Brad Setser

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

by Brad Setser
September 27, 2008

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

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

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

Lockart is the director of the Federal Housing Finance Agency.

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

They wrote:

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

China’s delegation, headed by a 60-year-old ex-banker who comes from the country’s depressed coal-mining region, has been among the most vocal, according to sources briefed on the discussions. China has a direct interest in the U.S. crisis. It is estimated to hold a fifth of its currency reserves — as much as $400 billion — in Fannie Mae and Freddie Mac debt. In addition, its banks have billions of dollars worth of exposure to the American International Group, Merrill Lynch, Lehman Brothers and other companies in crisis. The Industrial and Commercial Bank of China, for example, has $151 million in bonds issued or linked to Lehman; China Merchants Bank has $70 million of Lehman bonds; and the Bank of China has $75.62 million of Lehman bonds.

As U.S. officials were deciding in August whether to take over Fannie Mae and Freddie Mac, the Treasury Department held informal talks with officials from the People’s Bank of China, the country’s central bank. At that time, investors in Fannie Mae and Freddie Mac in China were dramatically reducing their holdings. The U.S. side told China that a cash infusion was in the works; China said that it expected the U.S. government to “do whatever is necessary” to protect the investments.”

China’s concerns are understandable: its holdings of US Agency bonds exceed 10% of its GDP.

Both Lockhart’s testimony and China’s lobbying of the Treasury are consistent with the story I told based on the Fed’s custodial holdings, namely that central banks weren’t willing to trust Paulson’s bazooka. And they seem to have been a big enough player in the market to offset ongoing Agency purchases (I would assume) from the largest US bond fund …

The august TIC data on Agency holdings will be interesting; the fall in foreign demand for Agencies in the July data was much sharper than the fall in the Fed’s custodial holdings.


  • Posted by Daedalus

    Non-economist with a (perhaps dumb)question:

    If Fannie and Freddie are now government backstopped, why would we still see a safety flight from these MBS’s to treasuries?

    Wouldn’t China or Japan rather have the higher yield on US-guaranteed MBS’s over the US-guaranteed 10-yr bond? Wouldn’t investors rather have a secured loan (even in falling homes), paying a higher interest rate than an unsecured loan paying a lower interest rate?

    Much appreciate your work

  • Posted by bsetser

    Agencies are not as liquid as Treasuries. Especially Agency MBS. The fact tho that spreads remain as wide as they are is consequently one sign of ongoing distress in the fixed income market.

  • Posted by Cedric Regula

    Uncle Bruno sez dey will be stuck holding agencies until maturity if’n deys ever wanna see der guaranteed face value back. In da mean time rising inflation/rising interest rates will make dem sell for a big discount.

    By da time dey come due we be paying dem off wid dollars held at da Smithsonian Institute.

  • Posted by Guest

    Dear Brad, with lots of love:

    You’ll remember me when the west wind moves
    Among the fields of barley
    You can tell the sun in his jealous sky
    When we walked in fields of gold

    So she took her love for to gaze awhile
    Among the fields of barley
    In his arms she fell as her hair came down
    Among the fields of gold

    Will you stay with me will you be my love
    Among the fields of barley
    And you can tell the sun in his jealous sky
    When we walked in fields of gold

    I never made promises lightly
    And there have been some that I’ve broken
    But I swear in the days still left
    We will walk in fields of gold
    We’ll walk in fields of gold

    I never made promises lightly
    And there have been some that I’ve broken
    But I swear in the days still left
    We will walk in fields of gold
    We’ll walk in fields of gold

    Many years have passed since those summer days
    Among the fields of barley
    See the children run as the sun goes down
    As you lie in fields of gold

    You’ll remember me when the west wind moves
    Among the fields of barley
    You can tell the sun in his jealous sky
    When we walked in fields of gold
    When we walked in fields of gold
    When we walked in fields of gold

  • Posted by JKH

    Looks an awful lot like Meredith Whitney singing that nice song on youtube.

  • Posted by Emma Zahn

    So China has ~$400 billion in Agencies, and ~$290 billion in Lehman paper, IOW, ~$700 billion. Isn’t that a little too obvious? What ever happened to subtlety? to finesse?

