Interesting
One of my usual laugh lines is that the CIC isn’t a sovereign wealth fund; it is a sovereign loss-minimization fund.
After all, selling debt denominated in an appreciating currency (and one that, given China’s current account surplus, should face ongoing pressure to appreciate) to buy assets denominated in a depreciating currency is generally a good way to lose money. All the more so if the interest rate on the appreciating currency is higher than the interest rate on the depreciating currency.
The PBoC has long faced the same problem. Consequently, Keith Bradsher’s story in today’s New York Times shouldn’t be a surprise. Some analysts warned China rather publicly back in 2004 (and 2005) that it would eventually face large currency losses on its reserves. The IMF wrote a paper noting that a central bank that takes capital losses from currency moves risks losing a bit of independence, as it could end up needing a capital infusion from the Finance Ministry.
China’s policy of holding the RMB down to support its exports produced highly front-loaded benefits (fast export growth, jobs in the export sector) and highly back-loaded costs (the bill for the losses on all the dollars and euros the central bank has had to buy to keep China’s currency from appreciating). The benefits are now shrinking — Chinese export growth to the US has stalled — while the costs becoming more visible.
But the fact that the PBoC is seeking a capital injection is still interesting.
“the People’s Bank of China has begun discussions with the finance ministry on ways to shore up its capital, said three people familiar with the discussions who insisted on anonymity because the subject is delicate in China.”
I guess falling US interest rates are starting to bite. Remember, the government of China is by far the United States’ largest creditor. China’s combined Treasury and Agency portfolio exceeds the total US holdings of the government of Japan.
Keith Bradsher is absolutely right to note that China has been pouring an enormous share of its GDP into US debt purchases and that its efforts to pass the costs of this policy onto the state banks and ultimately China’s depositors are an enormous subsidy from China’s savers to America’s borrowers:
” China spent more than one-eighth of its entire economic output last year on foreign bonds, and then picked up the pace during the first half of this year. …. Along with Treasuries, China has invested heavily in mortgage-backed bonds from Fannie Mae and Freddie Mac, the struggling mortgage finance giants that are sponsored by the United States government. Standard & Poor’s estimates China’s holdings at $340 billion (BWS aside — that seems too low to me; China’s total Agency holdings are at least $465 and probably higher, and while not all are Fannie and Freddie, a lot are).
Some bond traders suspect that the central bank has scaled back its purchases of these securities, as have China’s commercial banks. But the central bank trades this debt through many third parties in many countries, making its activity opaque to outside analysts.
The central bank has gone to great lengths to maintain its foreign purchases. The money to buy foreign bonds has come from the reserves required that commercial banks must deposit with the central bank. In effect, China’s commercial banks have been lending the central bank more than $1 trillion at an interest rate of less than 2 percent.
To keep the banks strong when they were getting such little interest on their reserves, the central bank has kept deposit rates low. The gap between what banks are paying on deposits and the rates they are charging ordinary customers to borrow is several percentage points. This amounts to a transfer of wealth from ordinary Chinese savers to the central bank and on to Americans who are selling their debt to the Chinese. “
That though has been China’s own choice — not something China has done because the US has sought its financial support.
Bradsher’s concluding point also illustrates something that has long worried me. He — citing Victor Shih — reports that many in China attribute the losses to bad US policy, not China’s efforts to keep its currency down:
Victor Shih, a specialist in Chinese central banking at Northwestern University, said that when he visited the People’s Bank of China for a series of meetings this summer, he was surprised by how many officials resented the institution’s losses.
He said the officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.
“A lot of policy makers in China, at least midlevel policy makers, believe this,” Mr. Shih said.
Many have argued that China’s investment in the US gives China a stake in the United States success, and thus should help to ease other sources of friction. I have always thought it was more likely to itself be a source of friction — in no small part because investments that generate losses tend to be viewed rather differently than investments that produce gains. Creditors through the ages usually think that the debtor’s own behavior is at least partially responsible for the loss.
I don’t think the US can be blamed for the currency losses China is going to incur. The US has consistently indicated that it would not direct its monetary policy toward maintaining the dollar’s external value. But I do think that the US could be blamed if China’s enormous holdings of Agencies ever were not to be repaid in full. Maybe it shouldn’t be blamed, as the US government never guaranteed payment in full. But I also am a realist.
In my opinion the real issue is US government to the real purchase power of USD. If in the future China were to start running a trade deficit (say to finance its own retirement) would US maintain a non-inflationary monetary policy even at the price of reduced domestic consumption? If so, China does not have anything to complain about. This will be tested soon as the boomer generation is going to start hitting 65 in three years.
I think it is a big mistake to assume that US consumers will keep buying stuff. I think they are overwhelmed. Its time US turns manufacturer and serviceman of the world. And economies allow their citizens into the consumer fold.
It will be better for income polarity as well.
Rahul
first line should have read “the real issue is US government’s commitment to the real purchasing power of USD”.
Another factor to consider is that not all the reserve comes from accumulation of trade surpluses. The rest (from investments or foreign currency borrowings) will have parties who will need to disburse in foreign exchanges one day (when exactly depends on the time horizon of the investment). If that were to happen en mass there is no reason why the RMB won’t depreciate in value — so the impact on the central bank’s capital position in not clear at all.
And most importantly the China could always run a faster inflation pace. Since RMB isn’t even available overseas China’s only commitment is to domestic depositors. Since the central government has a budget surplus (and local governments are not even legally allowed to issue bonds — in sharp contrast to the US) it should have ample fiscal resource to compensate low income workers and pensioners.
All this is merely money veil for saying that Chinese saves a lot and consumes less than it produces while US is geared towards letting the populace consume more than it produces. If US is willing to allow this to reverse without resorting to outright inflation why should China complain? I think the complaint is not so much that there is paper loss at the paper bank but that the commodity price has gone through the roof and US just kept on borrowing and spending… (now as much from oil exporting countries as China). China needs the commodity but US is competing for it with borrowed money. Now that a global slow down may be easing the pressure the complaint may subside as well.
Rahul,
It is easier said than done. Who are cutting our lawns, cleaning the houses, working the fields and nursing the young and the elderlies? Imported labor with borrowed money (on a net basis). It is not just stuff. And this is without the baby boomers retiring in large numbers, yet.
Brad, I’d be curious to hear what you think of the point with which Keith leads into the article — namely, that a small capital base is a problem for China’s central bank.
Whatever the sources say about its seeking a capital infusion, seems to me that notions of capital adequacy shouldn’t apply to cen.banks as they do to commercial banks. For starters, cen.banks issue legal tender and can force commercial banks to effectively give them capital through reserve requirements. There’s an argument that a bigger capital base affords a cen.bank greater mon policy independence, but that doesn’t apply in China where the PBOC is far, far from being independent.
