Brad Setser

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Scared (sovereign) capital

by Brad Setser
October 10, 2008

Central banks with lots of reserves have not been running away from the dollar. But they do seem to be running away from any dollar asset with a hint of risk. Right now, it is hard not to focus on the relentless slide of the stock market (the FT is calling this week a global crash), the enormous daily moves in the foreign exchange market or oil’s sharp slide. But New York Fed’s latest custodial data is stunning in its own way.

Since September 10, central banks have added close to $100 billion to their custodial holdings of Treasuries. Custodial holdings of Treasuries reached $1537.6b on Wednesday — up from $1513.1b last Wednesday, and up from $1438.1b on September 10.

Some of the increase in Treasury holdings is explained by a slight fall in Agency holdings — which fell from $956.6b on September 10 to $944.8b on October 8. But the roughly $8b fall in Agency holdings cannot explain the huge increase in Treasury holdings.

Solid data on global reserve growth in September doesn’t yet exist – China and Saudi Arabia matter, and they don’t release data quickly. But the reserves of nearly every country that reports data quickly fell in September. I have no doubt that the Fed’s custodial holdings are increasing far more rapidly than global reserves.

That either means that:

a) Central banks are shifting from euros to the dollar, adding to their dollar holdings;

b) Central banks reserve managers have also lost confidence in the international banking system — and in money market funds — and are moving into the safest dollar asset around.

I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.

Central bank reserve managers are scared. Understandably so. Central bank reserve managers’ primary goal is to avoid losing money — and to have all the liquid assets their country needs. Right now that means holding Treasuries and not much else.

But their actions also aren’t making the Fed’s job any easier.

There isn’t a shortage of demand for US Treasuries right now. There is by contrast a shortage of institutions willing to lend in dollars to a host of banks — or cut into the Treasury-Agency spread by selling Treasuries and buying Agencies. A year ago central banks couldn’t get enough Agencies. Now they won’t touch them, even though they are far better substitutes for Treasuries now than they were then.

UPDATE: Kuwait’s sovereign fund is gearing up to support the local market, which likely means that it is building up its liquid holdings abroad. I am also fairly sure that Norway’s fund isn’t the only fund in the unfortunate position of having lost a lot of money over the past year. Saudi Arabia’s fairly conservative portfolio almost certainly has outperformed Kuwait’s portfolio, or Abu Dhabi’s portfolio. A lot of oil funds invested a lot of money at what now looks to be the peak of a host of different markets. Hat tip: SWF Radar.


  • Posted by JJ

    Isn’t the dollar the last bubble in the cycle? As every financial asset and indicator deteriorates, the dollar gets stronger. The explanation so far is that this is a flight to quality, which is very lame. At some point someone will start to sell dollars and then anything can happen.

  • Posted by jck

    Of note, some large selling of Treasuries by Brazil, Mexico and S. Korea started last july and picked up lately.

  • Posted by fatbrick

    Nationalize your banks, and we can lend you some greens.

  • Posted by moldbug

    It’s got to be (b).

    This is why policy actions that guarantee bank liabilities need to be so clear and determined. The era of wink-and-a-nod, too-big-to-fail, informal insurance is OVER. What could possibly be the advantage at this point, for example, by preserving some kind of distinction between Agency and Treasury securities? Just kill the spread.

    Dear regulators, you have two options. Let M2 deflate to M0 by doing nothing, or make M0 reflate to M2 by accepting bank liabilities as sovereign. All options between these poles look less viable every day.

    Decide which financial institutions to nationalize. Start with “all” and make exceptions as needed. Buy equity at the current market price, a clean acquisition with no cram-down. For optics, reduce executive pay to the GS (civil service) pay scale, reminiscent of the old New Deal “dollar-a-year men.” Consolidate all bank assets and liabilities on Fed or Treasury’s balance sheet. Close the markets during the transition.

    Yes. This will leave a giant mess that needs to be cleaned up. It will not cure any of the old chronic problems, the structural imbalances and so on.

    Yes. If it is not followed by a fundamental rethink of central banking, it will be highly inflationary in the long run. But how could it possibly not be followed by a fundamental rethink of central banking?

    Yes. If it is not followed by privatization, it means Bolshevism, or Brezhnevism at least. But even Sweden privatized their banks after nationalizing them. There is just not an intellectual constituency in the US for a massive permanent expansion of government. As an extreme libertarian, I’m ready to risk it.

  • Posted by glory
    We—all of us from Nouriel Roubini to Lawrence Summers to John Taylor to Tim Geithner (except perhaps Ben Bernanke, who really did seem to believe in a long-run global savings glut)—were expecting a very different financial crisis. We were expecting the Balance of Financial Terror between Asia and America to collapse and produce chaos. We were expecting a free fall in the dollar… – it’s like the x86 ISA 😛 still i wonder!

