Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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So true …

by Brad Setser
September 7, 2008

Floyd Norris in the New York Times:

Remarkably, the country that prides itself on being the beacon of free enterprise finds itself with a financial system that needs government money to finance the most important asset most Americans will ever own. There have been bailouts before, but none that seemed more crucial than that of Fannie and Freddie. The housing boom and bust have left them virtually the only sources of large amounts of money for home loans in the country.

That isn’t the half of it. The US doesn’t just need US government money to support the US housing market: It needs money from foreign governments as well.

And no one more than China. China’s central bank borrows RMB from the state banks (whether by selling sterilization bills or by hiking the reserve requirement) and then uses those funds to buy large quantities of Agencies. The flow of Chinese savings into the US housing market is entirely a government flow. From June 2007 to June 2008, the foreign assets of China’s central bank increased by $681b. That is hard number — no fancy adjustments are required. I just added the central banks “other foreign assets” (the foreign exchange the state banks have deposited with the central bank) to its stated reserves. Adjust for valuation gains, and that works out to $620 billion or so. That is a low-end estimate for China’s foreign asset growth. It leaves out the funds shifted to the CIC, and the funds used to recap the China Development Bank. A lot of this went into Agencies. A lot more than the $70 billion in Agency purchases that shows up in the TIC data.* If that is true, then China also has more than $465 billion in short and long-term Agencies as well.

Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.

The New York Times reports:

Most worrisome, the companies’ cost of borrowing was growing more expensive, and central banks in Asia and Russia were scaling back their purchases of the companies’ debt

The Wall Street Journal adds:

Fannie and Freddie were still able to fund themselves, but it was getting more expensive to do so. Foreign officials, whose central banks own Fannie and Freddie debt, were calling Mr. Paulson to express concern. Sen. Charles Schumer, a New York Democrat, said he was told by government officials that foreign investors were threatening to bail out. “There was a real fear that foreign governments would start dumping Fannie and Freddie…and not buy the bonds,” he said.

I suspect this is the first case where foreign central banks exercised their leverage as creditors to push the US government to make a policy decision that protected their interests. The need for ongoing central bank financing certainly weren’t the only reason why the US government acted. US banks hold a lot of Agency debt too. But the need to maintain the confidence of the world’s central banks — and the attractiveness of Agencies as a reserve asset — was certainly a factor in the Treasury’s decision.

Last week (using the date for the end of the reporting week not the weekly averages), the Federal Reserves’ custodial holdings of Agencies fell by another $9.75b, significantly more than the fall in Treasuries. The Fed’s custodial holdings seem to account for about 90% of all known central bank Agency holdings. There are more central bank Agency holdings than show up in the survey data, but they are managed by private intermediaries — and I don’t have a good guess of their magnitude. No matter. The Fed’s custodial accounts pick up enough of the world’s total holdings to provide a pretty good picture of how central banks have acted over the last month.

As of Wednesday, September 3, central bank custodial holdings of Agencies were down $27.4b from their mid July peak. That is a sum comparable to the capital sovereign funds invested in US banks and broker dealers over the turn of the year.

The threat of a central bank buyers strike was real.

* The $25 billion in known purchases of long-term treasuries between June 07 and June 08 also looks low, as does the $150b in total Chinese purchases over this period. I personally would be surprised if China purchased less than $350 billion in Treasury and Agency debt over this period. I wouldn’t be totally surprised if China purchased close to $400 billion in Treasuries and Agencies over this period. That is a huge, and truly unprecedented sum. I won’t bore you trying to explain all the ways I have tried to stress test this number, but I will assure you that it is a robust estimate.

I also am fairly confident that China’s central bank now manages, counting the banks’ foreign exchange reserve requirement (“other foreign assets”) a foreign portfolio of over $2 trillion. This too comes from the PBoC’s own data. Dr. Cowen says China has over $300 billion of Agencies. I would say well over. $300b is only 15% of China’s total portfolio. Moreover, if you look hard enough, between $460 and $465 billion of Agencies can be found in the TIC data. Take short and long-term Agency holdings in the June 2007 survey and add subsequent flows and it you want to be really crafty, assume that the same share of China’s short-term holdings are in Agencies as at the time of the June 2007 survey. Then make one more adjustment: Last year’s survey revisions increased China’s Agencies holdings by around $70b. If that pattern holds true, China now has a bit over $530b of Agencies. And I would expect bigger revisions this time around because of the acceleration in China’s reserve growth this time around.


