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Central banks were not the big buyers of synthetic triple AAA …

by Brad Setser
January 28, 2009

Ricardo Caballero argues that the current crisis stems from (flawed) efforts to construct safe assets out of risky assets in order to meet a surge in investor demand for safe assets.

He is on to something.

There was a surge in demand for safe assets that pushed yields on Treasuries (and Bunds, OATS and Gilts) down at the peak of the boom. And investment banks – with help from the rating agencies — did respond by constructing new kinds of products that combined higher yields than Treasuries (or Agencies) and the appearance of safety.

Caballero thinks the banks constructed these securities to meet demand from central banks and sovereign funds.

Global demand for assets was particularly for very safe assets – assets with AAA credit ratings. This is not surprising in light of the importance of central banks and sovereign wealth funds in creating this high demand for assets. Moreover, this trend toward safety became even more pronounced after the NASDAQ crash. Soon enough, US banks found a “solution” to this mismatch between the demand for safe assets and the expansion of supply through the creation of risky subprime assets – the market moved to create synthetic AAA instruments. …. The AAA tranches so created were held by the non-levered sector of the world economy, including central banks, sovereign wealth funds, pension funds, etc. They were also held by a segment of the highly-levered sector, especially foreign banks and domestic banks that kept them on their books, directly and indirectly, as they provided attractive “safe” yields.

I don’t think that is quite right. Central banks and sovereign funds weren’t the main buyers of “structures” that produced a “synthetic” triple AAA credit Central banks generally stuck to instruments with cleaner cash flows and less risk. Many have mandates that require that they invest in fairly short-term instruments that have explicit government backing.

Let’s review the portfolios of the key players:

– Japan (MoF mostly) remains overwhelmingly in Treasuries, with a small number of Agencies. As far as I know, that is about as far as the MoF and BoJ went.
– Brazil’s central bank basically holds Treasuries.
– Russia’s central bank held a lot of short-term Agencies. But it liked the Agencies own debt, not the mortgage backed securities they guaranteed. Russia’s its investment guidelines are quite restrictive. It needed a government guarantee. It wasn’t buying any “private lablel” structured product.
– India has been quite conservative. It doesn’t even hold many securities. Most of its reserves are on deposit at an international institution — likely the BIS. Who knows, maybe the BIS dabbled in structures, but India wasn’t a big source of demand for CDOs.
– Mexico didn’t go further than dabbling with Agencies. Agency MBS were a bid deal. It is mostly in Treasuries.
– Saudi Arabia is a bit of a mystery. I doubt it holds any structures on its own book. But it also likely outsourced the management of a fraction of its fixed income portfolio, and well, maybe the managers had a mandate that allowed them to take a bit of risk. I just don’t know. The Gulf’s sovereign funds liked equities (and private equity) more than they liked complex debt instruments – though they probably invested in hedge funds that made levered bets on complexity. I would be surprised if the Gulf has more than $100 billion of exposure to structured products. the Gulf’s big bet was on the equity market.
– Korea clearly took a few more risks back when it wanted to juice returns to offset the won’s appreciation (how the world has changed). But even if it put a third of its dollar portfolio (say 20% of its total portfolio) in dollar bonds that lacked government banking, it wouldn’t have bought more than $50 billion of “product.”
– Norway also took credit risk with its bond portfolio. But the US only made up about a third of its bond portfolio. Back when bonds were 60% of Norway’s portfolio, Norway could not have have had more than 20% of a $300 billion portfolio in US bonds of all kinds. It thus could not have accounted for more than about $60b of demand for various structures. And it clearly wasn’t just buying structures.

Sum those countries up and they account for a large share of total central bank assets: Japan has a trillion portfolio, the big Gulf sovereign funds probably combined to hold around $800 billion of assets at their peak (less now); Russia and Saudi Arabia were around $500 billion; Norway, India, Brazil and Korea were in the $200-300 billion range.

That leaves China. China clearly dabbled a bit with some kinds of risk. The state banks got $100 billion or so to play with in 2006 (they seem to have gotten burned and retreated; they have been selling their foreign portfolio since mid 2007). SAFE bought a few high quality corporate bonds. It was a big buyer of Agency MBS – and perhaps bought a few structures too. But the overwhelming majority of its assets remained in Treasuries and Agencies not in “structures.’ China, inc – counting the state banks – might have bought $300 billion of bonds that lacked an explicit or implicit government guarantee, but probably not more.

The numbers just don’t work. Unless my accounting is way off, most central bank assets remained in fairly safe assets.* The big shift in the world of reserve management was the shift from Treasuries to Agencies after 20004. Most central banks still wanted bonds with explicit or implicit government guarantees.

Who then were the investors who wanted “safe” – i.e. highly rated – structures? Saturday’s Wall Street Journal provides the needed clue. Think State Street. Actually, think conduits run by State Street. Levitz and Anand in Saturday’s Wall Street Journal:

“It got into conduits, which are instruments that buy such things as asset-backed and mortgage backed securities, using short-term borrowings. It shifted its investment portfolio from predominantly government bonds into mortgage-backed securities which rose the housing boom. And then last year the housing market fell apart and ensnared the financial world – and State Street – in a credit crunch.

I don’t think State Street was alone.

As central bank demand pushed yields on Treasuries and Agencies down (and as the fed raised rates), a host of financial institutions took on more risk. Other financial institutions supplied the product that they wanted. And when it blew up, the financial sector – not the world’s central banks – was left with big losses.

Caballero’s argument works, but with one additional step. Central bank demand pushed yields on Treasuries and Agencies down, and low yields on traditional, safe assets triggered a surge in demand for assets that appeared safe but offered the kinds of returns private investors were used to.

Lord Turner of the UK’s Financial Services Authority:

Very low medium- and long-term real interest rates have in turn driven two effects:

First, they have helped drive rapid growth of credit extension in some developed countries, particularly in the US and the UK – and particularly but not exclusively for residential mortgages – with this growth accompanied by a degradation of credit standards, and fuelling property price booms which for a time made those lower credit standards appear costless. And secondly, they had driven among investors a ferocious search for yield – a desire among any investor who wishes to invest in bond-like instruments to gain as much as possible spread above the risk-free rate, to offset at least partially the declining risk-free rate. Twenty years ago a pension fund or insurance company selling annuities could invest at 3.5% real yield to maturity on an entirely risk-free basis; now only 1.5%: any products which appear to add 10, 20 or 30 basis points to that yield without adding too much risk look very attractive.

… The fundamental macro economic imbalances have thus stimulated demands which have been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments.

Incidentally, One implication of Caballero’s argument is that the US should have been running bigger budget deficits to meet the rise in demand for safe assets. That would have kept yields up and reduced incentives to create “synthetic” triple AAA. Rather than following Dr. Chinn’s advice and trying to bring about rebalancing with a tight fiscal policy, the US should have met the world’s growing demand for truly safe reserve assets by running large fiscal and current account deficits.

Who knows – that could be where we are heading.

Caballero attributes the surge in demand for safe assets to the integration of the emerging world into the global economy. He writes:

“since the late 1990s, the world has experienced a chronic shortage of financial assets to store value. The reasons behind this shortage are varied. They include the rise in savings needs by aging populations in Japan and Europe, the fast growth and global integration of high-saving economies, the precautionary response of emerging markets to earlier financial crises, and the intertemporal smoothing of commodity producing economies. The immediate consequence of the high demand for store-of-value instruments was a sustained decline in real interest rates.