Which also raises the question of whether the notion of the cen.bank’s capital base is really all that relevant in China. There is no evidence that the cen.bank booked its profits on currency intervention when U.S. rates were higher than Chinese rates and the yuan was going nowhere fast; and there’s no reason to think it would get saddled with losses now that rates have flipped around and the yuan has appreciated — esp. with the country’s finances in such rude health.
So, in short, is the capital issue a bit of a red herring?
cheers, Simon
@ HZ
Its going to be a tough world for next few years. Hope everyone shows the spine to make the difficult “right decisions”.
@ Simon,
I would add to your question - given that central banks have asked other Chinese banks to hold foreign assets - should we not count this as quasi capital?
This could be really big, for a variety of reasons:
1. China’s finally catching onto what it should have realized years ago– it’s getting shafted by the US here and screwed out of its savings. The Chinese would be much better investing their savings in their domestic economy– especially in R&D, new companies, technologies, education and better roads and trains. This won’t happen overnight, but the Chinese will finally start shifting away from an export-reliant economy to one with a more robust domestic economy.
The RMB, of course, will have to rise gradually, rather than suddenly, which was the mistake the Japanese made in 1987 with the Louvre Agreement– letting the yen zoom up too fast as a concession to the United States, losing exports before having an adequate domestic economy: http://tinyurl.com/6qrla4
So despite the US debt and dollar problems at the time, the Japanese basically just let themselves be taken advantage of, so that American debt servicing and currency problems became Japan’s problems instead. A truly monumental blunder by the Japanese government and banks.
Therefore, the Chinese will probably only allow gradual yuan appreciation, maybe a bit faster than they’ve been doing– but they’re not limited to worthless US Treasury Paper. There are Euros, won, yen, lots of alternatives, plus real, tangible assets that can be obtained in the USA and other dollar-using countries (raw materials, high-tech that hasn’t been too overvalued by inflation). China can manage a gradual currency rise and transition their economy from an export-driven to a domestic demand-driven one.
2. This means nothing less than the total unraveling of Bretton Woods II. Especially since the USSR fell apart, the US system has been a debt-driven economy, with one asset bubble following on the heels of another. Now, all those bubbles are unraveling and banks are going under– a nasty positive feedback loop that only grows bigger with each pass.
So I’m suspecting that September 2008 will be the start of a very nasty period for the US economy.
The truth is, the US economy (with both parties responsible) has utterly pissed away its assets on ridiculous defense spending, nuclear weapons and these wars. And now it’s all about to come apart on us. Like Jim Rogers was saying, this could take decades to unwind itself.
China may suffer losses on the dollar reserves (if they buy American goods in the future with those dollars, competing with American customers, then they won’t loose much). But the benefits of the current Chinese policy far outweigh any losses by orders of magnitude. Even if they loose all those dollars, they will be paid back many times by economic development and power. The jobs, infrastructure, higher standards of living, educated people (more PhD/year than in the US) etc. are worth a lot more, than a few trillion dollars. And all this is made possible by the current currency strategy of China. Or so think the Chinese government. I have no doubt, that this is the winning strategy. If they could maintain it for 10 more years, then China would become the strongest economy, in such a short time.
In the past 1-2 months the dollar appreciated more then 10% against the euro. This may have a rather negative effect on China. Fortunately for them, the Chinese government was smart enough to decide that inflation is not the number one concern anymore.
“The US has consistently indicated that it would not direct its monetary policy toward maintaining the dollar’s external value.”
Can that be said with a straight face? Every single solitary “spokesperson” for the U.S has screamed “STRONG DOLLAR” since, well, since I can remember.
Puhleeese!
This is speculation, but I suspect that the article missed the point of the PBC/FM discussions, which likely were “so what do we do if the either Fannie or Freddie default?” Looking at the PBC’s balance sheet a GSE default is the only obvious way that I can think of in which they would need a capital infusion since the liabilities that the PBC has are mostly non-interest bearing.
The GSE default would hit the PBC hard since not only would it wipe out part of the agency debt, but it would also cause the dollar to tank which would wipe out a large part of the treasury debt.
The quote be Victor Shih is obvious in reference to the agency debt.
It’s going to be interesting to see what the new world order looks like after the old one blows up.
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It’s slightly ironic that a central banking goliath with a consolidated FX exposure approaching $ 2 trillion would be concerned about a bookkeeping nuisance (for governments) like capital.
Presumably PBOC “needs” capital due to the potential inadequacy of US dollar interest revenues, when converted, in meeting RMB interest costs and operating expenses – rather than for reasons of marked to market FX exposure on asset values per se.
It’s easy to see the problem in covering 2 cent RMB interest on $ 1 trillion. With 20 per cent depreciation of the dollar against RMB, PBOC would need 2.50 per cent dollar interest rates on older positions in order to cover RMB interest with depreciated dollars. And that doesn’t include what’s need for other operating expenses.
This becomes onerous the more short term dollar debt they hold and the more they roll over higher interest maturing debt at lower rates.
This might suggest they must be in danger of running annual operating losses – hence the “need” for capital.
Apart from that, it seems unlikely they would capitalize against marked to market FX losses, unless they were preparing for the contingency of actually running down the size of their dollar balance sheet. Such an idea seems unlikely given the dollars they could sell now just from current operations. But even then, why would they advertise such a contingency plan with a pre-emptive capitalization?
Having said all that, I haven’t looked at the PBOC balance sheet proper in its entirety, to see the extent of the cushion there in terms non-interest paying liabilities, such as referred to by Twofish above. The article does mention $ 1 trillion at 2 per cent, and I assumed this refers to “sterilization bills”. As far as the GSE exposure is concerned, I would view it similar to FX marked to market risk. I’m not sure why the bank would execute a pre-emptive capitalization for the worst case scenario, whether or not it includes actual default and/or interest rate haircuts. That would advertise an expectation they wouldn’t want to encourage.
This must make for interesting office politics indeed between the bank and the ministry.
Milton: The “strong” dollar policy was articulated by the Treasury, and it was really (and understood as such in the market) as “we aren’t gonna intervene in the market” policy. Certainly the treasury took no policy steps directed at supporting the $ v the Euro, and it actively encouraged China to appreciate. And if you look at the Fed’s policy statements in official contexts — like the IMF article IV discussion of US exchange rate policy — is 100% clear that the Fed indicated exactly what I said. The Fed’s dual mandate does not include defending the dollar. The former division chief of the Fed’s international side Karen Johnson has said this often as well in public settings.
