Print
Email
Share
Facebook
Twitter
LinkedInThe role of the Agencies in the current crisis is something that has come up in the Presidential campaign. It is also something that can be assessed using real data — including the recent Flow of Funds data produced by the Fed.
I would argue that this data suggests a more complex story than is commonly told. The Agencies certainly played a role in turning US mortgages into an asset that credit risk adverse central bank were willing to hold: the availability of Agency bonds with an implicit government guarantee interacted with the acceleration of global reserve growth to help make too much credit available to American households.
At the same time, it wasn’t just a story of a market hopelessly distorted by the Agencies’ implicit guarantee. The Agencies implicit guarantee isn’t exactly a new development. Moreover, at the peak of the lending boom, regulatory restrictions kept the Agencies from growing their books rapidly. The big surge in risky, exotic mortgages was made possible by a surge in demand for so called “private” MBS — that is to say mortgage backed securities that did not have an Agency guarantee. From the end of 2003 to the end of 2006, the stock of outstanding Agencies increased by $550b, and the stock of outstanding “ABS” increased by $1850b. Not all those securities were mortgage backed securities, but a lot were. Central bank demand for Agencies freed up private funds to invest in riskier assets rather than directly financing the most risky mortgages.
Look at the following chart, prepared with help from the CFR’s Arpana Pandey. It shows the year over year increase in outstanding Agency and GSE debt (Agency pass-throughs as well as the GSE’s own debt) relative the year over year increase in the outstanding stock of asset-backed securities (ABS).
This chart also shows that the recent expansion of Agency lending has been absolutely essential to avoiding an outright recession over the past few quarters. A surge in Agency issuance has offset a total collapse in “private” MBS issuance. Without the Agencies, US households probably wouldn’t have had any access to credit over the past year. The US government actually started to intervene heavily in the market last fall, when it reduced limits on the growth of the Agencies to keep credit flowing. It isn’t an accident that the Agencies provided $1.1 trillion in new credit to the US last year, while ABS issuance fell from $900b a year to less than zero.
A couple of other charts based on the flow of funds data can help — I think — shed light into the global flow of funds over the past few years, the role of official demand and thus the global exposure to underlying risks.
The outstanding stock of Agency bonds didn’t increase by much from 2004 to 2006 — the period when home prices were rising and lenders were churning out ever-more-creative mortgages to allow Americans to pay more for homes even though their incomes weren’t rising by much.
During that time, though, central banks were both rapidly adding to their reserves and increasing the Agencies’ share of their reserve portfolio. US investors who sold their Agencies to central banks could have invested those funds anywhere, but in practice, they seem to have tried to increase their returns by buying “private” MBS. The US Treasury isn’t contemplating a $700 billion fund to buy up bad assets from the banks (with a risk of substantial taxpayer losses) because US financial institutions hold a ton of Agency bonds.
The rise in short-term rates — and the fact that long-rates didn’t rise when short-term rates rose — played a role as well. Investors who borrowed short to lend long — a group that includes the broker-dealers — couldn’t make a profit without taking on more risk. They could have scaled back their activities. They didn’t. At the time I was puzzled that bank profitability didn’t fall when the yield curve inverted. With the benefit of hindsight, it did — but only when the additional risks that the banks took on then to keep short-term profits up were realized.
The overall result was that central banks took on dollar risk and the risk that the Agencies might not prove to be Treasuries if things turned out badly, while private investors took on the credit risk associated with the housing boom. In hindsight, that looks to have been a bad trade on the part of private investors. Central banks have taken currency losses (though those are mitigated the more Asia sells off). But those losses are a lot smaller than the losses US banks (and European banks that borrowed in dollars to buy dollar-denominated MBS — i.e. institutions like UBS) took on their mortgage book. A lot less risk was dispersed than people thought at the time.
The chart above shows that foreign holdings of Agencies remain modest relative to the total outstanding stock of Agencies. Central bank holdings of Agencies only surpassed US commercial bank holdings of Agencies in q2 2008 (incidentally, the flow of funds data puts total central bank holdings at $1.1 trillion; for what it is worth, that is higher than the “official” holdings implied by the TIC data). So why have I emphasized central bank demand for Agencies?
