Yes, Virginia – Creditors do sometimes get a vote …
This is Brad Setser again. Thanks to Christian Menegatti and Rachel Ziemba for filling in when I was away. It is only fitting to return with one of my pet themes: central bank demand — or rather, the current lack of central bank demand — for Agencies.
In August, central banks added close to $46 billion ($45.92b) to their custodial holdings of Treasuries at the New York Fed. In August, they reduced their holdings of Agencies by a bit over $13 billion ($13.33b).
A chart showing the monthly change (using the end of period data rather than the weekly average, and taking the weekly period closest to month end as a proxy for the end of the month) shows the recent change clearly.
No wonder that the options market is now implies a significant probability that the Agencies existing common equity will be worth zero; look at this chart produced by Paul Swartz, a colleague of mine at the Center for Geoeconomic Studies.
If these trends continue for much longer, US Treasury Secretary Paulson will be forced to show his hand. The Agencies won’t be able to rollover their debt — at least not at a spread that works for them. The US government will then either have to step or let the Agencies fail. And, well, letting the Agencies fail, in the sense of default on their debt, is probably more than the US government is willing to consider right now. Any restructuring though would likely be bad for the holders of the Agencies common equity.
Dan Drezner argues – in a recent paper on sovereign wealth funds – that the importers of capital can still set the rules of the game.* He draws an analogy to the fact that larger consumer markets often set global norms in a host of markets for goods and services. In this case, the US — as a consumer of savings — has the market leverage, not the producers of savings.
Drezner is at least partially right, though I rather doubt the good practices that sovereign wealth funds are currently trying to hammer out will amount to much. Big emerging economies cannot easily limit their financing of the US without making dramatic policy changes at home. There really aren’t that many places that can absorb the huge surpluses China and the oil exporters are now generating. They do need places to invest.
In this case, though, the world’s central banks have a fairly clear alternative to buying Agencies: buying Treasuries. Shifting from Treasuries to Agencies cost them a few basis points, but it didn’t require a wholesale change in the currency regimes. It doesn’t require any big policy decision on their part. It is just a technical decision about reserve management – and probably a prudent one at that.
A chart showing the cumulative increase in the Fed’s custodial accounts since the end of December show this change almost as well as the chart showing the monthly changes.
The impact of such a shift, by contrast on the US is far more pronounced. Without central bank financing, the Agencies cannot exist in their current form. They certainly cannot be a conduit between the large pools of savings in the hands of emerging market governments and the US housing market. And right now, that is exactly what the US government wants them to do. Private demand for mortgages – and most other forms of household receivables – has dried up. The Agencies are the mortgage market.
Now, if the US could credibly threaten to allow the Agencies to fail – and by fail, I mean default on their debt, not their equity – the story would be a bit different. Foreign central banks would be faced with a true collective action problem. They all would prefer that everyone add to their Agency holdings, allowing the Agencies to refinance their maturing debt – and all their creditors to avoid taking losses. At least for now. Deferring losses isn’t the same as avoiding losses. Each individual central bank though would rather some other central bank take the risk of holding Agency debt.
This, of course, is analogous to the situation the world’s central banks face with respect to the dollar: if they don’t keep adding to their dollar holdings, the value of their existing dollar holdings will fall. Barry Eichengreen argued back in 2004 this meant that every central bank had an incentive to get out of the dollar. That obviously hasn’t happened.
In large part because of dollar pegs – and because diversifying out of the dollar is probably difficult if you peg to the dollar, and not pegging to the dollar has generally meant allowing your currency to appreciate against China not just the US. And that is costly.
And while central banks seem to have stopped buying Agencies, they certainly haven’t stopped buying dollars. Over the first 8 months of 2008, central banks have added an average of $43.14 billion to their custodial holdings at the New York Fed. Annualized, that works out to a pace of over $500 billion. That far exceeds the pace of early 2004, back at the peak of Japanese intervention.