I agree with JKH — the most logical reason for this is that the PBoC may be close to having difficulties covering its interest expenses. I haven’t tried to model it, but it would seem that:
a) A rising share of the PBoC’s RMB liabilities pay interest (due to fast reserve growth)
b) the PBoC’s assets have fallen relative to its liabilities because of the dollar’s fall v the RMB. This is potentially a fairly large effect — as China had substantial dollar holdings before it allowed the most recent burst of appreciation.
c) the interest income on China’s US assets is falling absolutely and relative to the interest payments on China’s RMB liabilities (even taking into account the reserve requirement’s lower interest rate). Remember China has added — counting the bank’s reserve requirement — over $600b to the central banks’ foreign assets over the last 12ms, i.e. after us rates fell. Plus it has been rolling over its existing stock at lower rates.
directionally, it is certainly heading for negative cash flow — tho i would need to figure out the average interest cost across the pboc’s entire liability base (including zero interest cast) to be sure.
2fish’s thought that this is contingency planning v the risk of an agency haircut tho is interesting …
Simon. A central bank can operate with negative capital so long as no one wants their money back — and so long as it is clear the government stands behind the central bank and will bail it out as needed. A central bank cannot operate with a negative cash flow for long. That may be the explanation. But I don’t know.
I also suspect that the PBoC used its operating profits from say 03 to 06 to help cover some of the costs of the bank bailout. i certainly got that sense when i tried to look closely at who was picking up the losses on the late 90s NPLs that were moved off the state banks balance sheet. it also may have been making contributions to the treasury rather than building up its capital.
From the Chinese perspective, any further revaluation of the yuan will be counterproductive. In fact, Hong Kong futures market predict less than a 5% further revaluation of yuan for the coming year. The word on the street is that the yuan revaluation will soon come to a abrupt halt.
The China PBoC doesn’t have any affinity for US Treasury bonds, but is forced to continue purchases of the devaluating bond securities in order to maintain global competitiveness for Chinese export industries. Under the US Dollar hegemony regime with over 80% of global trade transactions denominated in dollars, any nation that revalues its currency automatically suffers a massive loss in global economic competitiveness.
Already thousands of labor intensive textile manufacturers across China are facing bankruptcy. What will happen to the millions of unemployed Chinese workers is an issue that the Washington Consensus could care less about. As a declared socialist nation, the Chinese government has a legal and moral responsibility to ensure full employment of even low-skilled workers.
i think it is a rather obvious fact. What do we waste time here to discuss this? When China becomes wealthier, it is natural the RMB will appreciate. The pace of the appreciation is another matter. But once your money is more valuable. It is only natural that your reserve (especially from previous stock) will endure loss.
You really really do not want a profit from your central bank’s FX reserve, because that usually means that your economy is shrinking relative to other economies. The media is dumb enough to ignore this. However I expect that economists should know better.
“The ’strong’ dollar policy was articulated by the Treasury, and it was really (and understood as such in the market) as “we aren’t gonna intervene in the market” policy.”
how long do you estimate this kind of equivocation can go on before foreigners catch on ?
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Re: profit aspect of central bank reserves
The optimal central bank reserve management strategy is to have an arsenal of FX to sell when its own currency is weak.
This implies “reloading” on FX reserves as necessary when its own currency is strong and the reserve currency is weak.
The natural cycle thus suggests a trading band of sorts for FX intervention – buy cheap FX, sell expensive FX. This can even be profitable, although that is not the primary objective.
China’s strategy is suboptimal in this sense. Its managed appreciation of the RMB suggests its own currency is not strong, and much of the rest of the world would agree. Yet it’s continues to build its reserves.
China has no natural cycle for reserve management because its currency is perpetually weak as a result of its strategy.
Another question here is how did this article end up on the front page of the NYT. Presumably if the PBC and MOF wanted to have a quiet discussion they could, but someone wanted to talk to the NY Times, and that suggests some interesting internal politics going on.
bsetser: I agree with JKH — the most logical reason for this is that the PBoC may be close to having difficulties covering its interest expenses.
And the main beneficiaries of the interest that the PBC is paying is the Ministry of Finance, so that may be why they are talking to each other.
bsetser: I’m not sure why the bank would execute a pre-emptive capitalization for the worst case scenario, whether or not it includes actual default and/or interest rate haircuts. That would advertise an expectation they wouldn’t want to encourage.
They wouldn’t but it’s better for everyone concerned if there is a contingency plan so that if the worse-case scenario happens, all of the bureaucratic fights are already resolved rather than having the fight while the building is burning.
Now why they would advertise that they are doing contingency planning is an interesting question.
Twofish 10:06
My words, not Brad’s.
I agree with your comment.
Economist Henry CK Liu’s thesis that US geo-political control of the world’s financial system permits “deficit spending without tears” is finding an audience at the China PBoC. Wasn’t it VP Dick Cheney who stated “trade and budget deficits don’t matter” under the US Dollar hegemony regime.
From CNBC,
http://www.cnbc.com/id/26557978/site/14081545/page/2/
Chinese central bank officials blamed the United States and believed the controversial assertions set forth in the book “Currency War,” a Chinese best seller published a year ago. The book suggests that the United States deliberately lured China into buying its securities knowing that they would later plunge in value.
“A lot of policy makers in China, at least midlevel policy makers, believe this.”
Somewhat off-topic
Even BusinessWeek is objecting to the Bernanke “crony capitalist” bailouts of politically-connected Wall Street banks through a “stealth taxation” policy otherwise known as monetary inflation. Rising inflation transfers “real economic wealth” from middle class savers to those who have first access to Federal Reserve monetary inflation.
http://www.businessweek.com/magazine/content/08_37/b4099087568542.htm?chan=magazine+channel_opinion
Even with a current account deficit that, starved of domestic savings, requires $2 billion a day in foreign financing, economic policymakers are fixated on propping up the credit bubble.
Since August of last year, the Federal Reserve has slashed interest rates from 5.25% to 2.00%—wielding a blunt instrument that was swung enough to bend the yield curve in favor of suffering banks. You know, the institutions that screwed up but were too big and important to be deprived of an inalienable right to cheap deposits that they can loan out at several points higher.
Wholesale inflation has soared 9.8% in the past 12 months, the highest clip since 1981. The more widely cited consumer price index jumped to 5.6%. In other words, while your saved buck was adding 2 cents or so on one end (and even less after taxes), three times as much was getting singed off the other end of that dollar bill. “Inflation is just deadly to savings,” says David Gitlitz, chief economist at TrendMacrolytics, an investment adviser. Gitlitz observes that, taking into account the hit from inflation, rates haven’t been this negative since the dreary 1970s. (That, in turn, gave way to an early ’80s that saw the worst inflation in U.S. history since the Civil War.) “It steals your purchasing power and sets less and less of an incentive to keep money in the bank.”