  • Posted by Joe H.

    To Brad:
    Do you think we will see the hyperinflation of the dollar within the next year? Within the next 5 years?

  • Posted by Joe H.

    (Continued from previous post)
    To Brad:
    Or is the thought of the hyperinflation of the dollar just a scare tactic used by those who don’t really understand what’s going on?

  • Posted by Cedric Regula

    Uncle Bruno tinks Chinese stuff might cost a little more, we gets deflation in houses, an’ we gets hyperinflation in energy prices.

    Den we’s gets da choice of hyperinflation in taxes, which would be bad for da economy, or da ROW stops taking dollars in payment for stuff.

  • Posted by thomas j


    Maybe Agency MBS is still trading at a high premium to Ts because so far the US govt. has only committed itself to $200 billion on a combined $6 Trillion debt portfolio.

    When push comes to shove and the US govt is forced to decide between preserving its ability to fund deficit spending by issuing Ts or explicitly guarantee the full $6 Trillion GSE debt portfolio, what do you think the choice will be?

  • Posted by Dave C.

    Blaming the Chinese is a lame excuse for the US Treasury Paulson’s ulterior motive to bailout Fannie Mae and Freddie Mac ….

    Why the Fed and the Treasury bailed out Bear Stearns, Fannie, Freddie, and AIG, and not others such as Lehman Brothers may have less to do with saving the insurance business, the housing market, or the Chinese investors clamoring for a bailout than with the greatest Ponzi scheme in history, one that is holding up the entire private global banking system. What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an “event of default” that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.

    So, there you have it! The horrible, naked truth finally comes out–not in the corporate mainstream media.

  • Posted by Judy Yeo

    Look, China is still mr moneybags in the farce.

    If the authorities are to have any good chance of dealing with the mess , they will need loads of financing. Guess who will end up with a large part of that bill?

    Hint – look at the largest holders of treasuries

  • Posted by Dave C.

    Unfortunately, the American people never had any chance defeating the bankster special interest lobby. Goldman Sachs “de facto” regulates and controls the US Treasury Department, not the other way around.

    It has gotten to the absurd point that the US Treasury will be sending multi-billion dollar corporate welfare checks to Goldman Sachs monthly. At least for the Alaska “bridge to nowhere”, we get an unused bridge; for the taxpayer $700 billion, we don’t even purchase a sheet of toilet paper.

    An absolute total disgrace!!!!

  • Posted by joebhed


    The problem is too much debt, not only here but throughout the world – beyond the Bretton Woods-ers.

    Everyone seems to know that $700BIL has no relationship to the scale of stuff that’s out there.
    Seen the $5TRIL as a potential.

    One biggie – The TREAS has NOT the $700BIL, and needs to borrow.
    Who is $700BIL flush, and willing to bet that the other $4TRIL will be forthcoming?

    One bigger: With $50TRIL in debt-service-obligations to the holders of the public and private DEBT of this country, and with ALL new money created as more DEBT, aren’t we simply in an unsolvable arithmetic paradigm?

    Or, is that off-limits?

  • Posted by Blissex

    «If Fannie and Freddie are now government backstopped,»

    it is still an implicit guarantee, as some important people have remarked pointedly.

    What the treasury has done is to become the controlling shareholder and to lend a lot of money, but they haven’t formally guaranteed the GSE debt or insurance.

    Curiously they have instead guaranteed the totality of money market fund debt.

    It is all smoke and mirrors, sophistry and tricks.

    So investors in GSE securities are rightly worried, because conceivably the USA might renege on the implicit guarantee.

    They have already allowed losses to bondholders in the WaMu case to prevent the bankruptcy of the FDIC just before the elections.

    And despite people saying that Treasuries are absolutely safe because they are denominated in dollars, that is a joke because for foreign holders there is a colossal currency risk. And at some point the rating agencies were threatening to remove the AAA rating from them.

  • Posted by Blissex

    «Uncle Bruno tinks Chinese stuff might cost a little more, we gets deflation in houses, an’ we gets hyperinflation in energy prices.
    Den we’s gets da choice of hyperinflation in taxes, which would be bad for da economy, or da ROW stops taking dollars in payment for stuff.

