How a US financial crises rebounded to benefit the dollar: three pictures
How exactly can a financial crisis that started in the US — and that has hit the US hard — be good for the dollar?
Part of it is that other countries are now in worse shape that the US; what started as a US crisis turned into a global crisis. Part of it is that a fall in the price of oil is good for the US (lower oil import bill) and seemingly good for the dollar. And part of it is that — judging from the TIC data — Americans are selling their foreign investments in “risky” assets faster than foreigners are selling their investments in risky US assets.
The huge surge in demand for t-bills from central banks and private investors alike hasn’t hurt either.
The evidence? To start, there is no real sign that private demand for US corporate bonds has picked up. There was a blip up in the December TIC data. But a rolling 3m sum — a measure that smooths out a bit of the monthly volatility — suggests that overall demand for US corporate bonds remains subdued.
Moreover, what matters for the dollar is foreign demand for US assets relative to US demand for foreign assets. Foreign demand for US corporate bonds and equities remains very weak. Foreigners aren’t therefore providing the flows needed to sustain the dollar (and the US current account deficit) by buying risky US assets. But that doesn’t matter so long as Americans are selling their foreign portfolio. Over the last three months of data (October to December) net sales have generated a flow of close to $100 billion dollars.
And then there is global demand for treasury bills. That soared in the crisis. Call it a dollar shortage among private investors. Or call it a flight by central banks away from anything that hints of credit risk, as Agency sales offset some of the surge in central bank purchases of Treasury bills. But the graph still speaks for itself.
The real question is how long this pattern can persist. The last TIC data point comes from December — and we are now in March, so the pattern could have changed over the past couple of months. The dollar’s ongoing strength though suggests that there is an underlying supporting flow, and the market’s ongoing distress suggest it hasn’t come from a surge in foreign demand for risky US assets. Setting aside ongoing demand for Treasuries from central banks (the Fed’s custodial holdings have continued to rise) and dollar liquidity-starved investors globally, my guess is that global capital flows are still contracting. They just seem to be contracting in a dollar positive way …
The strength of the dollar also has to do with the perceived strength of our political system and government structure, something no living American has much to do with. Governments that collapse don’t pay interest on their debts.
Brad, while I understand your interest in analyzing published financial data, I think it’s important to realize two crucial points: (a) looking back in the rear-view mirror doesn’t help one navigate going forward; and (b) it’s the unpublished information (to keep with the analogy, the blind corner) that holds all the dangerous secrets.
Who cares if the respective citizens & governments of the world each repatriate foreign reserves and end up holding their own currencies? And that the US happens to have more?
The essential question is: what is the value of these monetary assets in comparison to the real value of the liabilities? Most of which still are unknown and/or unpublished? I’m of course referring to L3, CDO, CDS, etc.
The bottom line is that it doesn’t matter if the US has a net inflow of $1, 2, 3T – it’s dwarfed by the magnitude of very real losses in asset values which are, in the end, tied to nothing other than hope and the reliance on the good faith & credit of productive citizens and the ability of the US to use the power of the state & force of law to extract its tribute from taxpayers.
All of your models are absolutely dependent on stasis; none consider dynamic events. I guess that’s reserved for the DoD.
“Part of it is that other countries are now in worse shape that the US..”
When the US economy fares better than its trading partners, the dollar DECLINES, as US import demand outpaces demand for US exports. Strength in the dollar can be more accurately attributed to worsening US economic conditions relative to trading partners as trade deficits have decreased.
As for oil, the dollar is its trading currency, so your argument is flawed on this point as well. The dollar strength is best explained by my point above, your observations on the capital and financial account & Treasuries, and perhaps even some currency interventions (which I do not have documented) among trading partners to deal with their declining trade surpluses.
Strong dollar is due to deleveraging…
It´s actually horrible for U.S. exports…
and
is to some degree *artificial, there will be a huge reversal at some point when investors flee tbills.
A bit off topic.
One big question i have is this:
The world, and my interpration from reading articles posted on CFR.org is that we want a green revolution and our world should do more to reduce the hazards of global warming.
BUT…
The U.S. has a strong interest in increasing consumption by the domestic population of China.
How can a pro-green USA advocate increased consumption in China, when China is in all liklihood the world´s largest Polluter?
I traveled to China and was saddened and a bit outraged by the way large corporations treat the climate. I find it hard to believe that anyone should advocate increased domestic Chinese consumption under these standards.
Until China promotes more $$$ to greener solutions I encourage Chinese SAVINGS.
I would also encourage the Council to consider this prognosis. It may take time to unwind global imbalances, but China increasing domestic consumption under horrendous environmental standards would be DETRIMENTAL to the world long term.
Thank you.
When I look at your chart of foreign t-bill purchases and contemplate the massive tilt of global portfolios toward these assets, I can’t help but think again of my “reverse tsunami” metaphor of last October.
There’s one thing I’ve been wondering concerning the US balance of payments:
The US is a significant net debtor, yet its net investment income has been consistently positive (i.e. US investors earned a bit more on their investments abroad than foreigners earned on their US investments) year after year.
Part of the reason seems to be that foreigners like to invest in US bonds, whereas Americans like to invest in foreign stocks and direct equity investments. That worked well in the past, because equity returns were higher than bond returns.
