reflects the information about flows in the first half of 2006 from the 2006 survey and the information about flows in the second half of 2007 from the 2007 survey — indicates that the official sector provided about $500b in financing to the US back in 2006.


The scale of these revisions raises questions about a lot analysis that suggested that official inflows weren’t a major reason why Treasury yields remained low in 2005 and 2006. That analysis was based on the observation that yields didn’t rise after official flows – as reported in the TIC data — fell. Alas, it turns out that official flows didn’t actually fall. The TIC data just didn’t capture most of the flow — as China and the Gulf tend to buy through London. After the survey revisions, the US now thinks official flows for 2006 topped official flows in 2004.

What of the last four quarters? The US data indicates that official creditors provided the US with about $400b in financing — less than in 2006. It also indicates that “private” investors abroad bought about $250b of Treasury bonds (including short-term bills). If you believe that private investors abroad bought that many Treasuries, I have a lot of formerly triple AAA CDOs stuffed with subprime debt that I want to sell you at par.

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It seems like so long ago … documenting the role foreign central banks played in the US decision to backstop the Agencies

by Brad Setser Saturday, September 27, 2008

It is hard to believe that only three week have passed since the US government effectively took over the Agencies. Friday’s Wall Street Journal provided something of a post-mortem. And it sure seems like a fall in central bank demand for Agency bonds played a key role in at least the timing of the Treasury’s decision to take over the Freddie and Fannie. Jessica Holzer reports:

Mr. Lockhart said that by August, the firms’ borrowing costs were climbing higher and it became clear the firms wouldn’t be able to raise capital in any “meaningful size.” Meanwhile, central banks had stopped buying their securities, while ratings firms had notched down their ratings on all but the companies senior debt.

These factors “convinced us that the time to act was now,” he said.

Lockart is the director of the Federal Housing Finance Agency.

China — by far the largest official holder of Agency bonds — also seems to have expressed its concerns directly to the Treasury. Harden and Cha of the Washington Post report that Chinese officials told the US to do “whatever is necessary to protect their investments.”

They wrote:

“In recent weeks, finance chiefs from around the world have come to consult with their counterparts at the Federal Reserve and U.S. Treasury about possible interventions.

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Extraordinary times

by Brad Setser Friday, September 26, 2008

In the last two weeks — if I am reading the Federal Reserves’ balance sheet data correctly — the Fed has:

Increased “other loans” to the financial system by around $230 billion (from $23.56b to $262.34b);

Increased its “other assets” by about $80b (from $98.67b to $183.89b);

Increased the securities it lends out to dealers by $60b (from $117.3b to $190.5b);

That works out to the provision of something like $370b of credit to the financial system in a two week period. That may be a bit too high: the outstanding stock of repos felll by $40b (from $126b to $ 86b), leaving a $330b net change in these line items. But that is still enormous.

The most that the IMF ever lent out to cash strapped emerging economies in a year?

$30b, in the four quarters through September 1998 (i.e. the peak of the 97-98 crisis).

The most the IMF ever lend out over two years?

$40b, in the eight quarters through June 2003 (this covered crises in Argentina, Brazil, Uruguay and Turkey)

This is a very real crisis. The Fed’s balance tells a story of extraordinary stress. I never would have expected to see the Fed lend out these kinds of sums over such a short-period.

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Just how bad is it?

by Brad Setser Thursday, September 25, 2008

There seems to be a bit of a debate. I am not a fan of many of the policies of the current Administration, but I don’t think though that the Bush Administration is exaggerating the depth of the problems in the US (indeed global) financial system right now. The administration, in my view, was far more guilty of understating the potential for deep trouble over the past year.

The New Yorker’s Nick Paumgarten recently noted that in this case the pros are more scared than the amateurs:

Often, the media exaggerates the significance of the ups and downs of the financial markets, while the sophisticates in the marketplace take them in stride. Not this time. Last week, the most farsighted market players were flabbergasted, even as they comprehended that they were witnessing a capitulation to some kind of greater truth—that Wall Street had got caught up in a pyramid scheme of its own devising.