All of which might be tolerable to the lonely and beleaguered saver if he weren’t taunted daily by lopsidedly pro-spending, pro-creditor news stories. Forget about moral hazard. Forget about rewarding profligacy.
2fish,
“Now why they would advertise that they are doing contingency planning is an interesting question.”
————-
Why do you believe that it were the Chinese leak the story. It might well be IMF or someothers.
POBC’s capital is simply a bookkeeping matter within the state. As Twofish says, POBC has mainly non interest bearing liabilities. Hence a cash flow problem as a consequence of USD depreciation is unlikely. It is a mystery to me why an agency of the state (not a legal person like the SO banks, needs capital and what it means in a more general context.
I would be more concerned (as fan of the PRC) if this came from internal sources looking at a big calendar of USD withdrawals for investment purposes while there is scenario playing about possible write downs of investments. That might require some form of State Council authorization to change the portfolio mix for prudential reasons and require an allocation of state “funds” to cover losses on a portfolio almost certainly acquired with the explicit blessing of the state council. That is, if the POBC was indeed operating transaparently. However If the POBC had a mandate to “make money but not loses” and the elders would prefer not to hear any updates, as would be conceivable in the weird and wonderful world of post-Maoist politics, then it may be in the process of preparing the bad news.
Or simply, there may have been a translation error..
[...] it takes some explanation to understand how all the sloshing of money is likely to come out. See Brad Setser for a professional’s take on the situation plus interesting discussion. Here’s is [...]
Rein- This, I think, is the key passage:
“The central bank has gone to great lengths to maintain its foreign purchases. The money to buy foreign bonds has come from the reserves required that commercial banks must deposit with the central bank. In effect, China’s commercial banks have been lending the central bank more than $1 trillion at an interest rate of less than 2 percent.
To keep the banks strong when they were getting such little interest on their reserves, the central bank has kept deposit rates low. The gap between what banks are paying on deposits and the rates they are charging ordinary customers to borrow is several percentage points. This amounts to a transfer of wealth from ordinary Chinese savers to the central bank and on to Americans who are selling their debt to the Chinese.
The central bank is now under considerable pressure to reduce the commercial banks’ reserve requirements to encourage growth as the Chinese economy shows signs of slowing.”
The PoBC needs to constantly purchase dollars to fund the trade imbalance, especially with inflated commodity prices. It’s not the sunk costs, it’s the on-going extraction of capital in a weakening economy creating a political problem.
I have a theory about the “contingency plan” talked about by 2fish & Brad.
I still have this feeling that consolidation of Chinese businesses, the competition from not yet emerging countries on low tech industries like textiles, clothing and shoes, a need for surviving Chinese business to throw away maybe not yet paid for plant & equipment and upgrade to a cleaner and more energy efficient manufacturing base, may all be making a lot of commercial loans go bad.
Typically this may require a flow of funds from the central bank to commercial banks(or investment banks, however they call it there)
Now of course the flow has been going the other way, with the central bank essentially spending money to maintain a currency peg and thereby still underwrite US spending.
So could they be concerned of being pulled apart by two large opposing forces?
Quote from NYT: The gap between what banks are paying on deposits and the rates they are charging ordinary customers to borrow is several percentage points. This amounts to a transfer of wealth from ordinary Chinese savers to the central bank and on to Americans who are selling their debt to the Chinese.
This is somewhat garbled. There is a gap between what banks are paying on deposits and the rates they are charging businesses to borrow, but that money is going into cash for the banks. But that doesn’t represent a net transfer of wealth from the savers to the banks. The problem is that if that transfer wasn’t there, then the banks would be undercapitalized, and the savers would run the risk of losing their deposits.
The fact that Chinese are saving huge amounts of money does like the PBC do things like force sterilization bonds which allows it to import US currency without inflation, but that is a different mechanism that is unrelated to the interest rate difference. The US consumer is getting cheap loans from the 30% that people are saving and not so much from the difference in deposit and lending rates.
Regula: I still have this feeling that consolidation of Chinese businesses, the competition from not yet emerging countries on low tech industries like textiles, clothing and shoes, a need for surviving Chinese business to throw away maybe not yet paid for plant & equipment and upgrade to a cleaner and more energy efficient manufacturing base, may all be making a lot of commercial loans go bad.
Don’t think so. Consolidation and efficiency should increase corporate profits which means it easier for companies to pay off their loans. The big bad source of bad loans in China (as in the United States) will likely be stupid real estate deals. The question (and I’m an optimist on this) is when the banks have to absorb the losses due to real estate, what will happen, and I think that Chinese banks will end up in better shape than most American banks because they have cash.
One way of thinking about the difference between borrowing and lending rates in China is that it is something of a “preemptive bailout.”
I understand there is such a thing as good consolidation, where healthy companies buy out failing ones, and the bad effects are generally limited to equity holders.
But the not so good way is when a lot of highly indebted companies just fail.
And when you did have, in the not to distant past, hundreds of smaller competing companies in a particular industry I have trouble seeing how anyone could avoid the bad way.
China did semi-privatize major banks and got a big infusion of equity capital. So that would have to help. Then there is “hot money” and FDI, so much of the loss could be theirs, especially in real estate, like you pointed out.
But private savings in a country with $1800 per capita income seems kind of low to pay for it all with a couple points of interest rate spread.
So I still get this this spooky feeling there may be a lot “dark matter” there that hasn’t been detected yet.
2fish — the transfer to the central bank comes in two forms:
a) deposit rates are held artificially low, reducing returns to savings and helping the banks and everyone they lend too
b) the banks are forced to lend a high fraction of their deposits to the central bank at a very low rate.
and it is quite possible that the banks are now balking at the scale of this tax (the low rates on forced lending to the central bank); if they can lend more at the higher lending rate, they will do better in the short-run. this is one of the points bradsher makes
Brad,
The official reason that I heard the Chinese give for increasing state bank reserve requirements was to restrain bank lending.
Even the Chinese government was saying, for most of this decade, that lending was out of control.
They even made top down rules saying what industries banks weren’t allowed to lend to anymore.
Actually, I haven’t really been following the Chinese economy that closely, so it’s possible I missed a miraculous turn around in Chinese finance.
Regula: Even the Chinese government was saying, for most of this decade, that lending was out of control.
It was in 2003, it got back under control around 2004-2005, got back out of control around 2006.
Regula: Actually, I haven’t really been following the Chinese economy that closely, so it’s possible I missed a miraculous turn around in Chinese finance.
You did. It happened around 2003. The loss making SOE’s were closed down, and the banks were recapitalized. We’ll see in the next two years how everything goes, but I’m pretty optimistic since people in China have been preparing for the storm for the last ten years.
Regula: But the not so good way is when a lot of highly indebted companies just fail.
