Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

Not necessarily practicing what you used to preach …

by Brad Setser Sunday, September 21, 2008

Back in 1998, after Asia experienced a systemic banking crisis, the United States led a series of international working groups to develop best practices for handling future crises. One of the working group — the second working group — developed principles for managing a systemic banking crisis. The group’s recommendations included:

“Bank owners (holders of bank equity) should not be bailed out. They should lose their investments when banks are given public support, or their investment should be diluted through sales of equity (or some convertible instrument) to a government agency, which is then in a position to benefit and recover cots if the institution’s conditions improves.”

See p. 43-44 of the pdf of the Report on Strengthening Financial Systems.

“The extension of guarantees should be strictly limited, possibly by class of institution, instrument and agent;

“Guarantees should always be given in ways to reduce moral hazard risk. i.e. providing an upside risk to the guarantor.”

p. 41 of the pdf of the Report on Strengthening Financial Systems.

I doubt the Treasury’s recent guarantee of money market funds fully meets this criteria; very large investors in money market funds now have more protection than many depositors in banks. The US doesn’t seem to have been fully prepared for the contingency that the bankruptcy of a large investment bank would lead to a huge rise in the banks’ cost of funds and a run on money market funds — a key source of financing for the shadow financial system.

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Were the Agencies responsible for the current crisis?

by Brad Setser Sunday, September 21, 2008

The 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.

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Finance as foreign policy (Russia, 2008)

by Brad Setser Saturday, September 20, 2008

American commentators have argued that Russia’s current financial difficulties are evidence that Russia’s participation in the global financial system constrains Russian geopolitical adventurism. Russians have paid a (financial) price for the conflict in Georgia.

The Wall Street Journal notes that some in Russia see things rather differently: they believe that the US government put pressure on US banks not to rollover loans to Russian banks, and thus helped precipitate Russia’s current financial crisis. Gregory White reports:

As Russia’s stock market went into free fall this week, conspiracy theories circulated that Washington was egging on American financiers to punish Moscow for its incursion into Georgia last month. The theories gained enough credence that Russia’s finance minister, Alexei Kudrin, spoke with U.S. Treasury Secretary Henry Paulson late Wednesday and sought assurances that the U.S. wasn’t playing politics with Russia in the financial crisis, the Russian Finance Ministry said.

Mr. Paulson told Mr. Kudrin that the U.S. wasn’t, according to the Russian side. A U.S. account of the call wasn’t available. ….

The question broached by Mr. Kudrin in his phone call with Mr. Paulson reflects a view widely held in the opaque world of the Moscow elite. Russian officials have asked U.S. bankers in recent weeks if the banks have been ordered by U.S. officials not to lend to Russian companies, according to people familiar with the conversations. The banks deny any such order.

I believe Paulson. US banks haven’t been willing to lend to anyone, including other US banks, recently.

I suspect former Russian President and current Prime Minister Putin does not – perhaps because Putin and others know that they can influence the actions of Russian banks by whispering a few words into the right ears.

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Wachovia/ Morgan Stanley/ CIC?

by Brad Setser Saturday, September 20, 2008

The reporting from Asia on Friday suggested limits to the CIC’s interest in Morgan Stanley. Restrictions on the ability of foreign banks to participate in the “TARP” (the current acronym for the bailout) might be another.

But the Wall Street Journal’s reporting (see Lucchetti, Enrich and Sidel) suggests that discussions are ongoing:

“Wall Street firm Morgan Stanley and Wachovia Corp. plowed ahead with merger talks Friday, even though announcement of the U.S. government’s crisis-fighting plan eased the pressure to race into a deal, people familiar with the matter said. Morgan Stanley’s board was expected over the weekend to discuss a deal, which may take an interesting twist. In one scenario being contemplated in New York, China Investment Corp. would take a significant stake in the combined company.In one scenario being contemplated in New York, China investment corp would take a significant stake in the combined company. … CIC’s interest might be contingent on Wachovia being able to offload some of its mortgage assets. So far, the CIC discussions has been preliminary and hasn’t been broached with Wachovia’s board.”

This sounds like a scenario that would need to be contemplated in Washington and Beijing as well as New York. Moving risky assets over to the books of the US taxpayer to create a “good bank” that appeals to the investment arm of China’s state council (an accurate, if undiplomatic, description of the CIC) would be a significant move – even in a week marked by a host of significant moves. The US government would effectively be a party in the deal.

I can see how say a voter in Ohio that – correctly – believes that China’s neo-mercantilist policy of accumulating foreign assets to hold its exchange rate down and support China’s export sector has contributed to the difficulties segments of US manufacturing have faced over the past few years might not look favorably on a deal that requires the taxpayer to assume downside risk and gives China’s government the upside. The US Congress has bulked at increasing China’s IMF quota because they haven’t wanted to reward China for intervening in the currency markets. The ideas that Morgan Stanley seems to be considering would seemingly require rather direct bit of US government assistance for a agency that helps to manage foreign assets that the US government doesn’t think China should be accumulating in the first place.