  • Posted by Simon

    Isn’t it incredible how simple the evidence and outcomes are.

    No one likes to have a dodgy debtor.

    US housing is dodgy.

    Now….how secure is the US government? How capable is the US government financially? Can it manage to pull itself out of it’s debt dungeon?

    Will it face the frugal reality or kick the can once more? Will it come clean about its ability to fund its social security obligations or not?

    Or… will it destroy its own currency, say ha! ha! to its creditors and invite the collateral damage to the rest of the world?

  • Posted by KnotRP

    So the US home buyer, who couldn’t afford the mortgage loan, will somehow be able to afford the taxes necessary to make that same loan whole again? I wonder if they can devalue the currency fast enough to break the currency pegs but not crater the dollar….

  • Posted by Cedric Regula

    If I were any foreign holder of F&F corp bonds, I would be thinking the current dollar rally is good to sell into.

    Then if the US gov came along and told me they can pay my interest on my F&F bonds, if I buy ,say, 2-3 times as many Treasuries to fund it all, I would be sure its a great time to sell.

    It’s just that I’m not sure I think the same way as a Chinese central banker.

    But I remember an old Bill Gross blog topic from late 2004 (don’t worry, I don’t read him often), when concerns about the magnitude of foreign treasury holdings were beginning.

    Flight and the impact on the dollar was a concern back then and Bill Gross proclaimed “Whoever bolts first wins.”

    So sometimes he makes sense.

  • Posted by anon

    From Tim Duy today:

    “the bailout provides an important policy lesson – nothing truly bad can happen as long as the US Treasury is willing and easily able to float debt onto the global financial markets. Presumably, Treasury will finance any cash injections into Fannie and Freddie by issuing debt that will be forced fed to foreign central banks, the same way Treasury financed the now forgotten stimulus package. The US can always inflate away the real value of that debt at a later time. As long as foreigners are willing to continue to take that risk, let them.”

  • Posted by qingdao

    People who think about U.S. China economic relations seem to fall into four, mutually exclusive camps:
    1. Both C and US win
    2. Both C and US lose
    3. C wins; US loses
    4. US wins; China loses
    In the first group I would include those who accept Bretton Woods II and employees of the US Treasury. Group II includes those on the Left who believe that globalization simply feeds the Beast to the detriment of the environment and the overwhelming rest of us. I’m not sure who to put into category three (US labor?). I find myself squarely in the last basket, as do most Chinese. In spite of the recent financial turmoil, I am far more worried about the Chinese economy – near, medium and long term – than I am the US economy.

  • Posted by Rien Huizer


    What about 1, some of the time and 2, some of the time. I would be worried about any economy right now, but probably a bit less about China’s than the US. That is, what exactly means “worried about an economy”. My economy is perhaps different from yours. I like my economy to provide stable growth, adequate incentives for productive behaviour, some money left for good communal goods, like education and health care. Also it must make sure that what we do in our lifetime does not put future generations outside the reach of technological advances to repair whatever damage we humans do to our habitat whilst being economically active. Finally, the government should not give hand outs, except to the excusably (very) poor, and let people pay for what they consume, even where the state produces those goods and services, but that the state should organize efficient (yes, of course states can be efficient, in the sense of industrial efficiency. Just take a look at Singapore’s public management practices) insurance and savings schemes to provide for that. I am not quite sure that any of those conditions exists in either China or the US. But no doubt, some people like the economic environment they live in, and thrive. Some make money on the way up, and others on the way down. And then there are the ones who do both or neither.

  • Posted by Ethan

    So the Agencies, which paid an interest premium because they were NOT guaranteed, are now guaranteed. Isn’t that a financial windfall to the banks that bought a risky asset but can now transfer that risk to the taxpayer?

    What is the value of that windfall?