And when you did have, in the not to distant past, hundreds of smaller competing companies in a particular industry I have trouble seeing how anyone could avoid the bad way.
Been there, done that. You had massive layoffs and closing of SOE’s between 1998 and 2001. What’s left are the surviors that aren’t in bad shape.
Regula: But private savings in a country with $1800 per capita income seems kind of low to pay for it all with a couple points of interest rate spread.
Multiply everything by 1.3 billion and you end up with pretty big numbers. The interest rate spread was only part of the solution. Another part was to move the bad debt to asset management companies who were then financed by taxation. Estimate cost of clean up was in the $200 billion range financed over ten years.
Just noticed that Dave C. already beat me to the punch in another post on Henry CK Liu and dollar hegemony. Totally right.
I also agree that the Fed’s plan now is the “Dick Cheney method” of deficits-don’t-matter monetary policies– i.e., inflate ourselves out of debt.
This is fascinating because of the people who benefit (a tiny and well-connected few) and the people screwed over (almost everyone else).
The ultra-wealthy with access to the goodies from Fed policy, as Dave C. said, benefit, and massively indebted companies (and the US government) benefit by inflating away their debt.
Meanwhile, the vast majority of the US population, especially the middle and working classes, are totally screwed and see their savings disappear through inflation.
Furthermore, overseas central banks take a bath, with the USA basically exporting inflation. IOW, the USA fouls up, bankrupts the country in Iraq and with nuclear weapons, yet makes the “common people” here and in foreign countries pay for our profligacy. Classic imperialistic behavior.
This is why I doubt the Chinese will fall for it. While I doubt the thesis of the book that Shih is referring to (claiming that the USA deliberately lured the PBOC into buying up US T-bills with a false promise of guarding the dollar and keeping inflation low), the very fact that the thesis is so popular, suggests the Chinese are sick and tired of paying for our profligacy.
So China, Japan, the Arab countries will be focusing more on the domestic economy and infrastructure, especially as their own economies grow and become more high-tech, and less dependent on cheap exports overseas.
2fish:
OK. Then I did miss it.
But there was that GavKal newsletter I read less than couple years ago, and they must have missed it too. But I have suspected they slant their subject matter towards exciting reading rather than objective fact finding and analysis.
Corbanus:
“While I doubt the thesis of the book that Shih is referring to (claiming that the USA deliberately lured the PBOC into buying up US T-bills with a false promise of guarding the dollar and keeping inflation low), the very fact that the thesis is so popular, suggests the Chinese are sick and tired of paying for our profligacy.”
Absolutely preposterous thesis. May appeal to those who believe a central banker can’t read another central bankers intentions from interest rate policy. Or that a country with a huge account deficit and no foreign currency holdings in the central bank has any choice over inflation and a falling currency
Corbanus:
“So China, Japan, the Arab countries will be focusing more on the domestic economy and infrastructure, especially as their own economies grow and become more high-tech, and less dependent on cheap exports overseas.”
Actually, our Treasury has been telling them they should do that. Something about the dollar peg as I recall.
So I think blaming the US for screwing them up makes for nice press in China.
However, there has never been a large debtor country in the history of the world that hasn’t resorted to inflating out of it or outright default.
Problem is most of Europe is also high debtors, and so is Japan if you only count the government. Adding in the private sector, they still are net exporters of capital.
So I think there are lots of co-conspirators in inflation, plus Peak Commodities throws real price pressures into the works.
“However, there has never been a large debtor country in the history of the world that hasn’t resorted to inflating out of it or outright default.”
Yeah, and that’s why I think that foreign central banks are going to become increasingly wary. The baby-boomers in the USA haven’t even started retiring yet in large numbers, yet we’ve already crested $10 trillion in national debt as it is. It’s becoming increasingly obvious to our central banking creditors that the USA lacks anything in the way of a political system that would allow long-term surplus accumulation (in our tax and benefit policies) to pay off the increasing debt, which leaves hyperinflation or default as the only alternatives. The bankers aren’t going to continue holding, let alone accumulating, US Treasury debt once it becomes obvious that we have nothing in the way of a realistic ability to pay it back. The really sad thing, of course, is that it’s not just central banks that hold US IOU’s– over half is still held by mostly domestic private investors, very often retirees. And they’ll see the value of their holdings and their savings wiped out.
Robert Mugabe, meet the US government, your newest protege. You, Mr. Mugabe, are quite an inspiration to follow!
Also you’re right that we’re hardly the only debtor country among the G7 here, but we’re certainly the only one that insists on pissing away our already dwindling and limited resources on genuinely idiotic imperial forays abroad. Not just Iraq and Iran, but this useless, totally unnecessary sabre-rattling with Russia– which began over a rather ridiculous, media-driven invasion of Serbia and partition of Kosovo by the Clinton Administration (against international law), continued with a needless pull-out of the ABM treaty by the Bush Administration today, and in other respects. It’s almost as though recent US governments have been needlessly provoking and starting a new Cold War for– um, what, exactly? We obviously cannot afford this stupidity now.
So while the USA is also facing the same kind of baby-boomer retirement disasters as other G7 countries, we alone have already just about driven ourselves to bankruptcy due to neoimperialism, and this gives us much less flexibility.
Also, I agree, that thesis is totally preposterous, but the fact that it has any traction at all, shows the resentment building up within the Chinese economics establishment toward the USA. Which pours gasoline on the fire. I just don’t see them supplying our debt addiction much longer.
[...] http://blogs.cfr.org/setser/2008/09/05/interesting/ [...]
This just in,,,,,
Fannie and Freddie have just been nationalized….
http://www.nytimes.com/2008/09/06/business/06fannie.html
The really scary thing was that they were acting on legislation that was past only a month ago. And I have a feeling that there have been lots of calls between Washington and Beijing over the last month.
I have this feeling that the purpose of the article last night was to tell the world, don’t panic about China, we’re ok with what is about to happen. It’s going to be really interesting to see what happens when markets open on Monday.
Yup. We screwed on Social Security too. The surplus has been spent already and there are only “non-marketable treasuries” in the fund. That means the Treasury would need to sell real bonds to get cash in the bank so our checks really do clear. I don’t qualify for another 14 years, but I’m getting more and more sure it just runs out a few years afterwards because no one will buy treasuries anymore.
I think both the US and the Soviets, er, I mean Russians seem to be re-kindling the cold war. Probably over oil. Not sure we win this time and am considering learning Russian.
ABMs are a huge sinkhole for money. They make good sense as a defense against rogue nuclear powers as N. Korea and Iran want to be. But they are worthless against a Russian size arsenal that was a few thousand ICBMs during the peak of the cold war.
For one thing they are expensive as hell. And newer ICBMs like the one Russia just test launched has war heads that split into a payload and maybe half a dozen decoys. The ABM has to properly distinguish these approaching the ABM at a speed of Mach 20. Gets iffy.