The Fed’s custodial accounts don’t tell the whole story either. My guess is that most of the large oil exporters don’t make heavy use of the Fed’s custodial services. The Fed’s data consequently leaves out a lot of money. The increase in central bank and sovereign fund holdings outside the Fed’s custodial accounts – in my judgment – is about equal to the observed increase in the custodial holdings.
In some sense though that doesn’t matter.
Central banks don’t have to stop financing the US to have a bit of influence over US markets. The scale of central bank purchases is now so large that all they need to do is shift from buying one asset to buying another …
Call it a buyers strike by central banks on assets other than Treasuries.
*An aside: Back in the 1990s, the US didn’t exactly think that Argentina and Brazil got to set the rules just because they were importing large amounts of capital …
UPDATE. With Paul Swartz’s help, I was able to get the monthly data on the FRBNY’s custodial holdings back to 2001. The 12m change in FRBNY holdings — broken down into the increase in Treasuries and the increase in Agencies — makes for an interesting picture.
Federal Reserve policy paper states that deficits don’t matter under the US Dollar hegemony regime.
http://www.federalreserve.gov/newsevents/speech/kroszner20080901a.htm
“For more than 20 years, the U.S. net international investment position has been negative.” Yet, this condition seems to be of little consequence to the US economy. International trade so favors the US, that America’s deficits could continue to run far into the future without the US having to pay the piper. According to Fed Governor Randall S. Kroszner, the United States, United Kingdom, Canada, Australia, and New Zealand can, apparently, run up all the international debt they want, and still not have much of a real deficit to pay off. Krosner writes that other nations actually pay for the privalege of lending to the US and those other English speaking nations.”
Asia Times Article on US Dollar Hegemony
by Economist Henry Liu
http://atimes.com/atimes/China_Business/JG30Cb01.html
“The vast expansion of US-led globalized trade since the Cold War ended in 1991 had been fueled by unsustainable serial debt bubbles built on dollar hegemony, which came into existence on a global scale with the emergence of deregulated global financial markets that made cross-border flow of funds routine since the 1990s. Dollar hegemony is a geopolitically-constructed peculiarity through which critical commodities, the most notable being oil, are denominated in fiat dollars, not backed by gold or other species since President Nixon took the dollar off gold in 1971. The recycling of petro-dollars into other dollar assets is the price the US has extracted from oil-producing countries for US tolerance for the oil-exporting cartel since 1973. After that, everyone accepts dollars because dollars can buy oil, and every economy needs oil. Dollar hegemony separates the trade value of every currency from direct connection to the productivity of the issuing economy to link it directly to the size of dollar reserves held by the issuing central bank. Dollar hegemony enables the US to own indirectly but essentially the entire global economy by requiring its wealth to be denominated in fiat dollars that the US can print at will with little monetary penalties.
Under dollar hegemony, exporting nations compete in global market to capture needed dollars to service dollar-denominated foreign capital and debt, to pay for imported energy, raw material and capital goods, to pay intellectual property fees and information technology fees. Moreover, their central banks must accumulate dollar reserves to ward off speculative attacks on the value of their currencies in world currency markets. The higher the market pressure to devalue a particular currency, the more dollar reserves its central bank must hold. Only the Federal Reserve, the US central bank, is exempt from this pressure to accumulate dollars, because it can issue theoretically unlimited additional dollars at will with monetary immunity. The dollar is merely a Federal Reserve note, no more, no less.
Dollar hegemony has created a built-in support for a strong dollar that in turn forces the world’s other central banks to acquire and hold more dollar reserves, making the dollar stronger, fueling a massive global debt bubble denominated in dollars as the US becomes the world’s largest debtor nation. Yet a strong dollar, while viewed by US authorities as in the US national interest, in reality drives the defacement of all fiat currencies that operate as derivative currencies of the dollar, in turn driving the current commodity-led inflation. When the dollar falls against the euro, it does not mean the euro is rising in purchasing power. It only means the dollar is losing purchasing power faster than the euro. A strong dollar does not always mean high dollar exchange rates. It means only that the dollars will stay firmly anchored as the prime reserve currency for international trade even as it falls in exchange value against other trading currencies. “
I’d be very curious to know how the default probability based on option prices was calculated. The graph makes no sense to me since it doesn’t say default over what time period. The other problem is that it’s not obvious to me how you can distinguish based on option prices between a default and the stock price getting really, really low.