I would add two additional factors.

China’s integration into the global economy coincided with a huge rise in China’s savings rate. There is a world of difference between a China that saves and investing a constant 35% of its GDP and a China that goes from saving and investing 35% of its GDP to savings 50% (or more) of GDP and investing 40% (or more) as its economic size increases. In the first case China isn’t a net lender to the world. In the second case it is. China’s savings rate hasn’t been constant, and China matters.

And exchange rate management. China didn’t buy a lot of US bonds just to protect itself from a repeat of the Asian crisis. it had (and has) a host of controls that limit its exposure to a big swing in interbank flows. its reserve cover has been exceptionally high for a long time. China bought a lot of bonds because it didn’t want the RMB to rise even as China’s booming exports created natural pressure for appreciation. It is hard to separate the surge in demand for safe assets from the rise in Chinese reserves growth (counting the increase in hidden reserves) from under $50 billion a year to close to $700 billion a year (at its peak — it is now lower). Especially as that surge came at the same time that rising oil prices pushed up oil savings and the demand for reserve assets from the oil exporting economies …

Had China allowed its currency to rise in 2004 rather than tightening fiscal policy and limiting lending to avoid inflation, I rather suspect that Chinese demand for safe US and European financial assets would have become demand for US and European goods. That would have produced a more balanced – and ultimately less risky – global economy.

And, well, if the US and UK governments hadn’t looked the other was as leverage in the financial sector rose — as financial institutions made bigger bets to keep profits up as spreads fell — that too would have produced a more balanced and ultimately less risky global global economy.

* Many questions about the global economy could be answered more definitively if central banks disclosed more information about their portfolios to the IMF. Aggregate data on central banks equity holdings would be useful — as would aggregate data about the composition of their fixed income portfolio. Of course, getting more countries just to provide data on the currency composition of their reserves would be a nice start …

75 Comments

  • Posted by John Booke

    Banks had to strip away the toxic portion of these finanical creations in order to produce AAA instruements. How did they strip that toxicity out? They created off-balance sheet scavenger entities to gobble up the slug. That was great until the scavenger entities blew up. We need to get realistic about financial accounting. Off balance sheet entities should be illegal.

  • Posted by Albion

    Wondering who was up to something?
    When at the same time these years one could read
    Fed To Banks: Halt Bond Fraud

    Liz Moyer, 11.07.06, 6:00 AM ET

    « The Fed wants banks to stop fraud in the U.S government bond market before regulators have to step in.
    Regulators and members of Wall Street’s biggest bond-trading operations are discussing ways to strengthen the integrity of the U.S. Treasury market amid a probe of possible market manipulation.
    The meeting on Monday afternoon at the Federal Reserve Bank of New York included representatives of the U.S. Treasury Department and the Fed, as well as head bond traders and compliance »
    With friends help!
    A situation where knowing that yields will grow as much as vegetation in the Gobi desert, not too difficult dreaming up hybrid structured products to quash yield thirsty cash rich investors.

  • Posted by and

    in turn, this reduced the return on ‘safe’ assets making everyone else with a mandate to
    invest for a small return (conflating this with ‘safety’ somewhat) need to go into mroe risky assets. in particular they may have looked for a label of safety; a common ‘pre crisis way’ of getting return was to take a bunch of ‘safe’ assets with a small spread and lever the heck out of them.

    i guess that this — and not inflation — is what we get when there is too much cheap credit mney lying around amid deflationary pressures.

    boom.

  • Posted by cdr

    But isn’t “the bad bank inc” by far the biggest US investor in these instruments? Wait isn’t there a trade secret that covers Fed’s proxy investments on custody hold for the taxpayers account, until they finish rewarding $450m retention to the synthetics producers and manage to set up the bank, mop-up the congress, find some great managers, employ employees (why not the whole AIGs “arm”?) buy all the stuff and apply for the license.

    Incidentally, does one even need one to “badbank”?

    Anyway, I’d rather legislate (mark) the +/- $2tn of old DIs debt for mandatory (equity) conversion.

    Then again, I’m not the next FBNY “chief”.

  • Posted by cdr

    Ups, I’m sorry I forgot; we must not create a “credit event” or even few hundreds of them. Now that would be upsetting, dollar index at 200+ creating new demand for the “world’s goods”…

    Don’t know about the “world’s bonds” tho.

    Anyway, silly silly me.

  • Posted by Cedric Regula

    I think the “bad bank” should be created within the Federal penitentiary system. Arguably at one of the “country club” prisons. Then insure that we have an ample supply of qualified and experienced managers and board members to run the bank.

    We will of course need a bonus system to keep the boys motivated and interested in the banks portfolio performance. So I propose tying the balance sheet to the prison menu. On an up day, steak on the menu…down day, spam on the menu…something like that. We should also say they can’t apply to be a commercial bank and try and attract customer deposits. That would be unfair to the nice lady running the FDIC. Probably should get that as a Constitutional Amendment.

  • Posted by Twofish

    Booke: Banks had to strip away the toxic portion of these finanical creations in order to produce AAA instruements. How did they strip that toxicity out? They created off-balance sheet scavenger entities to gobble up the slug.

    Nope. There was no shortage of hedge funds and investors that were willing to buy “toxic waste” for CDO’s because you can get the stuff really cheap and if things didn’t blow up, you ended up making large amounts of money.

    That wasn’t the problem. The problem was that the whole thing was toxic so that if you just strip out what you thought the bad parts were, you still ended up with a mess.

    CDO’s work rather well in the corporate junk bond market because even in bad times, if one company goes under the risk of all of them going under at the same time is much lower. The trouble is that residential mortgages don’t work like that.

    Off balance sheet entities weren’t used to sell assets people knew were toxic. What happened was that to get a AAA rating, the bank had to guarantee the CDO. The cost of those guarantees were on-balance sheet, but they were much too low.

    Once things went bad, those guarantees become quite costly/

    Booke: That was great until the scavenger entities blew up. We need to get realistic about financial accounting. Off balance sheet entities should be illegal.

    The trouble is that the entire residential mortgage market consists of securitized off-balance sheet entities.

    It may be a good idea to completely redo the way that we do accounting, but don’t underestimate the difficulty of doing that, and that may not fix the underlying problem.

    Basically, any time you resell a loan with any sort of guarantee, you are creating an off-balance sheet entity. The problem as I see it is not that the entity was off balance sheet, but the cost of the guarantee was mispriced. If you move the things back on the balance sheet, but misprice things, then you still have problems.

  • Posted by Twofish

    One problem is that you end up with objectives that are self-contradictory. On the one hand you want banks that made bad business decisions to suffer and undergo a lot of pain and agony. On the other hand, a bank that is suffering and undergoing a lot of pain and agony is just not going to be loaning out money.

    Part of the idea of a good/bad bank is that rather than have one entity do two contradictory things, you have two entities doing different things.

  • Posted by Twofish

    The problem with the good/bad bank idea is that this was quite the opposite of what people were doing in October. In October, you had the government encouraging shotgun marriages between “good banks” and “bad banks” and in some cases the bad banks have been dragging down the good banks.