Yes, a CIC investment could help the banks raise needed equity capital and thus offers a potential alternative to an even bigger investment by US taxpayers. But a large CIC stake would also start to raise issues about who should provide the government backstop for the combined institution: China or the US? Bailing out US banks is one thing. Bailout out a Chinese-government-owned US bank is another.

That question hasn’t come up in the past because governments generally haven’t owned financial institutions with large operations outside their home markets. Singapore I guess is a partial exception; Temasek has large stakes in a lot of financial institutions. But it is at least worth starting to consider who has responsibility for such an institution in the new world of state capitalism.

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Why no dollar crisis? The needed flows don’t show up in the TIC data …

by Brad Setser Friday, September 19, 2008

Ken Rogoff notes that at least one thing hasn’t gone wrong during the United States current financial crisis: the dollar hasn’t crashed.

One of the most extraordinary features of the past month is the extent to which the dollar has remained immune to a once-in-a-lifetime financial crisis. If the US were an emerging market country, its exchange rate would be plummeting and interest rates on government debt would be soaring. Instead, the dollar has actually strengthened modestly, while interest rates on three- month US Treasury Bills have now reached 54-year lows. It is almost as if the more the US messes up, the more the world loves it.

He is right. There isn’t any data for the last month — but I suspect the dollar ‘s resilience is due both to a sense that the rest of the world is slowing far more than the already sluggish US and to of a general flight from risk, including emerging market risk. Americans seem to have started to bring some of the funds they invested abroad back home, supporting the dollar. I also suspect I know why the dollar didn’t fall by more after last August’s subprime crisis: the quiet bailout. The worst the dollar does, the more central banks tend to buy. That allowed the US to sustain large deficits over the past year.

The TIC data – especially after 2004 – has consistently understated official inflows. I won’t bore you with the details. Just trust me, it is true. Different data sources tell different stories – and they all tell us that the monthly TIC data understates official flows in general and flows from China and the Gulf in particular. We know, for example, that total official purchases of Treasuries between the end of 2000 and mid-2007 (the last survey data point) are roughly twice as large as implied by the TIC data.

Even so, total TIC flows provide some indication of total foreign demand for US assets, and total TIC official flows provide a rough guide to total official purchases. And, well, total TIC flows – counting short-term flows as well as long-term flows – are well below those needed to cover the US trade deficit. Indeed, total private flows, counting short-term flows, recently dropped to zero.


The TIC data isn’t a perfect reflection of all the line items in the balance of payments. Most notably, it doesn’t include FDI flows. But a host of data suggests that FDI inflows and outflows roughly offset. I don’t think big net FDI inflows explain why the US deficit hasn’t fall along with total net foreign inflows. There is something more going on. I just need to figure out what it is.

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The scale of central bank (and sovereign fund) intervention in global markets has been breathtaking

by Brad Setser Thursday, September 18, 2008

I think we now know why the US Treasury is selling Treasury bills like mad to raise money for the Fed.

$180 billion is a lot of money to lend to other central banks so that they can supply dollar liquidity in their national markets. The ECB is now prepared to lend out more than $100 billion US dollars to European financial institutions:

Under the latest action plan drawn up by central bankers, the ECB said it would expand its armoury by offering “for as long as needed” $40bn in overnight funds to eurozone banks. The ECB is also expanding its reciprocal arrangements with the US Fed to increase to $25bn the amount it provides in the market for 28-day funds and $15bn over 84 days. Under the expanded plans, the amount of outstanding dollar liquidity provided by the ECB could reach as much as $110bn – compared with $50bn previously.

No doubt the Fed is financing a host of US banks and broker-dealers as well.

The Fed’s balance sheet indicates that it provided an additional $100b in direct credit to the US financial system over the last week (look at the Wednesday to Wednesday change in “other loans” rather than the change in the weekly averages) — “Primary credit” rose by $10b, roughly $60b was drawn from the prime dealers credit facility and another $28b was provided in “other credit.” Then throw in another $10b increase in the securities the Fed has lent to dealers, bringing that total to $127b. By my count — which could be off — the Fed has now provided around $500b in credit to the US financial sector over the last 12m months.*

And given how much has happened, that will probably be a couple hundred billion or so out of date. Or something like that.

Financial institutions have loss confidence in each other. American savers may soon lose confidence in money market funds — a key source of financing for a host of financial institutions. That effectively leaves the Fed — and other national central banks — as the only institution willing to supply financing to many financial institutions. Just think how extraordinary it is for the chief economist of Goldman Sachs to say that there has been a complete loss of confidence in the markets.

““There’s a complete lack of faith in the markets,” said Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. “There’s a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act.”

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Morgan Stanley/ CIC

by Brad Setser Thursday, September 18, 2008

Reuters is reporting that Morgan Stanley has approached the China Investment Corporation (CIC) for additional capital; it isn’t just talking to Wachovia.