  • Posted by bsetser

    jck — that is precisely what makes the growth in the FRBNY’s custodial accounts so surprising. the only possible sources of global reserve growth in Sept were Saudi Arabia and China. Nearly everyone else was selling $ and euros to support their currencies — i.e. my baseline estimate for monthly reserve growth would be around zero, with ongoing chinese growth (at a more subdued pace) offsetting sales elsewhere.

    moldbug — for a moldbug you are quite pragmatic. If I was asked to develop a plan, it wouldn’t be far from your plan — tho I need to think more about the “right’ price to buy the banks equity. I suspect that in retrospect, the decision to allow LEH to default on its bonds (note the settlement on CDS today) ended the era of wink wink too big to fail informal insurance. and it turned out the highly leveraged financial system that had grown up over the past few years couldn’t survive without it.

    I was working on the fed flow of funds data, and it seems like the collective balance sheets of the broker dealers + funding cos increased by $2.5 trillion or so from 04 to mid 07, effectively doubling. the annual growth from q2 06 to q2 07 was $1 trillion. Big mistake.

  • Posted by Fullcarry

    I haven’t read all the comments and don’t know if this has been mentioned yet, but obviously dollar funding is in trouble. Why the simplest explanation is never accepted, I don’t understand.

    Interbank lending rates are sky rocketing. Obviously anyone funding carry trades with dollars is in huge doo doo.

    The numbers for the fourth quarter aren’t out yet. But I would venture that there will be far fewer hedge funds next year than we have now.

  • Posted by Jodie

    Looking back on this week’s market activity, there is nothing like a steep stock market selloff to get the Keynsian juices flowing. Previously unthinkable government interventions have now become a daily expectation.

    As Jim Grant said recently, nothing is as inflationary as a little deflation.

  • Posted by Michael

    Yes, interbank lending is frozen and financial institutions are failing, but we have barely commenced the gargantuan degree of deleveraging ahead of us (this is not “the end of the begining” it’s the beginning of the beginning).

    Homeowner deleveraging – by mortgage default – is so far tiny (less than 5% of mortgages), even though it was the triggering event at the tipping point in the credit supercycle, and it has run the farthest so far.

    Note that Lehman and WAMU are the only big U.S. institutions that have stiffed bondholders, so far. All the government action so far, and all the proposals for government action so far are aimed – understandably – at slowing down and/or stopping the deleveraging before it really gets momentum.

    Now, the deleveraging might be slowable in the shorter term (though no events since July 2007 would prove that thesis), but it is simply not stoppable, because the dgree and extent of leveraging was way too extreme to be sustainable.

    As the deleveraging proceeds, the outcome in the longer term on the dollar (in foreign exchange rates, in absolute deflationary/inflationary terms, and as the international reserve-commodity pricing currency) will not be foreseeable for some time. First, the deleveraging has to unroll, the extreme financial interventions have to peak, the fiscal expansions and trade contractions have to play out, and the competitive dynamic between nationalism and internationalism has to run its course.

    Any predictions about the value of the dollar (to anyone) down the road is very premature at this point.

  • Posted by Awake

    Moldbug: Not only a moldbug, but a Mencius indeed. I thought you were not returning until November! (a quick look at your blog suggests this is not the case).

    I do take issue with your idea that this is highly inflationary in the long run. Assuming we both take an Austrian view (which I know we do) do you really think that a salvation of the little inflationary credit creation the system has left will overweight the destruction in outstanding credit over the last year? It has been horrific.


    Which inning would you say we are in? To use the baseball metaphor. If you took a Bookstaber-esque approach, we are barely leading off the third. There has been some interesting further research into the effects of tightly coupled processes (which I tend to think of in the same vein with deleveraging) done by Richard Kline over at Yves’ site.

  • Posted by glory

    re: deleveraging, at least on the HH side…

    debt service ratio (DSR) probably needs to get back to 11 (and the FOR to the low to mid teens)

    btw, personal savings is also making something of a comeback at least measured on a FoF basis 😛 (F.10)



  • Posted by moldbug

    Awake, MZM is still a lot higher than M0! It is not a matter of creation, it is a matter of avoiding further destruction.

  • Posted by glory
  • Posted by Awake


    The thought comes to me with little pre-cognition required that M2 will under no circumstances deflate to M0.

    Also: The system must inflate to survive. I cannot even imagine what would be required under your nightmate scenario (a complete destruction of m2 in pursuit of m0) as there is not enough hard currency to allow such a move. Is this what you mean by inflation? a requirement of the LLR to print enough currency to accomodate such a move?

  • Posted by Soxfan

    My fear is that the government has waited too long to recapitalize the banks.

    This week alone the leveraged loan index dropped by about 10 points. Most of the bank’s sales of leveraged loans were dealer-financed, non-recourse. oops.