  • Posted by babar

    @twofish, how do you correctly price this kind of insurance? looks like the govt is preparing to say that it can do it by taking on old liabilities. the govt of course can do this cheaper (and model it simpler) than anyone because no counterparty can force them to increase collateral. i would guess that this was one of the pricing issues that was ‘overlooked’ in the original methodology of pricing and one which the government can conveniently ‘overlook’. but even the govt can’t overlook that expected default is much more correlated and prevalent than originally assumed.

    anyway, that’s a bit of blather, but i think the ability of any institution to write insurance contracts covering large parts of the economy is limited on one hand but very enticing on the other hand because it looks like you’re getting paid a premium for no risk. also, any instrument that separates risk and return causes an agency problem — the insurance holder has no incentive to make good choices — which only get magnified when failures become prevalent and the insurance seller gets close to insolvency.

    in any case, i don’t think it’s a simple matter of mispricing; is there a fair ‘price’ for this insurance which would give the insurer enough room?

  • Posted by DJC.

    The solution to the economic fiasco is a “sound monetary policy” and the elimination of fractional reserve lending. Unfortunately, every failed policy to date has been expanded by the Bernanke Federal Reserve and Paulson Treasury. The destruction of the nation’s capital continues apace as healthy banks and US taxpayers are subsidizing bankrupt but “politically connected” banking institutions. AIG should have been left to go bankrupt except that its counterparty positions were with Goldman Sachs. Treasury Secretary’s Hank Paulson’s $600 million in Goldman Sachs stock holdings were at personal risk.

  • Posted by Cedric Regula

    I guess we need another Constitutional Amendment. The Federal Prison Bank should not be allowed to sell insurance. The best reason I can think of for this is they have no money to pay off claims, and the most an insured party could hope to get would be a plate of spam.

    And again, it would be unfair to the nice lady at the FDIC to make this her problem.

  • Posted by babar

    DJC, that’s silly — paulson had already sold his stock.

  • Posted by cdr

    Sorry, but all this from the (bad) bank being established by the sellers of its future “assets” to the “we’re all gonna die” is getting truly ridiculous.

    It is far beyond me why anyone would voluntarily hold himself, his country and the whole wide world hostage to some of the most ludicrous papers ever created under the pretence of upholding contracts. In addition to which they are just continuing as if nothing had happened to OTC them on at the back door.

    I might understand that the “creators” will do that because the other “solution” might involve some jail time for them. But in fact it does not. Just claim black swans, acts of God and idiocy.

    I believe you. Besides, it’s the case law.

  • Posted by cdr

    Cedric – there’s no up or down days it’s all marked to model, steady as she goes…

  • Posted by Qingdao

    “The big shift in the world of reserve management was the shift from Treasuries to Agencies after 2004.” Does this not add to the debate between those who maintain that Fannie/Freddie were in part responsible for the crisis (Wallison) and those (de Long, Krugman) who do not?

  • Posted by Qingdao

    “The big shift in the world of reserve management was the shift from Treasuries to Agencies after 2004;’ should this not be a part of the debate between those who maintain that Fannie/Freddie were a significant part of the problem and those (de Long, Krugman) who disagree?

  • Posted by lem

    Qindjao

    Agencies were the catalyst of more risk awareness. Their risk status, full sovereign versus implicit had to be clarified. It has been done and their spread with government bonds shrank.
    Just yield greed ignore the risk status until it matters

  • Posted by Cedric Regula

    Qingdao:

    I don’t see how anyone could argue that F&F were not a significant part of the problem, except for perhaps the most devout Keynesians on the planet.

    They were instrumental in providing nearly unlimited cash to fuel the housing boom. They were lobbying Congress constantly to increase the conforming loan limit. They nearly doubled it this decade. Any economist should know that wherever you drop huge sums of money on a market, prices will follow.

    Even Greenspan complained they were getting too big. His concern was they had a competitive edge over banks because of the implicit guarantee, and that gave them a cost of money advantage. The real world result was other lenders went after the riskier portion of the mortgage market.

    Then F&F decided they needed to compete in the risky end of the market, even tho their charter was to make or buy high quality loans.

    Then there was a host of internal operating problems that were in news reports now and then. But I don’t remember all the details.

  • Posted by DJC.

    In and after the 1980s, the central activity of the financial sector became not service but rent-seeking. Finance doubled its share of Gross Domestic Product (GDP) in the 30 years to 2006, but very little of the addition represented products and services that provided true value to the economy as a whole. Securitization was mostly a complex and expensive means of getting assets off banks’ balance sheets. Derivatives helped manage risks, but only a tiny percentage of the multitrillion dollar outstandings in the derivatives markets represented risk amelioration; the rest was just trading noise or outright speculation. Hedge funds and private equity funds were mostly a means of multiplying excessively the fees charged for investment management; they almost drove out of business the true venture capital funds, which had a genuine economic value. Principal trading, the most exciting activity of all in the glory years for greedy investment bank partners, was simply a means of using large amounts of outside shareholders’ capital to trade on insider information about the market’s deal flow. All of these activities were legal; none of them added value to anybody but their immediate practitioners, while they represented additional costs and lower returns for everybody else. In other words, they fulfilled the dictionary definition of rent seeking.

    http://www.prudentbear.com/index.php/commentary/bearslair?art_id=10183

  • Posted by DJC.

    President Obama’s Treasury secretary, Timothy F. Geithner, made tough remarks about China’s “manipulation” of its currency during his Senate confirmation hearing last week. People’s Bank of China Vice Governor Su Ning was quoted as saying during the weekend by the state-owned Xinhua news agency that Mr. Geithner’s “remarks are not only inconsistent with the facts, but they are misleading about the reasons for the U.S. financial crisis.”

    http://www.washingtontimes.com/news/2009/jan/28/clinton-signals-china-policy-shift-beyond-treasury/

  • Posted by David Merkel

    From what I heard, European/Asian commercial banks took down a lot of the synthetic AAA assets, as did many US banks. Capital rules encouraged it.

    Stable Value funds, with their voracious appetite for anything AAA, were also purchasers.

  • Posted by Twofish

    DJC: The solution to the economic fiasco is a “sound monetary policy” and the elimination of fractional reserve lending.

    1) We’ve tried sound monetary policy in a recession. It kills the economy. The time for sound monetary policy is during the boom. We are not in a boom.

    2) How do you have “non-fractional reserve lending”?

    cdr: It is far beyond me why anyone would voluntarily hold himself, his country and the whole wide world hostage to some of the most ludicrous papers ever created under the pretence of upholding contracts.

    The problem is that the people who hold the contracts (i.e. you) will get upset if they are invalidated. You go to a bank, deposit money. You give the teller expecting the money back. If you bank suddenly says “well let’s not worry about this contract thing”, then you will get rather upset. There are processes for invalidating contracts (i.e. bankruptcy), but you have to be careful with those. If people thought for a second that the bank was going to invalidate the contract that the bank has with them (i.e. I can get my money at the ATM), there would be total chaos. OK, you go to the government and demand your FDIC insured money. But if the government doesn’t care about this contract thing, they really have no reason to hand you a dime.

    Since it is politically impossible to just tear up the contracts that banks have with their depositors, things get complex. If banks and governments could just tell their depositors, “sorry, we lost your money, bye, bye” things would be a lot easier to fix. But since people get really angry when they lose their bank accounts, it starts getting complicated.

  • Posted by Twofish

    DJC: Finance doubled its share of Gross Domestic Product (GDP) in the 30 years to 2006, but very little of the addition represented products and services that provided true value to the economy as a whole.

    I disagree. Without a system of finance, companies like Google would not exist and you wouldn’t have these massive university endowments that fund basic research. If you don’t get the money right, then nothing else matters.

  • Posted by DJC.