Unfortuntely, stock prices and equity returns are getting clobbered like never before. I’m wondering if this could significantly affect the US balance of payments going forward:
US investors owned 8.5 tr $ in foreign equity as of 12/07. That equals 70 % of US GDP. If the annual investment return on those investments goes from 10 % to 0 %, the negative effect on the balance of payments would be a massive 7 % of GDP.
Foreigners also owned 5 tr $ in US equities, so I guess there would be a counterbalancing effect of roughly 4 % of GDP.
Still, the overall negative effect would be substantial. That wouldn’t be good for the balance of payment, and therefore for the dollar, I suppose.
Just wanted to share some information that might be useful from the perspective of US dollar versus ASEAN currencies. The ASEAN plus 3 group of countries agreed on March 01 to increase their multilateral currency swap pact size to $120 billion from $80 billion. The $120 billion is meant to help stabilize their currencies, and this supplements existing bilateral arrangements that are conditional on adherence to IMF programs.
I got the link to the Reuters article from Mr David Goldman’s blog page.
http://uk.reuters.com/article/companyNewsMolt/idUKTRE5200TE20090301?pageNumber=1&virtualBrandChannel=0
Thomas:”US investors owned 8.5 tr $ in foreign equity as of 12/07.”
I’m curious as to what is your data source for this figure. Is it buried somewhere in the Flow of Funds report?
Obviously NET financial flows(be sure to add equities and bonds together, and don’t forget the principal) have a major impact on currencies. Milton Friedman even went thru all the trouble of doing a formal study to prove it.
So I’m trying to get my hands on the most current sources there are for data like this.
Thomas, Peter, confused, Andy, Duke and purple – six commentators seem to be disagreeing broadly with the analysis above,though they may be agreeing with some points.
In my case I partially agree.There’s a credit crunch on, so there’s no demand for US commercial paper as of Dec 2008 data. But the credit crunch also creates a need to recover dollar loans from foreign banks; and to liquidate foreign equities.
China’s demand for US Treasuries has also been high.
But looking forward, the above factors don’t seem to be strong enough to keep the dollar strong. Especially, a fall off in China’s demand for Trasuries can mean a balance of payments crisis for the US, even if Treasuries can be locally financed.
Interesting analysis and comments.
The US has some advantages other countries do not have. The three major ones (not in order of importance) are: (1) Perceived as strong militarily, stable politically, and with a disciplined work force. (2) Rich in natural resources. (3) The principal geopolitical force.
So, when the current account deficit is closing, the “natural” tendency is for dollar to rise. Now, we experience a significant drop in the trade deficit. In my opinion, this is what is driving driving the dollar up.
It is also useful to look at the “competition”. Europe’s locomotive, Germany, depends a lot on exports and is feeling the pain. If this crisis lasts, it is true that several European states may have trouble making payments (Iceland, Latvia, Ukraine, Hungary, Ireland, Greece, and who knows who else). But, then, if this crisis lasts much longer, I predict that Germany will be in trouble as well. Let us not forget that Germany’s GDP is high because it manufactures and exports expensive gismos. Well, when a $70,000 BMW is not sold, that is quite a hit on Germany’s GDP. In conclusion, it is silly to think that Germany will be able to bail out others in Europe. I suspect the EU is looking for ways to make the euro drop.
You did not mention the carry trade. The Dollar was not as big a funding currency as the Yen or Swiss Franc, but there was a lot of borrowing abroad in “cheap” Dollar loans to invest in either Dollar assets (RMBS) or foreign currency assets. Now that the carry trade is unwinding, the funding currencies are all becoming strong relative to the high rate borrowing currencies.
Note the Dollar was considered cheap even when the interest rate was the slightly higher than the rate for Euro investments because everyone knew that the Dollar could only decline in value. (House prices can only go up.)
One new consequence of dollar hegemony, petrodollars, eurodollars, reserve currency, or whatever name you want to use for it, is there was a lot of foreign bank commercial and business lending in dollars. So when we got the credit crunch, that apparently caused a lot of debtor demand for dollars in order to settle creditor demand for loan repayment(rather than rolling them over) in dollars. At least that’s the take I got from news reports eventually.
I was a little slow on the uptake of that dynamic helping the dollar, because I didn’t really believe the US could still be regarded as the “safe haven” for financial flows when it was clearly the epicenter of a financial meltdown. But the euro peaked and headed down thru the last 3Q’s of 2008, long before negative news of the euro economy and banking became apparent.
But I guess the amount of financial leverage used in the purchase of foreign equities was another factor I didn’t fully grasp at the the time. So similar deleveraging was going on there.
One thing I started wondering recently is whether the Chinese accept payment in dollars for exports to countries other than the US. Recently I hear they want to set up RMB as an ASEAN plus 3 currency. But if OECD countries are all paying for Chinese imports with dollars, then the Chinese have really been recycling the entire OECD trade deficit back to the US, exclusive of their oil bill.
I would be interesting in knowing the answer to that question, if anyone here knows. Don’t know what difference it makes really, but it may when trying to read the tea leaves going forward.
Cedric: One thing I started wondering recently is whether the Chinese accept payment in dollars for exports to countries other than the US.
Yes.
Here’s a bit of advice to Brad & commenters: step away from the reports and take a walk around the block to give yourself enough time to consider the core foundation of economics as expressed in accounting 101: assets = liabilities + equity.