    Its quite possible that we’re on the cusp of a cascade of hedge fund failures. Who gets left holding the bag there? Oops again.

    With asset values collapsing now, and the growth and employment outlook having deteriorated dramatically, how many sets of keys were dropped in the mailbox by on-the-fence homeowner in the past 10 days? Double-oops.

    What’s the outlook for good old fashioned loans now that the economy is hitting a brick wall? How about Commercial real estate? oops oops oops.

    The banks may no longer be realistically re-capitalizable. The amount of capital necessary would equate to de-facto nationalization. And then you’re simply taking a multi-trillion dollar problem onto the Treasury’s books. Presumably, the government would then go out and start making loans wily-nilly.

    Do the Chinese and the Saudi’s not see this as a house of cards? Let hope they remain asleep at the switch, because if they don’t, you can readily see that even the nationalization scenario becomes self-defeating as bond yields skyrocket.

    The banks, and the economy, are toast unless asset values rebound, but quick. The Fed needs to start buying assets (MBS and/or equities) with ink money. Create the expectation that the entire nominal price structure is going to pop by 20%, and the problem essentially goes away.

    Its a solution that is dangerous and distasteful in so many ways. But I believe its preferable to the alternative.

  • Posted by Awake


    Despite whether or not we are seen as a house of cards, I would be in the crowd that says the United States is still the safest place to invest your money. Indeed, if you look at Brad’s post that we are actually commenting on, Treasuries are being piled in on in lieu of agencies. Crazy things like Treasuries showing negative yields (as happened briefly last week) are proof of how stable our markets are in comparison

    Could you imagine the -national- panic if the Dow or SP opened 11% down the way the FTSE did this morning? Chaos.

    I wouldn’t worry about our government debt receiving bids right now.

  • Posted by moldbug

    The thought comes to me with little pre-cognition required that M2 will under no circumstances deflate to M0.

    I agree, but without intervention it most certainly would. This will not happen in practice for political reasons, but considering the thought-experiment lets us understand the value of the LLR insurance.

    An LLR is basically in the business of issuing free credit-default swaps. Without said CDS, MZM is M0, modulo a few charred scraps of ex-asset. See under: Lehman.

  • Posted by Simpson

    Brian, I wonder whether the increase in custodial holdings is not just a result of portfolio transfers.

    Some central banks like SAFE held big positions of Treasuries with custodian banks like JPMC principally I think to receive coupon payments before opening of business in the US.

    I would guess that SAFE does not feel comfortable holding anything with commercial banks anymore and has consolidated their holdings into their Fed account.

    As for the dollar, it will remain inflated so long as commodities are priced in USD. When a big market (China seems the only real possibility) forces export payments in non-USD, then the dollar is finished. But I can’t see that happening at least not until the RMB is freely floating.

  • Posted by Mark

    Excellent analysis regarding China’s sovereign risk and economic outlook:

  • Posted by London Banker

    @ Brad
    The explanation for the rapid growth in custodial holdings is quite simple – wholesale custody is not protected in US bank insolvency. Central banks are moving assets from custody at banks and investment banks to the Fed because when Lehman failed they were reminded that they don’t recover custody assets in an insolvency.

    Those assets were put in the banks to earn extra yield by allowing the banks to use them for repo and securities lending operations. Lehman’s receivers can’t find all the assets that wholesale creditors want to reclaim. The central banks know this, so are moving their assets from risky custody to safe custody.

  • Posted by DJC

    China PBoC Denies any rescue efforts for the U.S. financial markets

    So far, “China’s response to expectations at home and abroad has been unassuming. Although fortified with great liquidity and large reserves, Chinese banks and government investors have preferred to sit on their hands….Chinese bank officials have dismissed as groundless reports that China plans to buy up to $200 billion worth of U.S. Treasuries to help Washington combat the deepening financial crisis….Some of Beijing’s conservatism stems from the fact that the global credit crisis has walloped the value of the Chinese government’s initial batch of investments in U.S. financial institutions such as Morgan Stanley and Blackstone Group.”

    Reuters notes that although, reportedly, the head of the China Banking Regulatory Commission recently said that “China might consider injecting liquidity into the United States to help it save the market,” a spokesman for that Chinese-government agency has indicated that its chief “never made such comments anywhere.” For now, China’s foreign ministry has emphasized, “China’s main contribution in the face of the current uncertainty is to ensure that it keeps growing quite fast.”

  • Posted by Soxfan

    London Banker: Great insight. That sounds plausible. Another side effect of the credit-market seizure is that the Sec Lending business is drying up. According to the WSJ, this is one of the primary reasons AIG is burning through the $87bn like there’s no tomorrow, and had to be provided a line for $38bn more.

  • Posted by bsetser

    london banker/simpson — good insight. your explanation makes sense to me.