    China Prime Minister Wen Jiabao criticizes US Economic Policies for Global Financial Crisis

    http://www.reuters.com/article/GCA-Davos2009/idUSTRE50R5MW20090128?sp=true

    DAVOS, Switzerland (Reuters) – China’s Premier Wen Jiabao blamed the United States’ debt-financed spending binge and blind pursuit of profit for the global financial crisis in a speech at the World Economic Forum on Wednesday.

    “Inappropriate macroeconomic policies in some economies and their unsustainable model of development, characterized by prolonged low savings and high consumption,” was first in a list of reasons Wen cited for the crisis.

    This was a clear reference to the United States, which has a savings rate below zero and relies heavily upon Chinese buying of U.S. debt to finance its huge current account deficit of 4.8 percent of GDP and growing.

    In his speech, Wen also listed excessive expansion of financial institutions in the “blind pursuit of profit,” the failure of regulation, lack of discipline by ratings agencies, and the spread of derivatives for the financial turmoil that has sent major economies tumbling into recession.

  • Posted by Cedric Regula

    Banks were allowed to use CDOs as their reserve requirements, and did for the small interest premium over treasuries.

    But pension funds around the world were big buyers too. Also there are a ton of bond funds holding the stuff so its widely dispersed among retail investors.

    You can even get closed end bond funds. I saw some selling at a 20% discount to NAV during the peak of the panic. The NAV is already mark-to-market on the security value, and the security value may be below the “recovery value”.

    And they were paying 12%-14%, if divs can still be counted on.

    I almost bought a little, but then chickened out.

  • Posted by jonathan

    Terrific cogent post. A lot of people are “blame fishing.” This is not the right spot to hook one.

  • Posted by DJC.

    US-China currency war eclipses Davos, and threatens the world.

    Turning a corner in the labyrinthine corridors of the Davos nerve-centre, I ran smack into Chinese premier Wen Jiabao.

    Mr Wen Jiabao smiled at me benignly, but he is not in a good mood. Indeed, he is fuming over the remarks by US Treasury Secretary Tim Geithner that China was “manipulating” its currency to gain market share. Reports were circulating this afternoon in Davos that Mr Jiabao erupted into a tirade after lunch at the mere mention of Mr Geithner’s name.

    Mr Geithner – the first US Treasury chief who can actually speak Chinese, and Japanese, nota bene – is clearly operating under instructions from President Barack Obama. If his resolve fails, Hillary Clinton is there at Foggy Bottom (State Department) to renew the broadside verbal attacks against Beijing – at least judging by her Sinophobe reflexes in the campaign.

    This has the makings of an almighty superpower bust-up. It is fast becoming the theme of Davos 2009. It may soon be the burning issue of our times. We will all learn how to pronounce Renminbi.

    Mr Geithner is playing with fire. Beijing has amassed reserves of $1.9 trillion. From what we know, most of this money is held in the form of US Treasuries and other bonds. Creditors exercise power. Don’t be fooled by claims that China could not deploy this weapon without damaging its own interests. All kinds of things can and do happen when tempers flare, and they were flaring today.

    http://blogs.telegraph.co.uk/ambrose_evans-pritchard/blog/2009/01/28/uschina_currency_war_eclipses_davos_and_threatens_the_world

  • Posted by Cedric Regula

    2fish:”I disagree. Without a system of finance, companies like Google would not exist and you wouldn’t have these massive university endowments that fund basic research. If you don’t get the money right, then nothing else matters.”

    Google came from venture capital, then an ipo. University endowments came from alumni and philanthropists. They are however managed, for a fee.

    But keep trying.

  • Posted by cdr

    Maybe in avoidance of the use of word »fraud« one could legislate (call it the »Act of God« proposal) the new names for the old, the older and even the brand new banks: BAD BANK 1-n, remove all deposits with a single book entry of “no deposits at all”, make FED return all the securities that backed its recent loans and prescribe within this Act a model according to which all assets have to be disclosed in their balance sheets (marked to) at 100 times their nominal value and that any claims to this bank will be met in dollars that are obliged to be changed for assets or parts of assets of the bad banks at their new modelled prices the legal moment that the receiver receives the cash, change all the CUSIPs and the ISINs of securities they ever issued or intended to issue and then merge them into a bank holding company with a new brand »BAD BANK« that together with the whole Act is registered as a trade mark (in case Swedes decide to adopt similar approach in the future), and create a new one – THE GOOD BANK (for the depositors and public convenience) owned mutually by all US citizens and transfer hereto all deposits from the BAD BANKS 1-n. Then one can claim that the Act of God, passed by the Congress in 2009 can in no way be ever interpreted as a credit event because it was in fact a Black Swan that forced it into law and all the contracts, written in the previous names of banks or their securities are void precisely because they have all ceased to exist at the same time and it is widely known that this can’t ever happen. It was almost an Act of God. As for the counterparties of such contracts that happen to end up in a BAD BANK holding it, as a legal person, can claim idiocy as an universal legal heritage. One can even include an article that says that legally they never even existed. I’m not sure yet whether this would be labeled as conservative, anarchist, communist or liberal tho it would solve the “we don’t want a too strong dollar” policy while still politically enable the full employment of the good the bad (and we’ll forget about the ugly) banking approach that is currently being goodwilled to the public while the same would not turn things into angry chaos. Remember, this is a joke, right?

  • Posted by DJC.

    There seems to be a blame game making the rounds in U.S. policy circles these days in which Asia is at fault for the credit crisis and economic downturn. The meme goes like this: Everything was fine until the Asians started manipulating their currencies and creating excess savings to export to the West. This mercantalist policy of low domestic demand, high savings, and an export-oriented economy set up huge macro imbalances that created the debt bubble and recession we see today. Asians need to save less and buy more — and stop manipulating their currency. Do you buy this line of argument? I don’t.

    The focus here, of course, is blaming China. Tim Geithner, the new U.S. Treasury Secretary, has said, “Treasury has to be and Treasury will be a source of bold initiative.” What does that mean? Judging from Geithner’s other anti-Chinese statements, it means trade protectionism.

    This concept that Asia is to blame for the downturn and the massive losses at European and American banks must be rebutted before it gathers steam and creates a trade row that nobody wants.

    http://www.rgemonitor.com/asia-monitor/255320/the_blame_asia_meme

  • Posted by Twofish

    Cedric: Google came from venture capital, then an ipo. University endowments came from alumni and philanthropists. They are however managed, for a fee.

    So who manages venture capital firms, IPO’s, university endowments. For that matter where do many of these rich alumni and philanthropists get their money.

    Nothing at all to do with finance. Right?

  • Posted by Cedric Regula

    cdr:

    We may be able to grandfather your Act of God motion under the “It’s Too Late The Baby Is Here Already, So Know Whadda We Do Now Act” that got Saddam, but missed bin Laden.

  • Posted by Cedric Regula

    2fish: They did it in the 50s & 60s too, with a much smaller % of GDP. There wasn’t enough manpower to make all today’s alphabet soup, however.

  • Posted by Glen M

    Somebody should ask Wen Jiabao why, if the the US model was unsustainable, was China accelerating it’s funding for it?

  • Posted by Ying

    “Had China allowed its currency to rise in 2004 rather than tightening fiscal policy and limiting lending to avoid inflation, I rather suspect that Chinese demand for safe US and European financial assets would have become demand for US and European goods. That would have produced a more balanced – and ultimately less risky – global economy.”

