from Follow the Money

So true ...

September 7, 2008

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Floyd Norris in the New York Times:

Remarkably, the country that prides itself on being the beacon of free enterprise finds itself with a financial system that needs government money to finance the most important asset most Americans will ever own. There have been bailouts before, but none that seemed more crucial than that of Fannie and Freddie. The housing boom and bust have left them virtually the only sources of large amounts of money for home loans in the country.

That isn’t the half of it. The US doesn’t just need US government money to support the US housing market: It needs money from foreign governments as well.

And no one more than China. China’s central bank borrows RMB from the state banks (whether by selling sterilization bills or by hiking the reserve requirement) and then uses those funds to buy large quantities of Agencies. The flow of Chinese savings into the US housing market is entirely a government flow. From June 2007 to June 2008, the foreign assets of China’s central bank increased by $681b. That is hard number -- no fancy adjustments are required. I just added the central banks "other foreign assets" (the foreign exchange the state banks have deposited with the central bank) to its stated reserves. Adjust for valuation gains, and that works out to $620 billion or so. That is a low-end estimate for China’s foreign asset growth. It leaves out the funds shifted to the CIC, and the funds used to recap the China Development Bank. A lot of this went into Agencies. A lot more than the $70 billion in Agency purchases that shows up in the TIC data.* If that is true, then China also has more than $465 billion in short and long-term Agencies as well.

Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.

The New York Times reports:

Most worrisome, the companies’ cost of borrowing was growing more expensive, and central banks in Asia and Russia were scaling back their purchases of the companies’ debt

The Wall Street Journal adds:

Fannie and Freddie were still able to fund themselves, but it was getting more expensive to do so. Foreign officials, whose central banks own Fannie and Freddie debt, were calling Mr. Paulson to express concern. Sen. Charles Schumer, a New York Democrat, said he was told by government officials that foreign investors were threatening to bail out. "There was a real fear that foreign governments would start dumping Fannie and Freddie...and not buy the bonds," he said.

I suspect this is the first case where foreign central banks exercised their leverage as creditors to push the US government to make a policy decision that protected their interests. The need for ongoing central bank financing certainly weren’t the only reason why the US government acted. US banks hold a lot of Agency debt too. But the need to maintain the confidence of the world’s central banks -- and the attractiveness of Agencies as a reserve asset -- was certainly a factor in the Treasury’s decision.

Last week (using the date for the end of the reporting week not the weekly averages), the Federal Reserves’ custodial holdings of Agencies fell by another $9.75b, significantly more than the fall in Treasuries. The Fed’s custodial holdings seem to account for about 90% of all known central bank Agency holdings. There are more central bank Agency holdings than show up in the survey data, but they are managed by private intermediaries -- and I don’t have a good guess of their magnitude. No matter. The Fed’s custodial accounts pick up enough of the world’s total holdings to provide a pretty good picture of how central banks have acted over the last month.

As of Wednesday, September 3, central bank custodial holdings of Agencies were down $27.4b from their mid July peak. That is a sum comparable to the capital sovereign funds invested in US banks and broker dealers over the turn of the year.

The threat of a central bank buyers strike was real.

* The $25 billion in known purchases of long-term treasuries between June 07 and June 08 also looks low, as does the $150b in total Chinese purchases over this period. I personally would be surprised if China purchased less than $350 billion in Treasury and Agency debt over this period. I wouldn’t be totally surprised if China purchased close to $400 billion in Treasuries and Agencies over this period. That is a huge, and truly unprecedented sum. I won’t bore you trying to explain all the ways I have tried to stress test this number, but I will assure you that it is a robust estimate.

I also am fairly confident that China’s central bank now manages, counting the banks’ foreign exchange reserve requirement ("other foreign assets") a foreign portfolio of over $2 trillion. This too comes from the PBoC’s own data. Dr. Cowen says China has over $300 billion of Agencies. I would say well over. $300b is only 15% of China’s total portfolio. Moreover, if you look hard enough, between $460 and $465 billion of Agencies can be found in the TIC data. Take short and long-term Agency holdings in the June 2007 survey and add subsequent flows and it you want to be really crafty, assume that the same share of China’s short-term holdings are in Agencies as at the time of the June 2007 survey. Then make one more adjustment: Last year’s survey revisions increased China’s Agencies holdings by around $70b. If that pattern holds true, China now has a bit over $530b of Agencies. And I would expect bigger revisions this time around because of the acceleration in China’s reserve growth this time around.

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