  • Posted by moldbug

    bsetser, teh G7 needs ur halp:

    “I suspect that in retrospect, the decision to allow LEH to default on its bonds (note the settlement on CDS today) ended the era of wink wink too big to fail informal insurance. and it turned out the highly leveraged financial system that had grown up over the past few years couldn’t survive without it.”

    And from the FT today… wink wink. If I hear the phrase “de facto” one more time…

    People, there is this thing called “transparency.” It involves stuff like: keeping only one set of books; having all your liabilities, even contingent liabilities, on the books; not engaging in “implicit” or “de facto” financial transactions… if you don’t want your country to turn into a banana republic, don’t act like one! Doh!

  • Posted by moldbug

    In case anyone hasn’t seen

    Ur banks! Give us dem.

  • Posted by Simpson

    London Banker – Actually, custody securities are recoverable in case of insolvency.

    The problem is that cash is not and if the insolvency happens on the same day as a coupon or redemption payment then the cash is lost and you need to claim as an unsecured creditor.

  • Posted by Cedric Regula

    The G7 Finance Ministers showed up for free coffee and donuts at the White House this morning.

    Pledged to work together.

    I was hoping they’d give us some insight into where the missing dollar liquidity injections are, since they’d be the one’s who ought to know.

    It would be silly to think CBs took the $600B++ in swaps intended to get LIBOR rates down, and bought treasuries instead. Interest rates too low for that I think.

    But they should know if they lended it out or not in their banking systems.

    So I found a theory of what could be going on here.

    “The Fed’s massive and numerous liquidity facilities are making things worse. The problem is more than banks unwilling to lend to each other, they are also unwilling to borrow from each other. Banks can get all the funding they need (and then some) from their central bank so they do not need to seek a loan from another bank. I believe it has gotten so bad that they don’t even bother to make a decent market for inter-bank loans anymore. No reason to, they don’t need them anymore as central banks have replaced them. ”

    I have my own implicit conspiracy theory to fill out this explanation. Banks can borrow all they want from central banks at say 2%. If they don’t lend to each other, or quote high as the free market does it, which is coincidently somewhere near what they could retail money at, they force up all the variable rates on their existing loan portfolios. Very profitable, and works with the current need to deleverage because of deteriorating assets on the books. So less is more.

    This happens to be why our Fed normally charges a slightly higher discount window rate than the overnight rate in order to get banks to lend short term excess funds among each other and smooth out available liquidity amongst themselves rather than always going to the Fed for a better deal.

    So I can’t really believe the G7 Finance Ministers are unaware things could work like this. So why are hearing about things like guaranteeing interbank loans and other efforts to unfreeze this activity? Either you want the banks to get better, and the economy suffers, or you want the economy to get better, and the G7 can’t afford it unless they buy the world economy with money they don’t have.

    So that is how our euro dollar liquidity injection is fairing. Then I still have this old time notion that lots of treasury borrowing in the US somehow crowds out private borrowing. Combined with blowing $8 Trillion off the stock market this year that seems like we have moped up lots of excess liquidity in the US (I know stocks don’t count, but we all know they do.). But mopping up liquidity is not what we want, they tell us.

    So how they make this all come together in a seamless way confuses the hell out of me.

  • Posted by Cedric Regula

    Conspiracy Theory #2:

    If we accept the theory that CBs are pulling “custodial holdings” from broker-dealers and giving them to the NYFRB instead, then we are also seeing Act 2 of our round robin game of screw the pooch.

    Broker-dealers just greatly increased margin rates to hedge funds. Apparently if you are a hedge fund they did let you have 15% in your fund and gave you 85% in margin !!!

    So they have the first 2 weeks in Oct. as a grace period for hedge funds to decrease margin to levels more like retail investors get from Ameritrade or E-Trade.

    This coincidently coincides with the market swoon.

  • Posted by Blissex

    «the decision to allow LEH to default on its bonds (note the settlement on CDS today) ended the era of wink wink too big to fail informal insurance. and it turned out the highly leveraged financial system that had grown up over the past few years couldn’t survive without it.»

    That highly leveraged system, generating asset bubble after asset bubble, fueled by collapsed reserve requirements, Greenspan Puts and Bernanke swaps, could not have survived regardless without accelerating inflation.

    It could not survive because asset price increases due solely to momentum are partially cashed in, so the net is not zero.

    Latest example: if the housng stock of the USA has gone in value from 10 trillions to 20 trillions and then goes back to 10 trillions, things don’t go back to initial conditions; part of the 10 trillion have simply gone into somebody’s pockets, and most of it spent (e.g. via HELOCs).

    The amounts involved are so large that whether there was an informal policy or not, the leveraged system could not survive without accelerating inflation. And we may yet get it.

  • Posted by moldbug

    “highly leveraged financial system”: well, leveraged and maturity-transformed. I dislike the use of leverage ratios as a crude, really almost populist, substitute for actual risk models.