    I suspect that the amount of credit provided by US financial sector is much much bigger than the credit provided by all foreign central banks. That was shown by high leverage and dependence on short-term funding. Long term low interest rate for treasuries may also largely contributed to expansionary source from financial institutions, pension funds, and wealthy individuals etc. The system has been continuously monetized all illiquid assets into financial securities.

    Persuading China to appreciate its currency is going to rob millions of Chinese workers of their living standards through inflation while only a very few rich Chinese have the luxury to enjoy imported goods. Given the existing tension between labor and capital, I doubt it will make things better before it’s getting worse.

    Brad, try something else instead of just focusing on RMB/$ exchange rate. For example, trade some goods to US in RMB. Only advices that are beneficial to majority Chinese will be considered by Chinese policymakers. Chinese doesn’t want piles of Treasuries either. Mutual benefits is the key.

  • Posted by Cedric Regula

    DJC:

    I think the protectionist thing and Mr. Gs comments are getting way blown out of proportion. Everyone wants to prove they know as much about the Great Depression as Bernanke, and personally, I think they do.

    The Treasury has the power to brand a country as a “currency manipulator”. That takes away the “most favored nation” trade status, and your import duties go from the around 5% amount all the way up to around 50%.

    If the Chinese are taking the use of this phrase literally, then they would obviously be upset.

    But I don’t think the USG is dumb enough to do that(really, I don’t).

    The dumping of 2T in treasuries scares them too much. We already caved in on the implicit GSE issue.

    It was easy to get around much of the trade barriers before China was given most favored trade status anyway. The door was thru Mexico and NAFTA. For instance, the Japanese would ship PC boards stuffed in China along with a case and knobs made in China into Tijuana or Juarez and do final assembly there and get the few percent NAFTA duty into the US. It would probably work with tennis shoes and shoe strings too.

    I think it is more likely they push for something like Buffet’s trade voucher plan, where they have to buy something from the US for the right to import. I hope it’s something better than tax subsidized grain, or ethanol.

  • Posted by bsetser

    ving — i am pretty sure i will continue to focus on the rmb/$.. I am an fx/ bop economist afterall. and it matters.

    if china doesn’t want piles of treasuries, it needs to allow its currency to rise more (or encourage sustained hot money outflows). it really is that simple. the us doesn’t need to sell china RMB denominated debt so long as china is so keen on buy $ debt …

    (p.s. rmb appreciation would tend to reduce inflation, not increase it — and if the rmb rose, more chinese workers could afford imported goods)

    qingdao — i don’t think so. freddie/ fannie were growing their portfolios, but slowly until 07 (they really grew after privaet label securitization ground to a halt). the big growth in the outstanding stock of mortages was financed by an expansion of private label securitization. net CB purchases of agencies were almost as large agency issuance. they easily could have sold more if accounting scandals and the like hadn’t let to constraints on the growth of their balance sheet.

    David Merkel — you left out the broker-dealers. Merrill. UBS. No doubt others …. they ended up taking big positions in super-senior in order to keep the lucrative securitization game going … and they also didn’t need to hold much capital against it …

    so far, though, it seems that less was on the books of asian commercial banks than most thought, while US and Eiuropean investors had more. either that or Asia’s exposure has been effectively kept under the radar.

    glen M. Good question. if china thought US monetary policy was too loose and the US wasn’t doing enough to support the $, the obvious question is why did it continue then to import us monetary policy through its dollar peg.

  • Posted by Glen M

    Ying,

    It has really been China’s mercantilist practices that have been ‘robbing’ jobs from the west. That being said, there is enough blame to go around for everyone.

    Moving production to China from North America, Europe, etc. is aided and abetted by many corporations as China’s price advantage goes beyond the currency issue.

    Steve Navarro has estimated that export subsides account for 17% of the advantage, counterfeiting and piracy contribute 9%, and together, lax environmental and worker health and safety regulatory regimes add another 5%.

    Workers in China should be upset that it is their own government that grossly undervalues their labour cares little for their safety.

  • Posted by bsetser

    A finding of manipulation actually just requires ….. negotiations. No sanctions are specified in the legislation that requiires the treasury to issue a report on finding of manipulation.

    i think the Chinese threat to sell treasuries is being a bit over stated.

    game it out:

    a) China has to buy something else – if it buys euros, it would push the euro up/ $ down. that doesn’t obviously help china much .. unless it wants a weaker RMB/ euro and thus continues to peg to the $ even as it pushes the $ down through its sales.
    b) the fed would buy long-term treasuries to keep yields from rising … and that likely would put additional downward pressure on the dollar.
    c) to the extent that everything got disorderly, the fall in us output would mean less demand for china’s exports. and since the whole point of a weak rmb is to help exports, that kind of undercuts the original logic for keeping the rmb down ..

    i could be totally wrong, but i was much more worried about this threat when china’s growth was strong than i am now. it would go against china’s efforts to support its exports as much as allowing further rmb appreciation v the usd. and right now chinese policy seems to be geared to supporting chinese output thru all means necessary.

    the counter to this is that china already is worried about its treasury exposure and doesn’t want more. but then it has to either :

    a) engineer large hot money outflows so the pboc doesn’t need to add to its reserves
    or
    b) bring the current account surplus down w/o changing the rmb v the USD.
    c) but other us assets, like say agencies

    the best way out: a big enough stimulus to bring china’s current account surplus down. real appreciation plus a falling surplus woudl give the treasury something to work with …

  • Posted by DJC.

    Brad,

    The IMF once again demonstrates that it is a stooge to the US Treasury Dept and destroys its global credibility among developing world nations. Reiterating Timothy Geithner’s blistering attack on China PBoC monetary policy, the IMF illustrates its intellectual economic bankruptcy.

    It’s a flat out lie that the China yuan is a “weak” currency. In fact, the Chinese yuan has been strengthening against the dollar for the past 14 years. The Chinese are guilty of “manipulating” their currency only to the extent that they have sought to slow the pace of its appreciation vis a vis the dollar.

    With his ill-advised blistering attacks on China’s government, Geithner has single-handedly destroyed any prospect of global economic cooperation with the Chinese people. Chinese Prime Minister Wen Jiabao is infuriated with Geithner’s insulting comments during Congressional testimony. While there aren’t direct elections for high government officials in China, neither has Geither been confirmed to be the Chairman of the China PBoC.

    The US Treasury, IMF crony bureaucrats, and Washington Consensus think tanks should butt out of the internal monetary policy affairs of China. It’s also called minding your own damn business.

  • Posted by Cedric Regula

    Brad

    Ya. I think the golden handcuffs still work. But I also think they could peruse the S&P 500s products and see something they can buy. Need drugs? We got ‘em. They have a big rail project going…GM makes locomotives. We have a big pollution control industry…they got big pollution. Mining equipment, Cat Tractor, farming equipment and technology, medical equipment for the new health care system, waste water treatment, power plant & grid equipment….

    There has got to be something they can buy.

    Too bad Westinghouse already gave away licensing to them for nuclear reactors. The Chinese always try to create their own industry instead of buying the products.

  • Posted by DJC.

    P.S. Tim Geithner also criticizes the Chinese government as “irresponsible”. Why would you be suprised that someone who failed in his duties to protect the banks and regulate 900 trillion in derivatives would be given more power?

    It’s laughable that Tim Geithner would blame and scapegoat the Chinese. Is it always the fault of the Chinese? Does Geithner pass the laugh test?

