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The central bank panic of 2008

by Brad Setser
April 20, 2009

Central bank purchases of Agencies in 2007 (Setser and Pandey estimate, based on the survey data – the BoP data should be similar once it is revised to reflect the 2008 survey): $300 billion.

Central bank sales of Agencies in 2008: close to $100 billion.

That is a one-year swing was close to $400 billion.

It just occurred to me that this was a larger swing – in dollar terms – than the swing in non-FDI private capital flows in Asia in 1997 and 1998. According to the IMF’s WEO database, developing Asia attracted $70 billion in portfolio and bank inflows in 1996. In 1998, $110 billion flowed out, for a total swing of around $200 billion.*

So much for the notion that sovereign investors are always a stabilizing force in the market.

Maybe sovereign funds are different (as the FT argues), but central banks ultimately proved to be rather loss adverse. They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors …

Of course, the comparison between central banks now and private investors in Asia is a bit unfair. Developing Asia back in the 1990s had a GDP of about $2 trillion. The US today has a GDP of around $14 trillion. So the swing in demand for Agencies is far smaller, relative to US GDP, than the swing in private capital flows was relative to Asia’s GDP. The swing in capital flows to Asia was in the realm of 8% of its GDP. Even if the fall in Agencies in 2009 is around $150 billion (it was $125b in the 12ms through February, but the basis for the y/y comparison will start to shift as the year goes on … ), the swing for the US will be more like 3% of US GDP.

The comparison though should give pause to those arguing that sovereign investors are always a stabilizing force in the market because of their long investment horizons. If a few very large actors loses confidence in a certain type of debt, they can have a big impact.

There is a second reason why central banks’ sales of Agencies wasn’t quite as disruptive as it might have been: The US central bank – moved to offset the outflow of foreign central banks from the Agency market. Foreign central banks sold Agencies to buy Treasuries, and the US government sold Treasuries to buy Agencies. And American money market funds never lost confidence in the Agencies. When they stopped holding the financial sector’s paper, they bought both short-term Agencies and short-term Treasuries.

The willingness of the official inflows (from places like the IMF) to offset the swings in cross-border private capital flows has, historically, been smaller. With the benefit of hindsight, a strong case can be made that the IMF’s financial response to the Asian crisis was too timid, with the IMF asking for too much adjustment and providing too little financing. Loans from the IMF and World Bank were clearly far too small to offset the swing in private capital flows.

This isn’t just a historic debate either.

Eastern Europe has attracted large net capital inflows over the past few years. Bigger inflows, relative to its GDP, than Developing Asia in the 1990s.

And by all indications Eastern Europe is now experiencing a comparable stop in private inflows. In all likelihood, the large private inflows of the past few years will turn into large private outflows. But there also now seems to be a greater willingness to use the IMF to provide more financial support than in the past …

* The swing would be larger if I added data for the Asian NIEs (including Korea, a crisis country) to the total. Alas, the IMF WEO data set doesn’t have BoP data for the NIEs. Help, please! I am a heavy user of the IMF data, and this is something that they should be able to add …

30 Comments

  • Posted by vince

    It just occurred to me that this was a LARGER swing

    thank you so much for your work

  • Posted by locococo

    Hindsight? They were too small as part of the consensus (of them being too small).

    Also, when some large actors loose confidence, I d perhaps use a bit more polite wording (esp if being on the other side of that sudden loss) as in the reason that obliviated their confidence might in fact be a little responsible for the destabilization as well, wouldn t you? I d agree tho on the quantitative re-stabilizing aspect that followed to this easing (Sorry, today – after stress tested – I feel very well stimulated in a fiscal sort of way).