All of this discussion regarding Treasury flows, dollar values, foreign reserves, net equity holdings, etc are dwarfed, dwarfed, by the potential exposure of tremendously over-leveraged financial institutions holding illusory pieces of paper classified as “assets”.
This debt deflation cycle is based on the credit expansion of the private economy. It’s the dog wagging the government’s tail, not the other way around.
There simply are not enough funds available to issue new Ts to cover a $1-2T shortfall in the FDIC, as well as make good (HRC’s trip to China) the $1-2T equity/bond holder losses in case of bank defaults.
Focus on L3 assets, CDOs and the CDS market. This is where the action is and what will determine the future viability of not just commercial banking, but national governments as well.
brad, even warren buffet can be blindsided by a black swan -
dave chiang, at one time a daily poster to this site, said repeatedly that the fiat dollar was useless ‘toilet paper.’ i now see that the chinese rookie capitalists are now exchanging this ‘toilet paper’ for oil contracts, and for commodity investments, which may yet prove to be expensive, but are a lot cheaper than they were a little while back.
so are oil contracts and australian mines useless, too ?
nice to be ‘flush’ when everyone else is skint !
the japanese – who have few natural resources on their islands – must now sit and watch china, or follow suit.
between them they seem to have bernanke over a barrel ? if those bernanke helicopters flew – the bond market could head south faster than inflation could be generated. meanwhile might not the treasury shop have to reduce its prices to match the rival stores who stock real stuff like oil ?
i suggest (1) that the chinese policy, which is wise, will put a floor in the oil price and in certain commodities. the asians will be motivated to invest on any weaknesses in the market – (like when oil falls below $40/barrel ?)
and i suggest (2) that treasury market volatility and fragility is increased under global zirp tendencies. look at it this way : if the yield is approaching zero – the value lies 100% in the prospect of capital gain – (remember the condo flippers ?) – or loss, or preservation. thus when the treasuries are going up – they are going up. when they are going down they are going down. some elevators are also programmed that way . .
so however trivial the trigger, self reinforcing feedback loops can come into play. positive floops / negative floops.
that suggests a spike. show me any graph climbing vertically and give me a little time, and i will show you a graph falling like its evil twin.
how high the spike goes ? i am not clever enough to help with that.
but dave chiang was right in one thing – no one actually wants fiat currency. it is not a commodity, only a measure of how much you can get of something that you do really want, if you do the deal today.
@ duke
first the arab (iran) states are going to default.
then the actors will swindle the treasury and u.s. gov’t to donate trillions into a black hole.
eventually the u.s. govt balance sheet will be checked and foreign interests will realize the u.s. as a whole is insolvent, unable to pay back it’s outstanding loans.
it’s genius if you think about it. get rid of evil players in the middle east, force them into diplomacy through economic hardship (oil won’t cross 55 level) and then default the cancer (bretton woods/dollar global reserve) to create a new international system.
see the u.s. govt will continue to borrow trillions because alot of insurance companies and financial institutions 8+trillion (my estimate) of a black hole…they think they’re reducing systemic risk in the banking system, but really these policy makers are only creating systemic risk on a national level.
Within 60 days i promise (by my opinion) the banks will be back for more $$$$ and AIG will need even more $$$$, then you have players like Prudential, Metlife, GM, GE, and Hartford financial…take a look at L3 assets here.
black hole is so large that the U.S. balance sheet could be -25 Trillion by the end game.
Of course a default on debt, or AAA grading won’t come over night. +/- 5 years, but people should prepare.
As Jack Welch once said, as “GE goes, goes the U.S. economy”.
Remember that phrase.
This is in response to the off-topic of “confused”:
while Chinese industries are terrible to the environment, your conclusion of Chinese people shouldn’t therefore consume more is simply bizzard. You do know that US consumes something like 20% of the world energy with only about 5% of world population?
Brad,
Great post! I significantly increased my understanding of the dynamics of the situation. Thanks!
gillies
Jim Rogers recently said he sold off all his stocks around the world, except for a handful of Chinese companies, and that the only thing he would consider buying at this point are the soft commodities in the food group.
It’s obviously not a good idea to buy industrial metals right now with global industry having no demand. Been looking at some mining companies lately and true to economic theory they did go thru big capital expenditure programs during the boom years, but now low prices are causing free cash flow to disappear. The Chinese have been buyers for strategic reasons, but I think it’s balance sheet repair, tho more useful than what our government has been doing. So I’ve decided to wait a while on that, then follow the Chinese around eventually. Also Toshiba just put $240 million into Canada’s Uranium One uranium miner.
Oil is a bit tougher to figure out. It’s very possible $35 is a floor. But here SWFs and governments have a big advantage over retail investors. They can make big deals at wholesale and also get needed assurances from oil producer governments that take a lot of investment risk out(like ask Chavaz if he likes Chinese better than Americans). The Chinese can also strategically pour oil shipments into a hole in the ground whereas retail investors cannot do that with their OIL ETF.
On the other hand Americans may eventually find out everyone is in a 60% tax bracket, or alternatively our money is no good, and we will all be riding Chinese bicycles. This would have a dramatic impact on oil demand.
i didn’t explicitly mention carry related unwinds, but some of the sale of foreign assets by US investors can be interpreted as an unwind of bets v the (low carry dollar) as well as a general unwind of leveraged bet. my sense is that this explains the $’s strength in the fall better than it explains the $’s current strength. the recent $ rally v the yen for example isn’t driven by a carry unwind.
