Brad Setser

Follow the Money

Cross border flows, with a bit of macroeconomics

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The reserve manager panic of 2008 …

by Brad Setser
May 1, 2009

Yes, my headline is a bit overstated. Panic is too strong. A sudden stop might be a better term. or an (almost) orderly withdrawal. But there is more and more data suggesting that central bank reserve managers added to the stress in the credit markets during the crisis of the fall of 2008.

We have known for a long-time that some central banks shifted from buying huge quantities of US Agency bonds (Fannie, Freddie and the like) to selling fairly large quantities rather suddenly. Big buyers in the second quarter of 2008 were big sellers in the fourth quarter of 2008. And we now know that the world’s reserve managers pulled a fair amount of liquidity out of the international banking system in the fourth quarter as well.

The BIS data (table 5c) suggests that central banks pulled about $200 billion ($192.6 billion to be exact, summing “domestic” and “foreign” currency liabilities to monetary authorities) from the world’s big banks in the fourth quarter. Their euro deposits fell too, by almost $60 billion ($57.6 billion). That no doubt added to the pressure on the dollar liquidity of Europe’s banks: US money market funds and the world big central banks were pulling dollars out simultaneously.

The Fed and Europe’s central banks filled the breach, with their swap lines.

To be clear, when a country’s reserves fall, it has to run down its foreign assets — whether its holdings of Treasuries, its holdings of Agencies or its deposits with large banks. Emerging economies that ran down their reserves to — in effect — finance either capital outflows from their own country or to cover a current account deficit were helping to stabilize the system.

Think of it this way: some central banks ran down their deposits in the world’s banks to help their private banks repay the same international banks. That is stabilizing.

However, that wasn’t all that was going on. Global reserves were down by around $200 billion (my estimate, based on the COFER data) in q4, and dollar reserves were down something like $150 billion.

But central banks pulled close to $200 billion out of the big banks and another $150 billion or so out of the Agency market. That is a roughly $350 billion outflow …

So where was the money going? We know the answer: into short-term Treasuries. The Fed’s custodial holdings of Treasuries increased by $250 billion in q4.

I understand fully why reserve managers did this. Their core mandate is to make sure that their country has enough safe, liquid foreign assets to meet their country’s needs — and they over-estimated the safety and liquidity of some key assets. But the net effect of their actions was still destabilizing. They were pulling large amounts of dollar liquidity out of troubled financial institutions that were short of dollar liquidity.

Absent intervention by the Fed, the Treasury and a host of European central banks, a lot more illiquid financial institutions would have failed.

To be sure, emerging market central banks have at times played a stabilizing role in the market. They stepped up their purchases of dollars enormously when private investors’ lost their appetite for dollars in 2006, 2007 and early 2008. That big influx allowed the US to continue to run large current account deficits — and kept the dollar from falling further. Back then central banks were buying the assets private investors were selling. At a micro-level that was stabilizing, though I think a case can be made that at a macro-level it was destabilizing, as it blocked a needed adjustment in the US, and thus stored up future problems.

In the fall of 2008, though, emerging market reserve managers clearly added to the pressures in the credit markets. They moved money out of big banks at the same time private creditors moved money out of big banks. The overall result was destabilizing.

The conclusion that I have drawn is that reserve managers need to hold assets in good times that they are confident that they can continue to hold in bad times. When times were good — and when emerging market central banks were buying huge quantities of dollars to offset a fall in private demand for dollars (and large private inflows into the emerging world) — central banks reached for yield. At the end of the day, though, most reserve managers worry more about losses than returns, and the fear of losses meant that even countries with ample liquidity seem to have moved into the Treasury market, adding to the pressure elsewhere.


  • Posted by DJC.

    According to the BIS, which acts as a central bank for central banks, total bank claims shrank by $1.8 trillion in the fourth quarter, or 5.4 per cent, to $31 trillion. This was the largest decline ever recorded.

    “In other words, there never has been a global run on the banking system such as was seen in the final three months of 2008, which followed the bankruptcy of Lehman Brothers and the near-collapse of American International Group in September. The numbers serve to confirm the extent of the tsunami the swept through the world’s financial system….

    The bleeding continues in housing, business investment, manufacturing, industrial capacity, and global trade. Every sector is falling precipitously with no end in sight. Even worse, nothing has been done to remove the trillion dollars of toxic assets from the banks’ balance sheets which is causing credit to tighten even more.