    First, when asset prices fall by 30%, the difference between 10:1 and 50:1 leverage is not all that significant. Bankruptcy is boolean.

    Second, if risk models were programmed to include liquidity risk and not depend on the existence of a liquidity insurer, they would tell you not to construct structures that are rollover-dependent, ie, mismatch their maturities.

    The problem is not the use of fancy math but the details of the fancy math. Please resist the bias to favor answers which are intellectually accessible to the chanting hordes. The last thing this situation needs is chanting hordes.

  • Posted by Blissex

    «The problem is not the use of fancy math but the details of the fancy math.»

    Exceptionally naive: whatever math was used was one that resulted in the business case being approved and the bonuses being maximized. Banks don’t use risk models that minimize the incomes and bonuses of bankers.

  • Posted by Cedric Regula


    I think we should call it “servo gain cranked too high.” That’ll keep too many people from screaming about it.

    Or we could call it a Ponzi scam and the bozo’s wrote insurance on top of it and they had no funds to the back the insurance with. But that may make understanding the situation by the unwashed masses even worse.

    And show me the model that analyzes how a systematic, even minor, bank run due to mark to market of illiquid 30 year mortgage paper, which was constructed like making a milkshake from neopolitan ice cream so chocolate, vanilla, and strawberry are there inseparably to satisfy everyone’s taste for risk with the same mortgage instrument, will lead to the blowup up of the shadow banking system and hedgefunds, leading to a collapse of the stock market, and ultimately trigger bank loan covenants in corporate revolving credit facilities, insuring that even the productive part of the real economy goes into recession?

    Who needs math with a scenario like that? It’s horseshoes and hand grenades.

  • Posted by moldbug

    Cedric, excellent idea. I’d like to see W come on the tube and explain as follows:

    “Dear Americans, I have wonderful news: our technicians have tracked down the bug in your financial system. While it’s very technical, the basic gist is that the refulgurator had become hypersquatulated. This led to a massive backup of small change in the credit filter. When they finally managed to pry it open, our guys found over 37 quadrillion pennies in there! Our rotary-winged aircraft will shortly be disbursing these funds. In short, the crisis is over. Take the day off, go to the mall, shop a little – no, really, it’s on us.”

    As for risk models, it doesn’t exactly take NASA to see that a financial structure which depends on finding a new lender every 30 days for 30 years is unstable. What’s amazing is that anyone ever thought rollover dependency was stable. An absence of new financing should imply an absence of new projects, not the liquidation of the entire god-damned universe – excuse my French.

    Of course the simple answer is: finance your investments at their actual maturity structure. But there is always some wiggle room around the simple answers, and that wiggle room can always be expressed in Fortran.

    (I just read about the revolving-credit loan-covenant issue. Christ. This whole thing makes Chernobyl look like a masterpiece. Everyone will insist on payment up front in Krugerrands for the next 30,000 years.)

  • Posted by moldbug


    “Exceptionally naive: whatever math was used was one that resulted in the business case being approved and the bonuses being maximized. Banks don’t use risk models that minimize the incomes and bonuses of bankers.”

    Certainly true. But there were other players in the game: bankers, regulators, and (worst of all) economists all agreed to close their eyes and believe that there was no such thing as liquidity risk.

    All three groups profited. And while the first group made the most money, I’d argue that the third group was the most to blame. Because it was their job to tell the other two to stop, and – by and large – they didn’t.

  • Posted by Michael


    Bottom of the first.

    Or, to use the Great Depression analogy, 1932.

    Yes, we’ve had big gummint credit, business, and fiscal interventions, but while those would have made a some difference early in the game in “the old days” when America in 1930 had a balanced fiscal budget and a positive trade balance, in “the new days” its just throwing water at the crumbling dam to fix it (not an original metaphor); it’s also an election year.

    Just as the trigger was first pulled on the G.D. in the mid 1920’s by the collapse of commodity prices (but not grasped until the equity market crashed), the trigger was first pulled in the N.S.G.D. (Not-So-Great Depression) we are entering by the collapse of housing prices in the mid-2000’s.

    And don’t forget, even the massive market, fiscal, and social restructuring that took place for a decade in the 1930’s didn’t end the G.D. It was WWII (when the term “exigent conditions” really meant something), with the first-time-ever-created, never-to-be-paid-back astronomical government money-through-debt lend-lease and war bonds, and the concomitant transfer of all the stored wealth of Europe to our economy, that end the G.D.

    Definitely first inning.

  • Posted by Cedric Regula


    “Of course the simple answer is: finance your investments at their actual maturity structure. But there is always some wiggle room around the simple answers, and that wiggle room can always be expressed in Fortran.”