    We could have financed the whole mess at a lower rate with Treasuries – but now we’re stuck with the spread. How much EXTRA interest will be paid to Agency creditors, over and above the Treasury rate? How many billions of dollars to China and the Petro-States?

  • Posted by John Katz

    Paulson has skilfully managed to avert an imminent financial crisis that would have shiprecked the so called Bretton Woods II arrangements and sunk the America spends Asia lends paradigm.

    However the Fannie &Freddie arrangements involve recognising as US Federal liabilities implicit (not legal) obligations for Fannie and Freddie debt.

    The arrangements made up to now have been the easy part of the exercise. The challenge will be maintaining credibility and dealing as well with the far larger implicit liabilities on unfunded social obligations.

    After the glitzy party conventions politicians, legislators and number crunchers will have to satisfy US voters and creditors how this is going to be done. Analysis in my book The Goldwatcher suggets this will not be challenging.

  • Posted by John Katz

    Correction to last 2 lines of previous post – please delete ‘not – should read ‘suggest this will be challenging.’

  • Posted by Dave C.

    Mish Shedlock on his Global Economic Analysis blog details the blatant lies surrounding the federal taxpayer bailout of Fannie Mae and Freddie Mac.

    The GSE deal has been announced. Here is the Statement by Secretary Paulson on Treasury and FHFA Action to Protect Financial Markets and Taxpayers.

    The title of the statement suggests two things.

    1. This agreement will not reduce risk on the financial markets
    2. This agreement will not protect the taxpayer

    Let’s take a look at excerpts to see how long it takes to verify that cynicism. The US Treasury is willing to risk up to $200 billion taxpayer money ($100 Billion for each GSE) on this absurd bailout for Wall Street. Assuming the GSEs do borrow $200 billion, exactly how are they supposed to pay it back December of 2009?

    Taxpayer Risk Defined

    And what does the government (taxpayer) get for a potential $200 billion in lending while allowing the GSEs to add another $320+ billion of systemic risk?

    The answer is a mere $1 billion of senior preferred stock in each GSE and Warrants for the purchase of common stock of each GSE representing 79.9% of the common stock of each GSE on a fully-diluted basis at a nominal price.

    In other words taxpayers are rolling the dice on $200+ billion in risk backed by a lousy $1 billion in senior preferred stock and warrants on shares of common that are likely to be worthless.

  • Posted by Cedric Regula

    If anyone ever believes that the markets know what they are doing, print this and tape it to your computer monitor.

    1)Stock dives
    2)Bonds climb almost to treasury levels
    3) $62 Trillion in Credit Default Swaps are triggered because of negative credit event!!!!!!!!!

    Fannie, Freddie shares dive, debt rallies on bailout
    Monday September 8, 10:15 am ET
    By Pedro Nicolaci da Costa

    NEW YORK (Reuters) – Fannie Mae’s and Freddie Mac’s stocks took a dive while their debt soared Monday, as investors bet the U.S. government’s takeover of the mortgage finance firms would wipe out shareholders but fully guarantee their bonds.

    Equity markets around the world surged on the bailout news as hopes rose that the U.S. Treasury’s plan to take control over the companies, which together back about half of the country’s $12 trillion in mortgages, might put at least a temporary floor under troubled financial markets.

    The Dow Jones industrial average (DJI:^DJI – News) surged over 2 percent, but Fannie Mae’s (NYSE:FNM – News) stock got hammered, swooning more than about 80 percent to $1.30. Freddie Mac (NYSE:FRE – News) shares fell more than 75 percent to $1.25.

    any on Wall Street said the takeover of the institutions was merely a symptom of the dismal state of credit markets.

    “This euphoria might fade, because Fannie and Freddie (NYSE:FRE – News) are not the problem,” said Christopher Low, chief economist at FTN Financial. “Their woes are a symptom of a worldwide contraction in credit that may not be cured by the decision.”

    Treasury Secretary Henry Paulson, who made a number of television appearances Monday, said he could not estimate exactly how much of a burden the bailout would be for taxpayers. Speaking to CNBC, he said this would be impossible to tally until the extent of declines in the mortgage market were fully known.