    Yes, so far we have had asset inflation and consumer good deflation. Things are likely to reverse.

    Well, whatever happens, the basic story is that the USA have borrowed several trillions to create a house price bubble, and houses are more like consumption than investment; they are more like decorative than productive capital (beyond a certain minimum).

    If those trillions had been invested in factories, or infrastructure, this would have raised productivity and generate extra income with which to repay the borrowing.

    But the USA have borrowed trillions to build status symbol houses in the California and Arizona desert, or to provide capital gains to the owners of existing houses.

    Normally loans are repaid out of increased productivity, out of ROI; but the housing bubble hasn’t produced it. So it will have to be repaid by a reduction in consumption, probably around 5% of GDP transferred abroad for several years. Same for oil, another 5% of GDP transferred abroad, probably for a long time.

    All the bailout story is to postpone the inevitable adjustement (either a sharp fall in the dollar or in the living standards of USA workers, or both) until after the election. Then the new McCain-Gramm or Obama-Dimon administration will decide which of its sponsors to save.

  • Posted by indignant_prole

    Curious: does anyone see anybody abadoning the dollar? The chinese, russians, and opec are shackled to this corpse until they diversify their economies, and only the chinese have a hope (hope, that is it!)

  • Posted by ReformerRay


    Sept. 28, 2008 11:55 AM by W. Raymond Mills

    (The news that a “breakthrough” has been achieved and that a bill will be passed on Monday does not change any of the material below. Maybe enough stalwarts in the Congress will join Senator Shelby in voting against the bill.)

    Ben Bernanke recognized a problem a couple of weeks ago. Banks were no longer willing to lend to each other. They were spooked by the demise of Fannie and Freddie, Lehman and AIG.

    Bernanke panicked. He panicked partly because of what was happening. Short term credit markets were not functioning because banks were no longer willing to loan money overnight or just for a few days because of lack of confidence of being repaid. Nobody wanted to purchase mortgage contracts, so one firm wrote down some of their mortgage assets to 22% on the dollar.

    As if these problems weren’t enough, he also panicked because of what he knew. He knew that the contracts for credit default swaps were a mess because the promises to pay were not backstopped by enough assets, in some cases (how many cases he did not know)(AIG had 450 billion invested in the credit-default swaps market).. Uncertainty threatened to overwhelm the system on three different fronts. He also knew that the refusal of the government to intervene in the early stages of the Great Depression accelerated the decline in economic activity. As one famous economists said, Bernanke was determined not to repeat the mistakes of his predecessors. Impishly, the critic added, Bernanke was determined to make his own mistakes.

    A. First Mistake – Advance a solution and then look for a rationale.

    Benanke should have advanced understanding and then looked for a solution.

    The essence of his problem is and was uncertainty. Nobody knew which banks were trustworthy. Nobody knew what firm would be unable to meet its obligations.

    Instead of scaring the socks off of everyone, he should have said what we have to fear is uncertainty. Correct and careful identification of the problem would have been very constructive and would have set the country on the road to correction.

    The first and most immediate problem, generated by uncertainty, is the refusal of banks to lend money to each other in the short-term credit markets. The Federal Reserve Board has a remedy for that problem. We will step in and provide the liquidity that the private banks are not willing to provide. Then he should have described the steps he subsequently did take to provide funds to that market. The actions taken are described on the web pages of the Federal Reserve Board and the European Central Bank. Since the sky has not fallen in the last two weeks, I assume that these actions have temporarily solved the first problem. How long funding can be provided by the Federal Reserve Board, I do not know. I assume indefinitely.

    The other two problems should have been clearly identified. After describing the problem as they exist today, he should have moved to assure the public that these problems are not going to explode tomorrow. They have been festering for months. As long as no sales are taking place for mortgage contracts or credit default swaps, the status quo is tolerable. True, the uncertainty is not removed by continuation of the status quo. Banks that invested in these toxic securities will not have excess funds to lend. On the other hand, many banks and other financial institutions did not invest in toxic securities. These firms are profiting from their good decisions, as they should. They are increasing their business, by making loans and purchasing assets on the cheap. This is especially true on main street. It is possible to take a few months to allow the wise to profit and to discuss and consider how best to address the other two problems.