  • Posted by Twofish

    bsetser: They moved in mass into the Agency market for a few extra basis points, and then moved out faster than they moved in. Kind of like fickle private investors …

    Not quite. The central banks moved out over the time span of weeks. Private investors were moving funds out over a time span of hours. With Central Banks you can get on the phone to someone and ask them to do something. With private investors, there is no one you can get on the phone to.

    bsetser: And American money market funds never lost confidence in the Agencies. When they stopped holding the financial sector’s paper, they bought both short-term Agencies and short-term Treasuries.

    That only happened after Treasury but a guarantee on money funds. Once you have a guarantee that you won’t go bust, you start investing in something that will give you greater yield. It’s classic moral hazard but in this situation it was a good thing.

  • Posted by jolly

    twofish- what can we say, your always right!

    btw, i’m not a fan of you suggesting people should buy shares of financials if in fact govt taxpayer dollars are being subsized to the banks.

    i think it’s horrible moral. unethical, and completely out of line for you to suggest this.

    say for instance somebody does make over 250K a year but has a ton of outstanding loans, kids, wife, etc. you think they’re going to have money left to buy financial shares to subsidize for the increase in household tax rate???

    the idea to buy financials, subsidized by the gov’ts aid of taxpayer dollars stinks.

    let’s rephrase a line “there’s something rotten in the state of New York”

  • Posted by jonathan

    Twofish, how is movement over a period of weeks not fickle? Just saying that private investors were even more fickle doesn’t change the underlying truth. And your second comment doesn’t address the point that US money markets still hold Agencies and the central banks have been dumping them even with guarantees. I have to say that sometimes your comments seem nitpicky for the sake of being nitpicky.

    I wish I understood better what’s going on in E. Europe. It seems to be levitation and that always requires wires. Or so a magician told me. As in, only 2 months ago, people were talking about how Spain would hold up – which made no sense – and now they’re in free fall.

  • Posted by Twofish

    jonathan: Twofish, how is movement over a period of weeks not fickle? Just saying that private investors were even more fickle doesn’t change the underlying truth.

    Moving money over a period of weeks rather than hours is a difference between an orderly market movement and a total crisis. If you have several weeks, you can do things like issue more treasuries and react to the situation. If you have movements over a period of hours, you can’t.

    It makes a very big difference.

    jonathan: And your second comment doesn’t address the point that US money markets still hold Agencies and the central banks have been dumping them even with guarantees.

    It does. The important guarantee is not the guarantee on the agencies, which is pretty worthless. It’s the guarantee on the money funds themselves. Treasury guaranteed the money fund against losses so that if the money funds lose money on agencies, they wouldn’t have any losses themselves. This isn’t the sort of guarantee that any of the central banks have.

    jonathan: I have to say that sometimes your comments seem nitpicky for the sake of being nitpicky.

    Finance is like that. Very small differences turn out to have huge dollar differences.

    jolly: btw, i’m not a fan of you suggesting people should buy shares of financials if in fact govt taxpayer dollars are being subsized to the banks. i think it’s horrible moral. unethical, and completely out of line for you to suggest this.

    I have money in the banks. So do you. I’d like to keep the money that I have in the banks. So likely do you. If someone has to pay, then soaking rich taxpayers seems to me more ethical than soaking poor depositors or constricting credit, especially since a lot of those rich taxpayers contributed to the problem in the first place.

    jolly: say for instance somebody does make over 250K a year but has a ton of outstanding loans, kids, wife, etc. you think they’re going to have money left to buy financial shares to subsidize for the increase in household tax rate???

    Yes. They can do it through a 401(K) with an employer match. If you make 250K and you don’t have enough to save money for retirement, then you really, really need to cut spending, because you have more problems than high taxes.

    If you think $250K is too low, then fine, let’s increase taxes by 10% on people that make more than $500K.

  • Posted by Howard Richman

    Brad,

    The foreign central banks are taking their money out of the agencies (Freddie and Fannie) because they are investing intelligently. The Fed will lose big time when the housing bubble continues its inevitable bursting, making the new crop of Fannie and Freddie mortgages worthless.