Finally, those three lines should be more or less the same. The fact that they have the same shape but are scaling differently suggests to me that there is something wrong with the calculation.
2fish — Paul can answer your questions better than I. I know he assumed that equity holders would get nothing back in the event of an “event”. The lines though shouldn’t be the same as there is a high probability that the US government would step in to prevent any haircut on the debt — thus there is a high probability that the agencies equity will prove to be worthless (it currently trades as an option in a sense, as it could be worth a lot — or zero — depending on what happens) and that the agencies debt will be honored in full thanks to a government cash infusion.
bsetser: The lines though shouldn’t be the same as there is a high probability that the US government would step in to prevent any haircut on the debt.
But in that case the axis isn’t “probability of default” but rather something different “expected loss” In any case, the numbers are very, very different what you get when you look at the price of credit default swaps. You can get a five year credit default swaps for 50 basis points, which makes that the probability of default based on credit default swaps is 0.5%.
If people really were selling options with implied 80% default rates and credit swaps with 0.5%, you could make some serious money (i.e. hundreds of millions) by buying massively discounted equity options and credit swaps and then selling options insured against default, and this sort of mispricing would cancel itself out in very short order.
Here’s amount and timing on the sum of F&F corporate debt to be rolled over end of sept.
I guess Paulson was already given authority to do whatever he pleases. Another reason to keep IBs and Toll Bros. out of the Greater Washington DC area.
++++++++++++++
Fannie, Freddie Bailouts May Hinge on Debt Rollover (Update4)
By Dawn Kopecki
More Photos/Details
Aug. 20 (Bloomberg) — Fannie Mae and Freddie Mac’s success in repaying $223 billion of bonds due by the end of the quarter may determine whether they can avoid a federal bailout.
Rest of very long Bloomberg article:
http://www.bloomberg.com/apps/news?pid=20601087&sid=axNdvQ5TQLwI&refer=home
–
Brad –
David Chiang linked to an interesting speech by Fed Governor Kroszner in his first comment above. Nothing really new in it, but it offers a good analytical overview of the US international balance sheet.
(This is not quite on topic; although it’s hard for the US international deficit to be off-topic.)
You were doing some detailed work in this area about a year ago, following your paper with Nouriel Roubini a few years before that.
I was wondering if you had any further general thoughts on the sustainability question, as much from the perspective of the US international financial condition, as from that of foreign funding sources, whether be they central banks or others. Do you think this type of analysis remains useful?
There’s a lot of marked to market risk in that balance sheet. But it always seems to go in favour of the US. Kroszner seems to take some comfort in this perspective.
I think your analysis has always prioritized the income perspective, which I think is the right way to go.
The relationship between marked to market risk and income risk is an interesting one. It resurfaces persistently in different manifestations. On the credit crisis, there are those who quite intelligently caution against the use of full bore marked to market measures to appraise the likely true degree of asset deterioration. I’ve noticed recently that BIS is among these. And there are those who quite intelligently counsel bold implementation of marked to market in order to see what’s really happening and respond to it. I think the same tension exists implicitly in the case of the US international balance sheet and its income. But it’s not talked about very much. Perhaps the issue is incubating.
Any more thoughts on this while you were at the beach, or elsewhere, then, or now?