I agree. It is quite rare for an economist at a major bank to make as dire a warning as Tim Bond of Barclays Capital did recently (via the FT):

As the freeze in the money markets persists, credit is rapidly becoming either completely unavailable or punitively expensive. This presents the world with an immediate risk of a surge in defaults as borrowers are unable to refinance. Needless to say, without an ability to lend, an economic depression threatens, as defaults erode bank capital and lending ability further. The countdown to a dramatically bad economic outcome is therefore running at very high speed. Unchecked, the current crisis would turn into a self-reinforcing vortex of defaults, bank capital contraction and deep recession within a matter of weeks.

The FT’s Alphaville isn’t normally as pessimistic as say Dr. Roubini, but Alphaville still noted that absent action from the US government: “a systemic crisis could well be realised.” A run on the shadow financial system isn’t as visible as a run on a bank, but if not checked, it can have a similar impact.

Why the worry?

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Sharing upside and downside risk …

by Brad Setser Tuesday, September 23, 2008

Sovereign wealth funds have invested about $35b in US financial institutions. Adding in Qatar’s investment in Barclays and Singapore’s investment (through the GIC) in UBS brings the total up sovereign funds have invested in firms with a large US presence to around $55b.*

The US taxpayer is now being asked to invest $700b to help recapitalize the global financial system – a sum that is more than 10 times as much as the world’s sovereign funds put in.

But, at least as I read Paulson’s initial proposal, the US taxpayer would not get any equity in the world’s large financial institutions in exchange for this help.

Now the US isn’t making a pure equity investment, though some – like Doug Elmendorf and Sebastian Mallaby– think it should.

It is buying the banks’ illiquid assets.

But there is at least the possibility that it will “overpay” for those assets, and in the process effectively contribute equity capital to the US and global banking system. Indeed, there is a real probability it will overpay by more than the $55b sovereign funds have put into the global financial system.

There are broadly speaking two ways a government can recapitalize a banking system.

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Some ballpark math on the US financial sector (i.e. just how big is $700b?)

by Brad Setser Tuesday, September 23, 2008

The Federal Reserve’s flow of funds data indicates that US households have $11.2 trillion in outstanding mortgage debt on non-farm homes, another $2.4 trillion in outstanding “other mortgage debt” (a category that includes corporate farms, who knew … ) and $2.5 trillion outstanding consumer credit.

Figuring out how much households owe is the easy bit. Figuring out who owns the debt of US households is a bit harder.

For now, I am going to focus on the $13.6 trillion in mortgage debt. The Agencies have $7.9 trillion in debt and guaranteed bonds outstanding, but the GSEs hold around $800b of the debt that they guarantee, so their total holdings of mortgages and mortgage backed securities is more like $7.1 trillion. Like the Agencies or not, no financial institution is going to go bust holding Agency debt. That leaves around $6.5 trillion of outstanding mortgage exposure in the hands of the financial system, give or take. It might be higher because it is possible to create “synthetic exposure” to various kinds of securities — basically, financial institutions can make a side bet among themselves about the future value of a mortgage backed security. That exposure nets out, but the netting only works if the losing party to the bet can pay up (Note: this paragraph has been edited in light of the comments, which highlighted that my initial post failed to reflect the Agency backed mortgage pools held by the GSEs)

This math is not inconsistent with the Fed’s data on the outstanding stock of asset backed securities. There are $4.365 trillion in asset backed securities outstanding. Not all those contain mortgages, but many do. Table L 126 suggests that ABS issuers hold about $2.1 trillion in residential mortgages, another $640b in commercial real estate and a non-trivial $400b in Agency debt.

This math also seems consistent with data indicating that the commercial banks hold $3.7 trillion in mortgages and another $1 trillion in corporate bonds (a category that should include ABS) — i.e. up to $4.7 trillion in exposure. The thrifts report about $1.2 trillion in mortgage exposure — mostly from mortgages, “private” MBS and collateralized mortgage obligations (CMOs) sum up to under $100b — see table LII4). The broker dealers have $270b in corporate bonds (think ABS) — not a huge exposure. But they over half ($1.6 trillion of a $2.8 trillion total) of their assets is just labeled other.*

Willem Buiter thinks that the US Treasury will be buying up assets at roughly 33 cents on the dollar, which would broadly speaking move $2 to $2.1 trillion in face value of debt off the balance sheets of major US financial institutions. Buiter:

I assume that $700 bn will allow the purchase by the US Treasury (or its agents) of at least $2 trillion worth of mortgage-related securities at face value, as it would not make sense for the US tax payer to pay much more than 33 cents on the dollar for the mortgage-related rubbish that banks have loaded onto their balance sheets.

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