To start, central bank demand absorbed a significant share of the incremental growth in Agency bonds outstanding since 2000. If you believe flows matter — and I do — central banks have been big players.
Moreover, their activities have been heavily concentrated in one segment of the market — the bonds the GSEs and Agencies issue to fund their retained portfolio. The US data indicates that only China has a large portfolio of Agency pass-throughs (other central banks may hold pass-throughs as well, but if they do, they make use of private fund managers). Estimating the precise distribution of central bank holdings between “Agency ABS or pass-troughs” and the GSE’s own bonds in real time is hard — but I would guess that close to $800b of the $1.1 trillion in total central bank holdings is in the GSE’s own issues. That implies that central banks are quite large players in that segment of the market.
Indeed, central banks share of the GSE market may be comparable to their share of the Treasury market. The chart above wasn’t adjusted for central bank holdings of pass-troughs, but it directionally is right. It incidentally has been adjusted for private purchases of Treasuries since June 2007 – they have been reassigned to the official sector, for reasons I’ll explain in a future post of the q2 balance of payments data.
One major point of confusion in the discussion of the $ 700 billion (or whatever) bail-out plan is the failure to distinguish between deficit financing and debt financing.
The government plan as proposed does not add to the deficit, although it will require substantial debt financing in order to buy private sector assets. It will not affect the deficit until losses (or gains) are realized on round-trip asset transactions. (Interestingly, the Fed’s balance sheet investment in the Bear Stearns transaction remains valued for the time being at $ 29 billion. Its neutral impact so far on Fed profits means it has not affected the deficit directly at this point.)
By extension, there is no initial impact (purely at the margin) on the current account deficit. And there is no reason to believe (again at the margin) that China will have to absorb that many more treasuries at the outset.
There’s been a tendency to conflate these numbers with deficit financing requirements in the discussions so far.
That said, there is obviously huge risk in terms of eventual deficit impact – but not from the initial asset purchases.
The difference between ABS and agency bonds is crucial here since if the GSE’s had stuck to just packaging mortgages, we wouldn’t have gotten into this mess.
The problem was that because private label MBS’s were making huge amounts of money from subprimes, there was a lot of pressure for the GSE’s to do the same, and they were able to market their efforts at entering the subprime market as “making housing affordable for people with low incomes.”
When the subprime market blew up, people holding private label sub-primes also blew up but that didn’t matter. The trouble with the GSE’s is that they linked the bad subprime market with the general mortgage-backed securities market, so when the subprimes in Freddie and Fannie’s balance sheet blow up, it threatened to take down much of the financial system with it.
What you have here is the dangers of “regulatory arbitrage.” Basically if you have a regulated market that pays low interest rates, and an unregulated market that pays high interest rates, then what happens it that you make a lot of money by borrowing money from the regulated market and then investing in the unregulated one. This is what Freddie and Fannie did. You have FDIC insured banks, that buy mortgage backed securities from the GSE’s, the GSE’s then use that money to buy subprimes. The trouble is that when it falls apart, then dominos start falling.
The other problem is that since you make more money in the unregulated market, money starts ending up there, which means that you very quickly end up with a “too big to fail” situation.
As far as how to fix. The problem is not so much whether there is regulation or no regulation. The problem is when you have a bad mix of the two. You can drive on the right side of the street. You can drive on the left side of the street. If you have both then you end up with a mess.
Yeah. I tink yous on ta sum’thin der, Brad. Uncle Alfredo always said if’n dey ever cut off food stamps, he’d sell a lotta less groceries.
Wonder’en one ting doh. Ya sez GSEs financed 1.1 trillion in new loans da past year. Hank sez F&F gets to spend %200B on new loans next year. All da oder spending dat take da national debt go to $11.3T is a hav’en us buy da old loans so’s da banks don’t take hit 1 on forclosures den hit 2 on rising interest rates witch Uncle Bruno sez makes home prices work like bond prices, except’en yous donna gets your money back in da end.