  • Posted by Cedric Regula

    Ben is transforming the Fed into the next Citibank.

    Fed pledges to use all tools to help economy
    http://finance.yahoo.com/news/Fed-pledges-to-use-all-tools-apf-14184513.html

    “Specifically, the Fed said it is “prepared” to buy longer-term Treasury securities if the circumstances warrant such action.”

    “The central bank is buying up to $500 billion in mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. It also has agreed to buy up to $100 billion of Fannie and Freddie debt. Mortgage rates have fallen in the wake of the program’s announcement late last year. The Fed said it could buy more of these securities or extend the length of the program.”

    “The central bank also said it will be launching a program aimed at bolstering the availability of consumer loans.
    Under the program, which is expected to start in February, up to $200 billion will be made available to spur auto, student and credit card loans as well as loans to small businesses. To do that, the Fed will buy securities backed by those different types of consumer debt.

    The Fed said it will assess whether the program should be expanded in size or scope. Fed officials previously have mentioned the possibility of expanding the program to provide financing for other types of securities, such as those backed by commercial mortgages.”

    I hope someone reminds Ben that the French horded gold during the Great Depression.

  • Posted by bsetser

    DJC — tis rather hard for the us to butt out of the int. monetary affairs of china when china is importing us monetary policy through its peg …

    note as well that china’s peg increasing shapes monetary conditions in the us, through its impact on us rates — as well as setting the united states exchange rate with one its most imp. trading partners. china’s assertion of its sovereignty here infringes on others sovereignty.

    perhaps tho we should go back to discussing how CBs shaped demand for synthetic triple AAA …

  • Posted by ReformerRay

    As usual, Twofish has something important to say: “There are processes for invalidating contracts (i.e. bankruptcy), but you have to be careful with those”

    Invalidating contracts is the issue that should be discussed. If the total of some kind of contracts (derivatives) are larger than the federal government can insure and reamain solvent, what do we do?

    No all contracts are equal. A contract to insure that someone else will honor a contract is different from the original contract. It is not necessary for the existence of the original contract.

    I favor bankruptcy as the cleanest and best way to wipe the toxic assets off the books. No reason for the Federal government to back them.

    But Twofish rightly says (more later – I want to see if I added right)

  • Posted by ReformerRay

    goody – to continue – “you have to be careful with those” RIGHT

    The Federal Government needs to have available enough cash to provide insurance for all the banks left standing after the Fed’s permit the private sector to determine which ones should remain. The winnowing out process can be announced in advance to cease when the banks closed amount to X% of existing banks market value. X to be choosen at a level that will provide enough banks to serve the financing needs of a nation that has a GDP of 70% of the U.S. in 2008.

  • Posted by ReformerRay

    “This concept that Asia is to blame for the downturn and the massive losses at European and American banks must be rebutted before it gathers steam and creates a trade row that nobody wants”.

    I didn’t hear Geither or anyone else say that China is responsible for the current financial meltdown.

    I do agree that China is extremely sensitive to whether it is singled out for criticism.
    That is one reason for searching for a means of reducing the U.S. trade deficit that treats China the same as Japan, Germany, Canada and Mexico.

  • Posted by Sargon TM

    Brad,

    This is a very cogent post. People haven’t looked enough at the demand side of the toxic waste accounting identity. Thanks.

    I think that there is one source of demand that’s worth adding. There is a whole lot of supposedly conservatively managed money, pension funds, endowments, etc. that makes long term commitments based on income from a pool of money. Actuarial assumptions through the nineties, in essence, committed this money to roughly 10% annual returns, on the basis of which these pools made long term (~30 year) commitments. Many of these pools defined “conservative” as XX% in AAA whatever.

    As the central bank appetite for risk-free assets drove interest rates down this money produced a huge demand for higher return AAA assets with long payout terms, i.e. MBS. Supply grew to meet demand.

    My own university is very reticent about their finances, but it looks like they lost 30% of their pension fund and 30% of their endowment. They have less capital and lower rates of return on it. This puts them in a very hard position, because they guarantee salaries and defined-benefit pensions with a horizon of 30 yr on the basis of income from that money. Now they are struggling to meet their commitments.

    The amount of money in such pools is not neglible, and it’s a much likelier source of demand than central banks.

    Sargon TM

  • Posted by Don the libertarian Democrat

    “Most central banks still wanted bond with explicit or implicit government guarantees.”

    You clearly see the importance of implicit and explicit guarantees. How did this relate to US Banks? They did not seek less risk. CDSs and CDOs allow lower capital standards and hence more risk. My understanding is that the Senior tranches allowed the profit on the riskier tranches, and allowed for hefty fees from packaging. What was needed was a AAA rating in order to make more money on the other tranches. It allowed more leverage. The safety that you are claiming people were seeking was a method of lowering capital requirements.

    “a surge in demand for assets that appeared safe but offered the kinds of returns private investors were used to.”

    Maybe I’m missing something, but you seem to be saying that investors were use to, say, 7% returns. When interest rates declined, these investors started getting, say, 3%. So now they start looking for 7% returns. Of course, they could buy riskier bonds which pay what they used to get. Instead, investments are created which appear less risky and pay, say, 7 % , but they’re as risky in fact as the riskier bonds our investors passed up. This is fraud, which I believe it was. You seem to be assuming that the creators of these assets weren’t aware of what they were doing, which looks almost alchemical instead of scientific when you actually look at the risk of these new investments.

    “they had driven among investors a ferocious search for yield – a desire among any investor who wishes to invest in bond-like instruments to gain as much as possible spread above the risk-free rate, to offset at least partially the declining risk-free rate.”

    “… The fundamental macro economic imbalances have thus stimulated demands which have been met by a wave of financial innovation, focused on the origination, packaging, trading and distribution of securitised credit instruments.”

    This makes it sound like an engine. In fact, people were misled into thinking that alchemy was science. My scenario is that the CDSs and CDOs were used to make more money by requiring lower capital standards and hefty packaging fees. You’re saying that the buyers were investors who thought that they were getting a higher yield for free.

    The demand was then for something that didn’t exist, and the investments were sold as something that they weren’t. Again, that’s fraud. There’s no mechanical connection between low interests rates and poor investing. It takes actual people to make these poor decisions.

    Finally, back to the guarantees. The US banks indulged in this behavior, not because they didn’t know it was risky, but that they believed that there was an implicit guarantee by the government to intervene in an economic crisis. The guarantees that foreign banks were seeking with their investments, our banks believed had already been guaranteed by lobbying and collusion and precedent. They were right.

    The search for safe investments can only lead to tragedy when the investments are not in fact safe.

  • Posted by Twofish

    DJC: With his ill-advised blistering attacks on China’s government, Geithner has single-handedly destroyed any prospect of global economic cooperation with the Chinese people.

    I doubt it. The latest rumor is that some junior staffer copied Obama campaign literature into Geithner’s prepared remarks without thinking about it. It was one paragraph in a 240 page Q&A paper.

    If these sorts of random statements start World War III then we are all doomed. Fortunately they don’t, and the US and China have enough channels so that it looks like some storm over nothing.

  • Posted by Ying

    Agree with the principle that globalization needs to be scaled back. Democracy is impossible with a global system. It’s just too large to manage. Brad, you send a clear message to Chinese leaders and business sectors: don’t count on us for your export market and don’t buy our treasuries.

    However, means are subject to study and input from both sides. While US media is pushing their solutions to the imbalances of trade, have they ever considered Chinese leaders’ suggestions to reform the global financial and trade system?