    The takeover came as welcome news to officials in Asia, where central banks are some of the biggest holders of the agencies’ bonds. They had plenty of reason to cheer.

    The yield premium on agencies’ debt against Treasury bonds narrowed by at least 20 basis points, traders said. Bond prices move in inverse relation to yields.

    “This is the biggest event in my 21 years in the business,” said Arthur Frank, director and head of mortgage-backed securities research at Deutsche Bank.


  • Posted by Twofish

    DC: And what does the government (taxpayer) get for a potential $200 billion in lending while allowing the GSEs to add another $320+ billion of systemic risk?

    Protection from angry mobs that are unable to sell their houses at any price because the mortgage market is dead.

  • Posted by Rien Huizer

    Indeed, Twofish, indeed. The US is very much like China, full of normal human beings

  • Posted by Cedric Regula


    I was wondering about Plan B.

    Take the scenario that:

    1) The off chance that China and Arab CBs don’t play ball and don’t buy all our debt next year. Or worse yet, become believers in central bank diversification.

    2) The triggering of 62 Trillion in CDS has the odd effect of putting valuable GSE debt in the hands of the underwriters, and perhaps they decide to lock in profits and sell.

    3)The Treasury needs to all of a sudden buy a whole lot of GSE paper to support the price, and the program. (I know I am lumping MBS and corp paper together here, but I don’t know what the CDS are written against.)

    I’m trying to think of where the money comes from.

    It’s not considered kosher to just print it, ever since German Hyperinflation days. So modern governments do everything with credit strings attached, which makes it ok. 🙂

    Around 2004, the BOJ did the “soft” printing trick. Forgot the econ name for it, but it’s the one where the treasury prints up bonds, can’t sell them to the real market for whatever reason, and the the central bank steps up to the falling knife and buys them for their own account with printed money.

    Do you think that would be our last and final “backstop” to keep the game from reaching end game?

    Or is there some other trick you can think of?

  • Posted by Cedric Regula

    Also, here is a Jimmy Rogers interview. Boy, are his feathers ruffled.

  • Posted by Dave C.

    “Protection from angry mobs that are unable to sell their houses at any price because the mortgage market is dead.” – Twofish

    Hank Paulson “corporate welfare” ploy to bailout his Wall Street cronies at Goldman Sachs with a $200 billion taxpayer bailout of the GSEs doesn’t help the average American Joe6pack crushed by rising monetary inflation. As a result of the Federal government assuming the GSE debt and doubling the federal debt load overnight by a staggering $5 trillion, yields on 2 year Treasury bonds increased by 0.5% overnight. Further market-driven interest rate increases will be forthcoming as the Federal government AAA-bond rating comes into question. The new result will not be a lowering of mortgage interest rates, but a overall rise in all US dollar denominated interest rates.

  • Posted by Dave C.

    US Is “More Communist than China”: Jim Rogers

    The nationalization of Fannie Mae and Freddie Mac shows that the U.S. is “more communist than China right now” but its brand of socialism is meant only for the rich, investor Jim Rogers, CEO of Rogers Holdings, told CNBC Europe on Monday.

    “America is more communist than China is right now. You can see that this is welfare of the rich, it is socialism for the rich… it’s just bailing out financial institutions,” Rogers said.
    Rogers said in the long term the move spelled trouble.

    “This is madness, this is insanity, they have more than doubled the American national debt in one weekend for a bunch of crooks and incompetents. I’m not quite sure why I or anybody else should be paying for this,” Rogers told “Squawk Box Europe.”

  • Posted by Cedric Regula

    A trillion in CDS so far, but its not even lunchtime yet.

    SAN FRANCISCO (MarketWatch) – The U.S. government’s seizure of Fannie Mae and Freddie Mac has triggered more than $1 trillion of credit default swaps tied to the mortgage giants.
    The International Swaps and Derivatives Association said in a memo on Monday that 13 major credit default swap dealers unanimously agreed that a credit event had occurred.
    After a conference call this morning, the ISDA said it will launch a protocol to help traders settle these derivatives contracts. The protocol will contain details of an auction that will take place to determine the value of the agreements to be settled.
    Credit default swaps are a common type of derivative contract that pay out in the event of default. Fannie (FNM:
    ) are major counterparties in the derivatives market, with roughly $2.3 trillion of notional exposure built up by efforts to hedge the interest-rate risk of their mortgage operations.