But 2fish just posted we may be the proud owners of F%F, so I’ve got to read about that now.
So…read the F&F bailout article.
It’s not clear what happens going forward, but it looks like the taxpayer fallout is we are backing F&F corporate bonds, and assume the risk of the internal subprime portfolio. No mention was made of MBS.
$38B in preferred stock is wiped out and banks own much of it and use it towards their reserve requirement. Making that disappear will make things harder for the FDIC and their money is rapidly running out so they may need to go to the Treasury well sometime too.
No mention at all was made of how a nationalized F&F comes up with new money to lend. Treasury well?
Been reading more articles about F&F and looking for fun facts.
Came across this one, which deserves some more explanation.
“A government takeover could cost taxpayers up to $25 billion, according to the Congressional Budget Office.”
Last I heard $225 BILLION in F&F bonds were due to be rolled over at the end of this month. I guess that could have been a typo in the AP wire I read it in.
But if it’s not, that could explain why they went straight to nationalization rather than letting F&F go thru the embarrassment of have a bond issue fail or clear at a high interest rate. Or have Paulson spend a whole lot of his approved cash right in front of our eyes.
Maybe I’m the only one here that doesn’t know how it works now, but how exactly do nationalized companies roll over $225B in bonds in the next 3 weeks?
Again apologies, didn’t have the time to read much else apart from the post, so no intentional repetition of commentators’ points
Brad:
“not something China has done because the US has sought its financial support.”
and
” Creditors through the ages usually think that the debtor’s own behavior is at least partially responsible for the loss.”
would americans really have preferred china to sit on the sidelines and watch the financial equivalent of the titanic sinking? if that had happened, just think what the xenophobic lot would have to say?!
sure, it is partly the creditors’ fault for allowing the credit in the first place, but do debtors get no blame? is that why bankruptcy laws have been under scrutiny in recent years? consequences are what adults need to face, particularly when the choice is made by adults to pursue a certain course of action.
2fish
the “miraculous” turnabout may have seemed relatively quick but are there hidden problems? have all soe turned private organisations really made that transition smoothly? will the recapitalization really be masking a bigger problem - that NPL problem has not been fully resolved, sweeping things under the carpet hardly resolves matters? preparation for a disaster hardly reflects the emotional aspects which arise when disaster really hits. when faced with real disaster, logic rarely wins against anger and frustration. particularly when the problem is seen as having a foreign origin.
When the smoke settles, I think the Treasury’s plan will be to extend an unlimited line of credit to Fannie and Freddie, and/or take an equity stake in the two companies. This would eliminate default risk for holders of Fannie and Freddie debt, like Bill Gross and China. I don’t think the stock holders will be entirely wiped out, but I do think that the massive amount of credit that will have to be supplied to the GSEs will dilute what are already anemic stock prices.
The GSEs are probably insolvent. The government has to step in with enough funding and leverage to support the GSE’s $1.5 trillion debt and $2.3 trillion of derivative market exposure. Where does the Government show that kind of money for this kind of funding on its balance sheet? I haven’t a clue. So we’re talking about some serious leverage here.
This bailout should be a real magic trick, especially since Paulson, the chief protector of the banksters and his own personal stock holdings, stated, “Use of either the line of credit or the equity investment would carry terms and conditions necessary to protect the taxpayer”. How can the taxpayers go wrong with the former CEO of Goldman Sachs (the chief architect behind the creation of CDOs, SIVs, CDS and financially engineered, defaulting exotic mortgage paper) protecting them.
The most feared scenario for the Federal Government would be a major bank run that could lead to an epidemic of bank runs. Apply a similar scenaro to Fannie Mae and Freddy Mac, and you could have the equivalent of a giant international bank run.
China, which holds 33% of all GSE debt, and other major debt holders, have stopped buying GSE paper. The Russians, who have recently reduced their $100 billion GSE exposure by 40%, announced, yesterday, that they were reducing their exposure even further. If one more major GSE debt holder had engaged in a massive sell-off, the GSEs would have “officially” gone under. The Federal Government had to do something and had to do it quickly.
Here is a very serious unofficial warning from the Chinese:
“Aug. 22 (Bloomberg) — A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China’s central bank.
“If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,” Yu said in e-mailed answers to questions yesterday. “If it is not the end of the world, it is the end of the current international financial system.”
Here is what came out of Russia Yesterday:
“Russia says further cuts Freddie, Fannie holding”
“SOCHI, Russia, Sept 5 (Reuters) - Russia has slightly further reduced its holdings of U.S. mortgage agencies Freddie Mac (FRE.N: Quote, Profile, Research) and Fannie Mae (FNM.N: Quote, Profile, Research), central bank’s first deputy chairman Alexei Ulyukayev said on Friday.
At the start of the year Russia held $100 billion — or over one sixth of its gold and forex reserves — in Fannie Mae,
Freddie Mac and Federal Home Loan Banks.
In the summer, officials said that the holdings had been reduced by around 40 percent through not replacing maturing paper.”
Judy — i know you will think I am letting the US off, but the US (the debtor) had absolutely no responsibility to direct its macro-economic policies toward maintaining the dollar’s external value. If creditors had wanted such a commitment, they should have negotiated something more like bretton woods 1 — where the US promised to back the dollar with gold. The US probably wouldn’t have gone along, not so much credit would have been extended and in all probability the US and its creditors wouldn’t be in the hole they are in now.
Similarly, if the United sTates creditors worried about dollar depreciation, they should have lent to the US in their own currency — or euros. They didn’t. they voluntarily assumed the currency risk in the context of a system where the US had fully autonomoous monetary policy and had made no commitment to use that monetary policy to defend the dollar.
Creditors had options. They didn’t use them. Not even after a couple of American economists warned them that they were extending too much financing to a country with a large external deficit at too low a rate to get their funds back — as the USD had to depreciate! I consequently have no sympathy for creditors’ complaints about the dollar.
Their option now is not to rollover maturing dollar claims if they don’t trust the US to pursue policies that will generate full repayment. And here it isn’t an issue about will be the US pay or not or creating toxic securities or not. The US government will repay its dollar debts. The risk the creditors face is that the dollar’s value may fall.
Black Swan — I can see how China holds about 10% of GSE debt ($600b - including $100b that doesn’t show up in the tIC) v $7b in outstanding Agencies. it may have more of specific maturity buckets. But 33% seems high to me.
Cedric — a nationalized company would issue bonds that would be considered almost as good as treasuries, so it likely would have no trouble rolling over its debt. the agencies creditors would assume that any losses on the agencies underlying portfolio would be assume by the taxpayer, not shifted to bondholders.