  • Posted by Twofish

    bsetser: perhaps tho we should go back to discussing how CBs shaped demand for synthetic triple AAA …

    They really didn’t. Synthetic credit derivatives are trading at extremely low prices right now, and if any central bank has them, it would have been a blowup by now.

  • Posted by Twofish

    Don: When interest rates declined, these investors started getting, say, 3%. So now they start looking for 7% returns. Of course, they could buy riskier bonds which pay what they used to get. Instead, investments are created which appear less risky and pay, say, 7 % , but they’re as risky in fact as the riskier bonds our investors passed up.

    Actually no. If you look at CDO spreads, you didn’t get 7% for AAA rated bonds. Typically you got about 4% instead of 3% with Treasuries. It’s not so much more that you would say “what’s going on here”

    Also if you were worried about the CDO, you can get the investment bank to guarantee payment of those bonds. If you were really worried, you bought credit insurance on the CDO’s. So when everything fell apart, the banks went under and so the insurance companies that paid credit insurance.

    Finally, CDO’s have worked very well in the commercial bond market. It’s when people started applying the technology to residential mortgages that things really fell apart.

  • Posted by Twofish

    ReformerRay: I favor bankruptcy as the cleanest and best way to wipe the toxic assets off the books. No reason for the Federal government to back them.

    They’ll be mass chaos and riots if they don’t.

    The Federal government doesn’t have any choice. If you wipe out toxic mortgage assets, then most people’s checking accounts become worthless since there aren’t the assets to redeem deposits. Since the Federal government has promised to insure those deposits, it’s going to end up paying pretty hefty amounts of money.

    Right now, it’s a given that the Federal government is going to be paying large sums of money to keep people’s checking accounts from being worthless. The only real question is how.

    The big problem is that you have to fix the system in place. Bankruptcies can take years, and the you just can’t shut down the world’s ATM’s for a week to figure out what to do.

  • Posted by Twofish

    bsetser: A finding of manipulation actually just requires ….. negotiations. No sanctions are specified in the legislation that requires the treasury to issue a report on finding of manipulation.

    This manipulation thing is an example of how something unimportant can become important if people think that it is important. The reason that politicians played up this “currency manipulation” thing was that they could look tough while doing nothing, but this has taken on a life of its own.

    bsetser: I think the Chinese threat to sell treasuries is being a bit over stated.

    I don’t think that there is much of a threat. The funny thing is that the politicians on both sides are behaving more or less rationally. It’s the media circus that is playing things up to be have more confrontation that there really is.

    In any event, if the Chinese sell treasuries that will devalue the currency, and as such it is a curious “threat.” Stop complaining that I’m not devaluing the RMB, or else I’ll get angry and devalue the RMB. Huh?

  • Posted by DJC

    Brad,

    For the record, the Federal Reserve is on the record for being responsible for the suppression of interest rates to below inflation rates. The Federal Reserve’s monetary policy is irresponsible. See below Fed Statement.

    http://www.marketwatch.com/News/Story/fed-prepared-buy-treasuries/story.aspx?guid=%7BA9F7568E-3239-4B2F-A85F-3044349421F8%7D

    The Fed is using all the tools it has available including buying long dated treasuries to break the downward spiral of the economy.

    The Federal Open Market Committee kept its interest rate target in a range of zero to 0.25%, as expected. Rates will need to stay close to zero for “some time,” the statement said.

    The lack of action on interest rates was expected, as was the FOMC’s statement that rates were likely to stay low for a considerable length of time.

    All of the action in the statement was related to the Fed’s continuing efforts to flood the financial system with money.

    The Fed has adopted a “throw the kitchen sink” approach to combating the downturn, which is being fueled in part by weak banks.

    “The Fed stands ready to buy anything that anyone suggests might help. The sky is the limit,” said Mike Englund, chief economist at Action Economics.
    Buying longer-term Treasurys would be a new tool in the Fed’s arsenal to repair financial markets. Some economists worry that buying Treasurys would cause foreign investors to lose their appetite for the securities.

  • Posted by Rien Huizer

    Add a few thousand greedy people in investment banking departments without too much supervision to a mountain of easy, other people’s money and this is what you may get. Some people blame the mountain, others the greedy people and others the lack of supervision.

    I am sure that many people knew that this could lead to big losses (but, of other people’s money, all you may lose is your job or your franchise, well, if you do not play the game at all, you are out anyway) and (1) most of them were to inexperienced to understand it could also hurt them and (2) the end investors (the people financing the conduits, the bank depositors etc) were counting on being bailed out. So far so good.

    I guess that the main blame for the problems should be laid at the doorstep of governments:
    - poor macroeconomic management in the first place (imbalances). And Caballero’s argument that there should have been a lot more good paper available to service all those emerging market saving needs, is of course, nonsensical. That money should not have been saved in the first place. Governments, especially of not so rich countries with young populations should be small and basically balanced. BOP should be in deficit caused by private investment over savings..
    - lax supervision over pension funds. Pension funds should not be able to lower their premiums by gambling. Premiums should be adequate to fulfill obligations assuming only the risk free rate. Higher yielding investments should be fully disclosed and voluntary at the beneficiary/contributor level. The corrolary would be far more expensive pensions and less money available for true private sector risk capital, plain old equity.
    - ignoring the scope for trouble in the shadow banking system, especially the scope for non-regulated bank’s conduits ending up on bank balance sheets. Banks should have been explicitly forbidden to refuse assistance to shadow banks (in which case it would have been very hard to finance these things using commercial paper.

    Everyone with a minimum of financial services knowledge could have seen this coming. No doubt most people in charge of these activities and their regulators preferred to stick their heads in the sand, for fear of losing their short term benefit from keeping this crazy circus going and their private belief that the potential for a global catastrophe did hardly exist

    The trouble is, assuming that these issues will get fixed for a while (perhaps not the macro side, but the rest looks like it will offer totally different opportunities for the greedy (scavenging rather than selling snake oil) so reallocating the available “talent” will take a while.) But again, assuming we will tame finance for a while (a decade perhaps) how will the real economy look in the meantime, without borrowers being used to paying too little and savers expecting too much. What kind of new equilibria would a more correctly pricing financial system allow to exist. If the financial system is the brain of the economy (as several nobel laureates and lesser luminaries have asserted), what we are going to get now is a brain transplant. And the new brain is still underway but it may well have come from a 1930s economy. Plus, it does not look like we are going to get a single big brain that fits the world economy.

  • Posted by Cedric Regula

    Rien:”If the financial system is the brain of the economy (as several nobel laureates and lesser luminaries have asserted), what we are going to get now is a brain transplant. And the new brain is still underway but it may well have come from a 1930s economy. Plus, it does not look like we are going to get a single big brain that fits the world economy.”

    Someday they will make a sci-fi movie about this. But I think it is Ben’s big brain the US gets. He is rapidly transforming the Fed into the Big Bad Bank. And he pays cash for assets even if they are toxic.

    No global big brain. Maybe little IMF & World Bank brains. Everyone wants an independent brain thinking for their country, so CBs will volunteer of course. Eurozone will develop a split personality however.

    So it looks like we will try time travel back to 2002, and do what Keynesians do, same as they did in 2002, except we’ve used up everyone’s credit limit if we still figure that on ability to pay.

    We could have an alternative universe in the movie. One based on Milton Friedman’s later career suggestion that the Fed be abolished and replaced by an computer that added 2% to the money supply every year.