    By the way, I wrote a blog posting this week on your excellent Foreign Policy magazine article. You can read my posting at:

    http://tradeandtaxes.blogspot.com/2009/04/brad-setser-g-20-failed-to-address.html

  • Posted by bsetser

    vince — thanks for the catch. I edited the post to correct the large/ larger error. glad you caught it quickly.

  • Posted by Twofish

    Richman: The Fed will lose big time when the housing bubble continues its inevitable bursting, making the new crop of Fannie and Freddie mortgages worthless.

    It really depends on lending standards. The thing about mortgage lending is that huge drops in housing prices shouldn’t affect the value of the mortgage. For standard mortgages, you start off with a 20% down payment, and you start paying that off immediately. Also, if you have a good borrower, they will be able and willing to pay the mortgage regardless of the value of the house, since you’ve set up the payments so that they can afford it.

    So there are a lot of safeguards to insure that the mortgage is still good even if the value of the house plummets. Now if you remove the safeguards, then you have problems.

  • Posted by Howard Richman

    2Fish,

    Even if Fannie and Freddie mortgages are 20% down, that won’t be enough to cover the coming drop in house prices without Fed-caused inflation. According to the latest Schiller indices, house prices are still about 50% above their historic inflation-adjusted values.

    The incompetence of the Fed economists is pretty astounding. In September 2005, Charles Himmelburg, a senior economist at the New York Federal Reserve, co-authored a NY Fed staff report and an NBER working paper which claimed that there was no housing bubble at the time. Within a year, the non-existent housing bubble started to pop.

  • Posted by Twofish

    Richman: According to the latest Schiller indices, house prices are still about 50% above their historic inflation-adjusted values.

    Which still won’t result in massive defaults if you have done your lending right. As long as has their job and can cover their monthly payments, the mortgage is still good. The big unknown isn’t house prices but rather employment.

  • Posted by jonathan

    Ah well, humility is difficult and self-censorship is a skill that must be acquired.

    Thanks again, Brad, for the content. I was going through my normal list this AM and realized – again – that I learn a tremendous amount from your blog.

  • Posted by Indian Investor

    Brad Setser: If a few very large actors loses confidence in a certain type of debt, they can have a big impact.

    Me: I totally agree with this statement. The US Treasury has a cash balance of $255 b. (Source: Daily Treasury Statement)
    In March 2009, the Us Treasury spent $192 b more than it received. (Source: Monthly Treasury Statement)

    The moment a few large players lose confidence in the US Treasury debt, there could be a complete collapse.

  • Posted by locococo

    Over on c span there are showing 6 funny little circles and someone s nose is growing. All on air. No good banks tho.

  • Posted by q

    @twofish – Which still won’t result in massive defaults if you have done your lending righ

    i don’t think it works that way. if people can default on their mortgage and buy the house across the street for half what their current house costs, they will be tempted to do it. the probability that someone will default on a mortgage is very related to positive equity, or a loan to value of less than 110 or 120 percent.

    also, people who need to sell their home (either due to moving, change of family circumstances, death, etc) will still be defaulting on their mortgages.

  • Posted by RN

    Twofish wrote:

    “Richman: According to the latest Schiller indices, house prices are still about 50% above their historic inflation-adjusted values.

    Which still won’t result in massive defaults if you have done your lending right. As long as has their job and can cover their monthly payments, the mortgage is still good. The big unknown isn’t house prices but rather employment.”

    Such a facile point of view, and wrong on so many levels.

    1) Some people NEED to sell a home, for a variety of reasons.
    2) Underwater mortgages, especially ones that are deeply so, substantially change economic incentives.
    3) Twofish seems not have noticed, but things seem to be a wee bit interconnected. Falling home prices cause defaults. Defaults cause bank capital problems, credit to contract, spreads to widen, business unable to lend, job losses.

    If there’s anything we (most of us, anyway) have learned from the current crisis, it’s the remarkable connectedness of the different elements of the domestic and global economy.

