from Follow the Money

The housing market shouldn’t bank on a PBoC put …

August 6, 2007

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Yes, Virginia, seeking higher dollar returns to offset the dollar’s depreciation does mean taking on more risk.  And Steve Schwarzman wasn’t going to underprice his IPO just because China underpriced its bank IPOs -- and gave early strategic investors an even better deal.

But forget the arguments about the wisdom of China’s investment in Blackstone.

The real news in Keith Bradsher’s superb story last Friday about the internal debate over China’s investment strategy is that China has stopped buying US mortgage-backed securities: 

“Over the last several years, the People’s Bank of China has led the way among central banks in buying American mortgage backed securities, accumulating $100b worth, according to people familiar with the central bank’s trading.   The People’s Bank of China has reportedly chosen some of the most creditworthy tranches of these securities.   But with the current malaise in the American housing market, even the value of some mortgage investments once seemed conservative is starting to erode.   In May, the central bank abruptly halted further purchases of American mortgage-backed securities, although it does not appear to be liquidating existing holdings, said one person who follows the bank’s trading practices closely but insisted on anonymity because of its policy of banning transactions with any individual or institution that discloses information about it.” [Aside: Voldemort!]

The PBoC doesn’t trade securities with RGE, so I am under no such constraints.  

The available data leaves little doubt that the PBoC has led the way among central banks in purchasing both MBS with an Agency guarantee (as opposed to the debt the Agencies issue directly to finance their own mortgage book) and  “private” MBS.   The June 2006 US Treasury survey shows that China holds $107.5b of “Agency ABS” and total official holdings of Agency ABS are only $118b.   In June 2006, Chinese investors – public and private – held $58.5b in corporate debt (likely private MBS).  Most of that is likely in the hands of the PBoC – and if so, it would account for roughly two-thirds of all recorded official investment in corporate debt ($96.4b as of June 2006). That data is now a year old – which means it misses about $400b of Chinese reserve growth.  $100b in Chinese holdings of private MBS would be very consistent with the available data.

A shift from PBoC buying of MBS toward PBoC buying of T-bills could explain the unusual surge in T-bill prices (and resulting fall in yields) in early June.   And since then, I suspect PBoC demand for longer-dated Treasuries has contributed to the Treasury rally – though certainly it certainly is not the main reason for the rally. The PBoC is still accumulating reserves, and funds that don’t flow into American MBS have to go somewhere, whether into euros or “safe” Treasuries.

I get a sense that a set of institutions with relatively similar positions (long complex CDOs) have discovered that the majority of folks who think they understand how to value complex structures have relatively similar positions.   And at least right now, more want reduce their exposure than add to their exposure.   That has added to the problems facing parts of the credit market.  Randall Smith and Serena Ng of the soon-to-be Murdoch Journal report:

A Wall Street executive who markets hedge funds and other alternative investments said the valuation of some collateralized-debt-obligations pools backed by other securities such as mortgages -- which sport nominally top-notch credit ratings -- has become highly uncertain. "Someone says they're worth 50, and someone else says 90, and you can't sell at 30 because there aren't any bids," he said.

Such uncertainty creates a challenge for Wall Street firms that have made loans backed by such securities. Should they be marked down? And should investors who hold them with borrowed funds be forced to sell assets to give the lenders an extra cushion of safety?

Several institutions – AXA, for example; see Gillian Tett's story about how subprime losses have shown up in some strange places – have concluded that they don’t want to sell at current market prices. 

They are hoping new buyers for these securities will emerge.  Bradsher’s story, though suggests that the buyer of last resort won’t be the PBoC (sorry, Felix).  If the PBoC doesn’t want more high quality MBS tranches, it presumably doesn’t want securities assembled out of the more risky tranches (even at a deep discount). 

Perhaps the CIC will try to make up for its Blackstone losses with a big win on deeply discounted CDOs filled with subprime loans.  Or by betting on Bear itself, the former MBS king.  Both prospects seem somewhat unlikely though.  My guess is that the CIC will become more, not less, conservative after Blackstone, not less.  Plus, the CIC may be rather busy managing its participation in the restructuring of ABC (The Agricultural Bank of China).

The Gulf could be a better bet.  The big oil-exporting states have roughly $1.5 trillion in assets, and with oil at $75, the major funds in the Gulf collectively have at least $10b to place every month …

UPDATE: I should have noted that the big Chinese state commercial banks were large buyers of US securities last year, using funds raised in the IPOs and as well dollars likely obtained through swap contracts with the PBoC.   The Chinese BoP data shows over $100b in "private" debt purchases by Chinese institutions in 2006, and Goldman's sums (reported here) seem to imply even larger purchases, with the Bank of China leading the way.  The PBoC is not the only Chinese financial institution with exposure to the US housing market.

UPDATE 2: Sovereign wealth funds may have a bit more risk appetite than I thought.   The New York Times reports that a couple may be interested in taking a minority stake in Bear:

While it was unlikely that Mr. Cayne would sell the company at these stock prices, people close to Bear say that large overseas investors have been expressing interest in taking a minority position in the firm.

I assume large overseas investor means a large government investment fund ...  

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