    So true. I wrote a mortgage calculator program in Fortran back in college. You can plug in a new interest rate every thirty days and calculate the new payment. And you could do that for 30 years. So what’s everyone so worried about?

  • Posted by Michael

    My response to Awake suggests the only way to avoid (or shorten) the coming N.S.G.D.

    China and Russia need to have a nice protracted conventional war, that begins to exhaust their resources. They then commence(and throughout the war accelerate) massive purchases from the U.S. (we don’t have any resources of our own to sell them, so we’ll have to control other people’s resources so we can make our profit as middleman) so they can keep going to the bitter end. Along the way all their dollar reserves return to the U.S., our N.S.G.D. is over, and we are flush with cash and sitting on top of the world again. We can all call ourselves “The New Greatest Generation” and live happily ever after.

  • Posted by Cedric Regula

    Well, the good news is if we get started on WW3 before the end of the year, then we may entice GWB to run for another term or two.

    Franklin Delano Roosevelt (January 30, 1882 – April 12, 1945), often referred to by his initials FDR, was the thirty-second President of the United States. Elected to four terms in office, he served from 1933 to 1945 and is the only U.S. president to have served more than two terms. He was a central figure of the 20th century during a time of worldwide economic crisis and world war.

    Insert time warp here…..

    Then we can nationalize Canada as a strategic natural resource/security asset, have Goldman issue some secondary IPOs for Boeing,Lockheed,and the rest of the defense industry, sell some really good war stuff to both China and Russia, and employ most of the US in supporting the Asia/Eastern Europe War effort.

    Then upon both sides losing, America will be on top bathing in the Roaring 2020’s.Scantily clad women know as “Flippers” will sell distressed real estate by flapping their arms and high kicking their heels.

    TARP turns a profit for the taxpayers.

  • Posted by moldbug

    Cedric, calculating a new payment is no problem. It’s when you’ve gotta find a new lender – dat’s da problem. Of course, your friend Artie can always help us out. Ever since his place burned down, he’s been a real lender of last resort for all of us. What a guy, Artie.

    BTW, there’s only one policy action I can think of that could be planned, decided and announced before Monday: reducing the haircut on the Lehman CDS underwriters.

    (For those who don’t know: on Friday, Lehman’s assets sold for *under nine cents* on the dollar. Lehman was not just insolvent. It was insolvent by an order of magnitude. Vaporized, basically. According to its old risk models this was surely an event of infinite improbability, rather as if spontaneous quantum tunneling turned the Queen of England into a Bolivian anteater.)

    The result is that a few hundred billion dollars of financial assets will need to be liquidated. Promptly. Moreover, the withdrawal is one-way: the people who receive those dollars will almost certainly keep them in cash or Treasuries. Are MS and GS next? Who can know? Who wants to lend to an anteater?

    Treasury should step in, cancel the auction, and buy the whole Lehman portfolio. For at least fifty cents on the dollar. Probably more like eighty. Maybe even a hundred. Do this now, or at least before the market opens Monday.

    It’s one thing to say you’re not going to allow any more bank failures. Reversing the results of the last one would send a somewhat stronger message. It’s a kind of helicopter strike the rebels have not yet seen, and it should give the Empire at least a day or two to refuel, repair and rearm the rotary-wing attack squadrons.

  • Posted by chris

    some good stuff here. as the great unraveling proceeds, I’m paranoid enough to wonder if the house of cards was built on a house of cards. All these artificial assets have been created. We aren’t taking about assets; we are talking about smoke and mirrors ad infinitum. Fraud, collusion, incompetence on a massive scale.

  • Posted by Cedric Regula


    Calculating the new payment is a problem for the borrower.

    I still have this nagging suspicion that CDS are not real. Perhaps in a parallel universe, but not this one, and we know quantum multiverses can take their separate paths.

    The thing that makes me think this is that there is $62 Trillion of CDS “insurance” insuring defaults on mortgage paper that is only $11 Trillion in total means the market was “overinsured”. In spite of massive overinsurance, the people writing the insurance policies didn’t seem to have adequate capitalization for it. There is a NYC cocktail party story going around that it would be so complicated to untangle the mess and find the bagholder for the claim that it would take years in court, and therefore the risk to the participants is minimal(meaning the people, not the ongoing IBs).

    So I wouldn’t want the taxpayer to get stuck with that. I think you just declare all CDS null and void. The price of the insured securities dropped already because everyone knows CDS are a bunch of bull. And the taxpayer is buying reverse auction priced securities, per the released details of TARP. So that puts the loss so far were it belongs, but the taxpayer still has plenty to worry about. (My FORTRAN program says when interest rates rise, future value goes down.)

    So I’m sure this is a problem for Lehman creditors, some may have bought Lehman corporate debt instruments not knowing they were doing something dumb like financing an insurance scam. But that’s life in the unregulated bliss of modern finance. So I say kill them them all and let God sort them out.