My feeling is the carry trade is too risky right now when the carry target is only paying 3%. You have a low cost of funds available,for a considerable period of time, or whatever the words Bernanke is using to signal it, but with at least $3T of new sovereign supply coming this year between the US and Europe, the carry will just amplify losses from rising interest rates.
The disappearance of Japan’s trade surplus probably marked the peak of the rise in the yen, then my bet is that expectation sets off flows from Japan savings to the US, tho it is probably not leveraged.
duke: There simply are not enough funds available to issue new Ts to cover a $1-2T shortfall in the FDIC, as well as make good (HRC’s trip to China) the $1-2T equity/bond holder losses in case of bank defaults.
I think there are. Anyway if their aren’t, we just do a Japan. Close your eyes and make believe that assets are worth someone. It works. There is a price however.
duke: Focus on L3 assets, CDOs and the CDS market. This is where the action is and what will determine the future viability of not just commercial banking, but national governments as well.
No. That’s not where the action is. That’s where the problem started but that’s not where the problem is.
The problem is in your garden variety standard loans. Car loans, credit cards, prime mortgages, commercial real estate.
What happens is pretty simple. When people lose their jobs, they can’t pay their loans. When people can’t pay their loans, banks can’t lend. When banks can’t lend, people lose their jobs.
The big problems aren’t the CDO, CDS, stuff. The big problems are all of those “for rent”, “for sale” signs that are popping up all over the place.
Thanks, Brad for following the dollar and Treasury flows, as that pointy spike in foreign T-Bill purchases looks frighteningly familiar about the time the lid is blowing off planned Treasury sales.
I wish I could believe that the domestic financial unwinding will settle down soon and the US government will not have to borrow/print vastly more to implement the “save the economy by filling the financial black hole with liquidity” policy.
Here’s why: Banks’ total assets as of December 31, 2008 were over $13.853 trillion, with total industry equity capital of $1.302 trillion. But bank notional derivatives exposures as of December 31, 2008 were $201 trillion, sitting on top of another $7.166 trillion in commitments to lend, $2.028 trillion in securitized assets, and $1.005 trillion in standby letters of credit and foreign office guarantees, for a total exposure of $225.149 trillion, or a leverage ratio of about 173:1 on total industry capital.
It’s true that the government’s largess primarily goes to large banks. Looking only at the 86 U.S. banks with assets larger than $10 billion, there are still notional derivatives exposures as of December 31, 2008 of $201 trillion, sitting on top of another $5.570 trillion in commitments to lend, $1.991 trillion in securitized assets, and $0.950 trillion in standby letters of credit and foreign office guarantees, for a total exposure of $219.418 trillion, or a leverage ratio of more than 241:1 on large-bank capital of $909 billion.
There’s a long, long way to go to unwind this leverage while pouring borrowed/printed dollars into the banks (and insurance hedge funds like AIG) to try to keep them alive during the unwind. It’s not primarily international trade or fiscal deficit to fight recession that threatens to undermine the value of the dollar, it’s the enormity of the quantity of dollars that will be required to “save” the insolvent financial industry.
Cedric: But here SWFs and governments have a big advantage over retail investors. They can make big deals at wholesale and also get needed assurances from oil producer governments that take a lot of investment risk out(like ask Chavaz if he likes Chinese better than Americans).
No they can’t. SWF’s don’t have any more leverage as far as commodities go than any of the big banks. Also, Chavez may like China more than America, but if America comes with cash, he’ll sell to America. If he sells oil to China at a discount, all China will do (and they have done this) is to resell the oil to the United States and book a profit.
Micheal
Where do you find these aggregate numbers on the banking system? I’m turning into a data junkie and am trying to find the sources.
One thing, it is technically incorrect to think of the notational value all derivatives as credit or leverage. The example I’m thinking of is the %43T(notational) of mortgage CDS written against a total mortgage market of $11T. The way I understand it is these were written against both sides of a mortgage, short and long, and should “collapse” to an amount something like the loss they are covering in the event of a credit event.
The thing that has been bothering me is the mechanics don’t work that cleanly in the real world where this involves settlement between multiple parties spread among FIRE and anyone else that bought them. So if one counterparty in the chain breaks and that happens on a large scale, then we do get “contagion” on other parties for no good reason and the house of cards falls down.
So that’s why I’ve been thinking someone should step in these cases and just disappear the stuff (CDS Holiday???) before it becomes bigger than life.
But as usual, I may not totally understand the situation.
Brad-
Your posts are awesome. Your charts are awesome. Your insights are priceless. Don’t listen to all these losers posting nasty messages from the apartments they rent in their mothers’ basements.
That said, could someone explain to me what “official” purchases of corporate bonds are? Does that just mean government purchases?
Thanks.
Josh F”That said, could someone explain to me what “official” purchases of corporate bonds are? Does that just mean government purchases?”
Indian Investor just called me collect from his mom’s phone (since he can’t post here anymore), and says that is in fact what it means.
First item – I agree with Josh F
Second Item – You have written frequently about the discrepancies in incomes from foreign investments in the USA and American investments abroad. Somehow we were able to earn more income with far less investment capital. My theory is that this was primarily due to leverage and that once the current deleveraging process plays out, incomes from our investments overseas will be significantly less than payments on foreign investments in the US. This will put pressure on the dollar’s devaluation.