Yeo: the “miraculous” turnabout may have seemed relatively quick but are there hidden problems?
Sure there are problems, but the question is are things better or worse. You will never have a perfect economic system, and there always been be problems, the question is whether you have more serious problems or less serious problems, and the problems that the Chinese economy faces today are less serious than the ones that existed ten years ago.
Yeo: Have all soe turned private organisations really made that transition smoothly?
No. It wasn’t a smooth transition at all. Laying off several tens of millions of workers is messy, and the companies that exist now are hardly models of economyic efficiency. However, the worst SOE’s have been closed.
Yeo: that NPL problem has not been fully resolved, sweeping things under the carpet hardly resolves matters?
It does sometimes. What you really want to see is whether delaying things helps issues or hurts things, and sometimes delaying solving a problem actually helps. In the case of the SOE’s the first priority was to stop the bleeding and this was done in 1998. At this point the banks stopped loaning SOE’s new money. Once you have stopped the bleeding, then in the Chinese situation it makes sense to delay resolving the problem for as long as possible. If you delay the problem then each year you have more money (10% GDP growth) and deeper institutions that make resolving the problems easier as time goes by.
There is an American bias toward sudden dramatic changes that purport to fix everything. Sometimes a “big bang” solution is a good idea since delaying fixing the problem will make the problem worse. Often it isn’t. The fact that you aren’t solving every problem *right now* doesn’t mean that you are ignoring it.
Yeo: when faced with real disaster, logic rarely wins against anger and frustration. particularly when the problem is seen as having a foreign origin.
That’s why you need a plan. Plans are useless, planning is essential. What you likely will find when you are faced with a crisis for the first time, is that the plan you had in place, just won’t work and you have to do something origial. The thing about planning is that it means that you have some of the tools and people in place to do the new original thing, and most importantly it means that you’ve spent several months “thinking the unthinkable.”
Organizationally if the senior management doesn’t want you to think about something, then you really can’t organizational prepare for it. Planning for something means that you have permission to think and talk about an issue in a bureaucracy, and making something “not internally taboo” is vitally important in a bureaucracy. Bureaucracies always try to smile to reporters and outsiders, but the important thing is whether they can talk about something internally.
The reason that the government started worrying about the banking system was the fall of Suharto in Indonesia as a result of the Asian Crisis. Once the Party realized that a collapse of the banking system could destroy the Party, then this become a very high priority issue to resolve.
“Similarly, if the United sTates creditors worried about dollar depreciation, they should have lent to the US in their own currency — or euros. They didn’t.”
I didn’t know the US settles its debts in FX.
in the 70s, the US issued DM and yen denominated bonds in response to concerns about dollar weakness; so long as the United states creditors buy 10 year dollar bonds at 3.5%, why change?
Brad:
“Cedric — a nationalized company would issue bonds that would be considered almost as good as treasuries, so it likely would have no trouble rolling over its debt. the agencies creditors would assume that any losses on the agencies underlying portfolio would be assume by the taxpayer, not shifted to bondholders.”
So….they will issue F&F bonds that are almost explicitly guaranteed?
Brad:
Was wondering something else.
Do you think the Economist magazine will come up with a Big Mac index that adjusts the new F&F bond prices for Purchasing Power Parity?
Found todays analysis of the F&F bailout plan on the RGE website. Thought I’d post it here tho slightly off topic, but that’s where the conversation morphed to when the news hit.
Good to have the numbers close by. Final details of the plan not out yet, but it looks like the bonds may stay the same, but include a taxpayer pass thru to make up any interest shortfall in the portfolio.
Still no word how they get cash to make new loans. Won’t make the collateral re-flate either.
Next we will find out what it was that Greenspan liked about derivatives. There’s 62 Trillion of those, whatever they are.
We still need a nick name for the bonds. I propose either Big Macs, or perhaps White Dwarfs.
——————————————-
Key features of government intervention (final deal to be announced before Asian markets open):
1) Fannie and Freddie and their combined $1.6 trillion investment portfolio business financed through agency bond issuance will be taken under a government-run conservatorship for an orderly restructuring process–> new housing law says that under a conservatorship, the authorities would aim to preserve Fannie and Freddie assets, rather than dispose of them.
2) The value of the companies’ common stock would be diluted but not wiped out, while the holdings of other securities, including company debt and preferred shares likely to be protected by the government. (Washington Post)
3) taxpayer backstop for combined $5.3 trillion F&F owned or guaranteed debt: taxpayer funds will be used to pay any cash-flow shortfalls (e.g. due to borrower defaults) on mortgages F&F own or guarantee;
4) capital infusions to F&F in conservatorship on a quarterly basis depending on reported results instead of large capital infusion upfront;
5) Fire CEOs and replace the board
# compare with new William Ackman proposal sent to Treasury on Sep 5: “In the event the government needs to inject capital immediately, we suggest that the Treasury consider purchasing senior subordinate debt in the two companies in an amount sufficient to address their capital needs in the short to intermediate term. All of the outstanding sub debt, preferred and common stock would continue to remain outstanding according to their existing terms.”–> see overview of original plan
# Majority of $36bn preferred shares is held by small and regional banks and other financial institutions, incl. insurers, that have already written down over $500bn (FT via InvestorsInsight)
# cont: : There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Adding this up, a bail-out might cost at least $105 billion, not the $25bn as envisaged by CBO.
# Of the $314 billion of private-label securities (PLS) held by the Enterprises at the end of 2007, approximately $217billion were backed by subprime and Alt-A mortgages. At year’s end, PLS backed by subprime mortgages represented 9.2% of the Enterprises’ combined mortgage portfolio assets, securities backed by Alt-A mortgages represented about 5.8% of their combined mortgage portfolio assets.
# cont: There are $62 trillion (with a “T”) in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt–> depending on how the “credit event” is characterized, it may allow the seller of the insurance to postpone payment for five years.
# Brad Setser (CFR): Foreigners (mostly central banks but also big Japanese banks and the bank of China) hold over 20% or $1.3T of the outstanding long-term debt of U.S. government agencies. China and Japan are the largest holders with $376b and $229b respectively–> foreign central banks turned into agency debt net sellers for the first time as spreads kept widening.
# Lockhart (OFHEO): At the end of March, F&F had credit outstanding of $5.3 trillion, including agency debt of $1.6 trillion and guaranteed mortgage-backed securities (MBS) of $3.7 trillion. By Q1 2008, FannieMae ‘fair value’ Tier 1 capital ratio at 0.4%, and -0.2% for FreddieMac. The companies’ capital is leveraged 50 times.
# Ingo Walter: it is critical that the government obtain warrants or rights equal to the full and fair value of this subsidy and any upside that this support generates (similar to those received in the 1980 Chrysler bailout). It is critical to minimize costs to the taxpayers and to assure that the value of any support accrues to taxpayers and not to management, shareholders or debt holders.