  • Posted by gillies

    you all know what i think –

    sarah should let her hair down, and cindy should wear her hair up.

    as for economic matters, it is too late to paddle back up niagara. a philosophical resignation is in order. a fiat reserve currency unattached to gold or responsibility, is access to free credit. not to free money.

    you cannot print spare money without bubbling asset prices somewhere, and making a leveraged free ride both available andirresistably attractive. growth in the bubble goes exponential and ponzi fashion reaches a crisis when it is starved of new entrants to the game.

    at this point the bubble bursts and those who can flee to the next one. but the real bubble is in leveraged borrowing. if the music stops a right to free credit would leave mountains of money. this does not happen. what is left is near bottomless lakes of debt.

    to me this proves the thesis that fiat money is free credit not free money. it is only free money until the moment when the recipients spend it in their turn.

    in detail i do not follow what the fed is doing. but in outline i can see that they have just created the potential for a $5.4 trillion hole. who falls into that hole ? lots of people.

    i cannot see the north korean (alleged) dollar counterfeiters acting as irresponsibly as this. perhaps they can see from the far side of the world, that unlimited free credit creates bottomless chasms of debt.

  • Posted by gillies

    there’s an error in that last posting. you can probably correct it yourselves.

  • Posted by Jian Feng

    Dear Brad,

    Could you give us the lay people a simple rundown on whether the housing bubble will get worse even with the explicit guarantee of the US government? It looks like that once foreigners finally realize that US government is trying to defy the gravity of economic laws, they may view holding the US fiat as an extremely stupid, thus regrettable, past action. How much does the full faith and credit of Uncle Sam worth? Is there a number? Is this housing bubble fundamentally different from the Black Tulip thing or the South Sea Treasure thing several hundred years ago?

    There will be lots of frictions between US and China when more and more Chinese know that poor people in China are lending astronomical amount of money that they earned (in selling shoes, toys, etc.) to rich people across the ocean to buy big houses so that Wall Street geniuses can earn money on top of that. When China stops buying US debts, US government will try to pop up the virtual value of these debts until it creates an unsustainable situation. What will happen then? Will United States be prepared to issue visas to any willing Chinese buyers to purchase foreclosed houses in the US directly? When we are talking about money in terms of 10e9 US money units, it is no longer an economic issue, especially between two strange bedfellows with different dreams. To avoid a mutually assured financial destruction, what will US and China do?

    Brad, please stop just giving us the data. Give us your two cents on what will happen? You are a smart guy. It is not easy for a guy without a formal education on economy to parse your data. Please share with us your thoughts. Some cheeky guy said that prediction is a risky business, especially about the future. But human would still live in caves if we do not love to predict.


    Jian Feng

  • Posted by Jian Feng

    Sorry about my typo. It should be 10E12 (trillion) dollars. So mind-numbing that I could not believe it.

  • Posted by bsetser

    ugh — china has shown no willingness to stop buying us debt. the july data indicates $50b of additional foreign asset growth at the central bank, which mostly goes into treasuries right now. As long as China is resisting RMB appreciation, it has to buy large quantities of foreign assets.

    And china would far rather have $1.2 o r $1.3 trillion of Treasuries and Treasury backed Agencies than $650 of treasuries and $550b of agencies that stand of fall on their own.

    Long-term, both China and the US can manage a world where china buys less us debt, subsidizes its exports less and spends more at home. the challenge is how to get from here to there. I have plenty of views on that, but, well, i have spouted on and on about them to no avail, and have decided to stick to presenting the facts most of the time!

  • Posted by Twofish

    DC: Hank Paulson “corporate welfare” ploy to bailout his Wall Street cronies at Goldman Sachs with a $200 billion taxpayer bailout of the GSEs doesn’t help the average American Joe6pack crushed by rising monetary inflation.