    Treasury Secretary Timothy Geithner has failed to take advantage of the uptick in investor confidence to resolve the problem of underwater banks. Instead, he has stubbornly stuck with his Public Private Investment Program (PPIP) which has made less than $6 billion in transactions so far.

    Geithner continues to nibble at the edges, using unreliable accounting maneuvers instead of addressing the problem head-on and forcing a debt-to-equity swap that would recapitalize the banks by giving bond holders a haircut. Geithner thinks that if he stalls long enough, the rotten assets will regain their original value and the banks will be fine. He’s ignoring the fact that many of the mortgage-backed securities (MBS) are collateralized with fraudulent loans to borrowers who have no way of paying the money back. The losses need to be accounted for and written down while there’s still a glimmer of optimism in the market. The IMF believes that the losses on securitized assets may reach $4 trillion by the end of 2010.

  • Posted by CAMP

    Brad, you should also take account of the “cash-raising” at investment houses as well. While advising central bank and sovereign wealth fund clients to buy Dollars they appear to have liquidated vulnerable investments ahead of the flow. The cash on the balance sheet at GS is impressive (bigger reserves than the US government)with a large step-up in 2008:Q3,Q4. The cash is not likely to be redeployed until the benefits of the re-investment are allowed to accrue to the bankers’ bonuses. We should just get out of their way so that they can buy back at current depressed values and get on with re-flating the real economy. In the final analysis we will see that it was anti-social, but wildly profitable, behavior. There is that apochryphal story, after all, about trading in gilts after the Battle of Waterloo.

  • Posted by jonathan

    Another utterly massive argument for better reporting and openness about capital flows and funding. Potentially quite a different outcome if we’d known more.

  • Posted by Mike

    Hey Brad,

    I am looking for agency debt flows chart 2006-2009. Either broken down by country or total. Just looking for a quantifiable chart of Sudden Stop. This applies to anyone else that knows of a chart or a post of Brad’s showing one.


  • Posted by bsetser

    mike — data through January is presented here

    also follow the links in the posts to an older blog entry on shifts in the FBNY custodial accounts

  • Posted by Cedric Regula

    Brad:”The conclusion that I have drawn is that reserve managers need to hold assets in good times that they are confident that they can continue to hold in bad times.”

    Let’s extend that to anyone in the financial system that needs stable, liquid reserve values in order to be a stable, functional institution.

    Securitization is like turning a mundane loan, which used to just reside on a bank’s balance sheet in the old days, into a bouncing ball passed off into the financial system. Soon there are trillions in bouncing balls. Next we find out the bouncing balls are all synchronized and they have become like the mass of the moon exerting it’s gravitational influence on the tides of the economy. Throwing CDS anti-matter at it made things much worse.

    We have created the “financial cycle” and it’s interacting to synchronize with the “business cycle”. The thing we’ve been trying to tame all these years.

    The only groups that can buy these things, seems to me, would be pension funds, mutual funds and private portfolios as part of their long term, illiquid holdings.

  • Posted by Don the libertarian Democrat

    I believe that the Flight from Treasuries began after Fannie/Freddie in August. I’ve tried to find out if this is true, and, in the case of China, they did this, unless they perceived a real difference between implicit and explicit guarantees. Oddly, I thought that we were actually telling everyone that we explicitly guaranteed agencies with a wink and a nod. Apparently the Chinese didn’t believe this. Why?

    Geithner has recently been ridiculed for arguing for a complete govt guarantee. I would like to join the club of the ridiculed. We should have explicitly guaranteed Agency/Fannie/Freddie, and saved Lehman.

    The Flight from Risk is a serious issue because of Debt-Deflation. Here’s Martin Feldstein:

    “The resulting unusual economic environment of falling prices and wages can also have a damaging psychological impact on households and businesses. With deflation, we are heading into unknown territory. If prices fall at a rate of 1 percent, could they fall at a rate of 10 percent? If the central bank cannot lower interest rates further to stimulate the economy, what will stop a potential downward spiral of prices? Such worries undermine confidence and make it harder to boost economic activity.”

    A Debt-Deflationary Spiral is terrifying precisely because it has no natural stopping point. Theories which claim that there is one are way too optimistic. The Flight from Agencies was a signal that Debt-Deflation was a possibility. Unless you have a government guarantee behind this possibility, it becomes much more likely, because investors know that only governments have the resources to backstop such a guarantee.