Brad,
I think you are being disingenuous about the US responsibility for its debts:
(1) True, the US never undertook to maintain the external value of the dollar, but the Fed undertake to maintain its internal value, and the two are cointegrated.
(2) The total amount of debt owed by the US government to foreign countries is large, but less than the typical US family might take on to buy a house. The point is that the US has the ability to pay. The problem is, in the first instance, the honesty of its politicians to tell its people the truth about their situation, and secondly, their willingness to bear the burden.
We have the ability to pay?
“These firms back $5.2 trillion in mortgage securities, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Adding this up, a bail-out might cost at least $105 billion, not the $25bn as envisaged by CBO.”
The mortgage bankers assc. just reported 9% of mortgages are either foreclosed on or behind in payments.
The gov just announced a Federal deficit estimate for next year of $480B plus $90B in off budget war spending.
The economy is not in recession yet according to the government. But if it does go into recession, these things get worse.
I also see geological problems with nationalizing F&F. If they ever get The Big One in California, the government is wiped out and we will have to close down the country.
And the ultimate question in my mind is, if the mortgage stuff was insured already by Credit Default Swaps, why is the taxpayer still insuring it? $62 trillion in insurance is not enough?
“There are $62 trillion (with a “T”) in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt–> depending on how the “credit event” is characterized, it may allow the seller of the insurance to postpone payment for five years.”
Today RGE just updated the report I posted above. They include more detail of what the current Treasury plan is. In a separate blog today, Roubini critics the plan. I won’t try posting the whole thing here, so everyone can go there to read it.
+++++++++
Treasury Secretary Paulson GSE Program announced September 7:
Jim Lockhart, Director of the new independent regulator, the Federal Housing Finance Agency (FHFA), places GSEs in ‘conservatorship’ and replaces CEOs and board members–> “GSEs will no longer be managed with a strategy to maximize common shareholder returns.”
4 Step Program:
1) To promote stability in the secondary mortgage market and lower the cost of funding, the GSEs will modestly increase their MBS portfolios through the end of 2009. Then, to address systemic risk, in 2010 their portfolios will begin to be gradually reduced at the rate of 10 percent per year, largely through natural run off
2) Treasury and FHFA have established Preferred Stock Purchase Agreements: Treasury receives senior preferred equity shares and warrants that protect taxpayers. Additionally, common and preferred shareholders bear losses ahead of the new government senior preferred shares. Conservatorship does not eliminate the outstanding preferred stock, but does place preferred shareholders second, after the common shareholders, in absorbing losses–>” while many institutions hold common or preferred shares of these two GSEs, only a limited number of smaller institutions have holdings that are significant compared to their capital.”
3) Establishment of a new secured lending credit facility for GSEs incl. FHLB, intended to serve as an ultimate liquidity backstop (temporary authority expires in December 2009)
4) Treasury is initiating a temporary program to purchase GSE MBS starting later this month–> Given that Treasury can hold these securities to maturity, the spreads between Treasury issuances and GSE MBS indicate that there is no reason to expect taxpayer losses from this program, and, in fact, it could produce gains (temporary authority expires in December 2009).
–> The Preferred Stock Purchase Agreements minimize current cash outlays, and give taxpayers a large stake in the future value of these entities. In the end, the ultimate cost to the taxpayer will depend on the business results of the GSEs going forward.
–> Before Treasury’s temporary authority expires in Dec 2009, Congress must decide about a long-term solution. Government support needs to be either explicit or non-existent, and structured to resolve the conflict between public and private purposes. And policymakers must address the issue of systemic risk.
# Lockhart (OFHEO): At the end of March, F&F had credit outstanding of $5.3 trillion, including agency debt of $1.6 trillion and guaranteed mortgage-backed securities (MBS) of $3.7 trillion. By Q1 2008, FannieMae ‘fair value’ Tier 1 capital ratio at 0.4%, and -0.2% for FreddieMac.
# OFHEO: Of the $314 billion of private-label securities (PLS) held by the Enterprises at the end of 2007, approximately $217 billion were backed by subprime and Alt-A mortgages–> PLS backed by subprime mortgages represented 9.2% of the Enterprises’ combined mortgage portfolio assets, securities backed by Alt-A mortgages represented about 5.8% of their combined mortgage portfolio assets.
# Most of $36bn preferred shares is held by banks and insurers that have already written down over $500bn (FT via InvestorsInsight)
# cont: : There is $36 billion in preferred shares as of June 2007. Then there is $19 billion in subordinated debt. These firms back $5.2 trillion in mortgage securities, that means even a 1% loss from foreclosures would mean a $50 billion portfolio loss. Adding this up, a bail-out might cost at least $105 billion, not the $25bn as envisaged by CBO.
# cont: There are $62 trillion (with a “T”) in credit default swaps written against Fannie and Freddie debt, or somewhere near 12 times the actual debt–> depending on how the “credit event” is characterized, it may allow the seller of the insurance to postpone payment for five years.
# Brad Setser (CFR): Foreigners (mostly central banks but also big Japanese banks and the bank of China) hold over 20% or $1.3T of the outstanding long-term debt of U.S. government agencies. China and Japan are the largest holders with $376b and $229b respectively–> foreign central banks turned into agency debt net sellers for the first time as spreads kept widening.
# Ingo Walter: it is critical that the government obtain warrants or rights equal to the full and fair value of this subsidy and any upside that this support generates (similar to those received in the 1980 Chrysler bailout). It is critical to minimize costs to the taxpayers and to assure that the value of any support accrues to taxpayers and not to management, shareholders or debt holders.
Roubini’s critique is economically rational and politically naive.
And, if this is still the right time to throw a flood of liquidity to the housing market (but with reasonably conservative debt service capacity tests on the borrowers, forget about the loan to value ratios, no one knoew what value is in a market like this), people interested in moving or buying cheap can be accomodated and markets not in severe distress may be saved. That is the way to use taxpayers money here.
Of course everyone would like to see punitive action against moral hazard artists, but in this case, probably, this is all that was on the table for the gvt as a quick fix, in order to avoid lengthy legal battles and contagion of the severe market failure conditions to as yet relatively healthy markets. It is the best an outgoing administration can do without alienating its own fans. My main criticism is that it significantly narrows the policy options for an incoming administration. But it appears to save time, and that may be more important right now. If the price decline can be arrested at the national level (severely distressed markets still needing a lot of time) that may crate benefits that will dwarf the cost to the taxpayer. And, so far the taxpayer has not given a penny. We are talking about loans and a small amount of preferred stock. If this stabilizes the housing market, any definitive losses to the taxpayer will be dwarfed by the wealth effect of housing..
I