Perhaps you could research this area and determine orders of magnitude?
confused,
You’re right that there is an apparent disconnect between loving the environment and loving Chinese consumers. But, sometimes the surface impressions don’t tell the whole story.
Did you ride a city bus to a Chinese restaurant when you were over here? Calculating the amount of land, water and other inputs (and the environmental impact) required for the Chinese diet vis-à-vis the US diet shows that there is a lot America can learn from China. Next, look at the environmental cost of moving people around. That Chinese bus carried 50% more people than it was intended to carry, which is both unsafe and highly efficient.
As for “the way large corporations treat the climate,” that is the case with most of the developing world’s former state-run enterprises. Sad, but true.
.
Cedric Regula,
The US dollar is the currency of choice for global trade. “The Chinese” – by which I assume you mean the 40% of China’s exports coming from factories owned by Chinese citizens – prefer US dollars for all trade transactions, since it reduces the cost of doing business.
So do many foreigners exporting from China, although a bit less so with the Europeans.
@Cedric: I can still post here, but so many comments have been deleted I’m not motivated anymore. You’re right, official purchases intends to account only sovereign purchases.
Brad: the recent $ rally v the yen for example isn’t driven by a carry unwind.
Me: I thought borrowing against US Treasury securities was one of the critical intermediate steps you discussed with Andrew Rozanov in 2007 while describing the yen carry trade mechanics. The yen rally’s has been explained as unwinding of the yen carry, and that had a dollar borrowing as an intermediate step before it got invested in EM bonds/equities. Therefore.
DOR
Yes, well, anyone using the Chinese banking system for deposit of trade dollars. The surplus is what the PBoC eventually has to deal with, and so far it purchases treasuries with them. So I was mainly wondering if a piece of China’s trade with the entire world ultimately ends up as treasury purchases.
I know there are many different actors in the trade world. Many Chinese nationals in export actually reside on this side on the pond. The upscale city of Irvine in S. Cal has quite a few of them.
Then multinationals further muddy the picture. They could have local banking accounts or subsidiaries. US corporate tax policy has made it advantageous to keep foreign cash overseas, tho I have no idea how that game is played in China.
there are lots of ways to put on a carry trade, but the fundamentals are simple — borrow a currency with low interest rates (USD, JPY), sell that currency and then buy a currency with high interest rates. in practice, this can be done in more complex ways, but that is the basic dynamic. when you unwind the trade, you do the opposite — sell the high yielding currency to buy the low yielding currency.
josh f — official purchases is the BoP line item for purchases by central banks and sov. funds.
Josh F, I typically live on the family beds. Basements are too dark and cold.
On the carry trade, the more I think about it, the more I think that Japanese institutional investors, banks and brokerages, may decide the risk/reward ratio may be still pretty good.
Japan has a large pool of private savings in the hands of retail investors, dubbed by the caricature “Mrs. Watanabe”. In their case I think they will probably just decide with a weakening yen and zirp it’s a good time to buy long term treasuries. But they don’t use leverage.
In the case of professional and active traders, the yen has another 10%-15% fall to go yet just to get to normal. So they may employ leverage since the potential currency gain would more than offset rising interest rates on treasuries. Especially if they believe the Fed will move to buy treasuries to cap interest rate increases.
But they keep a trigger finger on the keyboard, so this does little to stabilize debt cost for the USG in the long term.
The weakness in the Yen could be signalling an end to the Yen carry trade unwind. If that’s the case, you would expect a collapse in the Yen to a level where their exports = imports. Not sure what that is, but someone on the blog may be able to assist.
red — that kind of depends on oil/commodity prices, and global demand for cars ..
Yen and USD-funded carry trades will be put on massively once the credit crunch eases. I’m not sure what level the yen and USD exchange rates will settle down at.
As the RMB gets acceptance as a reserve currency, Russia, Germany, France, Iran, Venezuela all continue to shift their forex reserves composition to a combination of RMB, JPY, Russian roubles, EUR, etc. The USD will draw strength mainly from its RMB peg.
The US still has a perhaps 4-5 years available to deal with an emerging balance of payments crisis. That period, according to Obama’s plan is to be used to reduce dependence on imported oil, and build a more skilled workforce that can provide better export performance in a weaker dollar world. These two can actually be expected to mitigate the effects of an emerging external finance solvency crisis for the US.
In between there are old-style trade protectionists in the guise of current account imbalance theorists calling for an immediate disruption to the external financing flow to the US. If this goes through, the US will definitely face a sovereign default before the end of this year or the middle of next year.
This paper sheds a much better light on the issue:
It’s the banks…
http://www.bis.org/publ/qtrpdf/r_qt0903f.pdf?noframes=1
… The current financial crisis has highlighted just how little is known about the structure of banks’ international balance sheets and their interconnectedness. During the crisis, many banks reportedly faced severe US dollar funding shortages, prompting central banks around the world to adopt unprecedented policy measures to supply them with funds. How could a US dollar shortage develop so quickly after dollar liquidity had been viewed as plentiful? Which banking systems were most affected? And how have funding pressures affected lending to non-bank end users of funds? …
The dollar’s ongoing strength though suggests that there is an underlying supporting flow of upcoming…
credit events.
Cedric Regula,
Every single company of any size I’ve encountered doing business away from its home country has a local bank account. Where available, they would also have local working capital loans and in some (few) cases, capital investment loans. Of course, that “local” bank account may be with HSBC.
