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Friday, August 22, 2008

 

foreign central banks quit buying agencies


agency spreads over treasuries have, to most everyone's surprise, widened dramatically in recent weeks even after it became apparent that hank paulson's treasury was making plans to bail out fannie mae and freddie mac. one would think that, as agencies got closer to becoming de facto treasuries, spreads would have narrowed. just the opposite has happened, raising mortgage rates.

via brad setser and the economist -- the reason why has been the near-total abandonment of GSE debt instrument purchasing by their last sizable buyers, foreign central banks. it's no wonder the GSEs have downscaled their operations. setser:

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.


and that is why the treasury will be intervening to explicitly nationalize the mortgage market -- which now has a vanishingly small private component and very soon will have none, being crowded out by the treasury -- sooner and not later. with spreads having blown out, and with the two leviathans facing a debt roll of $223bn between now and the end of september, paulson will have no choice. freddie had to pay a borrowing cost to issue just $3bn in debt recently that makes their business model impossible. the chances of the GSEs turning over a sum 75 times that size without turning to the treasury are nearly nil.

once the debt guarantees of the GSEs become the explicit guarantees of the american taxpayer, one can hope that foreign central banks will return to funding american housing markets. indeed a successful nationalization of the obligations of the GSEs will probably bring mortgage rates down significantly, particularly if treasury (and congress, ostensibly) get serious about pouring borrowed money into mortgages in an effort to support prices.

that doesn't mean, however, that money will get borrowed. as with the ineffective reduction in policy rates engineered by the fed, one might fairly characterize a decline in mortgage rates as pushing on a string. the truth is that credit standards have become much, much tougher and only a small slice of the people who could've obtained a mortgage in 2005 can do so today. moreover, we may be experiencing a shift in social mood that creates a decline in the demand for credit regardless of its availability -- particularly as profit margins are crushed and joblessness becomes more common.

the other important point that has to be made -- this is the first example in my recollection of a shock in the financial balance of terror. china cutting off the GSEs inarguably damages the performance of their stock of agencies by aggravating housing conditions in the united states -- exactly the kind of tradeoff that most westerners have steadfastly presumed china would never make. very probably, china and other GSEs are simply forcing the hand of hank paulson -- the first explicit example of systemic financial blackmail against the united states by its rivals, something nouriel roubini recently implied we should get used to. (note too that russia too is a large foreign holder of american government and agency debt instruments.) but the use of debt as a policy weapon in this instance should put the united states and particularly the bush administration on notice -- through our debilitating profligacy, we have effectively outsourced a great deal of our monetary policy, and do not alone determine our fate.

UPDATE: ben bernanke made some comments today that might be relevant to the upcoming GSE bailout.

A statutory resolution regime for nonbanks, besides reducing uncertainty, would also limit moral hazard by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors, analogous to what happens when a commercial bank fails.


i cannot imagine he is laying the groundwork for refusing to make GSE debt instruments money good, but it bears watching.

UPDATE: accrued interest relays merrill's view that no GSE takeover will come down this weekend. the intention of keeping the GSEs shareholder-owned may not bring the FCBs back to the table, though -- it would be interesting to listen in on the conversations which are (hopefully) now taking place between washington and beijing.

UPDATE: yves smith on the chinese threat to "end... the current international financial system".

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