Brad: Central banks seem to have stopped buying Agencies, they certainly haven’t stopped buying dollars
When you say they have not stopped buying dollars – is that achieved through buying treasuries? I am a little confused – if they buy treasuries, that would mean the FED is selling treasuries and buying back dollars.
confused — i’ll post a chart showing what i mean. Cbanks first buy dollars in the fx market, then they invest in interest bearing assets — and the fact that FRBNY’s custodial holdings of treasuries are increasing so fast tells up that central banks are still buying dollars.
the dollar’s rally in the fx market also suggests that CBs, at a minimum, haven’t been big sellers of US dollars
The second article DC posted, Asia Times Article on US Dollar Hegemony
by Economist Henry Liu, explains why its working.
It is basically regurgitating the observations of Richard Duncan in his book “The Dollar Crisis”, first published in 2004.
In years since, Duncan said that he underestimated the willingness of the world’s central banks to finance the US, and this has postponed any real severe crisis.
So it is the central banks that continue to grow the US dollar denominated credit bubble. China has said they need to employ the remaining third of their country, and now seem willing to live with inflation and maintain a low dollar peg to maintain their growth rate. So I guess that means we lose about 400M jobs in the US, or both Germany and Japan go on permanent holiday.
When you say income has something to do with sustainability, I assume you mean a positive current account. I have heard people use Japan’s large trade surplus as the reason they can seem to take on debt at 140% of GDP without dire consequences, even though they are not really a reserve currency.
Cedric — I am guilty of the the same underestimation as Richard Duncan. China’s current decision to essentially halt RMB depreciation against the $ plus the recent fall in oil prices seems likely — barring a huge fall in chinese exports — to keep China’s current account surplus in the $350-400b range. that together with $50-100b in FDI inflows implies — barring big hot money flows one way or another — chinese state asset accumulation of $400-500b.
recently the rise in Chinese exports (And surplus) has all come from selling more to europe/ the emerging world. us imports from china are flat. if that changes, pressure on china will go up quickly.
JKH — good questions.
I have though a bit about the question.
on the asset and liabilities side, US liabilities are still rising, with most of the rise in liabilities taking the form of low yielding debt. the net debt position of the us consequently will continue to deteriorate.
US assets aren’t rising as fast as they have been though. the dollar’s rebound means there aren’t any currency gains. and us equities have fallen by less than most foreign equity markets. so all other things equal, the NIIP will deteriorate this year — and maybe even give back some of the “valuation gains” of 07. I have never thought the kind of valuation gains the us has enjoyed since 02 were sustainable — if for no other reason than it didn’t make sense to fund the us deficit rather than deficts abroad if us assets produced so much worse returns than global assets. Krozner doesn’t exactly lay out the real reason the us has been able to attract funds despite the underperformance of us assets, namely central bank inflows, as explicitly as he should. it isn’t a market outcome.
as for the income side, it is moving in the opposite way as the liabilities side. the interest rate on us external debt is falling, and falling fast enough to offset the rise in stock. us fdi abroad is outperfoming foreign direct investment in the us. the european slowdown should cut into us returns, but not by enough to change the basic trend this year.
I am though worried about a future shock on the income side. say the US has $10 trillion in debt that pays an average rate of 3% (in part b/c a lot if short-term). then say the debt goes up to $12 trillion and the average rate rises to 5%. Total interest payments — in $ billion, double: they go from $300b to $600b. And i suspect that kind of shock is in the united states future should us rates ever normalize.
Twofish – The option line is using a strung together history of as far out of the money and as far from maturity put options as one can go and still have pricing. Given a far out of the money put option it not completely unreasonable to think of the world as having two plausible outcome, one where the option is worthless and one where the option is worth the strike (thus equity zero). (if you pretended normality because the price distribution is truncated at 0 you could argue that the zero point assumes all the negative probabilities and this assumption becomes somewhat reasonable). Also the stock should have at least the optionality value of the company and thus, unless it is very clear that it is toast, will not go to zero. A better argument is that acknowledging the non normality of returns it seems very reasonable thinking about the way this plays out and looking at other financial failures (although not all), BSC for example) that this two state world is reasonable. Once that assumption is made backing out the probability of the ‘event’ or price is zero world is trival…far from perfect but it is means to help look at the numbers and pull out the picture.