So’s ain’ta that like get’n less food stamps next year?
bsetser: But those losses are a lot smaller than the losses US banks (and European banks that borrowed in dollars to buy dollar-denominated MBS — i.e. institutions like UBS) took on their mortgage book.
The reason for this is that banks were required to hold large amounts of capital in supposedly high grade securities, like AAA rated corproate bonds. Naturally they would choose AAA rated corporate bonds that paid the most interest, which was how they ended with GSE’s. Of course it was “absolutely safe” since to protect themselves from the possibility of default, they would buy credit default swaps from AIG.
One reason European banks got hit hard was that Europe is a bit further and stricter with Basel II compliance, and so banks had more pressure to put their money in “absolutely safe” assets. The meltdown situation was that if AIG went under then the European banks would be below minimal capital, they would sell, mark-to-market rules would require that everything be revalued, and pretty soon dominoes would start falling left and right. The next dominoes would have been US regional banks, money market funds, the commercial paper market, and then youo have manufacturing companies. By the time the fire burned out, everyone in the world would have been bankrupt.
Victory has a thousand masters but defeat is an orphan. The GSE’s I think will get a large amount of the blame, not so much because they were particularly responsible, but because there is no need or desigre to fight back.
—
The main theme is again an illustration of a compound maldistribution of risk – credit risk bifurcation within global imbalances.
The other issue is that no one has talked too much about what the ultimate structure of the bailout looks like, because the major decisions can’t be made until after the election. This would be a wonderful time for the IMF and World Bank to chime in, since the Federal Reserve Bank is about the be the world’s largest sovereign wealth fund.
Also things are happening so fast that the conspiracy theories haven’t had time to react, and I’m trying to figure out what the new grand conspiracy theory is going to be, so that it can get pre-emptively stopped.
Excellent and informative analysis, as always, Brad – thank you !
JHK
Capice.
Dey are increasing de national debt ceiling to 11.3 T because dey need to sell treasureals to buy de bad loans. But they ain’ta telling us yet they giv’n houses away, so der would be some residual liquidation value, if they can figure out how to mark to market. Uncle Enzo Enzo just disappeared da deadbeats an’ rented his places out, but da feds might nada do it that way.
Hank wants $2ooB for new loans to price stabilize de market. Dat adds to de deficit.
So’s I figures de deficit is
$480B projected
$90B projected iraq spending
$200B new F&F loans
Total %770B
Ana Brad’s gonna see’s if’n he can find it anywhere’s.
But they still need to sell da treasureals to buy da bad loans and da subprime loans in da housing bill. I tink Brad gonna have a tough time find’n dat much.
One thing about the bailout is that someone is going to be making quite huge amounts of money from this, and right now while we are figuring out what to do, we need to make sure that the money that gets made from all of this gets distributed in some reasonable ways.
The thing about Wall Street types is that however the rules get written, someone is going to figure out how to make large amounts of money from them, so a year from now there will be stories about how company X profited from crisis. The important thing is to set things up so that when company X profits from the crisis, people don’t feel as if those profits came from their pocket, otherwise you’ll have a more general sense of hostility toward the finance industry, and that would be bad for business.
2fish — right. that is exactly why the financial sector should want the deal to have a significant equity component — i.e. to share any future profits with the taxpayer!
jkh — I am trying to get my head around the proposal. I agree that it initially impacts the debt level rather than the deficit, the deficit only increases with realized losses. But i think the current plan is to sell Treasuries into the market rather than say swapping treasuries for ABS and the like. That implies a big increase in issuance. it would be similar to the proposal to have the treasury issue treasuries to buy Agency ABS — it puts the government in the intermediation business, and has the effect of increasing treasury supply.
on the flip side, buying bad assets for cash should allow the banks to recap their various credit lines with the fed, which in turn would lead to a large increase in the fed’s treasury holdings as it unwinds its various credit programs of the last year. at least that is how i see it.
the net effect probably is an increase in the net supply of treasuries in the market, but by less than the $700b headline number.