  • Posted by Glen M

    Twofish,

    Keep in mind that in the US most mortgages are non recourse loans.

  • Posted by Howard Richman

    The incompetence of the Federal Reserve economists goes way beyond not recognizing that the house price bubble will continue to pop until house prices get back to their historical values:

    1. They have been allowing foreign central banks to buy dollars in order to steal our industries when they could have easily reciprocated by buying the same amount of foreign currencies.

    2. They have been making long-term loans to Fannie, Freddie, AIG, and other bankrupt institutions. These loans have poured taxpayer money down black holes.

    3. They have been giving American taxpayer money to foreign central and private banks as part of their Fannie, Freddie, and AIG bailouts.

    4. They have stuck to the discredited classical economics school’s view of trade deficits even though realistic economists, starting with Keynes, have long understood that chronic trade-deficits cause financial disaster.

    Economic historians will blame the incompetence of the Federal Reserve for this great recession just as they already blame the incompetence of the Federal Reserve for the Great Depression.

  • Posted by Twofish

    q: the probability that someone will default on a mortgage is very related to positive equity, or a loan to value of less than 110 or 120 percent.

    It depends on the type of borrower. For prime borrowers the probability of default is rather insensitive to house value. A person that believes in paying their bills on time will try to pay their bills on time, and if you offer then a huge loan that they know they can’t afford, they just won’t take it. The big sensitivity for prime borrowers is to unemployment.

    For subprimes, LTV is the big factor. However in the case of Fannie/Freddie most loans are prime mortgages, and the subprimes are mostly dead already.

    q: also, people who need to sell their home (either due to moving, change of family circumstances, death, etc) will still be defaulting on their mortgages

    If you have a good borrower that has to do a short sale, you can arrange financing so that they can get out of the house. Yes theoretically they could walk away but….

    a) people that are prime borrowers believe in paying their bills, and

    b) if you have a default and foreclosure it will kill your credit rating.

    One has to remember that a lot of banking is about trust, and in the end it involves looking someone in the eye and figuring out if they will pay back the money that you lend them.

  • Posted by q

    @twofish –

    i think that borrowers are likely to change state.

    and as far as prime vs subprime, the distinction is not always that clear.

    take a look at the cumulative default curves for fanny / freddie mortgages (available in their 8-Ks) and compare the <2003 loan vintage with the 2005-7 vintages. it’s clear that recent ‘prime’ borrowers from the recent vintages are defaulting far, far more often than the older vintages. the reason is that they are in crappy mortgages, not that they are crappy borrowers.

  • Posted by Twofish

    Glen M: Keep in mind that in the US most mortgages are non recourse loans.

    Depends on the jurisdiction, but it doesn’t matter much. If someone defaults on their mortgage, it’s not as it they have much more income that you can get from them.

    The main thing that keeps someone from defaulting a house that is underwater is that it will destroy their credit rating. This doesn’t matter for someone who is subprime, but it’s enough to keep most prime borrowers paying even if they could default.

    Believe it or not, there are people out there that believe in keeping their word and will try to pay their debts even when it is not financially advantageous for them to do it. It’s sometimes hard to loan these people money, because if you offer them money and they figure that they can’t pay it back, they won’t take it.

    The thing that will stop a prime borrower from paying is if they lose their job and just don’t have the money to pay. Which is why the critical thing to keep the banks solvent is to stop/slow job losses. If you can get and keep people working, then everything is going to be fine.

  • Posted by bsetser

    Howard — it is actually hard for the fed, or any other central bank, to buy CNY.

  • Posted by Twofish

    q: i think that borrowers are likely to change state.

    I don’t think so. Someone that has been taught since childhood to avoid debt and to keep their word isn’t going to suddenly change.

    q: and as far as prime vs subprime, the distinction is not always that clear.