    Or maybe the Keynes universe that listened to Keynes’ later career suggestion that the government pay off debt in good times. Then we could have Germany invade France to get France’s gold and pay off Germany’s debt.

    But we will see how it goes first, then we can see the movie later.

  • Posted by beezer

    Seidman and three ex fed govs were asked, on CNBC by Larry Kudlow tonight, if they favored the bad bank idea. None of them did, unless using the bad bank also wiped out insolvent bank shareholders first.
    The CNBC house economist was on the panel as well (seems like a nice fellow but can’t remember his name), and he did favor the bad bank, even if shareholders were not taken out. Just another confirmation one shouldn’t pay too much attention to economists.

  • Posted by Rien Huizer

    For some reason my tirade (which could have been written for, and discarded by Mr Wen for balming the virtuous savers as well) stated that banks should have been forbidden to refuse financing to conduits. Hmmm, should have been the opposite I guess. Certain types of bank facilities enabled conduits to raise money in the commercial paper market. Disallowing support to own conduits is not enough, because banks have friends and do each other favors.

  • Posted by Ying

    An interesting article about Asia Trap by Steven Roach in 2007

    http://www.morganstanley.com/views/gef/archive/2007/20070529-Tue.html

    Latest comments from Steven Roach(from Bloomberg): Allowing the yuan to strengthen would be “economic suicide” amid an economic slump, Stephen Roach, Morgan Stanley’s Asia Chairman, told a panel in Davos, Switzerland, yesterday. “I’ve never seen an economy in recession voluntarily raise their currency. It’s horrible advice.”

    I think that the timing of exchange rate adjustment and adjustment of trade imbalances are not working for anybody.

  • Posted by ReformerRay

    Twofish says there will be chaos and mass riots if the Federal Government were to declare that they were not going to back the bad assets. The entire banking system would fail, according to him.

    There are banks in my town that have not participated in the party going on in New York.

    Let’s give the bankruptcy idea another test. In my mind the Lehman experiment worked out very well. A considerable amount of toxic assets were eliminated. What other action has eliminated toxic assets?

    My proposal is to announce that AIG and Citi group have received all the money they are going to get from the Federal government. And that all the other firms that are going broke because they are tied to these two firms also will get no help.

    BUT, that a large sum of money has been set aside to be loansed to banks that are still alive after 35% of the existing bank resources have been destroyed.

    If they choose, those in the current administration who have all this money at their disposal could arrange a procedure where a certain % of banks will fail but the rest will be sustained by government help.

    This process means that no bureaucrat will decide which banks fail and which do not. After the market sorts out the first few victims, those that remain will be sustained.

  • Posted by ReformerRay

    Should be “There are banks in my town that have not participated in the greed in New York”.

  • Posted by Don the libertarian Democrat

    Twofish,

    CDOs were used because you could use the senior tranche’s rating to get lower capital requirements for the riskier tranches. That’s how they made more money. They locked up less capital. They also charged for fees and made a bit more more on the risk in the split up into tranches.The benefit and money from them was not made on the safest assets. I understand that is what is being claimed. Many banks kept the safer tranches for themselves, and sold the riskier ones, because that’s where the money was.It was not a flight to safety that led to CDOs. CDOs were used precisely because they lowered capital requirements, which is inherently riskier.The flight to safety occurred in the crisis.

    As to my example, it was simply to show that people wanting the same old returns needed to increase their risk. They could not, in any real world, expect the same old returns for the same risk. My point stands.

    Thanks for the response,

    Don

  • Posted by bsetser

    Sargon — i agree with your point. Rien — i also agree with most of your points.

  • Posted by Cedric Regula

    We should also keep in mind that inflation will kill pension funds. It won’t take much to make real return on fixed income go negative. Then you still get to pay taxes on it, which is very annoying.

    If the ’70s were any indication, inflation was not good for stocks since the DOW was at 600.

    And if somehow the market ever takes back the ability to set interest rates, stocks get pressured to go down when fixed income yields go up(unless there is a very strong bull market).

    On average pension funds need 10% gains to meet obligations.LOL.

    So if all this stimulus gets out of hand and roils markets, or ends up causing inflation either sooner, or later, we can look forward to 80 million impoverished retired baby boomers, because it looks like SS is a goner too, and Medicare will gobble up what’s left.

    Have a nice day.

  • Posted by Indian Investor

    Rien:
    Everyone with a minimum of financial services knowledge could have seen this coming.

    In the absence of too much knowledge I’m evaluating the possibility that stock markets have already bottomed out. As far as the Nifty is concerned, we can tell by the end of this week’s earnings releases. The two considerations are the earnings releases of firms, and the macroeconomic policy announcements. Barring widespread trade protectionism, markets can be expected to recover.

  • Posted by Observer

    Brad, what role if any did restrictions on direct investments of foreign capital have in this crisis? Would great freedom of foreign ownership have resulted in less of a logjam for the Treasuries?

  • Posted by Glutton for Gluts

    Brad,

    Savings glut? Global? Correlation? A good contrarian contribution.

    http://mises.org/story/3203

  • Posted by Glutton for Gluts
  • Posted by locococo

    so it s official now. we ve had gold vs the derivatives in the “safe asset” contest. all you had to do is keep the gold bugs terrified and naked short the treasuries. Another two sets of derivatives for this op. then you get to attract all the pensions and the other cb s to subscribe to the idea that gold is out and derivatives are in and that they should start hedge funding for yields. and now, the financials are currently in the lead.

  • Posted by Twofish

    ReformerRay: There are banks in my town that have not participated in the party going on in New York.

    They did. Indirectly or directly they did. This is why you have to be careful with how you structure the bailout. If you do it wrong, then the people that didn’t know they they were benefiting from bad behavior get hit, and the lesson becomes “if I’m going to get punished for something that I didn’t do, I might as well be hypergreedy the next time.”

    Look at your typical community bank and see what they have their balance sheet in.

    ReformerRay: My proposal is to announce that AIG and Citi group have received all the money they are going to get from the Federal government. And that all the other firms that are going broke because they are tied to these two firms also will get no help

    Which is pretty much everyone in the entire world.

  • Posted by Twofish

    I assume that the comment was reversed:

    Huizer: Banks should have been explicitly forbidden to refuse assistance to shadow banks (in which case it would have been very hard to finance these things using commercial paper.

    The trouble is that the whole reason for investment banks existing is to support the securities market. I don’t think that the solution is forbidden them from doing this sorts of investments. The basic problem was that risk was not well valued here.

    Also people talk about the “shadow banking” industry as if it was some small side light. In fact most capital allocation in the United States takes place through the securities market, and the “non-shadow” bank sector is smaller than the “shadow banking” sector. So the tail is larger than the dog.

  • Posted by Phillip Huggan

    IDK the motives of Central Bank secrecy. Maybe preserves sovereign power, maybe allows some strategic investing activities. *If* transparency decreases odds of financial crisis, can’t the WB/IMF/BIS/illuminati just give discounts to open CBs and penalties to secretive ones?

    Your analysis of low Chinese currency stimulating savings instead of spending on imports is good. But China might not be looking at it from that point of view. Developing economies (SK) have functioned best by initially protecting their new industries while those (South America) that free traded and followed IMF reforms lost their social nets, new industries and a generation. China was/is probably keeping Yuan low to develop a manufacturing base. 2/3 of the country is still 3rd world.

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