Brad,
This is one of those pieces that you can look at ten years from now and say, that is how we ended up with this mess: stupid second term politicians and greedy halfway-house-managers (the agencies are a halfway house between the private sector and the gvt) happened to share incentives and, presto.
Twofish, like your contributions here (a lot) , especially about regulation. Whether one is a Chicagoan, an Austrian or a market practitioner, one knows that regulation is there to be exploited and shaped to one’s advantage. Once home in the residential neighborhood and wearing the consumer/depositor/private investor/voter hat one starts to get a little confused. The Austrians were right about politics, but look at their country: small and a shadow of its former glory..
Incidentally, it is good that the investment banking people (plus many in the GSEs and commercial banks) with stock in their firm got punished for the reckless behaviour of some of their pals, but it is also a pity, because they never got to veto these idiotic things
You don’t think that Wall Street will “share the profits” with the taxpayer, do you? Pretty naive. When Wall Street is in control (Paulson as Tsar) it is not into “sharing.” The “little people” will get fleeced as always and the rich will make out like bandits as always. That’s the way of the (US) world. Wall Street gets the money and the masses get fobbed off with religion, etc., etc.
Here is the way things are “shared” on Wall Street:
Staff at Lehman’s New York office who helped to cause the world’s biggest corporate bankruptcy are to share in a $2.5 billion bonanza.
The bonus, which has been described by London staff as a “scandal” has been pledged by Barclays Capital, the British-based bank that last week acquired Lehman’s American operation and took on 10,000 staff.
The $2.5 billion (£1.4 billion) pot, which has been ring-fenced as part of the acquisition, has caused huge resentment among the 5,000 staff in the firm’s European and Middle Eastern operations who are not guaranteed to be paid after this month…
A Chapter 11 bankruptcy document filed by Lehman Brothers Holdings Inc says that Barclays has identified eight individuals out of the New York staff of 10,000 who are vital to make the deal succeed and a further 200 who are identified as “key”. It is thought that these eight directors will be locked into two-year contracts worth between $10m and $25m a year.
The $2.5 billion had been accrued as part of the contribution to Lehman’s group profits for the first nine months of the year. Barclays said there is no obligation to pay it out but analysts say the competitive pressure to keep key staff means he will have to….
jkh, please look back a few posts for my response to your questions about the reciprocal swap lines, which for some reason, I was unable to post at the time.
However the cost of the TARP is presented, it is unfortunate that the proposal does not include an immediate tax increase, which would encourage a more rigorous examination before it is approved. I suggest some ideas for who to tax in my thoughts on the TARP on my blog:
http://reservedplace.blogspot.com/2008/09/end-of-beginning.html
Twofish wonders who is going to make money out of this. Although it is not politically expedient to say it, some of the biggest winners, albeit after some temporary stress, are going to be the chancers who bought more house than they could afford, especially, as I think likely, their (reduced by modification) debt burden is eased further by elevated inflation. So there are a lot of “little people” who are going to do well out of this. The little people who are going to lose are the small unsophisticated savers who tend to keep their modest wealth in the form of bank deposits.
Hal mentions the resentment of the Lehman London staff at the bonuses for Lehman New York. An emerging news story here in the UK tonight is the removal from the London business of $8bn swept to New York before the bankruptcy, which the London administrators want returned.
rebel — as of know, there isn’t a “relief for those who borrowed too much on their mortgage” component to the legislation; it is just authorization to buy up a lot of MBS.
bsetser Says:
rebel — as of know, there isn’t a “relief for those who borrowed too much on their mortgage” component to the legislation; it is just authorization to buy up a lot of MBS.
Exactly. And not only that, it is the littlest of the little guys the poor, minority subprime borrowers who are in the front of the foreclosure line. Unless the mortgage relief comes really fast, they are going to miss out and the relatively richer mortgage holders who are able to avoid foreclosure are going to be the biggest beneficiaries (after the financial types of course).