    It’s actually quite clear. You can distinguish between prime and sub-prime borrowers via FICO scores, and if you look at statistical models, their behavior is very different. Prime defaults are very insensitive to LTV and everything but unemployment. Sub-prime is extremely sensitive to LTV.

    In any case, as far as lending goes, prime and sub-prime are different worlds. In prime lending, you aren’t lending against the house, you are lending against the borrower.

    q: take a look at the cumulative default curves for fanny / freddie mortgages (available in their 8-Ks) and compare the <2003 loan vintage with the 2005-7 vintages. it’s clear that recent ‘prime’ borrowers from the recent vintages are defaulting far, far more often than the older vintages.

    I couldn’t find that particular graph. All of the one’s I’ve seen put all defaults together. It happens that Fannie/Freddie started jumping into the subprime business in a big way in 2004. In 2004, HUD loosened the regulations to allow Fannie/Freddie to into subprime, which they did in a big way.

    Bad idea.

    q: The reason is that they are in crappy mortgages, not that they are crappy borrowers.

    The two are correlated. Crappy borrowers get themselves crappy mortgages.

    If you are a crappy borrower it either means that you are selfish or naive. If you are selfish, you will try to take advantage of the bank. If you are naive, the bank will try to take advantage of you. In neither case is the outcome good.

  • Posted by Howard Richman

    Brad,

    You are correct that the Fed cannot easily buy CNY (the Chinese currency). Chinese financial interactions with the United States are purposely kept totally assymetrical by the Chinase government.

    For example, the People’s Bank of China (PBoC) buys our government bonds, but foreigners are not allowed to buy their government bonds. However, with a little determination this hurdle could be overcome. Here are some possible actions the Fed could take:

    1. The Fed could buy Chinese stocks. Why should Sovereign Wealth Funds be a one-way street?

    2. The Fed could finance Chinese hospital purchases of American medical equipment. Other governments have been doing this.

    3. The Fed could be financing the sale of American prefabricated homes to Chinese citizens through Walmart credit cards. What better way to put the American house construction industry to work?

    But the real answer is that if the Fed made an issue of the assymetry, China could be forced to open up its financial markets. The Fed could deny the PBoC access to American financial markets until it got this access.

    Instead, the Fed has been doing exactly the opposite. For example, the Fed recently guaranteed that the PBoC wouldn’t take losses on its risky holdings of agency bonds.

    Howard

    p.s. I have been trying to figure out why the Japanese yen has been falling so fast against the dollar, from about 89 yen/dollar in February to about 99 yen/dollar today. Are there any indications that the Japanese central bank is back to buying dollars in order to support the Japan-carry market?

  • Posted by Twofish

    Richman: Here are some possible actions the Fed could take.

    The Fed doesn’t have legal authority to do any of what you suggest, and you can’t really force someone to take a loan if they don’t want it. Now Congress can act and give the Fed this authority, but it probably won’t. If you give subsidies for one industry, all of the other industries will start screaming.

    Richman: The Fed could deny the PBoC access to American financial markets until it got this access.

    Pretty hard to do. First of all, neither the Fed nor Treasury has legal authority to bar a nation from US financial markets, outside of some conditions that don’t apply here. In order to get something like that done, you’d have to get Congressional authorization, and you won’t get it.

    Richman: Instead, the Fed has been doing exactly the opposite. For example, the Fed recently guaranteed that the PBoC wouldn’t take losses on its risky holdings of agency bonds.

    No it hasn’t. The Fed doesn’t have authority to issue this sort of guarantee.

  • Posted by Howard Richman

    2Fish,

    You wrote that the Fed doesn’t have the authority to do what I suggest. However, since 1962 they have had the authority to purchase currency reserves under their own account without being subject to any control by the U.S. Treasury.

    The other actions that I suggest are no more radical in their extension of Fed power than the long-term loans that the Fed has been issuing lately.