Maybe I missed it somewhere in the story or in the comments, but I do believe there is still only one world currency at the moment. The one that’s responsible for 65% of all trades around the world. The one that allows Brazil to buy Copper from Chile. The one that allows Belgium to buy palm oil from Malaysia.
1. The world economic system is as dependent on a ONE world currency as a heroin addict is dependent on one drug.
2. Currently, there are zero pretenders to that throne.
3. It is incumbent on ALL world players to ensure that their “fix” stays potent lest chaos wins the day.
4. At this rate, the closest pretender is the renminbi and it is about 18 months to two years away still.
5. Enjoy the ride while it still goes through the new world. I understand that withdrawals can be a real beatch.
Brad,
Could you provide your comments on what could happen when the demand in Treasuries dissipates ? Clearly, at some point in the future it will. What are some of the possible ramifications ?
Indian: As the RMB gets acceptance as a reserve currency, Russia, Germany, France, Iran, Venezuela all continue to shift their forex reserves composition to a combination of RMB, JPY, Russian roubles, EUR, etc.
It’s going to take decades for the RMB to be a reserve currency. Part of the issue is that right now, it’s pretty clear that the Chinese government doesn’t want the RMB to be a reserve currency and this is unlikely to change any time soon.
If you want something to be a reserve currency, you have to remove capital controls, and the financial crisis has likely made the Chinese government even less likely to do that than before.
Cedric: The example I’m thinking of is the %43T(notational) of mortgage CDS written against a total mortgage market of $11T. The way I understand it is these were written against both sides of a mortgage, short and long, and should “collapse” to an amount something like the loss they are covering in the event of a credit event.
Notional values are meaningless. The way that the contracts are written, I pay you $1000 each money and you pay back $1000 +/- some relatively small amount. It’s a bookkeeping artifact, nothing else.
Now you might ask what happens if I can’t pay you $1000, and the answer is that the contracts are written so that if you don’t pay me $1000, I don’t owe you $1000 +/- some small amount.
Some of the dollar weakness is due to a reversal of trade hedges. Exporters to the U.S. predicted a certain amount of business over the next few years, hedged it, and now find themselves having to unwind their hedges now that half or more of the business has evaporated.
RE — I too was impressed by the BIS paper.
Mike Hudachek — Best case scenario is that the waning demand for treasuries reflects revived demand for high quality credit (or even less than high quality credit), which in a broad sense allows the banks to repay the Fed — and that in turn allows the Fed to restock its supply of Treasuries without expanding the monetary base. Remember the Fed was a large net seller of Treasuries in 08. it could become a net buyer.
Worst case is that there is a fall in demand for treasuries not generated by a rise in demand for other US assets, and that fall in turn pushes up a host of US rates — including mortgages — and adds to the distress we are in.
2fish:”Cedric: The example I’m thinking of is the %43T(notational) of mortgage CDS written against a total mortgage market of $11T. The way I understand it is these were written against both sides of a mortgage, short and long, and should “collapse” to an amount something like the loss they are covering in the event of a credit event.
Notional values are meaningless. The way that the contracts are written, I pay you $1000 each money and you pay back $1000 +/- some relatively small amount. It’s a bookkeeping artifact, nothing else.
Now you might ask what happens if I can’t pay you $1000, and the answer is that the contracts are written so that if you don’t pay me $1000, I don’t owe you $1000 +/- some small amount.”
My original post:
One thing, it is technically incorrect to think of the notational value all derivatives as credit or leverage. The example I’m thinking of is the %43T(notational) of mortgage CDS written against a total mortgage market of $11T. The way I understand it is these were written against both sides of a mortgage, short and long, and should “collapse” to an amount something like the loss they are covering in the event of a credit event.
The thing that has been bothering me is the mechanics don’t work that cleanly in the real world where this involves settlement between multiple parties spread among FIRE and anyone else that bought them. So if one counterparty in the chain breaks and that happens on a large scale, then we do get “contagion” on other parties for no good reason and the house of cards falls down.
So that’s why I’ve been thinking someone should step in these cases and just disappear the stuff (CDS Holiday???) before it becomes bigger than life.
I don’t know what a mortgage CDS is. Mortgage CDO, I know but that is something different.
Cedric: So if one counterparty in the chain breaks and that happens on a large scale, then we do get “contagion” on other parties for no good reason and the house of cards falls down.
Which very nearly happened. Now you should see that why the government has pumped $130+ billion into AIG. European banks were and are using AIG CDS to back their deposits. Once the CDS gets tripped, then AIG must pay large amounts of cash, and CDS holders can seize AIG’s other assets.
Cedric: So that’s why I’ve been thinking someone should step in these cases and just disappear the stuff (CDS Holiday???) before it becomes bigger than life.
Too late. Frankenstein is already awake.
We already stepped on that landmine and it’s cost the Fed $130 billion and counting. The good news is that we’ve already stepped on the landmine, it’s gone off so right now we are trying to repair the bloody mess.
The truly nasty problem is that you are trying to unscramble the egg, and everything is interconnected with everything else, and in order to defuse the bomb, you have to start breaking the connections.
Right now with AIG, what they are trying to do is to separate out the hopeless bad stuff from the stuff that is either essential or worth saving, and it is a total mess. Well…. At least it is good practice for when we have to do it with the big banks…..