    Actually it will, if there is inflation then the value of hard assets like houses will increase and the value of consumer debt will decrease. If Joe Sixpack has a house and a job, and owes huge amounts of money in credit card and mortgage bills, he really wants massive inflation.

  • Posted by pseudorandom

    KnotRP Says:
    So the US home buyer, who couldn’t afford the mortgage loan, will somehow be able to afford the taxes necessary to make that same loan whole again?

    The US taxpayer can easily afford the taxes – if they are targeted correctly. Delinquent homeowners are usually (except for the small number of flippers/speculators) poor. If the rich pay more in taxes, then absolutely yes, the loans can be made whole again.

  • Posted by Twofish

    Regula: A trillion in CDS so far, but its not even lunchtime yet.

    It’s actually notational. If I owe you a trillion but to get that trillion I have to surrender one trillion in securities, we are even.

  • Posted by Cedric Regula

    Aw c’mon now, why would anyone do that?

  • Posted by KnotRP

    Pseudorandom: you believe the rich will not move assets out of reach, after the historically low taxation rates cease? Taxing the wealthy and corporations is like herding cats, imho…and the big rise in earnings at the top happened already…or were you advocating retroactive taxation of the rich?

    I think we may get the worst of all possible worlds, where many home owners lose their homes, after which the homes nominally appreciate while on the bank’s ledger.
    But real wages will still go no where, since
    the 2 billion laborers are not yet integrated
    into the global system….

    My guess is that protectionism kicks in eventually, when the political pain becomes

  • Posted by Twofish

    Jian Feng: Is this housing bubble fundamentally different from the Black Tulip thing or the South Sea Treasure thing several hundred years ago?

    No. You don’t even have to look back several hundred years. There has been a financial crisis every few years ago for the past several hundred years. There will probably some sort of crisis every few years for the next several hundred years.

    Jian Feng: To avoid a mutually assured financial destruction, what will US and China do?

    By very, very nice to each other. Which isn’t a bad thing.

    Jian Feng: Will United States be prepared to issue visas to any willing Chinese buyers to purchase foreclosed houses in the US directly?

    My guess is that there are going to be massive purchases of US companies and hard assets over the next few years.

    Also, I don’t think that people are talking about the really big problem which makes the housing situation seem like a tiny firecracker. Around 2030, a lot of old people are going to start withdrawing their money from the US at the same time people get old in the US and Social Security and Medicare costs start becoming a major drain.

  • Posted by Greg


    I think even scenario number four is a relative term.
    US may only win relative to China. Chinas economy is gonna get hurt worse but ours is gonna get hurt.

    Seems to me a very hollow victory. “Yeah we suck but you suck worse”

    Unfortunately this is where American culture has driven itself to. We take solace even in ugly victories.

  • Posted by Jian Feng

    Dear Brad and Twofish,

    Thanks for the information and comments. As might see, I have been following Burton Malkiel’s book with my own investment, which relies on the long-term health of the US financial market. It is very unnerving to see United States practicing “socialism” to its financial system. Like it or not, a Darwinian system seems to be the only way to survive and prosper. Maybe the 21st century will see the coming of Karl Marx to New York and Adam Smith to Beijing.

    Professor Malkiel urgently needs to update his book on the efficiency of the market, so little guys like me who have a day job outside economics won’t be sucked into any Black Tulip-styled games.

    Jian Feng

  • Posted by bill

    “I have plenty of views on that, but, well, i have spouted on and on about them to no avail, and have decided to stick to presenting the facts most of the time!”

    Brad, would it be a pain asking you to summarize these very views? Or-less painfully-provide a couple of links where one could dig them up?

    Thanks v much

  • Posted by don

    Now, if only the foreign lenders could bully the U.S. into acting responsibly with its government debt. That would really be nice.

  • Posted by Roland

    What twofish forgets is that more than a third of Americans pay taxes but don’t own their own homes.

    So the poorest one-third subsidize wealthier people who took bad risks.

    So both booms and downturns widen the gap between rich and poor, and smart entrepreneurship has nothing to do with it. Rather, it seems to be deliberate policy to create and widen social gaps!

    Marx and Lenin are just sounding wiser and wiser with every passing year.