    You wrote that the Fed did not have the authority to guarantee the Chinese investment in the agencies. You are correct. The guarantee was implicit not explicit. Brad discussed this implicit guarantee in his September 21 2008 posting.

  • Posted by Twofish

    Richman: However, since 1962 they have had the authority to purchase currency reserves under their own account without being subject to any control by the U.S. Treasury.

    Can you cite the particular section of the Federal Reserve Act?

    The only section I know of that allows this is Section 14(b) which limits the Fed to purchasing fully guaranteed Treasury bonds.

    http://www.federalreserve.gov/aboutthefed/section14.htm

    The Fed can lend under Section 13(3), and they have been stretching 13(3) through Maiden Lane LLC.

    The other problem is that the Fed can’t legally force you to borrow money or even take money if you don’t want to.

    Richman: The other actions that I suggest are no more radical in their extension of Fed power than the long-term loans that the Fed has been issuing lately.

    And the extensions of Fed power took heaven and earth to pass. The big extension to the power of the Fed and Treasury was EESA and that took two tries after both Bernanke and Paulson (correctly) argued that it would be a disaster if they didn’t pass.

    There is a wonderful paper that by Paul Swagel that discusses what people were thinking and when, and he complains that people were advocating solutions that involved legal powers the the Federal Reserve just doesn’t have.

    http://www.brookings.edu/economics/bpea/~/media/Files/Programs/ES/BPEA/2009_spring_bpea_papers/2009_spring_bpea_swagel.pdf

    Richman: You wrote that the Fed did not have the authority to guarantee the Chinese investment in the agencies. You are correct. The guarantee was implicit not explicit. Brad discussed this implicit guarantee in his September 21 2008 posting.

    1) Implicit guarantees are worth nothing. There is an explicit guarantee of about $100 billion against the Agencies. That’s it. Any more losses than that, then you take your chances with Congress.

    2) The Chinese government obviously doesn’t believe any of those guarantees, otherwise they wouldn’t be dumping them right now.

  • Posted by bsetser

    easiest explanation for yen’s depreciation is probably the best: japan’s economy/ exports are in the deep doldrums, with exports down 45-50%. that is a hard environment to sustain a strong yen. revival of some carry trades in march also played a role.

    2fish — suspect it is philip swagel not paul swagel

  • Posted by Cedric Regula

    Indian Investor,

    Those sound like many of the reasons that I am not President. Plus the fact that you need to run for the position, which is a real pain in the arse.

    Anyway,

    The IMF credibility is not improving here in my view. They say US banks need 300B to get back to pre-crisis leverage levels?

    1) Why would we want to when the old level of leverage was unsustainable (along with the old global GDP).

    2) How do you reconcile the other numbers of $2.8T in US bank losses(and $4T global) with a “need” for only $300B?????

    And the IMF lends to governments…not the customers that banks are supposed to lend to. So I think the IMF will be dealing with another level of insolvency…not the one we see now with banks and the private economy.(yes, I know the governments will stimulate the private sector…but we always wonder about the path the money takes to get there.)

    But the recent G20 announcement that the IMF will have $1 trillion to lend (we will have to see if that happens still, of course) was well received by foreign currency and sovereign bond markets.

    Here’s a chart of my favorite foreign bond fund. It has been looking like a stock chart the past year, just less magnitude in the swings. It does have a average A credit rating and is mostly in better rated sovereign bonds but doesn’t have US treasuries and that AAA rating pushing up the fund credit quality.

    http://finance.yahoo.com/q/bc?s=TGBAX&t=6m

    But it tells a story…something magical happened on March 9th that I still haven’t been able to put my finger on, then it got another nice boost from the G20 announcement about IMF lending. So private flows are loosening up somewhat.

    However, $1 trillion is still just a drop in the bucket relative to a $55T global GDP…

  • Posted by Cedric Regula

    Whoops. Just noticed I posted this in the wrong thread. Will repost. Damn math.

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