    None of this information would have been news to the people who invest in the stock market. Most would welcome some clarification of the situation.

    If he had approached his problem in this straightforward manner, he would have done much to reduce the uncertainty. His effort to scare everybody into hasty action made the problem worse.

    Bernanke was wrong when he said the entire financial system is in danger of collapse if we do not do something immediately, if not sooner. He will be proven wrong when the stock markets open this Monday (tomorrow). Hopefully, no law will be passed before then. We will see that the markets will do their thing, going either up or down, by large or small amounts, and the markets will open again on Tuesday and all the other days of next week, to allow people to shift their bets. The financial system is not going to collapse. The work Bernanke has done to provide liquidity to the short-term markets has helped stabilize the system.

    It may be that the markets will decline more than usual next week because of all the attention placed on the issue by the panic-induced effort to get something passed by last Friday or today (Sunday). My fondest hope is that no bill is passed today and that we will see that Bernanke was crying wolf when there was no wolf at the door. Massive losses in the stock market are different from collapse of the financial system. The market goes down by great gulps and then it goes up by great gulps. Where it will be two or three years from now will depend, in part, on whether a stupid bill is passed to respond to the Bernanke Panic.

  • Posted by Howard Richman


    Anybody who has read Ayn Rand’s book Atlas Shrugged understands just what is happening in Washington today. In Atlas Shrugged, some businesses treat the U.S. Treasury as their own personal piggy bank. U.S. economic problems multiply as the government keeps trying the same ideas that have been failing. Eventually there is a total economic collapse.

    The current economic crisis is being brought about by a lack of American investment and savings. Businesses don’t invest because they expect that the mercantilist governments, especially China, will make any future investments in American production unprofitable. Americans don’t save, both because the U.S. interest rate is too low and also because our tax system has a special capital gains tax rate that encourages them to consume their capital through stock buybacks.

    The Bush administration keeps repeating the mantra that foreigners invest in the United States because the United States is such a good place to invest. But, as you documented, private foreigners are not investing at all in the United States.

    It is clear to any observer that foreign Central Banks do not care whether or not they make money from their loans to the United States. In fact, as your recent table of long-term interest rates on U.S. Treasury Bonds shows, they have forced U.S. long-term interest rates into negative territory, after subtracting for inflation.

    Their loans to the United States are designed to drive up the price of the dollar in international currency markets as compared to their currencies, which prevents American businesses from investing new money to modernize American production.

    They are occurring because countries like India and China are practicing the mercantilist policy of maximizing their exports and minimizing their imports. They restrict their imports through a combination of tight money policies, tariffs, and other import barriers. The Doha Round of the WTO negotiations just collapsed because India and China would not give up their 25% tariffs on foreign made vehicles.

    It is possible to look down the road and see where Paulson’s plan leads. The United States will lose its remaining industry. Eventually, the ever increasing U.S. government borrowing will cause the U.S. government’s credit rating to collapse. The only way to prevent the collapse of the United States government will be to inflate away its debt. The United States will be left impoverished.

    There are effective alternatives to this looting of the US treasury. Unlike the Paulson plan, these alternatives would actually enhance US savings and investment. Too bad nobody in Washington is even considering them.

    Howard Richman

  • Posted by RebelEconomist

    Ah, Howard. Glad to see you back again, mentioning mercantilism! I wrote the following post on my blog with you above all in mind:

  • Posted by Howard Richman

    Dave C.,

    There is another explanation for why the Fed and Treasury bailed out Bear Stearns, Fannie, Freddie, and AIG, but not Lehman Brothers:

    Federal Lobbying Spending in millions (January 1st 2006 to June 30, 2008)

    AIG — $25.99m
    Fannie Mae — 18.7m
    Freddie Mac — 21.83m
    Lehman Brothers — 2.07m

    Source: National Journal (9/20/08 p. 46).