I think it is way premature to assume that “a lot of little guys” are going to benefit. History strongly suggest otherwise.
I have been watching with dismay, over the last several years, the developments in USA economy and her financial system. The financial and banking elite led by the Wall Street created an enormous credit bubble which eventually encompassed the whole world. These people were selling worthless paper all over the world extracting huge, hundreds of billions of dollars worth of fees in the process. Now when the whole Ponzi scheme was exposed and the paper that the Wall Street sold turned out to be nothing but the worthless toxic waste, the resulting trillion dollar loses are being dumped onto the innocent US taxpayer.
This is socialization of loses and privatization of profits at its worst. When will the looting of the taxpayer end? This is the greatest transfer of wealth from the Main Street to the Walls Street in US history and it MUST be stopped. Giving absolute power and mandate to deal with the crisis to Mr. Paulson, unelected official, the man who while working at Goldman Sachs, was the chief architect of the Wall Street generated Ponzi scheme that is underming the world financial system is beyond comprehension. To add salt to injury, the people who looted the entire world are not only allowed to keep the spoils of their crime, but are also rewarded with the job of running the new program. How many more trillions of dollars are they going to steal from the taxpayer? By voting for this heinous bill you give Wall Street green light to embark on the next round of looting, and another one, ad infinitum. This is an ultimate moral hazard. Where will it stop? When US Treasury is completely bankrupt? NO BAIL OUT FOR GAMBLERS AND FRAUDSTERS. By voting for this legislation you will mortgage not only future of your children, but the children of their children. Although I can?t participate in November 4th elections I can vote with my valet. I will, if this bill is adopted, lose confidence in your legislative, governmental and financial systems, and I will liquidate all my holdings of US treasuries and convert the proceeds into Canadian dollars.
slightly edited by brad setser for tone (last sentence deleted; i do not like all caps)
“I will not wait on events, while dangers gather,” Bush told Congress. “I will not stand by, as peril draws closer and closer. The United States of America will not permit the world’s most dangerous regimes to threaten us with the world’s most destructive weapons.” 2002 State of the Union Address
next speech I say:
…The United States of America will not permit the world’s most dangerous financial instruments to threaten us with the world’s next Great Depression.”
Hal: You don’t think that Wall Street will “share the profits” with the taxpayer, do you?
People on Wall Street are sharks that will do anything to make an extra buck, and the system only really works when you have the sharks fighting each other, and if you do your own research to figure out what is going on and push back if necessary.
But you have to be careful.
Chris: the resulting trillion dollar loses are being dumped onto the innocent US taxpayer.
Actually a lot of the taxpayers are rather guilty. One thing that is really slippery about Wall Street types is that if you want to catch them you really need to be careful. My guess is that a lot of executives have left the burning building and are now posing as “innocent taxpayers.”
Also, I’m actually not that concerned about Paulson leading the bailout. It takes a thief to catch a thief, and someone with less experience and more sincerity is likely to get totally outmatched. The thing about Paulson is that he knows most of the tricks, and so you just need to adjust the incentives so that he does the right things.
For those interested:
Futures have opened sharply lower. Dow -217, S&P -32, NDQ -46. (As of 7:19 PM, Sept 21st)
http://www.cnbc.com/id/17689937
Looks like the Paulson ‘short squeeze’ lasted a day and a half.
I bought some more Gold over the weekend. The fiat US dollar is toast. It’s only a matter of time. LOL.
Since, at root, this crisis appears to begin with the average Joe consumer, who is tapped out, why not just deliver the 700Bn in the form of across the board 20 percent tax rate reductions.
Seems to me, that would immediately put 50-75 dollars a week in pockets of every family, and go a long way toward reversing stagnant incomes people have suffered for several years.
Meanwhile, let the credit markets sort themselves out.
What good does it do to bailout the credit markets, when the consumer can’t afford to take on more debt.
I am not an expert here, so I probably am missing something.