I then annualize that probability as to make it comparable to the standard spread implied probabilities. Sorry about that; we are working straddling the fence between cramming too much text on the chart and not having enough explanation.
‘You can get a five year credit default swaps for 50 basis points, which makes that the probability of default based on credit default swaps is 0.5%.’ The right hand axis is probability of default but the analogous line in the chart to the CDS is the green debt line. I don’t know what the reference security is for the agency CDS or what would technically trigger a default on the CDS but the right comparison is the CDS spread vs the agency spread, not much difference. A trade exist if you have a view on how it plays out but no arb between the options and the CDS that I’m aware of.
Brad & JKH
OK, I understand what kind of income is being talked about here. US FDI abroad, and I have a vague recollection of Milton Friedman saying that was a very important component of floating rate currency valuations.
The US is forecasting 480b in the next fiscal budget plus another 90b or so in off budget war costs. So it looks like if the Chinese do well and the Arabs kick in a little extra we will cover that.
But Japan is kicking around a 100b stimulus package and we still have Europe to hear from, so are we sure there is enough to go around?
The other thing I’ve been wondering about ever since Greenspan had his conundrum, is why hasn’t the US Treasury tried to take advantage of the apparent low long term rates and lock them in with 10 or 30 year treasury sales? If no takers is the answer, does that mean Greenspan had his conundrum for no reason at all?
The reason I think about these things is that I have the same worries about a interest rate shock that Brad just pointed out. And if CBs are all in 3 year and less treasuries, it would come fast and furious.
I think it’s a bit premature to speak about a shortfall in agency bonds, those huge trends have inertia and should be followed on a 6 months rolling avg period.
The story of early 2008 is a “stealth bailout” has you name it. And what we are observing now is more the end of this timely an useful foreign help than the beginning of a serious dumping. Some questions remains about this “bailout”, was it effective and is there any other trend behind ?
This help wasn’t in fact a full bailout regarding the financial institutions, the inflow “package” was fifty fifty Treas/Agency and the agency part was reduced by a heavy selling from offshore centers.
Adding this another trend, which is a shift
from equities to … treasuries again.
So finally we end up with a strong support for treasuries which helped to stabilize long term rates at a low level. And a average support for agencies. In any case the GSE’s are a trillion dollar story and remain a inner border problem to solve.
Brad
precisely, when rates normalize and the current “crisis” is deemed to have blown over, will there be a nasty shocker of a debt and the necessary financing that goes along with it? Will that in turn lead to an economy waking up to slow pain after the morphine wears off?
cedric may have a point regarding europe, what seems to be taking place in the markets is this round robin chase after short term gain/protection partly ‘cosw fund managers who still have their jobs can’t twiddle thumbs indefinitely; it may not be the capital flight of the 90s but the line between long term and short term investments seems to have more or less disappeared , unless you’re a SWF – in which case, you emphasize the long term perspective which will hopefully fend off criticism over short term losses?
if the pound and the euro suffer a beating, the US $ will almost certainly have to rise, almost every other target has gone south; NZ and Aus have been seeing more realistic levels, asian currencies, well, hope whoever’s playing them has a good heart. If one were paranoid, one might well suspect that Mr Soros revisiting the pound for pocket change.Hmm, would next year see the headlines ” Darling no more”? Wonder what Ladbrokes thinks the odds are?
apologies brad, was off topic there
I haven’t seen the last graph so you have it
judy — not really off topic. i grant a lot more latitude for comments on currency markets, the financing of the us and global capital flows than for topics on other subjects, b/c i think of those topics as central to this blog. and the USD’s rally is relevant going forward to the magnitude of likely central bank flows (a weaker USD v the euro is reasonably correlated with asian reserve growth)
julieng — i like the term “stealth” bailout better than my term (the quiet bailout). i basically agree with your point, but also think there has been a meaningful reallocation away from agencies on a high frequency basis, and in this case, there is good reason to think it is more than noise.
if others disagree, i am all ears.
i also incidentally think your point that the agencies are an inner border problem (i.e. lots of us financial institutions hold lots of agencies) is true, and i plead guilty to the charge of emphasizing the china and russia angle a bit too much. they matter more on a flow than a stock basis. that matters. but it is important not to loose sight of the extensive domestic holdings of agencies.