Also notional values have gone down considerably. Last I checked they were at $30 trillion and falling. CDS’s are only five year contracts so as they expire, people aren’t writing nearly as many new ones.
I’m not too worried about CDS’s and derivatives right now, it’s straight loans and unemployment (both in general and personally) that scares me.
Brad:
On the demand for treasuries.
Here are the Ts&Cs for the TALF program. Looks like the Fed is headed further towards becoming a pawn shop. They are taking AAA rated ABS as collateral(AAA rated consumer loans in a recession..hahaha, another funny thought). Looks like it has some things that make it unattractive for rampant abuse, like haircuts and compensation guidelines. But there is no requirement that participating institutions use the cash for making new loans. So it sounds like TALF is the way the Fed spells TARP.
But anyway, I see a big challenge for someone that likes analyzing the Fed balance sheet. We could see mysterious happenings where low quality assets are on the rise, and simultaneously high quality treasuries appear too in order to fund the fiscal deficit. Then we can watch how much the US national debt ticks up, and also how much the Fed balance sheet grows. Kind of like having two governments instead of just one. Cool Dude!
However I am warming up to the idea that the Fed monetizing everything may be the best case scenario. I just like to have a handle on how much.
Also I did remember one thing from econ 101. Whenever it does come time to drain liquidity to head off inflation, the Fed could raise bank reserve requirements. This would still work, tho I think they’ve broken all their usual tools they use to do this. The question will just be whether they want to or not.
http://www.federalreserve.gov/newsevents/press/monetary/monetary20081125a1.pdf
@ twofish
You won’t here Obama say it but:
“If AIG fails on the payment of these obligations, it is quite possible that EVERY MAJOR BANK IN THE WORLD WOULD BE INSOLVENT.
so option 2:
For how long will the AIG bailouts continue? They will likely continue until the US Dollar is reduced to toilet paper. If the bailouts were to come to a halt, the consequence would likely be a global systemic bank run unlike the world has ever seen.
*We will have a slow, continual dollar death rather than an overnight collapse.”
How a US financial crises rebounded to benefit the dollar: three pictu…
The USA is being hit by the worst financial crisis in years, and yet the dollar is performing well. How can this happen? This article explains why….
While the dollar may benefit in the short term from the financial crisis, I fear that in the long run the US and UK are going to pay for their present policies. I cannot see either country being able to avoid at least rolling over existing debt, if not increasing the stock of their debt further still, and then the market will demand an insurance premium for their record of abusing their creditors, as my comparison of twentieth century dollar and sterling total returns suggested. As Mrs Thatcher used to say, “you can’t buck the market”.
Finally finished reading the BIS paper posted by RE.
It went a long way towards sharpening up my vague notion of what was happening out there, but my head is still spinning and it didn’t improve my mood much.
But my gut feel is that the world is never going to get the hang of highly leveraged global fractional banking and maturity transformation, all based on a mix of more or less floating currencies.
Then the paper didn’t even touch on the impact of securitization, it’s role in hiding credit risk, and selling insurance with inadequate backing of reserves in order to make everyone feel good about their securitized assets.
Predictor: If AIG fails on the payment of these obligations, it is quite possible that EVERY MAJOR BANK IN THE WORLD WOULD BE INSOLVENT.
Yes you’d get a massive domino effect. No one knows where it will lead, and no one is particularly interested in finding out. The trouble is that once one bank goes under, the CDS blows up, causing a nasty chain reaction.
Predictor: For how long will the AIG bailouts continue?
At some point you’ve paid down all of the CDS’s, so there isn’t a problem any more. I don’t think that AIG is the big problem right now. The big story is the huge and increasing mortgage default rates.
When you fire a machine gun at someone, it’s kind of pointless to try to figure out exactly which bullet killed the target. AIG is only one bullet that is hitting the banks. There are a lot of others.
Predictor: They will likely continue until the US Dollar is reduced to toilet paper.
Unlikely. AIG is only a trillion dollar company. If the US had to wipe out AIG, and pay all its liabilities, it could do that. AIG is a big problem, but it isn’t the biggest problem right now.
Predictor: If the bailouts were to come to a halt, the consequence would likely be a global systemic bank run unlike the world has ever seen.
Maybe. Maybe not. Right now, I really don’t care to find out. In any event the AIG story is about half over. Things have blown up, they are in the process of getting fixed, and there people have a plan for what to do with AIG.
The hard part is that what has been done with AIG is now going to have to be done with a lot of other institutions.
We are long past the point of “bail out”. It’s an expensive toxic waste clean up, and we only just started….
Rebel
Read your blog. I think we should be worried. We had our problems in the ’70s too, then Volker fixed them with 20% interest rates. I had a 12% mortgage in ‘81 that I couldn’t re-finance until rates finally dropped to 9% in 1990. Creditors have a long memory.
Just found out Britain only has a short life left to live. Do you think Paul McCartney will move back to the states?
“On Monday, if you accept the OECD’s figures, Britain’s public debt was 42% of GDP, or about 600 million pounds. Today, Britain’s public debt is about 142% of GDP, or about 2 trillion pounds. In one week, Britain’s debt has increased by 1.4 trillion pounds. That’s 2 trillion dollars of debt added in a single week. It’s likely the fastest, largest increase in net national indebtedness in the history of the world.”
http://blog.heritage.org/2009/02/20/britain%E2%80%99s-public-debt-up-by-14-trillion-pounds-this-week/
RMB is a new Reserve Currency: Links to Reuters and China Daily reports
Cedric,
I am apalled by today’s BoE move. It seems to me to be a reckless gamble with insufficient regard to the exit, that will extend moral hazard even further and probably end in inflation. We are using up the capital so painfully accumulated in Mrs Thatcher’s time.