It order to get the equity it needs, the CIC’s stake would need to be quite large. Bloomberg reports:

“Morgan Stanley pared its loss on the New York Stock Exchange after the person said China’s state-controlled fund may buy as much as 49 percent of the New York-based investment bank. The person declined to be identified because the talks aren’t public and may end in no agreement.”

This kind of investment (some might say “risky bet”) would have to be approved by China’s State Council. And I would have to say that the CIC has yet to demonstrate a track record of apolitical, transparent management of its external assets — in part because it hasn’t been around for very long and in part because it hasn’t been very transparent.

It also is obviously something that the US regulators would need to approve — and especially in light of the Fed’s recent decision to exempt the CIC from the requirements of the Bank Holding Company act.

UPDATE: The FT’s alphaville has more.

CIC, the Chinese sovereign wealth fund which already owns 9.9 per cent of Morgan Stanley, is definitely talking to the investment bank.

The President of CIC even travelled to the US on Tuesday accompanied by Morgan Stanley’s China CEO.

CIC was previously part of the Bank of America-led consortium that was considering a takeover bid for Lehman Brothers, alongside JC Flowers & Co.

Christopher Flowers manages about $3.2bn of CIC’s money in a fund dedicated to taking stakes in financial institutions.

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No one wants to hold risk …

by Brad Setser Wednesday, September 17, 2008

In July, the TIC data indicated that foreign central banks migrated in mass toward the Treasury market.

Today everyone did.

The 3 month Treasury bill now yields nothing. The Treasury though will give you your money back …


The fall in Treasury yields came even as the US government indicated that it was going to issue a lot of bills and bonds to help the Fed grow its balance sheet.

I guess this is what a close to systemic financial crisis in the US looks like.

The broker-dealers were performing many of the economic functions of banks: The expansion of their balance sheets financed a lot of credit expansion in the US over the past few years. They no longer can access the debt market. That is a problem.

It looks like the United States’ no bailout policy lasted all of two days

by Brad Setser Tuesday, September 16, 2008

AIG’s bondholders got a huge break. That is an observation, not a criticism. The credit markets were not reacting well to Lehman’s bankruptcy filing.

$85 billion is a lot of money. The terms of the loan are onerous. 850 bp over LIBOR (a penalty rate) plus equity warrants. The US government now effectively owns a significant chunk of the US financial system, and provides liquidity to an even bigger chunk of it. To state the obvious, the crisis has entered a new phase.

Rogoff and Reinhart’s paper on the cost of systemic banking crisis looked good when it first came out. It looks even better now.

An anonymous Federal reserve official was quoted recently in the Wall Street Journal saying:

“We’ve re-established ‘moral hazard,'” said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they’re insulated from the consequences. “Is that a good thing or a bad thing? We’re about to find out.”

Felix is right; the person involved in the talks didn’t quite get the concept of moral hazard. The US government removed ‘moral hazard” — the availability of insurance that protects investors from losses on risky assets — from a portion of the credit market. I am still not sure if it was a good or a bad thing. But it sure seems to have revealed that a significant portion of the US financial system wasn’t strong enough to stand on its own, without a government backstop.

The flight from risky US assets

by Brad Setser Tuesday, September 16, 2008

It is hard to focus on data from over a month ago when a large emerging economy’s stock market is down double digits and the Fed is debating whether or not to extend a lifeline to the largest US insurance company. But the TIC data is stunning in its own right.

It tells a simple story: demand for risky US assets disappeared in the month of July. That continues a long-standing trend. But that trend intensified significantly. And I suspect its intensity increased even more in August.

Among other things, the TIC data challenges the common argument that sovereign investors have been a stabilizing presence in the market. Best I can tell, sovereign investors joined private investors in retreating from all risky US assets in July, and thus added to the underlying distress in the market. I don’t fault sovereigns for limiting their risk. It has proved to be a sound financial choice. But I also find it hard to square their (inferred) actions in the market with many claims about their behavior.

The TIC for July pains a very clear picture: Treasuries were the only US asset foreign investors were willing to buy. Foreigners bought $34.3b of long-term Treasuries, while selling $57.7b of Agencies, $4.2b of corporate bonds and $5.2b of equities. On net, foreigners sold about $25b of long-term US assets.*

That would normally make it hard to sustain a large current account deficit. The US still needs roughly $60b a month in net inflows to cover its external deficit. Net sales of foreign assets of $32b provided some financing — but not nearly enough to cover the outflow of short-term funds. $75b in net outflows isn’t exactly a good sign, even if the dollar’s rebound suggest more flows (perhaps from large US sales of foreign assets) in August.

The same basic trend is apparent in the data for the 12ms through July 2008, which can easily be compared to the 12ms through July 2007 — think pre-crisis and post-crisis.

After the crisis, foreigners have bought roughly:

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