Brad, Julie..
Stealth bailout of whom/what? What is the present cost?
Hey, Brad, think you could spare a post on the Santiago Principles just agreed by a consortium of SWF’s if it’s within your new purview? I think this is pretty important stuff.
Naive questions here. Is the Fed able to help in the rollover by swapping Treasuries for the GSE debt that needs to be rolled over? How long could this last? Long enough until Jan 2009, when the Republicants pass the ball to the Democrats?
Also, you say there is a rate at which the rollover doesn’t “work” for the GSEs. I think the GSEs will be willing to rollover even if it loses them (a bit of) money. So they lose a little money, so what? What they have to avoid IMHO is a rate or an auction which indicates a lack of confidence, because then things will quickly snowball out of control.
Yeah sustainability could be an issue. The Chinese factory worker makes maybe 30 cents an hour in shitty conditions and lives in a hundred person dorm. Saving away to lend to a Joe houseflipper. Someday he or she may want his own ipod, perhaps a small room, maybe even one car for 3 families. They are not starving now but how long before they guillotine their cap- I mean Communist leaders? The ant and the grasshopper is pure fable. We all know an army of ants cooperating can kill a horse.
a — there presumably is a difference between the rate that the agencies can afford to pay for a short period of time and the rate that they can afford over time. with their funding costs rising as the start to accrue losses on their retained portfolio, they would face a nasty squeeze. moreover, in order to support the mortgage market as they have over the past year, the agencies need to be able to grow their book — not just rollover existing debt.
ndk — i don’t quite know what to say about the santiago principles, as the actual principles haven’t been disclosed. i don’t have high hopes tho. I think SWFs need to agree to something that would in effect create a SWF COFER data base, i.e. data on their aggregate currency split and bond/equity/alternatives/ perhaps commodities split. And if the biggest firm still isn’t willing to disclose its size (and the potentially fastest growing fund — the cic — hasn’t disclosed anything yet either, including just how much fx it has bought and when from the central bank) I don’t think you will get very far through this exercise. I hope to be surprised though — the evolution of ADIA’s disclosure via its website is one test, ADIC’s disclosure is another. And I am still waiting for the CIC to match norway’s transparency.
moreover, recent events suggests state banks and state firms probably warrant as much attention as SWFs, so their are lots of vehicles for state investment that won’t fall within the scope of the good practices.
At our blog we took the FRBNY data that Reuters uses to track weekly trends in central bank net buys of treasuries and agencies. We constructed a data set going back to when FRBNY started posting these numbers in February 2000.
The resulting charts tell a story like the one in the second chart above. We put up those charts last Friday in an article which also included a link to the data set as a comma separated values (CVS) file.
http://housingdoom.com/2008/08/29/foreign-central-banks-and-agency-debt-2000-to-present/
Brad, the mortgage principal paydowns that FNMA and FHLMC receive total ~$25 B per month anyway. So they won’t need to refinance as much debt as you suggest, and if they can keep getting the ever-decreasing amounts done, even at widening spreads, then they can avoid further pain from the liquidity crisis. Basically, I’m talking about an involuntary reduction in the size of their portfolios through paydowns.
Hey, isn’t that what Greenspan, Bush and GOP congressmen have been wanting to occur for 8 years? Maybe they’ll get their wish, with the “only” collateral damage the demise of an orderly consumer market for mortgages.
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