    Then downsize the financial industry. Last thing we need is to re-capitalize too many banks just a little bit. There will be just enough to go around for management bonuses.

    We also need to keep some powder dry to spend it where it may directly do some good. Like we may need a National Airline soon so we don’t end up with an Amtrak monopoly.

  • Posted by chris

    Cedric, I have been thinking the same thing: just declare all CDS null and void. Would that really be any worse than hurtling into the unknown abyss we are already falling into.

  • Posted by moldbug

    Cedric, note that if you nationalize all the banks, the fact that they were all involved in a web of insurance transactions against each other nets out to nothing – especially if you include “hedge fund” in your definition of “bank.”

    Basically, you’re right. The whole financial system isn’t real. As Roubini says: it’s subprime. The only thing we should keep from it is a database with 300 million rows and two columns: your SSN, and how many of USG’s little green brownie points you have. The latter should be tied in some way to the magnitude of your former portfolio. As for the former assets, Secretary Paulson – he haz dem.

  • Posted by KnotRP

    > the market was “overinsured”

    Where I come from, the overinsured universally have an “accident”, like a break-neck tumble down the stairs.

    Maybe the overinsurance is an indicator that
    none of this was a suprise to anyone but the chihuahua sleeping at the bottom of the stairs.

    Given that an insurer does not pay out when foul play exists, perhaps nullifying default swaps is actually the correct reaction.

  • Posted by London Banker

    @ Simpson
    With all respect, the risk of loss of custody assets is very, very real. SIPC insures retail investors recovery of their custody assets, and acts as official receiver to effect it.

    Wholesale creditors have a pro rata claim for return of a share of the pool of equivalent securities remaining. As the point of depositing Treasuries or other assets with a bank custodian (as opposed to the central bank) is to gain higher yield from repo or lending, it is quite likely the pool remaining on insolvency will be smaller than the claims made on it.

    @ Moldbug and Cedric
    I was involved in the early days of the 1980s in promoting and protecting financial derivatives from “over regulation”. Now I see the folly of believing mankind was capable of resonsibly managing what Buffett has called financial weapons of mass destruction. I tend now to think that declaring all off-exchang derivatives null and void is not such a strange solution.

    For the regulatory historians out there, this was actually attempted back in 1988 by Kalo Heinemann as acting chairman of the CFTC, but overturned when Wendy Gramm, wife of Phil Gramm, was made chairman of the CFTC.

  • Posted by moldbug

    LB, at the very least I think mankind needs to close out its existing weapons of mass destruction! Perhaps then we can start to think rationally about the question you ask.

    The only trouble I can see with cancelling derivatives is that you are making someone take a large portfolio hit, because yesterday he had a Lehman CDS worth $921 and today he has a Czarist bond. Moreover, he has something of a right to complain – after all, he was one of the people smart enough to buy protection.

    If USG buys that CDS off him for $921, or CDS plus bond for $1000, or whatever, he gets the protection he paid for. And those who wrote Lehman CDS owe nothing, and therefore need sell nothing to come up with it. Result: a big relief rally Monday morning.

    It’s true that most of the relief is achieved by removing the penalty against the sellers of protection, which your plan would do as well. But I see no harm in making everyone whole, and plenty of advantage.

    (The situation is of course easier with companies that are not Lehman, and have not yet collapsed, but show high-value CDS. As Yves pointed out at NC, there are serious legal obstacles to this sort of tricky financial exhumation.)

  • Posted by Rien Huizer

    So good to be in the company of sound minds. Why are the others so dumb?

  • Posted by DJC

    Quote of the Day:

    “The market for derivatives grew at the fastest pace in at least nine years to $516 trillion in the first half of 2007, the Bank for International Settlements said. Credit-default swaps, contracts designed to protect investors against default and used to speculate on credit quality, led the increase, expanding 49% to cover a notional $43 trillion of debt in the six months ended June 30, the BIS said… ‘The pace of increase in the credit segment outstripped the rises in other risk categories,’ Christian Upper, a BIS analyst…wrote…The money at risk through credit-default swaps increased 145% from last year to $721 billion…”

    Bloomberg, November 22, 2007

  • Posted by Dave G

    The notion that these custodial holdings are moving to the FED and leaving GS and MB among others goes a long way to explain the panic on Friday.

    Makes perfect sense if these holdings are uninsured. And also explains why these companies all of a sudden will receive capital injections from Paulson’s plan to stop further collapse.

    A question for LB or BS, is the Fed obligated to take all such holdings and are there implications here?

  • Posted by moldbug

    I just found a lovely explanation of the crisis in Mises’ Theory of Money and Credit:

    “For the activity of the banks as negotiators of credit the golden rule holds, that an organic connection must be created between the credit transactions and the debit transactions. The credit that the bank grants must correspond quantitatively and qualitatively to the credit that it takes up. More exactly expressed, ‘The date on which the bank’s obligations fall due must not precede the date on which its corresponding claims can be realized.’ Only thus can the danger of insolvency be avoided.”