Ever fiat currency in world history has ended up at toast. That includes the Roman Empire and Dynastic China. The US Dollar will be no different. There is absolutely a complete lack of discipline in Washington DC to control spending. The multi-trillion taxpayer bailout of Wall Street banks will rapidly erode what’s left of the US Dollar’s monetary value. Hank Paulson has absolutely no personal shame. Congratulations Paulson and Bernanke for wrecking what’s left of the US bubble economy. LOL.
Jehu: I am not an expert here, so I probably am missing something.
You put a few dozen dollars a week in the hands of the poor and working class, and then several tens of thousand a week in the hands of the rich.
I don’t think that is a good idea.
Maybe the Congress should require Paulson to committee 50% of his personal asset into the $700B pool, in exchange for the power he wants.
This seems to be topic provoking comments at the extremes of the profound/goofy spectrum. A joy to behold!
A few observations: no one seems to worry about the complete lack of wealth management expertise at US gvt level (this in contrast to little Singapore, where aspiring politician/official/manager types get exposed to the responsibility of looking after the nation’s wealth). Listened to Stiglitz on the BBC just a few minutes ago and he said, uncharacteristically politely, that information asymmetry makes solving the crisis very difficult. In my book, there is lots of money to be made off the government (I would caution against equating government and taxpayers in the US, seems that the taxpayers contribution is becoming more and more theoretical). Apart from the asymmetry Stiglitz seemed to imply (between private sellers of impaired assets and the sole gvt buyer) there is another information asymmetry: only the US gvt knows how much seignorage it is aiming for (if there is any kind of management in this at all) and only the creditors (eg Laobaixing Inc) know where they will suicidically call it quits. We are moving from a contest between many more or less independent and pretty chaotic private capitalist actors against a handful of state capitalists (the situation where the US exports mainly private financial assets and domestic leveraged asset ownership is mainly funded by private liabilities) to one where a giant debt ridden state capitalist (possibly captured by a tiny minority of the business community), who happens to have the power of seignorage, faces the same handful of foreign state capitalists. What will happen? Will anything constructive come out of this? Will the US gvt invest in skills to protect/manage state capital? Or just a burst of inflation (plus international instability to boost the external value of the USD for a while) followed by sloppy privatization of the newly acquired assets. Those who remember the S&L crisis and have cash may already be licking their lips.
However, there are quite a few smaller scale winners and losers in this too: the little guys needing a small subrime loan to get a roof over their head on the one end and the professional type with just enough fat to survive the winter and then benefit from high inflation low interest during on the next hole.
I dislike comments connecting Mr Paulson’s employment past to his role in this crisis, no one deserves to be accused of inappropriate behaviour without even a hint of factual evidence. However, it is a pity that people with that kind of a background seem to be the only ones passing through the selection filters. Someone should take a look at requirements for senior office in the US. You would not appoint a non-lawyer to a Supreme Court but also not a wealthy legal entrepreneur in the litigation business. The Treasury has a very complex mandate and perhaps that should be changed. Financial regulation of a capitalist system (i.e. the one that was just buried in the US but flourishes elsewhere) should be in the hands of non-partisan or balanced management teams appointed for lengthy periods and completely independent under a stable mandate. More or less like central bankers and judges. Everyone with even a little intuitive familiarity with supervising people, managing options with very short remaining terms, out of the money and under severely leptocurtic conditions, will know what this is all about. When it is also close to bonus time, it becomes even more interesting..
I think that the hand being dealt to the incoming administration is becoming increasingly unattractive. Those who wanted to Kill the Beast (the Beast being spending and taxing for bad, non-discretionary things like welfare and healthcare, thus removing space for tax cuts or more deserving and variable forms of spending) seem to have called in a nuclear strike just before the end of the quarter. But, it will not work. The Beast happens to be democratic and has nuclear weapons of its own.
«the Federal Reserve Bank is about the be the world’s largest sovereign wealth fund.»
It is already the world’s largest off-balance-sheet SIV, together with the GSEs, and it is the greater-fool-of-last-resort.
But the Paulson-Bernanke-Bush plan is to add the treasury to the count, not the fed.