from Follow the Money

Faltering central bank demand for agencies ...

August 22, 2008

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Central bank holdings of Agencies at the New York Fed have fallen by $9.4b this month (from $981.7b to 972.3b), while central bank holdings of Treasuries are up by close to $28.4b (from $1394.6b to 1423.0 b)

Most central banks hold the bonds the Agencies themselves issue, not the bonds they guarantee. But there is a big exception: China. And China too seems to be scaling back its purchases. In the course of a (good) article on the Agencies, the Economist notes that China was -- until recently -- buying $5 billion of Agency MBS a week.

The situation in agency-backed MBS is even worse, with foreign buyers all but on strike. China’s central bank, which alone had been lapping up more than $5 billion-worth a month, has barely touched the stuff in recent weeks.

$5 billion a month is a large sum: $60 billion annualized. But it seems a bit low to me. The Treasury survey indicates that China bought nearly $100b of Agency MBS between June 2006 and June 2007 (bringing total Chinese holdings of Agency MBS above $200 billion), and Chinese reserve growth has picked up substantially since last June. (Edited from the initial post, see the note below)

Over the last year (think the period after the subprime crisis), central bank holdings of Agencies and Treasuries have increased by $419.5 billion -- with a clear shift toward Treasuries recently after a long period where Agency holdings were growing faster than Treasuries. This quiet bailout far exceeds the roughly $35 billion that sovereign funds have invested in US banks. The US TIC captured most of these investments, and its shows $34.2 in official purchases of US equities over the last 12ms, with almost all the increase coming right after the big recapitalizations. The total would be higher if UBS and Barclays are added in -- but also remember that many central banks don’t use the New York Fed’s facilities, and some rely on outside managers for even a Treasury and Agency portfolio. Central banks likely added more than $420 billion to their total holdings of Treasuries and Agencies over the last year.*

Americans have long criticized other countries for financial systems that direct credit to sectors favored by the government. Many argued that such directed credit contributed to the Asian crisis. It was inefficient. Countries would be far better off if they let the market pick winners. Or so the argument went.

Yet I think you can argue that the US right now isthe recipient of the largest government directed credit program in the world.

On one end, a private Chinese saver adds to their RMB account at a Chinese state bank. That state bank in turn buys the short-term bills the central bank issues to sterilize its reserve growth, or, put differently, the central bank finances its growing external portfolio by borrowing money rather than printing money. The central bank, having bought dollars in the foreign exchange market using the RMB it borrowed from the state banks, then buys US agency bonds -- in effect, directing credit to the US housing market.

And on the other end, the US government-sponsored agencies bundle mortgages into securities that are sold globally -- whether MBS with an Agency guarantee or the bonds the Agencies themselves issue to finance their retained portfolio -- not on the basis of underlying credit but on the basis of the implicit US government guarantee.

That feels like directed credit to me. It only could have happened on the scale it did with the support of governments on both sides of the Pacific. The Chinese government took currency risk that private investors in China weren’t willing to take. The US government turn mortgages into liquid bonds that risk-adverse central banks would hold out by promising -- implicitly -- to take the credit risk.

And the resulting flow has been huge -- and until recently, it was getting bigger. It now seems to have come to something close to a stop. Unless it restarts quickly, I suspect the US government will have to make its role in the process explicit.

In the short-run, the US needs this directed credit program to continue. Demand for non-Agency MBS has disappeared. And if credit isn’t available to buy homes, home prices will fall further, faster -- adding to the distress of the US financial sector.

In the long-run, though, the US probably shouldn’t continue to favor investment in housing over investment in other sectors (to be precise, the US supports borrowing to buy homes, and thus indirectly supports the housing sector) to quite the degree it does now. The United States skill at turning mortgages into foreign exchange reserves interacted with China’s desire to avoid renminbi appreciation to produce an unhealthy economic cocktail.

NOTE: I initially reported that the Economist claimed that China was buying $5b a week in Agency MBS (which seemed a bit on the high side, though not implausible). The Economist actually said (as should have been clear from the quote I pasted in) that China was buying $5b a month in Agency MBS, which conversely seems on the low side. The text has been adjusted as a result. Thanks to Mitch (in the comments) for catching this.

* The increase in the Fed’s custodial holdings recently has been larger than recorded official purchases in the TIC data, yet more evidence that the TIC data understates official purchases. The last TIC data release shows -- including a strong rise in holdings of t-bills and taking the rise in other short-term custodial holdings as a proxy for Agencies -- $272.8 billion in Treasury and Agency purchases. The 12m increase in the FRNBY accounts at the end of June was $347.16b. I suspect the survey data will end up showing an increase of over $500 billion.

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