    Since Theory of Money and Credit was first published in 1912, I think this refutes any suggestion that preventing, or at least regulating, maturity transformation is a new and untried one. It may be untried – but at least it’s not new.

  • Posted by LB

    awesome find moldbug.

    is there any banks that exist today to your knowledge that apply these principles?

  • Posted by Bernardo A

    Dear Brad,

    we are experiencing the worst financial crisis after 1929, and this seems the obvious consequence of years of living above their possibilities by the US citizens, i.e. of a massive US current account deficit and negative savings. Crises, as hangovers, may be helpful to restore integrity. But what if integity will not be restored after this crisis? In other words, what if, say in two years time, the US financial system will be bailed out but still characterized by a massive external deficit? I would not be so confident, as you are, the the CA deficit will shrink by more than the IMF predicts.

  • Posted by mel

    “I would bet that this is more a flight away from risky dollar assets toward Treasuries than a flight into the dollar.”

    That is precisely correct sir, and it is the reason why they will lose more. This time they are selling risky assets when they should buy them, and buying treasuries when they should sell them.

    Correct course of action here is to do the opposite of Joe Public and Sovereign funds:
    Buy stocks, and sell dollar, and sell treasuries.

    To understand why, read posts from Friday to today, on these blogs:

    Sovereign funds and Joe Public share this in common: they are SCARED of risky assets at the BOTTOM, and CONFIDENT in risky assets at the TOP. The opposite of what they should do.

  • Posted by moldbug

    LB: no.

  • Posted by Michael

    We don’t need the government to invalidate ALL the Lehman (and other) CDS obligations (though that would be fine with me – I proposed a total CDS moratorium here at this blog last week before the settlement).

    Of the $400 billion in Lehman CDS liabilities, “only” $128 billion was actual insurance for real owners of Lehman bonds. The remaining $272 billion represented pure speculative plays (or some ninth-level-of-hell complex counter-counter-party pseudo-hedging, which is operationally the same thing).

    Get out your calculators: What’s the leverage when $170 million in premiums was paid by these speculators on the gamble they would receive $272 billion if Lehman defaulted? Do they have a right to get fabulously rich at the expense of the world economy? No wonder they banned short-selling for a while; with this kind of potential returns at stake, you mortgage the children if necessary to short Lehman).

    The compromise resolution is to validate the $128 billion in CDS obligations that was real bond insurance (there’ll still be some bailing out necessary of the insurers who can’t pay up), but CANCEL the $272 billion in CDS obligations to the non-bondholders (they didn’t have that much skin in the game in the first place).

    Make a clear, firm, absolute policy that henceforth all existing non-bond-insuring CDS are WORTHLESS JUNK that shall NOT be paid. Problema resuelto!

  • Posted by LB

    “Problema resuelto!”

    si si si,

    EXCEPT for one rather formidable obstacle.

    JPM has $8T in notional CDS exposure.

    that’s 8,000,000,000 dollas.

    of course, they’re playing market marker. now let’s assume they played good market marker and balanced out their risk. they’re still making the spread on every transaction, yes?

    correct me if i’m wrong, but under your proposal, they don’t get to collect the spread if the contracts are deemed null & void, correct?

    how much do you think the spread is on $8T of CDS?

    how ever much is the size of your obstacle.

    (and behind that hurdle are smaller hurdles, BOA, CITI, etc.)

  • Posted by vlade

    LB: “is there any banks that exist today to your knowledge that apply these principles?”

    Sort of. Zopa ( is (or was, I haven’t looked recently) a loan market matching bank, where you lend to a specific borrower, for a specific term. So, no MT.

  • Posted by LB

    vlade, this zopa link is wonderful.

    thanks for sharing.

    perhaps a glimpse into future possibilities???

    here’s another…

  • Posted by Michael


    Well, we have to decide who “wins” and who “loses,” anyway, now that we’ve decided not to let the free market operate freely. My compromise supports the integrity of bond insurance and does not support other functions of CDS. Agreed, it’s arbitrary. The alternatives appear to be:

    1. A meltdown of the $62 trillion CDS obligations as the deleveraging and defaults proceed. JPM’s $8T is a fraction of what’s to come. Oh yeah, we’re still living in the fantasy world that the Central Banks can prevent further deleveraging…HAHAHAHA.

    2. Paulson guarantees all CDS obligations to be “backed by the full faith and credit of the U.S. Government” (like everything else). Why not? It seems like the obvious next step.

    My problem with #2 is that when all currency becomes dollars and all debt becomes Treasuries, then the benefits for America of having a special currency and a more credible debt instrument disappear. All this, just to get through a classic credit contraction!!