    By the way, the point of the guarantee is not to spend the money, but stop the panic and allow an orderly process of losses.

    China has clearly stated that they believed that our govt had guaranteed these assets, and, since Lehman, have been getting more and more vocal about it. Why then, if that’s true, did they jump the gun in selling agencies in August?

    Finally, I want to reiterate what China has said about QE. According to the Chinese, in the Asian Crisis, they did not resort to QE. They claim that they were “responsible”. I do believe that China is making some headway in convincing the world that they are responsible, while we are not, even as they buy our bonds. To the extent that letting Lehman fail is seen around the world as the cause of this crisis, the US is seen as not being responsible.

  • Posted by Cedric Regula


    It was last July that the Chinese pressured Paulson to make an explicit guarantee on Chinese holdings of MBS and Agencies.

    Paulson was in process of ramrodding the TARP blank check thru Congress, and made some more weasel word answers to the Chinese, then when he got his TARP money he made 100B of it available to buy MBS.

    This was not what the Chinese had in mind, so they sold GSE stuff and bought t-bills.

    More recently we are buying 1.25T in MBS and 200B in GSE corp bonds as a result of expanded Fed and Treasury programs.

    Bernanke did say during his 60 Minutes interview that the Fed couldn’t save Lehman because legally the Fed must take collateral, and Lehman didn’t have any.

    So they had to let this investment bank fail.

    Lately the Chinese say they are worried about the Dollar losing value. There’s always something.

  • Posted by ReformerRay

    Brad suggests that a lot of illiquid banks would have failed if the Feds and Treasury had not come to their rescue by providings dollars through swaps with the Central Bank of Europe.

    Wasn’t that a mistke? If many of those banks had failed, there would be much less of “toxic assets” to clog up the system.

    Instead of trying to recapitalize the banks, the U.S. should be trying to get more of them to fail, so the remaining sound banks will be recapitalized by the private sector.

  • Posted by q

    reformer ray: if a bank fails, how exactly does that make their holdings go away?

  • Posted by guest

    A now prevalent thought,is that leaving Lehman going bankrupt has brought more pain than gain.From memory LH balance sheet was 600 billion usd and the loss heavily syndicated within the international financial community.From a US exentric standpoint that is a gain.From an intl perspective,no banks was too big to fail and interbank money markets frozen,that is the negative side effect trigering a first step towards financial deglobalisation and noticeable through BIS papers showing a contraction of cross boarders banks loans (most of these loans are money market)
    As a side demonstration the LH collapse is a case study of unintended consequences when large enough banks are allowed to meet with their fate.
    The most striking observation,efforts are deployed to avoid countries autarcy on the intl trade when the international financial community is striving towards this end.
    This explains as well for the needs of more transparencies in the financial sphere.

  • Posted by bsetser

    there was a real debate inside the republican party about the logic of bailing out entities like the Agencies, and in the end Paulson offered a halfway house that fell short of complete backing. that apparently wasn’t enough for china. many countries concluded that the political cost of holding agencies (especially fannie and freddie) when the risk that they would need to be bailed out was in the news was also higher than the yield.

    for what it is worth, though, the fed’s custodial holdings of agencies have now stabilized.

  • Posted by Cedric Regula


    Now the Dems are trying to re-flate all the bouncing balls, MBS and Agency corp bonds, by buying $1.45T of them.

    Maybe we’ll get rich playing this game?

  • Posted by guest

    The agencies were evolving in grey risk area an implicit sovereign risk,never ratified through congress.
    The investor was rewarded with a better spread than a US sovereign risk.Each party seller and buyer,was aware untill risk tolerance prevailed.The bi polar is on going evolving risk, where the creditors survival is predicated upon risk assessment and transparency of the information flows.
    The ultimate question is always who stand to lose more in the aftermath?

  • Posted by K T Cat

    Don, you can guarantee whatever debt you like today, tomorrow’s deficits will wash it all away.

  • Posted by FollowTheMoney

    Countdown is on to break of the T-bill bubble. As risk returns to the market, investors will look for more attractive returns. This will be evident as investors flee treasuries for products that may seek greater returns.

    This in turn will send interest rates upward, or perpetuate a hard landing for the dollar which will throw the world into a DEEPER RECESSION just as many thought we were on our way out.