TWofish says he is not longer worried about deriatives and such, it is the auto loans that are not being paid that worry him.
Ok. Let’s assume tht the various “instruments” that were created to create the great profit bubble have been whittled down to size. Aig is said to have gone from 450 to 300 billion in notional value on their books of these kinds of toxic assets. If that process has reduced the problem down to size, it would seem that the way is clear to allow AIG to fail – or, here is my preference, for the U.S. govenment to declare that no more funds will be available from them to purchase these toxic assets – that any losses must be borne by the parties to the toxic contracts.
I want the Federal government to declare that funds will be made available to banks and insurance firms to backstop all debts created in the regulated, public exchange market but that no funds will be available to pay for CDS, CDO or any deriatives created outside the regulated market.
Suppose all the counterparties to these assets-liabilities with AIG would have to settle between themselves, because AIG can’t pay.
The problme would be 5 times larger than that created by the bankruptcy of Lehman’s.
All the Credit Default Swaps with Lehman’s as a couterparty were settled with a total of 5.2 billion exchanged between agents.
Five times that amount would be 25 billion. That is not an impossible sum. Spread among all the myrid counterparties, it could be that each of them could absorb that amount without bankruptcy.
The Depository Trust Clearing Corporation reported that 72 billion of CDS were on their books before the settlement. Five billion in 7% of 72 billion. If the 300 billion of notational value at risk on the books of AIG is similar to the 72 billion on the books of Lehman’s, that would say that the toxic assets on the books of AIG could be settled among the parties for 21 billion.
The available evidence says that AIG is no longer too big to fail. The firms that would be hurt by its inability to pay should mop up the problem. They were a part of creating the problem.
If default of auto loans and credit cards is the emerging problem, that says that trying to get credit flowing again is a mistake. No gain from providing credit to people who cannot pay back the loan.
Better to accept the notion that the finance system must shrink, that U.S. citizens and firms must adjust to a world with less credit available. In that respect, what is happening today is constructive. The problem is overshoot. Before the system can began on a non-credit basis, too many firms will be out of business.
On the other hand, demand not being fulfilled will be the condition that will get the economy growing again.
Cedric,
The numbers come from the Federal Reserve via Joseph Mason.
Micheal
Ok. So the Fed uses an outside university professor to add up bank numbers for them???
What will they think of next.
http://faculty.lebow.drexel.edu/MasonJ/index.html
Here’s is opinion on the programs.
http://www.businessreport.com/news/2009/feb/09/10-questions-joseph-mason-fnc1/
ReformerRay: If default of auto loans and credit cards is the emerging problem, that says that trying to get credit flowing again is a mistake. No gain from providing credit to people who cannot pay back the loan.
That’s reversing cause and effect. People can’t pay back the loan because they have no jobs, and they have no jobs because people aren’t buying autos and appliances. If you provide credit for people to buy, this creates jobs, and once you have jobs, you have salaries for people to pay back loans.
ReformerRay: Better to accept the notion that the finance system must shrink, that U.S. citizens and firms must adjust to a world with less credit available. In that respect, what is happening today is constructive. The problem is overshoot. Before the system can began on a non-credit basis, too many firms will be out of business. On the other hand, demand not being fulfilled will be the condition that will get the economy growing again.
This was tried in 1930-1932 and it failed utterly. The trouble is that demand falls faster than job losses. So that you have lower demand leading to jobs losses leading to even lower demand leading to jobs losses.
Without massive government intervention, the system never stabilizes. I can’t think of a single situation in which this policy has *ever* worked, and off the top of my head I can think of five examples, where it has destroyed an economy for over a decade.
[...] Read the original: Brad Setser: Follow the Money » Blog Archive » How a US financial … [...]
The five examples Twofish has in mind were not like the U.S. today. No other country has had so much purchasing power available and not used as the U.S. has today. We have plenty of people employed with good jobs. We have plenty of people on disability, social security, pensions, living off investments. Also, no country that has had problems has the % in the service sector like the U.S. today.
I was pleased to see that consumer credit stopped growing for a while and I was disappointed to see that it grew recently. It is too early for consumer credit (debt) to start growing again.
The stimulus already committed is more than enough to jump start the economy. The problem is not lack of purchasing power, today or tomorrow. The problem is lack of trust in the government to continue to prop up insolvent banks and insurance companies.
I hope that lack of trust will finally be dispelled by the federal government by admitting that attempting to keep alive zombie instutions has gone on too long. No more money to keep AIG and Citigroup alive. Especially, no more money to make good Credit default insurance that AIG and banks cannot pay.
Nationalization or not nationalization is a minor question. The major question is will the debts created by the shadow banking system be disowned by the Federal government.
If the government would just reverse course I would freely predict that the economy will see a turn around in 2009.
[...] What it says for the future of the dollar is, as usual, open to dispute, as the comments on his article show. How a US financial crises rebounded to benefit the dollar: three [...]
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[...] http://blogs.cfr.org/setser/2009/03/04/how-a-us-financial-crises-rebounded-to-benefit-the-dollar-thr... [...]