  • Posted by JKH

    Larry Summers does a proper analysis of the fiscal effect of TARP:

  • Posted by Howard Richman


    Thank you for your welcome back comment and for sharing with me your posting about my writing on your blog. Too bad you didn’t mention my book when you were criticizing its ideas. Trading Away Our Future is readily available (see ).

    In your analysis of mercantilism, you should also look back at what Hume actually argued, in the light of modern mercantilism. He claimed that mercantilism could not succeed in the long run because an inflow of gold drives up prices in the surplus country and drives prices down in the deficit country, and that the price changes tend to correct the trade imbalance.

    Hume was correct about the mercantilism of his day, but did not anticipate modern mercantilism. In fact, if the goal of the ancient mercantilists were to build their industry (not their gold hoards), they could have practiced the same system that the modern mercantilists practice today by using the gold obtained from trade to buy assets in the trade deficit country.

    It’s also too bad you haven’t yet checked Peking University Heng-Fu Zou’s 1997 mathematical treatment of mercantilism, “Dynamic Analysis of the Vineer Model of Mercantilism” (Journal of International Money and Finance). So you would have realized that your consumption argument was a short-term argument.

    Indeed, as you point out, Chinese mercantilism enhances present US consumption, and what you fail to realize is that the increase in consumption is only a short-term phenomena. As Zou demonstrated mathematically, the modern form of mercantilism results in long-term gain in consumption for the practicing country, even though in the short run it has less consumption. The converse side of his argument is that it results in a short-term gain in consumption for the victim country, but a long-term loss.

    The huge factor that you missed entirely in your analysis was the effect of mercantilism upon investment opportunities in the practicing country and the victim country.

    By holding its exchange rate approximately 40% below where it should be, China makes its products 40% less expensive to American consumers and American products 40% more expensive to Chinese consumers. As a result China gets investment while the United States does not, making Chinese products even less expensive to American consumers, compared to American products.

    Seeing as the current US investment slump is causing our economy to go into economic stagnation with the definite possibility of an economic talespin, you really should look into the factors that are causing it.

    Howard Richman

  • Posted by Howard Richman


    I’ve got a new angle on the AIG story that you might want to break.

    AIG now requires a government bailout to recapitalize it. One reason it is so low in capital is because its Board of Directors decided, last March, to spent $8 billion more of its profits buying back its own stock! Here’s a selection from an article that was posted on March 2, 2007:

    “American International Group Inc. reported after the bell yesterday its fourth-quarter profit increased eightfold from the prior year quarter, in which the company had to pay out $1.64 billion in one-time charges. By the numbers, profit was $3.44 billion… In other news, AIG’s board approved a new share buyback and dividend program. The buyback plan will be worth up to $8 billion, of which the world’s largest insurer plans to spend $5 billion in 2007 while the dividend will rise roughly 20% a year, under “normal” circumstances. AIG shares rose $1.03, or 1.53%, to $68.44 in after hours trading.”


    If anybody still thinks that the low capital gains tax rates that encourage the consumption of the US capital stock are a good thing, they should read the commentary that my father, son, and I wrote for Enter Stage Right:

    Howard Richman

  • Posted by bsetser

    guest — thanks for the link to fields of gold. I am sure that it can be understood on many levels, but for me the image of fields of gold is fields of wheat, and indeed, my (enormously missed) grandparents’ farms. Wall street thought it had found its own field of gold, but, well leverage proved to be a double edged sword.

  • Posted by RebelEconomist


    Without going into off-topic detail, I suspect that many of the arguments against mercantilism that you mention are reasonable (I will review your book if you send me a free copy), but do not allow for the possibility of government intervention to exploit it. It is like a man in a boat complaining that the wind is making the sea choppy, when he would be richly compensated if only he would put up the sail. You provide one example yourself when you say that mercantilism – which nowadays involves buying debt rather than gold – has deterred investment in the US. Assuming that you are right about this outcome, does it not strike you that there is an opportunity being missed somewhere?

  • Posted by Twofish

    I don’t think it is such a big deal that the central banks were screaming at the US to back Freddie and Fannie because *everyone* was screaming at the US to back Freddie and Fannie.